Economic Notes:

This Weeks Leads:

Diners Invited to Rate and Review Salt Lake & Park City Restaurants

Betting on biofuels

The industry is still in its infancy but evolving rapidly. Companies that hope to compete must devise their entry strategy now.

Billions of dollars, euros, pounds, and reais are pouring into biofuels. High fuel prices and generous regulatory support have given the industry healthy margins and relatively short investment payback times. Meanwhile, the triumphs of the first movers and dreams of future growth are enticing companies in industries from petroleum and agribusiness to biotechnology, chemicals, engineering, and financial services. And of course, the allure of a greener future has raised the expectations of investors and bystanders who hope that biofuels will help meet the world's energy needs while lowering greenhouse gas emissions.

Can biofuels deliver? The answer appears contingent on fuel prices as well as three other variables that directly influence the profitability and environmental impact of biofuels: the cost and availability of feedstock, government regulation, and conversion technologies. All are in flux, so an investment today is a bet on how these interrelated factors will evolve. Feedstock costs vary tremendously by region and could change significantly in the years ahead. Governments may alter the industry's ground rules to match changing priorities in climate change, energy security, and economic development. The energy, cost, and carbon efficiency of various biofuels are already quite different,1 and new conversion technologies could make them even more so-at different rates in different regions. Decisions about where to produce and distribute biofuels could have dramatic implications for the feasibility of the business.

Amid all this uncertainty, why enter now? In many commodity industries, the winners are the latest entrants, at the bottom of the cost curve-wielding the newest, most efficient technologies. But waiting may be a costly strategy in the nascent biofuel industry because land and other essential resources are at a premium.

Biofuel players should consider different ways to mitigate the risks, but every strategy will require trade- offs. Betting on a number of geographies and technologies will make things more complex, for example, but helps balance risk. Vertical integration, though both complex and costly, may be essential in helping to establish this young industry. Companies that want to play should try to get a head start on the difficult task of reducing the seemingly infinite number of options to a feasible set of solutions.

A world of uncertainty

Not long ago, the biofuel industry was relatively straightforward. Producers mostly used mature technologies and local feedstock to supply domestic markets with a single biofuel: bioethanol from cornstarch (in the United States) and sugarcane (in Brazil) or biodiesel from rapeseed oil (in Europe). Now, as global demand increases, companies are beginning to produce and sell biofuels in a number of geographies-and that's when things start to get tricky.

In many industries, the factors affecting returns vary geographically, and companies combine locations accordingly. With biofuels, these factors are particularly dynamic, often interconnected, and mostly uncertain. Two of them-feedstock costs and government regulation-are critical to any geographic strategy today, and conversion technologies will increasingly affect production costs as next- generation processes become commercialized. (Capital expenditures vary tremendously across regions, but no more so in biofuels than in any other industry.)

Feedstock costs and consequences

Feedstock accounts for 50 to 80 percent of biofuel production costs, so its price has a huge effect on the producers' returns. In the United States, for example, every dollar increase in the price of a bushel of corn raises the production cost of bioethanol by $0.35 a gallon and reduces the producer's operating margin by 20 percent.2 Many different forms of biomass can be used as feedstock, and costs vary hugely by region. Fermentable sugars from Brazil's sugarcane, for example, are less than half as expensive as those from European sugar beets. Government subsidies and alternative uses of feedstocks also affect feedstock costs.

In many regions, rising demand threatens both the cost and availability of feedstock. From 2003 to 2006, the percentage of the total US corn harvest used to produce biofuels rose to 16 percent, from 12 percent. But now that the federal government has adopted a goal of 35 billion gallons of alternative fuels a year by 2017, the use of domestic corn-based bioethanol to meet even half of this target would require 40 percent of that year's expected harvest. Not surprisingly, the cost of corn has soared: average wholesale prices rose from $1.90 a bushel in 2005 to $2.41 in 2006, and corn has regularly surpassed $4 a bushel on the spot market since late 2006.

Other unintended consequences of greater demand could bring a consumer backlash like the one that broke out in Mexico when tortilla prices skyrocketed because of bioethanol-related corn shortages. Environmental concerns were also raised after last autumn's burning of Indonesian forestland to make space for palm oil crops that were linked to increasing demand for biodiesel. The environmental impact of other aspects of biofuel production, including the widespread cultivation of fast-growing jatropha (a plant that produces a toxic vegetable oil), are unknown.

