The Economics of Missing Variables

Written by Brian Hicks
Posted December 28, 2005

I'm getting some emails regarding Spectrum Organics. Specifically, that it appears that Spectrum hasn't traded for the past few days.

The fact of the matter is that Spectrum was acquired by Hain Celestial. Here's the announcement:

Spectrum Organic Products, Inc. (SPOP - OTCBB) announced that the merger with The Hain Celestial Group, Inc. ("Hain") was completed on December 16, 2005. Under the terms of the merger, Spectrum shareholders will receive $0.7035 per share, after deducting for excess company expenses, consisting of $0.3485 per share in cash and $0.355 per share in Hain Celestial shares, which is based on valuing the Hain shares at $19.80 per share, as provided in the merger agreement. The Spectrum merger will increase the amount of Hain Celestial shares outstanding by approximately 924,459 shares.

I originally brought Spectrum Organics to your attention in the Spring of this year when the stock was trading for about $0.45.

So there you go.

Spectrum is going to be just one of many homeruns we hit as the trend in the LOHAS market explodes in the coming years.

I hope you join me for the ride.

Now, for the next round of profits...

Last Saturday I took a trip up to Pennsylvania to visit my cousin. He lives on a street with three other homes tucked safely within miles and miles of pristine farmland. It's really quite a sight.

About an hour away from my destination, while at a gas station in the middle of nowhere (a pleasant respite from the traffic outside the Wealth Daily office in Baltimore) I thumbed through a local paper to see what kinds of things were going on in this rural area of the keystone state during the holidays.

After a brief chuckle over the police blotter, where it seems that a couple of traffic cones were stolen from a road construction site (and wishing that was the type of criminal activity that gripped Charm City on a daily basis), I came across a story about a nearby farm that's about to start pumping out ethanol.

Now before you write the first draft of your "are you insane?" e-mail to me regarding the inefficiencies of ethanol - let me assure you that my intention today is not necessarily to sell you on ethanol efficiencies…but rather ethanol profits.

That is why you're here, isn't it? Yeah, me too.

The economics of missing variables

Often, the economics of any new energy technology (not that ethanol is necessarily new) are compared with those of oil. It has become our measuring stick as it tends to be quite inexpensive when there's plenty of it around.

However, are we as investors being given all the necessary variables of the 'efficiency' equation to make an educated decision?

The argument against ethanol production is simply that it uses more energy than it delivers. (I have stacks of studies that both support and contradict this argument)

In other words, the energy returned is less than the energy invested. I'm sure you know about energy returned on energy invested (EROEI), so I won't waste your time with an economics lesson here.

But how accurate is the analysis of EROEI in regards to ethanol? Are we really taking everything into consideration here?

Well, I suppose it depends on who you ask and how much they have invested in their respective market.

Newer technologies have certainly enabled ethanol producers to disprove the argument that ethanol production uses more energy than it delivers. But until we see the utilization of these newer technologies on a mass scale, opponents will continue to dredge up studies that, fortunately for the ethanol industry, will probably be completely irrelevant by the end of 2006.

But newer technologies aren't the only thing that's keeping the ethanol momentum alive.

The MTBE factor

Back in 2004, California, New York and Connecticut discontinued the use of MTBE in reformulated gasoline (RFG). The ethanol industry was quick to fill the void and grab a sizeable chunk of these new markets.

Ethanol opponents predicted that the switch to ethanol in these three states would massively increase consumer gas prices. But the switch ended up going so smoothly, both state and federal observers agreed that there was no negative impact on gasoline supplies or prices.

In fact, increased ethanol use actually helps lower gasoline prices by expanding U.S. gasoline supplies and reducing the need for importing high-octane, petroleum-based gasoline components or more crude oil from the Middle East.

There's no doubt anymore that MTBE bans will continue from both state and federal rulings - and you can be certain the ethanol industry will be there to tap those markets as well.

As of June, 2005, 21 states have banned MTBE.

Renewable Energy Cycles

Ethanol producers also tout their ability to produce lucrative co-products.

Sure, we know they exist - but to what extent do these co-products have on the end-use of ethanol production and production facility operations?

And are these co-products being figured into the equation as well?

Again, it depends on who you ask.

Nonetheless, today's newer wet mill ethanol plants are producing a number of different products - from carbon dioxide used in soft drinks to corn gluten which is used to feed livestock to massive amounts of corn sweeteners that can be produced during the summer months, when demand is at its highest, while the ethanol is being produced during the winter months.

Another lesser-known co-product of ethanol however, is one that is still relatively new…and rarely mentioned as the technology used to extract this co-product is still in its infancy.

