US Congress Passes Energy Bill That Boosts Ethanol Commitment
Commodities / Ethanol Dec 23, 2007 - 12:46 AMBy: Roger_Conrad
Is it a giant leap forward toward America's energy independence or a grab bag for corporations and campaign contributions? Did Congress and the president cave in to big business, or did it stick big government's nose in yet again where it can only do harm?
In the final analysis, the energy bill passed this week in Washington probably comes down somewhere in between. Like every other government bill, it was more the result of compromise and negotiation than hard science. The solution reflects the balance of power more than a debate on the merits to society.
If you're one who believes ethanol is the secret to our country's energy problems, you no doubt disagree with me. That industry got nothing less than a government guarantee for a quantum leap in market share in coming years.
Under a bill passed just months ago, ethanol was already on track for a massive ramp up. This bill nearly quintuples that commitment, with the mandated target rising from 7.5 billion gallons in 2012 to 36 billion in 2022. The goal is to cut America's use of petroleum-based gasoline by 20 percent by mixing in ethanol, as well as by raising the mileage standards for cars and trucks to an average of 40 miles per gallon.
Leaving aside the mileage standards—which will almost surely be met by consumer demand for smaller cars—meeting the ethanol goal will require roughly doubling production of corn-based ethanol, which is now the dominant form of the fuel in the US.
But Congress and the president are counting on something else: At least half the new production will have to come from a new form of cellulosic ethanol that's not yet commercially available or economically viable. The legislation requires this new industry to be up and running by 2012, with a massive ramp-up in the years following. In contrast, corn-based ethanol production is expected to basically top out by the middle of the next decade.
The cellulosic provision is no doubt an answer to the growing political pressure that's resulted from the massive increase in corn prices of recent years, which in large part is due to government ethanol mandates. The requirement for refiners to use it does, in effect, amount to a massive subsidy and huge profits for those who meet the new demand. It will be interesting to see if that incentive is enough for the science to develop within the legally mandated time table.
In any case, ethanol producers and refiners are set to be major winners from the new legislation. If the industry meets these ambitious goals even halfway, it will create one of the largest alternative fuels markets in the world, rivaled only by Brazil's sugar-based ethanol sector.
In my view, the biggest winners will be agricultural minerals providers and refiners. For one thing, as my colleague Elliott Gue has pointed out in his advisory The Energy Letter (http://www.energyletter.com), ethanol plants are already being overbuilt in this country and many are losing money.
This new legislation will inject some new life. But it's the refiners—particularly giants such as CHEVRON CORP and VALERO ENERGY CORP—that will make the margins, mixing it with traditional petroleum to meet the government-mandated requirements.
As for agricultural minerals, it's axiomatic that meeting new requirements for ethanol production means you've got to increase yields. That means either getting more out of existing lands or else opening new ones.
Either way, you need more potash for fertilizer. You need more ways to access clean water supplies. And ironically, you also need more energy for the entire process. In fact, it's highly debatable whether or not it takes more energy to produce ethanol than it creates.
The leading producer of potash is, appropriately named, POTASH CORP OF SASKATCHEWAN. That stock has definitely run in recent years. But it has a long way to run and not just from growth in US ethanol production.
Developing Asia is enjoying rising incomes and, therefore, demand for more complex foods is soaring. That means more demand for fertilizer and water.
THE REST OF THE BILL
Ethanol's victory, of course, represents the power of farm state congressional representatives and senators, which has been augmented by election-year politics. As far as investing goes, however, the reason for passage is irrelevant. What's important is the opportunity it presents, which is considerable.
Power utilities were more modest winners from the energy legislation, both for what was and what wasn't in the final bill. The biggest example of the latter was a provision to mandate a national standard that all utilities derive at least 15 percent of their output from designated “renewable” energy.
Under the version that passed the House of Representatives initially, that included only sources such as wind, solar, biomass, tidal and geothermal, most of which are still in their infancy. Such standards already exist in two-dozen states. Imposing them nationally, however, would have required massive changes in many states, particularly in the South and Midwest, where coal is most heavily used.
Coal reliance has meant these areas have enjoyed some of the lowest customer rates in the country for decades. A massive government-ordered switch to wind, for example, would have presented enormous technical and possibly financial difficulties for many companies.
