When President Bush claimed we were addicted to oil, alternative energy stocks surged, ethanol in particular. The only two pure plays on this traditionally corn-based fuel, Pacific Ethanol ( PEIX - Get Report) and Xethanol are each up threefold since the beginning of the year. Even with those returns behind them, I believe these stocks still have plenty of upside. Ethanol is the new dot.com, except unlike all those Internet stocks that crashed and burned at the beginning of the decade, ethanol-focused companies will have earnings that live up to the hype. Before I explain why this is so, I'd like to note that ADM ( ADM - Get Report) is up almost 50% since the beginning of the year, and Deere ( DE - Get Report) is up 20% because farmers have more money. That's in part thanks to increased demand for corn for ethanol. If you're a regular reader of mine, you will know that I was
way ahead of the government and the market on these alternative energy issues. The U.S. is just beginning to see the ethanol boom. President Bush has required that 7.5 billion gallons of ethanol be used annually by 2012, up from the approximately 6.3 billion gallons expected to be used this year. Meanwhile, four states have mandated 10% ethanol in all their gasoline, and many more have plans to follow. That means ethanol use could easily exceed President Bush's target. Why? Because the 7.5 billion gallons mandated by 2012 amounts to just 5% of the 140 billion gallons of gas Americans use each year. It's true that the 51 cent-a-gallon tax incentive for ethanol is likely to be phased out, meaning that taxpayer money will no longer be going to farmers in the form of subsidies. But as long as crude oil remains above $50 a barrel, and corn costs less than $3 a bushel, simple economics will be in ethanol's favor, making it cheaper than gasoline.
There's another twist, too. The gasoline additive MTBE has been shown to be toxic in drinking water and is to be replaced by ethanol on May 5. This has quickly caused us to have an ethanol shortage in our country. To replace MTBE, ethanol production will need to be beefed up by 130,000 barrels per day, a 50% increase over current levels. The U.S. has been slow to really use ethanol to lessen dependence on fossil fuel, at least compared to Brazil. The South American nation began an aggressive -- and successful -- alternative energy program amid the oil price shock of the 1970s and mandates a 25% ethanol blend. Our country didn't have such foresight, and we are now being forced to be reactive instead of proactive, not an ideal situation. However, as investors, we can make a wheelbarrow full of cash on our government's unfortunate past ineptness. Of the two ethanol pure plays I mentioned earlier, my favorite is Xethanol, which has a way of making ethanol without corn. That's right, its cellulose ethanol technology is designed to produce the alternative fuel from paper mill waste. President Bush likes this technology and plans to spend $150 million in 2007 to promote it. The President wants cellulose ethanol to be price-competitive by 2012, yet Xethanol says it can achieve that goal by 2007. The cellulose ethanol technology is a true win-win for everyone involved. Xethanol plans to build its plants near paper mills, giving them an easy way to dispose of their waste. The paper mills will no longer have to pay big shipping bills to haul waste to landfills, and Xethanol gets its raw material cheap. In fact, it might even get paid to take it. It also doesn't have to worry about corn or corn prices.
There are two other nice side benefits. That paper-mill waste no longer piles up in landfill, and by purchasing Xethanol's product, we make Americans rich, instead of having to buy oil from countries that don't like us. Talk about a perfect scenario. Xethanol just raised $46 million to expand its presence on the East Coast and has hired Christopher Dillow to explore expansion along the West Coast. The West Coast -- specifically California -- is a big market. Almost all of the 900 million gallons of ethanol that California used in 2004 were imported by rail or ship, and the Golden State currently hosts only about 8 million gallons of production, even though it accounts for one-third of naitonal ethanol consumption. The company that is currently answering California's ethanol shortage is Pacific Ethanol, which is building a plant in Madera County, and has four more West Coast plants coming online. This company just received an $84 million from Bill Gates' investment arm Cascade Investment LLC. Pacific Ethanol recently delayed its annual report to record this money and an additional $34 million dollars. Both of these companies are the only pure plays on ethanol, though I would imagine others will try to take advantage of the capital available in the public markets. However, it will be hard to catch up to these two. I plan on holding Xethanol for the foreseeable future. Everything has aligned just right for ethanol. My only knock against ethanol is that a 10% blend of it in gasoline may result in a 2% to 3% reduction in fuel efficiency. This means I might have to fill up the 528 horsepower truck I have in Texas more often. But I can live with that to be more energy independent. Remember, being poor is bad, staying that way is stupid.