Ethanol Investments: Answers to the Questions on Ethanol Plus Three Promising Stock Plays

by Mark Skousen

Ethanol Investments: Answers to the Questions on Ethanol Plus Three Promising Stock Plays

by Mark Skousen, Chairman, Investment U

Tuesday, August 15, 2006: Issue #571

Is investing in stocks whose products are heavily subsidized by the government a guaranteed way to make money?

We can answer that question by looking at ethanol investments, today's most popular "guaranteed" way to profit from the current energy crisis...

Given that two-thirds of oil and gasoline consumption comes from foreign sources, alternative energy is all the rage these days, whether it be electricity, coal, nuclear power or more exotic sources such as solar power, fuel cells, wind power, manure, and of course, ethanol.

Not all energy alternatives require heavy subsidies, but most exotic energy sources are far from profitable in an unrigged market, and therefore many producers are insisting on a break from the government. The federal government has gotten involved in a big way by offering billions of dollars in tax breaks and subsidies to farmers and manufacturers as Americans seek ways to reduce their dependence on foreign oil.

"From wind or solar to generate electricity to diesel fuel made from soybeans or lard, just about every conceivable alternative that hasn't been able to compete on its own is getting favorable tax treatment," states the Heritage Foundation.

Today, let's focus on ethanol in particular...

Ethanol Investments - Investing in the Fuel Favored By Congress and Auto Makers

The government's biggest example of corporate welfare is ethanol. For the uninitiated, the fuel is distilled grain alcohol blended with gasoline. The purpose is to subsidize American corn farmers and at the same time reduce dependence on foreign oil. Recently, Congress has encouraged U.S. refiners to replace the additive MTBE (methyl tertiary-butyl ether, which is used to make gasoline burn cleaner) with ethanol.

The Energy Policy Act of 2005 required gasoline producers to nearly double the use of renewal fuels such as ethanol by 2012. It passed by a large margin, with support from democrats and republicans, as well as most state legislatures. Moreover, GM, Ford and Chrysler all favor the greater use of ethanol.

With a 52-cent tax credit associated with every gallon of ethanol, the price of ethanol has risen sharply over the past few years. (See the chart below.) Wholesale ethanol is selling today for $3.40 a gallon. But since ethanol contains only two-thirds the energy content of conventional unleaded gasoline, the equivalent price of a gallon of conventional unleaded would be $5.10 a gallon! Meanwhile, the wholesale price of conventional unleaded is around $2.10.

In short, we are paying an awful lot for our fear of foreign oil.Choose Your Ethanol Investments Wisely

Despite the rising price of ethanol, investing in ethanol producers is not always a guaranteed moneymaker. Pacific Ethanol (Nasdaq: PEIX) is the biggest pure play on ethanol production, yet it is not expected to turn profitable until next year. A few months ago, Pacific Ethanol was selling for more than $40 a share. The stock has recently corrected, though, trading under $20.

The giant agriculture company Archer-Daniels-Midland (NYSE: ADM) obtains about 25% of its operating profits from ethanol and related byproducts, and is spending billions on ethanol and bio-fuel production in Europe. Its stock has tripled in the past two years, though it has recently pulled back.

There is an exchange-traded fund (ETF) that specializes in ethanol and other alternative energy sources: PowerShares WilderHill Clean Energy (AMEX: PBW). PBW came out at around $15 in March 2005, climbed to $24 in May 2006, and is now at $18 a share.

It may be a good time to buy ethanol stocks and alternative energy stocks. Just remember that they can be hurt by lower and higher inflation. If oil prices drop, the demand for ethanol will drop accordingly. On the other hand, higher commodity inflation is no guarantee that ethanol stocks will go up with other commodity stocks. If corn prices climb with other commodities, the profit margin of ethanol producers could fall and their stock price could fall with it.

The lesson is clear: Government subsidies are no guarantee you will make money.

Good trading, AEIOU,

Mark

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