Fortunately for them, they had an extremely powerful champion—SOUTHERN COMPANY—who lobbied heavily to strip the provision from the bill. In the end, enough senators pledged to block the mandate, and it was taken out.
Renewable-fuel mandates are far from dead, and proponents have vowed to take them up again next year. Failing that, they'll be back in the Congress that will take over in 2009 and, barring a huge drop in fuel prices and global levels of carbon, support for them will only become more intense.
The key for industry, however, is they now have more time to put their plans in motion to meet likely future mandates in their own way. Major coal user DUKE ENERGY, for example, has dramatically increased its presence in wind power in the past few months, buying 100 wind turbines capable of producing 150 megawatts of power from GE this week.
Southern's Southeast US service territory isn't as wind-rich as Duke's Midwest and mountain Carolinas base. But it's also bought time to get its house in order, especially for controlling carbon-dioxide emissions.
The company's strategy centers on plans for major new nuclear power plant capacity, as well as revolutionary new clean coal technology. Southern is part of the FutureGen Coal Power Plant consortium, a 275-megawatt, commercial-sized prototype plant that will couple integrated gasification combined cycle (IGCC) with carbon-capture technology.
If successful, it will be a model for producing economic power even while removing virtually all harmful emissions from even the dirtiest coal. The latter it will have in plenty, courtesy of the plant's newly announced Illinois location.
FutureGen is being heavily financed by direct US government grants and tax breaks. It's considered a signature project by the Bush administration in its drive to find another path to reduce carbon emissions in the US, without establishing hard-number requirements for companies.
That strategy has earned the president a great deal of scorn in Congress and among environmental advocates. Success of FutureGen—which projects to be operational by 2012—could go a long way toward silencing those critics. It would also be a huge step forward toward reducing carbon emissions economically, i.e., without massive rate increases.
On the other hand, the technology is in development, and the estimated cost of the plant has risen 56 percent in the past three years. Those federal grants are essential to FutureGen and, like everything else in Washington, are subject to politics.
A future Democrat in the White House may not be so favorably inclined toward such coal projects, given the clout of the environmental lobby in the party. That probably wouldn't apply to Sen. Obama, however, given his coal-state origins.
Although the success of FutureGen-like prototype projects remains dependent on favorable politics, one provision of the new energy legislation will provide a huge boost to projects based on more established technology: a huge increase of guaranteed loans from the US Dept of Energy for builders of a new generation of nuclear power plants ($18.5 billion), uranium enrichment projects ($2 billion), clean coal technology ($8 billion) and renewables/energy efficiency projects ($10 billion).
In effect, the loan guarantees will cover up to 80 percent of approved projects. That amounts to an enormous reduction in financial risk for builders of these projects and dramatically increases the chances the new plants going through the approval process will ultimately be built.
Last week, Duke Energy filed with the Nuclear Regulatory Commission (NRC) to build a two-unit nuclear power plant in Cherokee County, S.C. It was the fourth combined construction and operating license application submission to the NRC by a US utility for new nuclear-generating units and the first to request permits for an entirely new plant.
Loan guarantees or not, the nuclear power industry still has huge barriers to entry. Giant, independent power producer NRG ENERGY is attempting to build one in Texas, with the output to be sold entirely into the state's unregulated power market. But its effort is the exception that proves the rule in an industry that's increasingly dominated by the handful of companies that have been buying up existing nukes around the country in recent years.
The big seven--CONSTELLATION ENERGY, DOMINION RESOURCES, Duke Energy, ENTERGY CORP, EXELON CORP, FPL GROUP and Southern Company--aren't the only owners and operators of nuclear power plants in the US. But by applying the economies of scale of multiple plant ownership, they're easily the most profitable. And their dominance of this type of power will only grow in coming years because they're the only companies with the size and financial power to build new nukes.
As for nuclear power itself, the problem with the last generation of plants was construction costs, which mushroomed well beyond original projections of the builders. When the bills came due, regulators balked at passing the overruns onto ratepayers, and the result was financial disaster to the utilities.
This time around, there are some of the same potential problems. For one thing, raw materials costs are soaring across the board. For another, it's been nearly a generation since the last building cycle for power plants, and there's a potential shortage of qualified personnel.
