Global Market Brief: A New Step in the Ethanol Revolution?

By: John_Mauldin

This week in a Special Outside the Box we look at the discussion of alternative energy sources, specifically, ethanol derived from corn or sugarcane. The Stratfor piece discusses the economic implications of ethanol usage; geopolitical ramifications in terms of how current oil producers will be affected, comparable cost advantages between corn and sugarcane processing, and the advantages and disadvantages of ethanol production and consumption.

OPEC has expressed concern over capital allocated to alternative energy research, suggesting, implicitly threatening, that oil producers may be driven to lessen investment in vital infrastructure leading to supply constraints in the future and higher oil prices. If the assertions emanating from Brazilian government-funded researchers are confirmed to be true, the viability and time frame in which ethanol usage becomes economically feasible has made great strides, and shortened, respectively.

This Stratfor piece is an objective, thought provoking assessment of technology that will have drastic implications on our global economic and geopolitical landscape. Stratfor continues to provide insightful and pertinent research on economic and geopolitical events and their respective ramifications. Stratfor continues to provide significant savings to readers of Outside the Box, for further information please click here .

I hope you find this article enlightening and thought provoking as we continue to address the implications of alternative energy resources.

John Mauldin, Editor

Global Market Brief: A New Step in the Ethanol Revolution?
By George Friedman

At a Brazilian ethanol conference June 4-5, Brazilian government-funded researchers said they have perfected a method of producing cellulosic ethanol that drastically reduces the cost of processing. At this point, the assertion -- and many other similarly optimistic claims made at the conference -- is unconfirmed. But should it prove true, the world could well be peeking over the horizon at a massive geopolitical, not to mention economic, shift.

Discussion of all things ethanol has been all the rage in U.S. policy circles ever since oil prices rose above $50 a barrel. And why not? Ethanol already is commonly fabricated in Brazil and the United States -- which account for 35 percent and 37 percent of global production, respectively -- from agricultural products. The stuff is made and consumed domestically, bolsters a politically powerful lobby and reduces U.S. exposure to -- and dependence on -- Middle Eastern energy supplies.

But despite all the hype and the Bush administration's fascination with ethanol, there are three critical obstacles to making it a mainstay of the global (or even "simply" the U.S.) energy mix.

First, ethanol currently is produced only on an industrial scale from the food product portion of sugarcane (in Brazil) or corn (in the United States). These edible portions constitute a small percentage of the total plant mass, though, which means a large-scale ethanol sector would require massive amounts of agricultural land dedicated to it and would drive up food prices. For example, rising U.S. demand for corn-based ethanol has affected North American corn prices, contributing to the "tortilla" crisis in Mexico.

This means that if the world is truly going to make a go of mass-producing ethanol, it needs to find a way to use more than the edible portions of corn or cane. The potential solution to this problem is cellulosic ethanol, which uses enzymes to break down the whole corn or cane plant.

But cellulosic ethanol generates the other two obstacles.

The first is processing cost. Ethanol production essentially ferments the sugar in the plant, which is why traditional ethanol production deals only with the edible portions, where the natural sugars are concentrated. Cellulosic ethanol production has to first break up the cellulose. (Cellulose is polymerized sugar.) Though the price of doing that has dropped by a factor of 10 in the past decade, it is still around $2.25 a gallon.

The last -- and most critical -- is the issue of gathering the feedstock. Currently the United States has no built-in infrastructure for gathering the 90-plus percent of the corn plant that is not used in the food chain. For cellulosic ethanol to work, this chaff needs to be gathered to centralized locations for processing, and moving such bulk is an energy-intensive task to say the least. Until now, this obstacle has been the true deal killer. Making cellulosic ethanol work in the lab is easy -- making it economically viable on an industrial level brings in supply chain complications that have kept its mass application firmly on the drawing board.

Traditional corn-based ethanol is simpler in this respect not just because of chemical characteristics, but because there is already a transport chain for bringing corn to market. Cellulosic ethanol will likely have an easier time getting moving in Brazil, because it already has an infrastructure in place; farmers regularly collect the sugarcane chaff, or bargasse, and burn it to generate electricity.

