Crude Oil Markets and Alternative Fuel -- An Investment Catch-22?

Granada, Nicaragua… The Hotel Dario. It’s 7 o’clock in the evening, and our group is sitting at a long table in the back room of the hotel’s restaurant drinking the local specialty, maqua, and feasting on langoustines and steak.

Jared and I are sitting in the middle of the group on this first night of the Rancho Santana Chill Weekend, and we’ve enjoyed a huge lunch and a boat ride on Lake Nicaragua before relaxing at dinner, a two-piece guitar band playing softly in the corner.

Someone brings up food prices… how everything is so inexpensive and plentiful in Nicaragua… and how food prices are skyrocketing in most places in the world.

We’re off to the races: It’s the falling dollar, it’s droughts in Australia, it’s rising populations in emerging markets…

It’s ethanol.

Many of you who’ve been following me for the past six years or so know that I’ve done my fair share of research into renewable energy and alternative fuels… and I’ve done my best to debunk some of the myths surrounding ethanol.

The No. 1 myth being energy content.

A study by the United States Department of Agriculture says that corn-based ethanol produces 34% more energy than it takes to make it… including all the energy it takes for the corn to grow, be harvested, transported and distilled.

A lot of folks who dislike ethanol claim that ethanol is a net energy loser.

There’s no doubt that there’s more energy in a barrel of crude oil than in a barrel of ethanol, but that doesn’t mean ethanol isn’t a viable alternative fuel.

The problem comes from comparing apples to oranges, and this issue extends to the topic of food versus energy.

In 2010, the United States produced more than 316 million metric tons of corn… more than any other country in the world, and nearly double that of China, our nearest competitor.

That’s about 12.9 billion bushels grown on 86.4 million acres of land.

By the 2015/16 season, those numbers will increase to 14 billion bushels and 89.5 million acres. Here’s the hard part of the equation, though. There’s no exact reference to how much extra land would be needed to plant more corn should production of ethanol increase substantially.

Some estimates say that 1 billion gallons of new ethanol production would require 726,000 acres. Other estimates are much higher… around 1.64 million acres per billion gallons of ethanol.

One of the reasons for such discrepancy is yield. There’s no surefire yield prediction for corn production, though more often than not, yields have risen. And some analysts suggest that about 30% of increased corn production can be met through higher yields, rather than more acres planted.

So how do these two topics — crop yields and fuel — converge on the investment stage?

Well, as an investor who is surely hearing about rising food and fuel prices, you might be wondering if there’s a way to offset your grocery and gas station bills with an investment in either the crude oil sector or the renewable fuels industry.

The other night, I was at the local bar when I overheard a conversation about environmental energy and crude oil prices.

The conversation was between a 26-year-old self-proclaimed Libertarian and a 50s-ish retired Army Republican. It was not going well: Neither side had the truth, or even anything close to cold, hard facts.

The young guy was saying that the energy companies are gouging the American public, and the Army guy was saying that oil prices are so high because of supply and demand. Both statements are false.

Though some companies have overcharged in the past (and some allegations persist from Hurricane Katrina’s supposed gasoline supply disruptions), that’s not what’s happening now.

Nor are sustained prices above $100 a barrel the result of supply and demand.

According to the latest report from the Energy Information Administration, crude oil stocks climbed by 2.1 million barrels for the week ending March 18, 2011. That means inventories are still higher than their five-year average.

The situation in Libya has certainly raised fears of supply disruption. But these are just fears. Libya produced about 1.3 million barrels a day before the uprising. Saudi Arabia has a spare capacity of 5 million barrels a day.

High prices are not due to supply and demand.

High prices are the result of three main things: speculation, fear and a falling dollar.

Interestingly, these three main factors can be applied to agricultural commodities, though there are stronger arguments for supply-and-demand factors influencing prices for these commodities than for energy commodities.

And this is where energy prices and commodities meet, and have spawned the alternative fuels industry. It was a boon for investors six or seven years ago when the EPA started to phase out MTBE due to leaks contaminating water tables.

But is it a smart investment now? Should you be looking at ethanol over oil, or vice versa?

(Investing doesn’t have to be complicated. Sign up for Smart Investing Daily and let me and my fellow editor Jared Levy simplify the stock market for you with our easy-to-understand investment articles.)

We know that ethanol production and consumption has been on the rise. In 2008, the U.S. consumed more than 9.683 billion gallons, and produced only 9.309 billion gallons. The following year, production jumped to 10.938 billion gallons, but consumption jumped to 11.037 billion.

And last year, consumption jumped again, totaling 11.990 billion gallons. But for the first time in eight years, we produced more ethanol than we consumed. Production totaled 12.036 billion gallons in 2010.

This is not an anomaly, however. Nor does it signal a move away from ethanol. Consumption continues to rise.

In fact, only one year, since 1981 did the Energy Information Administration record a drop in ethanol consumption. That was 1996, and it was most likely due to a very poor corn crop and a doubling of corn prices.

So here’s how you gauge if ethanol is worth investing in through production companies like Pacific Ethanol (PEIX:NASDAQ) and Green Plains Renewable Energy (GPRE:NASDAQ).

I’m not including the country’s largest producer, Archer-Daniels-Midland Company (ADM:NYSE), because ADM is primarily as seed and seed processing company. Net sales for ADM’s “bioproducts” (which included ethanol) accounted for less than 7.5% of the company’s total net sales.

If corn prices are climbing rapidly, along with rising oil prices, the cost of producing ethanol climbs, too. During times of high demand above production, higher costs don’t matter as much. That is not the situation we’re in right now.

Indeed, we’re seeing ethanol stocks higher than they’ve ever been at more than 18 million barrels in 2010.

Now, we’re also seeing slightly higher oil inventories, but sustained oil prices over $100 a barrel may tip the favor to oil producers over ethanol producers… for now.

Yesterday we watched oil prices fall below $104 a barrel, its second day of falling prices. A drop below $102 could send prices back below $100. This means that you might want to choose oil producers over ETFs or futures for the time being, with a slightly longer time frame.

High oil prices will certainly boost quarterly earnings, whether they’re above $104, or above $94.

Editor’s Note: No one in America wants to talk about this. Not even the people who think the dollar is on its last leg. And we don’t blame them — This crisis is scary. Get the full details from Taipan’s Safe Haven Investor.

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