Consequently, it's entirely possible the cost of this construction cycle will wind up being well beyond what anyone expects now—and that regulators with the benefit of 20-20 hindsight will disallow a good chunk of the costs as imprudent.
What's different is the US financial guarantee, along with the fact that this industry is far better consolidated than it's ever been. The last generation of nukes was built largely by individual regional utilities. In some cases, the cost of the plants wound up equaling more than shareholders' equity. Writeoffs and disallowances literally melted down balance sheets.
This time around, however, the giants are larger. And after five years of financial recovery from the 2001-02 bear market, they're financially stronger than ever. Risk is further reduced by obtaining rate commitments from regulators for the cost of major new projects in advance.
The upshot: The group of seven nuclear giants is set for big gains as their existing plants sell into a carbon-constrained market. Meanwhile, their new generation of plants—though still some years off—ensures those profits will keep flowing.
For the utilities that can't afford to build a nuclear plant, energy efficiency and conservation technology are the most attractive road to meeting carbon regulation, as well as the projected 40 percent increase in US demand for electricity by 2030. Every “negawatt” in energy savings achieved is one megawatt of new capacity a utility doesn't have to build and wrestle with regulators to recover investment. In fact, companies nationwide are reaching deals to recover investment in negawatts immediately, resulting in an immediate payoff in earnings
Negawatt technology is, of course, still in its infant stages. But one essential element is already clear: measuring it. The linchpin is advanced metering technology, which allows customers and utilities to monitor how they use electricity as never before.
The leader by far is ITRON, a former subsidiary of a regulated utility that's now grown into a multinational enterprise serving more than 8,000 energy and water utilities. The company recently inked a major contract to upgrade some 5.3 million meters for EDISON INTERNATIONAL'S utility unit Southern California Edison. Revenue has more than doubled in the past year, and there's a lot more ahead as rising energy prices induce more companies to get a grip on usage.
Oil companies were beneficiaries of the energy legislation in one major way: A provision to tax them an additional $13 billion was stripped out, even though it was designed to pay for subsidies to extremely popular wind, solar, geothermal and other alternative energy sources.
Odds are heavy this is one provision that will come back in future legislation. That's a fight for another day for this industry, which is enjoying record demand and high prices but also is dealing with increased scarcity and rising resource nationalism.
On balance, it's not a bad situation to be in. Super Oils in particular are the strongest they've ever been financially. And the stocks are arguably cheap because some investors have sold on recession fears.
Ironically, these are precisely the kind of stocks you want to own in times of economic weakness: AA and AAA-rated companies that dominate what's still the most important commodity to the modern world. And they pay big yields as well.
My favorite of the bunch is Chevron, which ironically stands to be a major winner from the ethanol boom as well, thanks to its large global refining operation. The company also has very promising projects in conventional oil and gas around the world, as well as unconventional, such as extremely deep drilling projects in the Gulf of Mexico.
Some may call me a cynic. But after living in the Washington area for more than two decades, I call it realistic. Basically, the real winners from any piece of Washington legislation are going to be rich, powerful companies—those who finance the campaigns that get people elected.
As investors, those are usually the best companies to invest in to take advantage of legislation. And happily, they also tend to be the best stocks to own anyway.
Whether you love this legislation or hate it, it won't be the last for energy. And it's no secret energy companies will be spending heavily to influence politicians and the public in coming months and almost surely well past the November 2008 elections.
It's up to the companies to try to influence what happens and then position for it. And it's up to us investors to keep tabs on what they do, how successful they are and, most important, whether we want to own them.
By Roger Conrad
KCI Communications
Copyright © 2007 Roger Conrad
Roger Conrad is regularly featured on television, radio and at investment seminars. He has been the editor of Utiliy Forecaster for 15 years and is also the editor of Canadian Edge and Utility & Income . In addition, he's associate editor of Personal Finance , where his regular beat is the Income Report. Uniquely qualified to provide advice on income-producing equity securities, he founded the newsletter, Utility Forecaster in 1989. Since then, it's become the nation's leading advisory on electric, natural gas, telecommunications, water and foreign utility stocks, bonds and preferred stocks.
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