Ethanol’s Government Intervention
The Smart Profits Report: Issue #344
Tuesday, August 15, 2006
Ethanol’s Government Intervention: Why the “High-Growth” Ethanol Business Matters to Investors
By D.R. Barton, Jr.
Advisory Panelist, Mt. Vernon Research
“Markets can remain irrational longer than you can remain solvent.”
- John Maynard Keynes
Nothing gets the investment community excited like a fresh round of government subsidies. This is the case with the fervor over ethanol. Ethanol’s government intervention has made this the hottest investment topic since, well, solar energy. (Jimmy Carter, where are you?)
But interestingly, the whole “ethanol as a gasoline replacement” gig is a clever ruse. Far from being an energy panacea, ethanol is merely a politically-correct Band-Aid. A sign of hope in a country that’s scared to death of paying $80 to fill up the family SUV for the foreseeable future.
And when voters get scared, politicians leap into action. Unfortunately, fast government action almost always results in irrational action. And what could be more irrational than stuffing a perfectly good ear of corn into your gas tank?
Now don’t get me wrong: I believe ethanol will continue to be a high-growth business for the foreseeable future. But hang on a second. How can I say in one breath that ethanol is a ruse, but in another say that it’s a high-growth business? Simple. I can explain this seeming contradiction in two words…
Government intervention.
Despite Irrational Government, There’s Money in the Ethanol Business
Governments can remain irrational indefinitely. After all, for many years now, governments have gladly sent our tax dollars to farmers to not plant crops… paid artists to create art that nobody will buy… and paid scientists to study whether overeating causes obesity. So why should we be surprised that the problems with the ethanol-as-fuel story are swept under the rug?
Make no mistake about it, though: There will be tons of money made as the ethanol industry builds out. Just don’t be surprised at the areas where the money is to be made. But before we look at where the money is hiding, let’s first look at ethanol as a business.
Corn - It’s Not Just for Breakfast Anymore
Let’s start by ignoring a few hard facts…
For example, it takes more energy (or at least close to same amount of energy) to turn a pile of corn into a gallon of ethanol than the energy you actually get from the resulting gallon of ethanol. So what if we have to manufacture ethanol at an energy deficit? That’s a small price to pay to get something that’s kind of like gasoline but doesn’t take millions of years of rotting stegosaurus rump to produce. We’re talking convenience here, not economics or thermodynamics.
Another inconvenient fact we need to ignore when talking about ethanol: If we took every kernel of corn produced annually in this country (and we grow an awful lot), mashed them up and made ethanol, we would produce about 12% of our annual gasoline consumption.
12%!
And that’s only if you took every kernel of Orville Redenbacher’s stash, plus all that we eat and feed to our livestock. This means that ethanol from corn is only a small part of an energy solution.
While that doesn’t exactly make the ethanol industry sound very impressive, here’s the thing: Government subsidies and political pet projects tend to prolong irrational exuberance. So ethanol will continue to matter. And it will matter to investors.
Exploit Ethanol Inefficiencies for Corn-Fueled Profits
So what do you do? One good idea is to:
- Look for inefficiencies in the system and exploit them.
And right now it looks like the ethanol distillers (the Johnny-come-latelys to this game) are enjoying the beefy profit margins while the corn farmers (the heroes of our story) are getting squeezed.
But remember… this is going to be a supply-driven business. You can only distill as much corn as you can grow. So a good bet now is that as corn prices go up, distillers’ margins (and hence their burgeoning valuations) will be driven down.
Let’s look at market darling Archer-Daniels-Midland (NYSE: ADM) as a ratio to corn:
It’s no secret that corn prices have risen over the past year. But one look at this chart shows that they haven’t nearly kept pace with the ethanol distillers like ADM.
Looking for a profitable scenario? A good way to do it is by placing your bets on the ratio of ethanol distillers’ share prices compared to how much raw corn futures will decline. This is a longer-term play (several months to a year or so), so be patient. But buying corn futures on dips and selling ADM and other distillers on spikes will most likely pay handsome dividends in the long run.
Good Trading,
D.R. Barton
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Today’s Smart Profits Cribsheet
- In last Thursday’s Smart Profits Report, the other Mt. Vernon Research editors offered their take on the ethanol market in a special forum. So in case you missed what they had to say, you can read the Smart Profits Report Ethanol Forum in Part 1 and Ethanol Forum Part 2.
- You now have a great chance to ride the wave of this heavily government-backed industry. To find out much more about the ethanol market, its prospects and how you can profit from it, read our brand new report.
Related Articles:
- Ethanol Investments: Two Ways To Profit from the Shift Towards Ethanol
- The Future of Crude Oil Prices: How a New Saudi Development is Bearish for Oil Prices
- The Best Commodities Website on the Internet
The Chart of the Week
As you can see, Archer-Daniels-Midland (NYSE:ADM) has enjoyed a very impressive run. However, the chart is now showing signs of consolidation with momentum dwindling. Chances are good that the ethanol windfall is already priced into this agricultural giant.
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