Ultimately, the trick will be to make enough progress in making the enzymatic process cheaper and more efficient so that it overrides the sheer cost of collecting the plant waste and building an infrastructure of trucks, trains and barges to collect and transport the stuff.

This is why the Brazilian scientists' announcement is so important. They claim the process they have perfected reduces cellulosic ethanol production costs down to the realm of 10 cents to 15 cents per liter (35 cents to 50 cents per gallon). Furthermore, though the biochemical processes for ethanol production vary based on feedstock, they are not fundamentally different. Sugarcane is the easiest crop to turn into ethanol, but corn is only slightly more difficult, so a sugar ethanol breakthrough would be only a few steps ahead of other breakthroughs -- such as making cellulosic ethanol from nonfood crops like switchgrass -- that would democratize the technology globally.

Cheap ethanol -- meaning cheap enough to compete favorably with gasoline in a side-by-side comparison -- is one of those world-changing technologies that comes only once in a generation.

If -- and it is a big if -- the collection process can be managed, the rest of the cost of changing over to use cheap cellulosic ethanol is rather moderate; the existing vehicle fleet can already operate on a 10 percent ethanol blend (and much of it already does). Already something called E85, an 85/15 ethanol/gasoline mix, is available at limited locations throughout the United States. About 8 percent of new vehicles sold in the United States are flex-fuel capable -- able to switch between E85 and traditional gasoline -- and the Big Three automakers plan to make half of all new cars flex-fuel capable by 2012. Though an existing car on the road cannot be retrofitted, the cost of making a new car flex-fuel capable is only $75-$200, a figure that will most certainly drop as the change becomes more common. The biggest changeover cost would be distribution, since ethanol would likely require the construction of a new pipeline network specifically designed to transport it.

Should cellulosic ethanol prove cost-competitive, its cost would not be nearly as volatile as oil prices, which are notoriously fickle based on political developments in places such as Venezuela, Russia or Iraq. It also could radically change the energy and social pictures of vast regions. At the macro level it would benefit states with large agricultural sectors -- such as India, Ukraine and France -- that are traditionally energy importers. Closer to the people, it could revitalize rural regions since most of the refineries that turn cane or corn into ethanol are rather small and therefore need to be close to wherever the feedstock comes from.

Though cellulosic ethanol is obviously not a cure-all from an environmental point of view -- burning it in an internal combustion engine still produces carbon dioxide -- it is certainly a step in the right direction. According to the Environmental Protection Agency, if one takes into account all production and transport for gasoline and ethanol, cellulosic corn-based E85 reduces the greenhouse gas output by 15 percent to 20 percent.

But the real dramatic shift would hit the oil markets. Roughly 25 percent of all oil demand, and 50 percent of U.S. oil demand, derives explicitly from demand for gasoline. Erase that demand -- which amounts to 10.5 million barrels per day for the United States alone -- and oil prices would plummet. In comparison, the 1997-1998 Asian financial crisis slashed a "mere" 10 percent off of global oil demand, and that sent prices down by 75 percent.

Such a price differential would of course spur oil demand for nongasoline uses, somewhat mitigating the price plunge, and oil would still be required to fabricate everything from plastics to heating oil to fertilizer. But the underlying trend of sharply lower oil prices would be unavoidable. For states dependent on petroleum, the impact would be disastrous.

Those likely to suffer less-than-catastrophically would be the countries that could cash in on ethanol via their large agricultural sectors (Argentina and Mexico), or that are buttressed by hefty natural gas exports (Norway, Qatar and Nigeria) or both (Canada and Russia). But states that are hooked on oil as a single source of income -- Saudi Arabia, Iran, Venezuela and Azerbaijan come to mind -- would encounter massive problems.

But rather than talk about the specific effects, perhaps it is simpler to paint the broad picture. A good portion of the geopolitics of the past half century has involved obsession with access to energy, which has made the geography of energy of critical importance globally. Ethanol could well loosen that relationship, reducing the centrality of oil and the importance of geographic access. That is, of course, if it can be made to work.

