Biofuels: Supply increases are inevitable based on US RFS. How should you capitalize?

Substantial supply will be driven by the US 2012 Renewable Fuel Standards (RFS), and the US 2012 Clean Air Act, which require 18.7 billion gallons of domestic production of cellulosic, biomass-based diesel, advanced biofuels, and renewable fuels Demand for biofuels is being largely supported by the Department of Defense, and the Commercial Aviation sector, as well as the Petroleum refining sector (with E5, E10) ethanol.

It is clear that supply of biofuels, particularly drop-in crude/diesel, bio-diesel, and some variant of blended ethanol/biobutanol will increase in 2012.  Demand should also increase. 

But how should an investor play this surge in supply/production activity?

My opinion: Play the catalysts

Catalysts for biodiesel conversion: Sodium Hydroxide

Catalysts for Fischer-Tropsch diesel: Cobalt, Iron

Catalysts for ethanol and butanol conversion: Engineered yeasts, GMAX strain

Recommendations

As production scales up, the quantity of catalysts required for catalytic conversion of feedstocks to biofuel will increase accordingly.  As  companies shift from demonstration biofuel plants to commercially viable facilities, the quantity of catalysts required will increase substantially.

Who should benefit:

Codexis (CDXS), a publicly traded bioenergy firm engaged in the research, development and commercial production of engineered biocatalysts, is well positioned to capitalized on increased biofuel production.  See this brief from the company, which explains the major biofuel platforms targeted.  In addition, their operating earnings are trending positive on strong increasing revenue.

Rentech, Inc (RTK), is a firm that specializes in the Fischer-Tropsch diesel production process, and can produce F-T diesel from a variety of cellulosic and non-cellusosic sources.  This agility minimizes risk exposure to rising agricultural commodity prices, as they can shift into a lower-cost feedstock in the short-term.

Cosan (CZZ), is a Brazilian firm engaged in the production of ethanol, using switchgrass as a feedstock.  Substantial quantities of sugarcane and switchgrass are being diverted from food production to ethanol production, resulting in high sugar prices.  Cosan’s top-line revenue is accelerating.  While their debt relative to assets is higher than I prefer, I see increasingly improving market dynamics that should benefit Cosan.  Their current P/E of 4.5x earnings suggests they may be undervalued against similar peers such as Green Plains Renewable Energy (GPRE) at 10.38x earnings.

DOW Chemical (DOW), is the world’s largest producer of sodium hydroxide (lye).  Lye is used in both the biodiesel production process, and the treatment process of natural gas.  The growth in demand from commercially viable biodiesel and biofuel providers, coupled with the massive exploitation of US and Canadian shale plays, should result in greater demand of lye, which may subtly boost Dow earnings, although Dow is a massive integrated conglomerate, and the contribution of this component is obviously relatively small.   Dynamics in the manufacturing sector, and low natural gas prices for the foreseeable future, though, suggest that in the short-term Dow should see more downstream and upstream demand.  Their financials, in my opinion, are less attractive.  Their net debt relative to assets remains relatively, so I see this as a short-term opportunistic play only.

Players to Watch:

Gevo (GEVO) recently filed a lawsuit against Dupont and Butamax patent dispute over their commercial fermentation process.   The outcome of this lawsuit will be sometime down the road, but the intent indicates that Gevo’s production process may be commercially viable.  My assessment of their financials suggests that investment is premature, but their positioning, shifting from an ethanol to biobutanol production strategy, is in line with my assessment of growth opportunity in biofuels space.

Sources:

Bloomberg.com

http://www.dow.com/productsafety/finder/caustic.htm