Government regulations

Whether through subsidies, import tariffs, or research grants, government regulation has helped drive both demand and profitability in the industry. Because the energy policies of most nations are still evolving, regulation is perhaps the greatest uncertainty of all. Lower subsidies, for example, could diminish profits. A production cost of about $2.90 a gallon and a government subsidy of $1.81 a gallon helped German producers to earn $0.42 for every gallon of biodiesel in 2006. The role of taxpayer money in creating new millionaires hardly went unnoticed, and the government decided to eliminate these subsidies, gradually, by 2012, replacing them with a mandated blend rate (the percentage of conventional fuel that blenders must replace with biofuel). Blend rates guarantee producers a certain level of sales, but the elimination of subsidies and the fact that supply will likely exceed mandated demand in the short term should depress margins. In such a market, companies generate attractive returns only when the cost curve is steep and lower-cost producers operate under the price umbrella established by marginal, high-cost producers. Since vegetable oil, itself a globally traded commodity, accounts for 80 percent of the production cost of biodiesel, the biodiesel cost curve isn't steep. Analogies with industries that have similar cost structures suggest that biodiesel margins could fall by 80 percent from 2006 levels.

The impact of mandated blend rates is also unclear. US regulators could set any ethanol blend rate from 10 percent (the maximum suitable for current vehicles) to 85 percent (the maximum suitable for most flex-fuel vehicles).3 Minnesota, for example, has mandated a 20 percent ethanol blend rate to take effect in 2013. What's more, mandated blend rates below 85 percent could be met either with the uniform blending of biofuels at the mandated rate or with a disproportionately high share of high-biofuel blends. All of these regimes would increase overall demand, but they could have vastly different effects on bioethanol companies and on other businesses, particularly car manufacturers. For now, car companies can keep selling vehicles with current engine designs, but some already plan to offer more flex-fuel vehicles, which use high-concentration biofuels, conventional fuels, or a mix of the two. Of course, the way carmakers deal with these issues will influence their other product-development decisions, especially for different low-carbon approaches, such as hybrid or hydrogen-fuel-cell cars.

Other policies are also in flux. With some exceptions,4 current biofuel regulations in the European Union and the United States protect domestic producers, but these policies-especially import tariffs-may change. Regulators increasingly recognize that current trade policy, which taxes imports of ethanol but not of petroleum, may not serve the goal of energy security. As evidence amasses confirming sugarcane ethanol's importance for reducing carbon emissions,5 regulators may ease restrictions on its importation.

The impact of new conversion technologies

New conversion technologies are going to cut overall production costs; regional variations will either validate geo-graphic strategies for biofuels or turn them on their heads

Take, for example, bioethanol, produced when microorganisms such as yeast ferment sugars into ethanol. Next-generation technology will allow producers to use the sugars that make up cellulose (the main structural component of plants). Cellulose is found in all manner of vegetation, so cheap feedstocks-such as corn stover, sugarcane stalks (bagasse), and high-yield "energy crops" like switch- grass, energy cane (a relative of sugar cane), and wood-will become important feedstocks. The technology involves "pretreating" feedstocks physically or chemically and then using enzymes to digest the cellulosic components to release the fermentable sugars. For every step, competing technologies are under development.6 Each could lead to different production processes, biorefinery designs, and costs.

When this "lignocellulosic" technology becomes commercially viable-as early as 2010, by some estimates-the savings in costs and carbon emissions will vary by feedstock. Since feedstocks vary by region, their costs could change a region's attractiveness to producers. Consider these examples:

• Today biofuel production in China is uncompetitive, because feedstock costs are relatively high. Cellulosic technology, however, could lower production costs to as little as $0.60 a gallon, from about $1.80, making Chinese bioethanol one of the world's cheapest biofuels.
• In the United States and Brazil cellulosic ethanol production costs won't be much lower than today's corn- and sugarcane-based ethanol costs. Facilities processing cellulosic material thus will likely supplement rather than replace older ones, though cellulosic technology would have a significantly better energy balance when compared with the corn ethanol currently produced in the United States.
• In Europe cellulosic technology could lower production costs enough to threaten companies producing beet (or wheat) ethanol with current methods.

Governments can help to advance technologies, but not without risk. In 2006 the government of Spain allocated $29 million to finance a joint Spanish- Argentine biodiesel research project. Likewise, the US Department of Energy recently announced $385 million in grants to six different cellulosic ethanol research projects. Technology could make it practical to use biobutanol, a molecule that outperforms ethanol as a premium gasoline replacement. Biodiesel, though far from cost competitive with regular diesel today, could in time be produced from jatropha, which provides a low-cost vegetable oil and can be cultivated on marginal land. Biomass-to-liquid (BTL) technology, a gasification process long used to convert coal into fuels, could eventually make it possible to produce high-quality synthetic diesel and gasoline. Most of these new technologies have yet to prove that they can be cost competitive. However, farsighted governments should avoid policies that favor today's technologies at the expense of tomorrow's.

Continued Next Week