You see, because ethanol packs a lot of energy - about 80 percent that of gasoline, researchers at the University of Minnesota looked into extracting hydrogen directly from ethanol - which would make for a type of renewable energy cycle.

It works like this...

The Virtuous Circle

You feed ethanol with water into the top of a reactor. The fuel injector vaporizes the fuel and sprays the drops onto a hot surface to make a mixture of mostly ethanol with a little air and water. The end result is an application that quickly makes hydrogen which can then be fed into fuel cells.

My point is, ethanol is not the only resource an ethanol plant can pump out. Therefore, these additional outputs also need to be figured into the equation from as early as R&D (if we plan to move towards energy independence and away from backward-thinking stubbornness leading to stalled innovation) to practical use - as we see in today's E85 mixtures (85% ethanol, 15% gas).

Of course, there is the argument that ethanol, and the E85 mixtures we're now seeing in use only exist because of tax credits and billions of tax dollars funneled into the DOE's research programs.


But let us also not forget the billions of tax dollars spent on military costs that are directly related to our dependence on imported oil from the Persian Gulf. In other words, we spend tens of billions for the US Navy to protect shipping lanes, potential chokepoints and to protect oil tankers from pirates.

Though the cost doesn't get passed to you at the pump, the American taxpayer subsidizes the military protection of precious oil. So the real cost is somewhere in the neighborhood of $5 to $6.

According to Richard Clark in his book Petrodollar Warfare:

"Some believe that the Iraq War was justified so that the US can continue to enjoy 'cheap' gasoline. Americans think that their gasoline prices are far lower than elsewhere, partly because they believe their gasoline taxes are 'lower.'

This false construct does not withstand careful analysis.

When the indirect/hidden taxation for our empire of military bases is included, the fully loaded price of gasoline for a US consumer equals or exceeds the prices in other industrialized nations.

In 1998 the International Center for Technology Assessment computed that Americans indirectly pay a minimum of $5.60 per gallon, and potentially much higher based on current tax subsidies to US energy companies, defense department expenses, environmental costs, and other externalities.

In 2003 the conservative National Defense Council Foundation's study debunked this powerful myth of 'cheap' gas. The truth is much more complex, stemming from the real taxpayer cost of the US' empire of bases.

Their study, which revealed the true cost to be over $5.20 per gallon reported: Almost $49.1 billion in annual defense outlays to maintain the capability to defend the flow of Persian Gulf Oil -- the equivalent of adding $1.17 to the price of a gallon of gasoline; The loss of 828,400 jobs in the US economy; The loss of $159.9 billion in GNP annually; The loss of $13.4 billion in federal and state revenues annually; Total economic penalties of from $297.2 to $304.9 billion annually."

So, are these costs accurately being figured into EROEI equations as well?

Understand, this is not a political stance regarding the war or fighting terrorism in the Middle East. You won't find my footprints on that soapbox. This is simply an observation of a real cost that's conveniently being ignored.

Ethanol opportunities

Now I'm not naïve enough to believe that everyone and his mother is going to run out tonight and demand E85 from the local gas station/mini-mart. In fact, ethanol is just one part of the collective patchwork that's validating the acceptance of renewable energy.

However, I do believe that savvy energy investors know an opportunity when it hits them in the face with all the subtlety of a brick.

Thanks in large part to a 'cent-per-gallon' excise tax credit, ethanol producers have been able to move forward with new technologies that have allowed ethanol production to become more economically viable. And whether you like ethanol or not - they're not going to stop pumping it out anytime soon.

In fact, under the passage of this past summer's Energy Security Act, provisions were made that will double the usage of renewable fuels in the United States - such as ethanol.

And some of today's biggest agribusiness, like Cargill and ADM are now building 'super-sized' ethanol production facilities to get in on the action.

ADM currently owns seven ethanol plants, and announced last September that it plans to expand its ethanol capacity by 500 million gallons through the construction of two new dry mill facilities.

And Cargill announced last month that it was planning to more than double its ethanol capacity with a new 110 million gallon per year ethanol plant in Blair, Nebraska…raising its total annual U.S. production capacity to 230 million gallons.

Granted, based on U.S. demand, this is just a drop in the bucket.

In 2004, U.S. demand was 3.57 billion gallons. And by 2012, the renewable fuel standard increase will take us to 8 billion gallons.

Over the next few years especially, ethanol producers will be pumping this stuff out faster than ever before. New facilities will be constructed all over the world, new technological advances will be made to further the efficiency of ethanol production and new fortunes will be built in the process.

In January I'll have a new ethanol recommendation for Green Chip Stocks subscribers. As well, I'll have more on ethanol in my free daily Green Chip Review.

If you're not already a member, you can sign up for the free Green Chip Review here.

Until next time...

Jeff Siegel
Editor, Green Chip Stocks