Debunking the ethanol bust

NEW YORK (CNNMoney.com) -- Recent reports of an ethanol bust may be greatly exaggerated.

Sure, the fuel has seen its price tumble in the last few months. Spot prices for a gallon of the stuff in Chicago went from about $2.30 five months ago to about $1.50 today, according to numbers from the Oil Price Information Service. In 2006, ethanol briefly sold for over $4 a gallon.

Ethanol prices have tumbled, along with the stock values of some big industry players. But experts say don't write off the corn-based fuel just yet.

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Plus the price of corn - the raw material for most ethanol produced in the U.S. - has nearly doubled since the start of 2006. This one-two punch has hit shares in ethanol companies - Verasun (Charts) has lost about half its value over the last year, as has Pacific Ethanol (Charts).

The drop in ethanol's price has been attributed to too much product on the market, the result of overeager investors pouring money into the sector and new plants springing up across the Midwest. But ethanol is unlikely to remain in oversupply for long, thanks to ongoing investments in bringing the product to market, a renewable energy bill that calls for expanding ethanol's use and a base price that's now about 50 cents less than gasoline.

"It's cheap, and you can cheapen the price of gasoline," said Tom Kloza, an analyst at the Oil Price Information Service. "Everybody is trying to get the logistics worked out, so they can have ethanol in their gasoline by 2008."

By everybody Kloza means the gas stations, most of which are independently owned and would make more money on already thin profit margins by using the cheaper ethanol as a blending agent in gasoline. Normal cars can run on a blend of 90 percent gasoline and 10 percent ethanol with no modifications.

Kloza said using that blend would shave 4 to 10 cents off the price of a gallon of gas.

But transporting ethanol out of the Midwest to markets on the East and West Coast is a challenge, primarily because ethanol is corrosive and absorbs water and therefore can't be shipped in normal gasoline pipelines.

Problems transporting ethanol have been cited as one reason for the build up in supply.

"I've always seen this as one of the big issues," said J. Bryant Evans, a portfolio manager at Cozad Asset Management in Champaign, Ill. "It's going to take a couple of years for the infrastructure to catch up."

With regular pipelines out of the question, most ethanol is currently transported by rail.

Both railroads, such as Burlington Northern Santa Fe (Charts, Fortune 500), and companies that build tanker cars, such as Trinity Industries (Charts), said they've seen a sizable increase in infrastructure investment.

"It's been a major part of our orders for the last few years," said James Perry, an executive at Trinity, who noted the company had converted two facilities from making box cars to making tanker cars in the last year.

A spokeswoman for Burlington Northern said the railroad has been transporting nearly 20 percent more ethanol every year for the last 10 years.

"It's definitely a growth area for us," she said.

While the long-term prospects for well-established companies are good, Cozad's Evans said some of the smaller ethanol companies may not last the couple of years it will take for the infrastructure to get built. He also said ethanol stocks in general could fall substantially more during the next 12 months before bottoming out.

But in the long run, he expects a healthy industry, especially for big ethanol players, such as Verasun or, even better, diversified big boys, such as Archer Daniels Midland (Charts, Fortune 500).

"I see it as a bump in the road," he said. 'It's fairly typical when any new product gets ramped up."

The ethanol industry itself points to the relatively low percentage they have of the current transportation fuels market as evidence that they have plenty of room to grow.

"We're using 140 billion gallons of gasoline a year," said Bob Dinneen, president of the Renewable Fuels Association. "How does 6.5 billion barrels [2007's projected ethanol production] mean a glut?"

Dinneen, along with others in the ethanol industry, suggested refiners and others who blend gasoline were deliberately shunning ethanol so they could use more of their product and keep the price of gas high.

A spokesman for the National Petrochemical and Refiners Association, who pointed out several of the criticisms against ethanol in general, denied those charges, saying the industry was blending more than they were required to by law and that demand for more ethanol just isn't there.

But Kloza, the analyst from the Oil Price Information Service, said there's probably some truth to the ethanol industry's gripes.

"If you're a refiner, you say, 'Well, I don't want to cede 10 percent of my production to ethanol,'" he said.

Dinneen said that was all the more reason to push the federal government to increase the amount of renewable fuel gasoline companies are required to sell.

Currently the mandate is 7.5 billion gallons by 2012, a level that's expected to be reached well before then.

But a proposal that has the support of the president and fairly strong backing in Congress would increase that to 36 billion gallons of renewable fuel by 2030.