Thursday, March 4, 2010

EPA Ruling Could Mean a +50% Increase in Biofuel Demand

Wednesday I told you what an EPA rule change regarding cellulosic ethanol could mean for the Obama White House and, more important, what it could mean for the shareholders of an ethanol-industry leader.

That EPA ruling is a done deal.

Another proposed EPA rule is not a done deal, but investors should be aware of what could happen nonetheless.

What could happen is a +50% increase in the demand for ethanol.

The EPA -- that is, the Environmental Protection Agency -- was created in December 1970 by an executive order from President Richard Nixon, who also created the Occupational Safety & Health Administration (OSHA) later that same month. The EPA has since come to have a pretty wide regulatory throw. The agency oversees air and water quality, hazardous waste, land use (scenic rivers, surface mining, etc.) and endangered species. Most recently, the agency has been in the spotlight for adding carbon dioxide to its list of regulated air pollutants as part of President Obama's environmental agenda.

In December 2009, the EPA said initial tests had concluded that vehicles made after 2001 likely could burn gasoline that contains up to 15% ethanol, a fuel blend sometimes called E15. Take a look at the pump next time you fill up your tank: You'll likely see a sticker that says the gasoline you're buying is 10% ethanol.

This government action would increase the market for ethanol by +50%.

That's a nice number. But what does it mean? Well, according to the Renewable Fuels Association, it could mean an additional 5.38 billion gallons in demand. That's what adding 50% to the nation's current output would mean.

At the average rack price for ethanol of $2.72 per gallon, that's $14.5 billion in new ethanol dollars.

And that brings me to a point that all investors should realize. Yes, the government spends a lot of money. It's the most powerful financial force on the planet. But its regulations, which "cost" nothing, have a huge impact on the economy. The amount of new ethanol dollars this rule change would create is larger than the budget for the U.S. Treasury. It's also more than Mr. Obama has requested for the Social Security Administration, the Departments of Interior and Commerce, the Army Corps of Engineers or even the entire EPA itself. The total value of our nation's ethanol production is roughly the same as what Uncle Sam will spend on the Department of Justice in fiscal 2011.

U.S. Ethanol Production
Year Gallons Year Gallons
1980 175 million 1995 1.4 billion
1981 215 million 1996 1.1 billion
1982 350 million 1997 1.3 billion
1983 375 million 1998 1.4 billion
1984 430 million 1999 1.5 billion
1985 610 million 2000 1.6 billion
1986 710 million 2001 1.8 billion
1987 830 million 2002 2.1 billion
1988 845 million 2003 2.8 billion
1989 870 million 2004 3.4 billion
1990 900 million 2005 3.9 billion
1991 950 million 2006 4.8 billion
1992 1.1 billion 2007 6.5 billion
1993 1.2 billion 2008 9.0 billion
1994 1.3 billion 2009 10.8 billion

Why is the EPA suggesting this rule change? It's not, really, the agency is simply looking at the potential environmental effects of burning more ethanol. What's behind the change is not the chart above, which shows the long-term historical uptrend in ethanol output, but about the chart below, which shows the 2010-2022 output quotas for biofuels written into federal law.

You'll note that the demand for traditional corn-based "renewable" ethanol limits out at 15 billion gallons, a little less than the total the new 15% rule would necessitate. (Current 2009 production of 10.8 billion gallons plus 5.4 billion more = 16.2 billion gallons.) The ceiling on corn based-ethanol, as the chart shows, is only +25% above projected 2010 production.

Year Corn Ethanol (gallons) Cellulosic Ethanol (gallons)
2010 12 billion 65.0 million
2011 12.6 billion 250.0 million
2012 13.5 billion 500.0 million
2013 13.8 billion 1.0 billion
2014 14.1 billion 1.8 billion
2015 15.0 billion 3.0 billion
2016 15.0 billion 4.3 billion
2017 15.0 billion 5.5 billion
2018 15.0 billion 7.0 billion
2019 15.0 billion 8.5 billion
2020 15.0 billion 10.5 billion
2021 15.0 billion 13.5 billion
2022 15.0 billion 16.0 billion

However, that is not true for cellulosic ethanol, a biofuel that can be derived from any plant material -- not just corn. Its output is expected to go from this year's federally mandated 6.5 million gallons -- recently lowered from 100 million gallons -- to 16 billion gallons by 2022. That's a gain of +24,515%.

No other industry has this kind of growth potential.

And let's remember where that growth potential comes from. Not from fickle consumers but from federal law. This timetable was established by an energy bill passed by Congress and signed by President Bush in 2007.

So if corn-based ethanol roughly meets the existing demand and the demand with the revised 15% figure, where is all the rest of the ethanol going to go?

Answer: Right into your tank. Sen. Ben Nelson of Nebraska has already asked the EPA to look at E20 or E25 -- gasoline blends that contain 20% and 25% ethanol. He noted that that's the standard in Brazil -- the world's largest ethanol producer -- and that it has reported no damage to cars or even to small engines that power boats or chainsaws. EPA Administrator Lisa Jackson said EPA staff was already studying the data from Brazil.

And then there's E85. Some 2,233 gas stations in 1,586 U.S. cities sell motor fuel that is nearly pure ethanol, with only 15% gasoline. (You can find where to buy E85 in your neck of the woods here, but don't put it in your tank unless your car is designed to use it. E15, on the other hand, can go into any vehicle.) E85 is a great idea: It's the only type of fuel that could totally and permanently end U.S. dependence on Middle Eastern oil. We could literally grow all of our gas.

I'll be honest with you. For years all of this has been pie in the sky, the sort of stuff that a college professor said would one day be possible.

Today, it's the hard reality of the new energy economy that Mr. Obama has been talking about. It's no longer the fancy of utopian dreamers, it's the inevitable future of U.S. energy.

And the whole shooting match depends on one thing.

Enzymes.

Enzymes are compounds that help certain chemical reactions take place. Special enzymes make your jeans softer, for instance. In fact, one of the leading producers of denim-aging enzymes has become one of the leaders in the production of cellulosic ethanol.

His name is Mark Emalfarb. His fascinating biotech company is Dyadic International (OTC: DYAI). And its shares have already meant a triple-digit gain for readers of my premium Government-Driven Investing subscribers. Not only are these shares held in the newsletter's portfolio, I personally own them.

You see, cellulosic ethanol production isn't possible without these designer enzymes. I'll spare you the arcane chemistry behind what happens, but suffice it to say that Dyadic is a clear leader. Such a clear leader, in fact, that Royal Dutch Shell's (NYSE: RDS-A) $12 billion cellulosic ethanol deal with a Brazilian sugar company depends on it. At least that's what the new venture told the Securities and Exchange Commission. It noted that losing Dyadic's technology would have a materially deleterious effect on its business model.

The bottom line is that Dyadic, with a market cap of about $55 million, has an exclusive right to an enzyme that is crucial to a $12 billion deal. And it should be pointed out, as Mr. Emalfarb surely would, that this is a nonexclusive licensing agreement. Dyadic is free to rent its technology to anyone it sees fit. Anyone who might be scrambling to gain a share of the +50% increase in business that the new EPA rule, expected in late summer, could mean. Or anyone looking to take advantage of the +24,515% increase in business that Uncle Sam is guaranteeing.

The EPA -- and here I am just being honest -- typically doesn’t do anything to business but add cost. For Dyadic, however, it's creating a vast new market with nearly unlimited profit potential. No investor who wishes to reap a windfall from the green energy economy can afford to ignore Dyadic.


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