SOUTH AFRICA: Some unions participating in the public sector strike in South Africa voiced lukewarm support for a 6.5 percent pay increase for public sector workers the government proposed June 4, but the unions overall rejected the new offer. The government has consistently said that meeting the union demand of a 12 percent pay raise would contribute to already rising inflation, but the strike threatens to hurt South Africa's economy if it continues. Union members -- particularly health care sector workers -- seem less willing to strike than the Congress of South African Trade Unions (COSATU) leadership would prefer, which means COSATU -- which organized the strike -- is likely leaning toward finding a resolution. The African National Congress and COSATU collaborate on political goals, so both sides are likely to seek a resolution to avoid risking their political relationship. COSATU initially called on 700,000 workers to join the strike, which began June 1.

CHINA: The Chinese government released a climate change policy paper June 4 that dovetails with U.S. President George W. Bush's June 1 statement on climate change. China's recommendations include increased energy efficiency targets, a reduction in greenhouse gas emissions in certain industries and increased use of renewable energy sources. China, like the United States, stopped short of supporting mandatory carbon emissions caps. China released the report before the G-8 summit being held in Germany on June 6-8, likely in an attempt to improve its image and standing among the other industrialized countries and to deflect criticism on more controversial financial and trade issues. China's goal with its climate recommendations appears to be to help quell rising localized tensions regarding pollution concerns and drive new foreign investments in so-called "clean technologies" such as nuclear energy, carbon sequestration and capture methods, and cleaner burning coal options.

CHILE: Chile will soon begin two projects to reduce its dependency on Argentine natural gas. Chilean energy firms Empresa Nacional del Petroleo, Endesa Chile and Metrogas, along with British firm BG Group, signed contracts to supply Chile's first liquefied natural gas (LNG) import and re-gasification terminal in Quintero Bay. Each of the Chilean firms holds a 20 percent stake in the project, and BG Group -- which will be the primary LNG supplier -- owns a 40 percent stake. The terminal, slated to be operational in the second quarter of 2009, will be able to meet up to 40 percent of Chile's natural gas demand. BG Group's 21-year contract with Chile calls for 1.7 million tons of LNG per year to be supplied to the terminal. Chile also is exploring to determine the technical and economic feasibility for submarine natural gas and methane reserve operations. The one-year project will include the analysis of seabed samples from a 965-square-mile area in the Gulf of Arauco.

RUSSIA: Rumors that Norilsk Nickel could purchase RUSAL caused the former's shares to surge 8.5 percent June 1. A merger between the two giants would create a new entity with virtually unprecedented power in the commodities industry, rivaling even Gazprom's influence. The importance of this merger, however, lies in the consequences for Russian oligarch and RUSAL owner Oleg Deripaska and the Kremlin's moves in the commodities market. If true, the merger rumors indicate that Deripaska has either become a favorite of Russian President Vladimir Putin or is making a grand finale before bowing out of Russian politics and big business.

UNITED ARAB EMIRATES: The Dubai Mercantile Exchange (DME) claimed a successful start after the exchange traded 4,008 sour crude futures contracts June 5. DME, which began trading May 31, is seeking to become the leading exchange for Middle Eastern "sour" crude -- oil that is high in sulfur content that makes up most of the Middle East's reserves. The New York Mercantile Exchange (Nymex), Dubai Holding and the Oman Investment Fund are backing DME. The exchange will benefit countries that primarily import sour crude from the Middle East because it will provide a more accurate commodity price -- traders in sour crude have typically used Nymex, which trades in sweet or light crude, to price their transactions. DME is looking to expand into other contracts, such as natural gas and metals. The exchange will likely benefit Asian countries, like Japan, that consume large amounts of sour crude and could point to further liberalization of the oil markets in the Middle East, particularly in Saudi Arabia, which has refused to trade its oil on an open market, creating the primary obstacle to establishing a crude market.

Your looking forward to paying less for gas analyst,

By John Mauldin
http://www.investorsinsight.com

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John Mauldin is president of Millennium Wave Advisors, LLC, a registered investment advisor. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. John Mauldin and/or the staff at Millennium Wave Advisors, LLC may or may not have investments in any funds cited above. Mauldin can be reached at 800-829-7273.

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