Profiting in biofuels

Production of ethanol in the U.S., nearly all of it distilled from the starch and sugar in corn, is growing explosively. Although the federal government mandated that the oil industry use at least 7.5 billion gallons of biofuels by 2012, the main impetus behind the surging demand has been its role as a replacement for a gasoline additive now believed to be a carcinogen. Many states now mandate at least 10 percent ethanol content ("E10" at the pump) in gasoline.

What are the risks of investing in ethanol? Falling oil prices and rising corn prices would squeeze ethanol refiners' profit margins. Demand for ethanol now exceeds supply, but dozens of plants are under construction, and supply could catch up by the end of 2008. For now, however, the established companies are solidly profitable.

Any discussion of ethanol stocks should start with industry giant Archer Daniels Midland. ADM pioneered the U.S. industry in the 1970s, lobbied aggressively (and successfully) for tax breaks and has dominated ever since. ADM declined to talk to us, but it's clear that the ethanol boom is behind a 160 percent surge in profits (to $1.3 billion) over the past two years. The big commodities processor is also a major factor in Europe's biodiesel industry, the most developed in the world, and its expertise is carrying over to its operations in the U.S. and Brazil. The stock (symbol ADM) recently traded at $38 a share.

If it's a pure ethanol producer you seek, consider Aventine Renewable Energy (AVR). Since going public in June at $43, Aventine's shares have slumped to $22, making them far more attractive. Aventine is both a major producer of ethanol and a distributor for other distillers. Analysts expect Aventine to earn $1.95 a share in 2006.

If ADM is the king of corn processing, then Bunge (BG) rules over oil seeds. So it's no surprise that Bunge, based in White Plains, N.Y., entered into biofuels through Europe, where rapeseed (canola to North Americans) is the crop of choice for biodiesel. Now cosmopolitan Bunge is building biodiesel plants in Illinois and has announced ethanol projects in Iowa and Mississippi situated near its corn elevators. The stock recently traded at $59 a share.

You can play Brazil's booming ethanol market through Petrobras, whose shares trade in the U.S. as American depositary receipts. The company doesn't produce ethanol, but as the nation's dominant oil refiner and largest gas-station operator, Petrobras (PBR) is the world's largest purchaser of ethanol. At $84, the stock trades at six and a half times estimated 2007 earnings.