Tar Sands to Ethanol: Wacky Year for Energy

One year ago, when the price of crude oil sat comfortably above $100 a barrel, the energy space was a feeding frenzy as investors tripped over each other looking for companies that were exploring new, sometimes zany sources of fuel.

Petrobras ( PZE) dumping $240 billion into new oil wells off of Brazil's coast that go five miles deep?

Royal Dutch Shell ( RDS.A) spending billions of dollars to extract oil from tar-sand pit mines in Canada?

Refining biofuel from blades of grass, or even the from the gizzards left over from your Thanksgiving dinner?

All of those ideas and more were deemed economically viable when crude oil was above three digits.

Today, oil is trading for about $40 a barrel, and the world that once offered infinite possibilities is now uncomfortably cluttered with limits, restrictions and caveats. Some energy sources that were considered cash cows a year ago now yield only marginal rates of return.

Other efforts to find energy sources have been shelved, and some investors and companies promoting them have gone bankrupt. The Des Moines Register reported that 16 of the country's 182 ethanol plants have filed for bankruptcy and cited a source that that number would likely surpass 40 in early 2009.

Here are some of the most newsworthy energy ideas that emerged in the commodity bubble, along with their current status as a viable source of fuel in the future:

Canadian Tar Sands: Let Them Keep This Dirty, Expensive Oil Resource

Recent estimates suggest that Canada's tar sands could hold more recoverable oil than Saudi Arabia. Unfortunately, current science requires that oil be extracted from tar sands in a pit-mining process that is extremely expensive (as well as harmful to the environment).

Tar-sand investments were considered risky and marginally profitable until the price of crude oil soared above $100 a barrel, after which oil sand investments became instantly appealing. Companies like BP ( BP), Royal Dutch Shell, ConocoPhillips ( COP), Total ( TOT), StatoilHydro ( STO) and Marathon ( MRO) all initiated major investments into Canada's oil sands through independent vehicles and via joint-venture partnerships like Syncrude Canada.

If last year's list of proposed new oil-sand investments was a knee-jerk reaction to soaring oil prices, a diametrically opposite knee-jerk reaction occurred last fall when oil submerged below $100 a barrel. Shell, StatoilHydro, and Canadian Natural Resources ( CNQ) have all canceled or delayed major oil-sand investments in the past six months.

Break-even analysis on the tar sands is vague. Total reported last fall that it needs at least $90-a-barrel crude oil to generate a 12.5% profit margin. However, most analysts contend that $70-a-barrel oil can support new oil-sand investments, while $35 oil can cover the expenses of existing operations. If those figures are correct, most existing tar-sand mines are currently viable with oil trading near $40 a barrel, but brand new oil investments won't measure up financially.

Conclusion: Existing oil-sand investments are marginally profitable, but new investments into oil sands are uneconomic when oil is trading below $70. The space offers moderate opportunities for stockholders with three-plus years' investment horizons.

Petrobras' $240 Billion Tupi Oil Field: Good News for Brazil (and Owners of PBR)

Last summer, when the price of crude passed $120 a barrel and crude futures markets lost all signs of rationality, Brazil's national oil company PetroBras added fuel to the fire when it announced the discovery of a brand new field off its coast containing an estimated 5 billion to 8 billion barrels of oil.

Analysts at Cambridge Energy Research later estimated that the new field, named Tupi, would require 15 oil wells to be drilled at a staggering cost of $240 billion.

The enormous cost seemed manageable under the guise of $125-a-barrel oil, and the company's NYSE-floated American depositary receipts motored from $50 to $75 in less than two months due to the excitement surrounding the Tupi find.

During the fall of 2008, as oil prices plummeted from their summer highs, energy analysts started rethinking the complexity and cost of the Tupi project, and PetroBras ADRs followed crude prices downward to their current price of $24 a share.

However, most analysts suggest that Tupi is still economical at today's oil price. Furthermore, Tupi will likely have a life span of at least 20 years, during which the global price of crude will probably average out at a level that is well above $40 a barrel.

Most analysts also believe that PetroBras' fair value is well above $24 a share, and that PetroBras shares will likely appreciate for its investors in the medium to long term.

Conclusion: Brazil will set the market price for crude when Tupi comes fully online. The field will be economically viable unless a major new oil substitute is discovered and brought to market. PetroBras offers stockholders excellent medium and long-term growth potential.

3. Biofuels: Still Just a Pipe Dream

Ethanol entered the year with celebrity status; it exited 2008 on life support. The following chart sums it up well:

Ethanol's Nasty Year
PRICE: 1/2/08
PRICE: 12/30/08
Archer Daniels Midland (ADM)
Aventine Renewable (AVR)
Green Plains Renewable (GPRE)
Pacific Ethanol (PEIX)
VeraSun Energy (VSE)

What caused ethanol's downfall? For one, the industry's own lofty projections for the future demand for ethanol. These projections suggested that ethanol would soon compete with food processors for corn, which is the dominant feedstock in the U.S. ethanol industry.

U.S. commodity markets were already acting screwy from the increased trading activity in the oil and gas pits. Those traders quickly learned that corn markets operated on similar fundamentals, and corn futures began to follow a trajectory similar to energy futures during the first half of 2008.

Corn prices ultimately grew faster than the market price of ethanol, and they stayed high even after oil and ethanol prices began to slide early last fall. Pure-play ethanol companies like VeraSun ( VSUN) and Pacific Ethanol ( PEIX), already struggling to service loads of debt they had incurred to pay their huge infrastructure bills, found that they couldn't cover their high corn feedstock costs at the same time.

2008 produced one major winner in the U.S. ethanol space: the ag old-timer Archer Daniels Midland ( ADM). ADM's ethanol position is small relative to its stake in farming corn. Rising corn prices infused ADM with cash, which it is currently using to slowly comb through the remains of the once-fertile ethanol industry, annexing what it wants for pennies on the dollar. In a year-ending jab at its old competitors, ADM announced last November that it would also use some of its cash hoard for a $370 million investment in Brazilian sugar-cane ethanol.

Most analysts say that a competitive ethanol industry won't reappear in the U.S. until cellulosic technology becomes viable. Cellulosic ethanol, which metabolizes cellulose fibers instead of the sugars that corn ethanol digests, could use switch-grass and other green plant life as feedstock without pitting ethanol fuel against the American dinner-plate for feedstock dominance. Cellulosic ethanol appears to be at least seven years away from being a cost-efficient method for producing ethanol fuel.

Biodiesel fuel, a hydrocarbon-diesel substitute made from organic compost, garbage, animal remains or algae, uses contemporary technology and has been proven viable by a short list of refiners. However, the market for biodiesel is young and segregated and is likely five to eight years away from outgrowing its present status as a novelty item in the global energy economy.

Investment opportunities in biofuel technology and refining remain spotty and risky. Investors are better off pursuing opportunities in other green-tech vehicles.

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