Ethanol war brewing
Grain alcohol is seen as the new gasoline. But which recipe is the one for investors to bet on?
By Chris Taylor, Business 2.0 Magazine senior editor

SAN FRANCISCO (Business 2.0 Magazine) -- Everywhere you look these days, tech and business world luminaries - like Richard Branson, Paul Allen, Steve Case, Vinod Khosla, John Doerr, and Bill Gates - are laying down big bets on ethanol, a substitute for gasoline that's already finding its way into pumps.

The price of the stuff has shot up 65 percent since May from $2.65 a gallon to $4.50, largely thanks to the oil companies who have started to put small quantities of it in our gas as a clean-air additive (most cars can handle a blend of up to 10 percent ethanol in their tanks).

That means the fuel for our cars is now about 60 cents a gallon more expensive than it would be if it were just gas, according to analysts at JPMorgan. As drivers, ethanol is lightening our wallets; as investors, though, it could well fatten them.

But before you jump on the ethanol bandwagon, consider this: There is an ethanol format war looming that will make the Blu-Ray vs. HD-DVD tussle look like a schoolyard spat. If you're making an investment for the long term, you have to ask yourself whether the future's dominant fuel is going to come from corn, sugar, rape seed, or switchgrass - or if it's going to be synthesized from scratch.

The winner is going to be whoever can make ethanol in mass quantities for as little money per gallon as possible - a tall order, no matter how you go about it.

Prices as high as an elephant's eye

First of all, consider corn - which, thanks to the farm lobby and the importance of Iowa in presidential politics, is the source of nearly all the ethanol in the US. It has the most government subsidies, and is the form of the fuel that Richard Branson says he will invest in, and market, to the tune of $400 million. Last month, Kleiner Perkins -- the VC firm where Doerr and Khosla are partners, and which brought us Amazon.com (Charts) and Google (Charts) - invested in Altra, a Los Angeles-based corn ethanol company.

Corn has the advantage of being planted in the ground now. But it has one vast economical disadvantage: Corn, according to a much-cited Cornell study, takes more energy to grow, harvest, transport and refine than you get out of it at the pump. The Department of Energy is more generous, putting the ratio of energy in to energy out at 1 to 1.4. Whatever the exact numbers, the costs grow considerably for those of us living in coastal states, so far away from the amber waves of grain in the heartland.

Sweet alternatives

There is already a sweeter alternative. "Ethanol from sugar cane is far more efficient," says Steven Schneider, CEO of Santa Rosa, Calif.-based Zap, an alternative transportation outfit. That's why ethanol-fueled cars are all the rage in Brazil, where 70 percent of new cars are equipped to run on the stuff. Zap has started importing a particularly popular Brazilian model of "tribrid," a gas-electric hybrid car that can also run on ethanol.

In theory, sugar cane is the cheapest substance you can make ethanol out of - unless you live in the U.S., that is, where import tariffs make it prohibitively costly. (Blame the corn lobby, which doesn't want a competitor to high-fructose corn syrup, and domestic sugar interests.)

So where is the better corn alternative? Step forward, cellulosic ethanol. This is the kind of ethanol that's produced from any part of a plant that you don't eat - straw, stalks, corn husks. All of that waste is rich in cellulose, which, in theory, can be converted into sugar, and then ethanol.

Cellulosic ethanol has more than its fair share of eager investors. Last month Goldman Sachs (Charts) put $27 million into a Canadian company called Iogen, which wants to produce ethanol from switchgrass, a perennial grass that's cheap to grow. Iogen is building the world's first cellulose-to-ethanol factory.

Microsoft (Charts) co-founder Paul Allen is investing in a Seattle firm that wants to use canola oil, which comes from rapeseed, to create ethanol. And Vinod Khosla, the Kleiner Perkins partner and Sun Microsystems (Charts) co-founder, has investments in two cellulosic ethanol companies.

The advantage of cellulosic ethanol is its potential efficiency. It can use wild-growing plants that we wouldn't have to cultivate - and it promises to reduce greenhouse gas emissions by up to 80 percent.

The problem: Making it involves a complicated process that breaks down plant material into sugars using enzymes that aren't yet commercially available. The most promising methods, like one at the University of California at Berkeley to use an enzyme derived from a cotton-eating fungus, are still at the laboratory stage, and the first commercial enzymes aren't expected until 2009 at the earliest, according to some experts.

Brewing ethanol from scratch

So keep your eye on Craig Venter, the scientist who helped map the human genome. His latest venture, Synthetic Genomics, is using $31 million in venture-capital funding to make genetically modified plants and plant-eating enzymes. Such an ambitious, DNA-level project will take a lot longer than three years.

And by then, Bill Gates' bet may prove to be the smartest of all. Microsoft's chairman, who will step down from his day-to-day role at the company in a couple of years, has bought 25 percent of Pacific Ethanol, a Fresno, Calif. company that is planning to build dozens of ethanol refineries in the U.S.

Those refineries will be easy to adapt to whichever ethanol production method ultimately wins out. That could put Gates in a familiar spot -- as the gatekeeper to a must-have product.

And he's a pro at winning format wars.

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Most stock quote data provided by BATS. Market indices are shown in real time, except for the DJIA, which is delayed by two minutes. All times are ET. Disclaimer.

Morningstar: © 2014 Morningstar, Inc. All Rights Reserved.

Factset: FactSet Research Systems Inc. 2014. All rights reserved.

Chicago Mercantile Association: Certain market data is the property of Chicago Mercantile Exchange Inc. and its licensors. All rights reserved.

Dow Jones: The Dow Jones branded indices are proprietary to and are calculated, distributed and marketed by DJI Opco, a subsidiary of S&P Dow Jones Indices LLC and have been licensed for use to S&P Opco, LLC and CNN. Standard & Poor's and S&P are registered trademarks of Standard & Poor’s Financial Services LLC and Dow Jones is a registered trademark of Dow Jones Trademark Holdings LLC. All content of the Dow Jones branded indices © S&P Dow Jones Indices LLC 2014 and/or its affiliates.