26/01/07  (BusinessWeek Online) -  In his State of the Union address, President Bush pleased some audience members by proposing to radically increase the amount of alternative fuel usage. Corn Belt congressional folks beamed and cheered their approval. So did their constituents, producers of ethanol, the biofuel expected to fill most of the gap created by lower gasoline consumption.

And with good reason: Were it to become legislative reality, Bush's call on Jan. 23 for 35 billion gallons of alternative fuels in the U.S. economy by 2017 -- nearly seven times current capacity -- would guarantee ethanol producers and corn growers strong demand for at least a decade.

Ron Miller, chief executive of Aventine Renewable Energy Holdings (AVR), a leading ethanol producer, was among those who welcome Bush's proposal. Aventine supplies and markets more than 500 million gallons of America's ethanol supply to major integrated oil companies like BP (BP) and Exxon Mobil (XOM).

"The president got his arms around a realistic goal to get us to focus on solving the energy dependence problem," says Miller, who took Aventine public last June after starting the company in 1981. "It's a stretch, and it'll take effort, but it's achievable."

Skepticism Aplenty

But despite the feel-good rhetoric of energy independence and a more environmentally friendly future, Wall Street remains skeptical. In the days preceding Bush's speech, the shares of ethanol producers surged, but by Wednesday they headed down sharply, and continued the descent on Jan. 25.

Aventine's stock has taken a particularly low dip. Having opened at $43 with the company's initial public offering last June, the shares have since lost more than half their value.

The stock fell another 8.4%, to close at $16.24 Jan. 25 on the New York Stock Exchange.

Other ethanol producers suffered a similar fate. Shares of VeraSun Energy (VSE), which went public last year at $30.75, fell 2.6% to close at $17.49 Jan. 25. Pacific Ethanol (PEIX), a California-based refiner of corn-derived ethanol whose stock hit $44.50 last May, has fallen to $16.53.

Archer Daniels Midland (ADM), the largest producer of fuel ethanol in the U.S., declined less than 1%, to $31.82, after having rallied 2.6% just ahead of Bush's speech.

Investors have been skittish about ethanol because they're concerned about the short-term obstacles to the industry's profitability, analysts say. "These stocks rallied ahead of the news more because of trading and gamesmanship than people investing in the long run," says Chris Shaw, an analyst at UBS (UBS) who covers ethanol producers Aventine, VeraSun, and Archer Daniels Midland. "[Bush's> speech suggests a strong long-term demand, but it's not clear how profitable this industry is. The most important factor long-term is that it's a commodity industry; expansion requires favorable market conditions."

Price Volatility

Ethanol's profitability is also linked to corn prices, which have been steadily rising, now trading at about $4 a bushel.

The conundrum for ethanol producers is that ethanol demand is driving up corn prices by gobbling up supply -- thus making production more expensive for companies trying to boost capacity [see BusinessWeek.com, 1/10/07,

"Commodities: Who Profits from Corn's Pop?">. The 5.3 billion gallons of ethanol produced in 2006 consumed nearly one-fifth of the U.S. corn crop. And if the new ethanol plants currently slated for construction go into operation by next year, about half the corn supply will be used for ethanol.

In other words, the ethanol market is closely tied to the price of corn and oil. When oil prices are up, so is interest in energy alternatives such as ethanol. As UBS' Shaw points out, the ethanol market faces a central paradox: Its success depends on high oil prices -- which make alternative fuels more attractive -- but its own success lowers demand for oil, which in turn trims oil prices.

That correlation explains why, in the near-term, the ethanol market is as volatile as crude oil prices. The past year's performance proves the point. Three ethanol producers went public in 2006 and raised a combined $950 million from their offerings. As oil prices climbed and alternatives became more attractive, shares of a number of ethanol producers shot up midyear, but retreated in the second half.
Federal Subsidies

But Aventine's Miller sees the setbacks as temporary, and says that enduring volatility now will lead to future profitability -- especially with greater demand for alternative fuels. Aventine, which is both an ethanol producer and marketer, operates a wholly owned plant in Pekin, Ill., and a partially owned Nebraska Energy plant in Aurora, near Chicago.

"As a CEO, going from $43 [per share> to $16 is embarrassing," says Miller, adding that that the market overreacts to news items to create volatility in prices.

"But I'm bullish on the stock because I know in my heart the strength of the government support behind ethanol; it's guaranteed growth."

Ethanol producers like Miller continue to benefit from a federal subsidy -- a credit worth 51 per gallon for refiners who purchase ethanol. The credit makes ethanol much cheaper, putting prices on par with those of gasoline. The excise tax, passed in 1978, remains in effect through 2010, when Miller expects it will be renewed.

The U.S. government continues to provide rhetorical and financial support for ethanol, but with so many interests at play -- from oil conglomerates to auto companies to alternative forms of ethanol -- the future of energy regulation remains unclear. Oil price volatility will also continue to cause headaches for Miller and his colleagues. Still, ethanol producers remain optimistic that talk of a greener future will translate into action -- and profit.

Author: By Moira Herbst

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