Government mandates in Brazil have an even longer history, dating back to 1976. The mandated percentage of ethanol is higher than in the US (it has mostly fluctuated between 20% and 25% for a decade), and car companies there have developed flex-fuel vehicles that can run on varying concentrations of ethanol. Ethanol in Brazil is produced from sugarcane, as opposed to US ethanol, which is almost entirely derived from corn.

Weather and market forces have recently been kind to US ethanol producers, with an expected bumper corn crop lowering the price of their main input, while ethanol prices have been propped up by the high price of gasoline refined from increasingly expensive crude oil.

Investors looking for exposure to this industry with historically volatile fundamentals need to be aware of the specific risks involved. In addition to the inevitable fluctuations in commodity prices these include the risk of changes in public policies supporting biofuels. Continued government support is critical for the industry, but in my estimation is unlikely to waver.

Those wishing to invest in publicly traded ethanol companies have options in Pacific Ethanol (NASDAQ: PEIX) — which we recommended in the previous Energy Strategist — or Green Plains (NASDAQ: GPRE), which we’re adding to the Aggressive Portfolio today. REX American Resources (NYSE: REX) and agribusiness giant Archer Daniels Midland (NYSE: ADM) also produce ethanol. So does the refiner Valero (NYSE: VLO), which purchased 11 corn ethanol plants with a production capacity of more than 1.3 billion gallons per year; Valero blends much of this ethanol into its gasoline.

Biodiesel

Biodiesel is the second largest category of global biofuel, accounting for 6.9 billion gallons globally in 2013 — 22.6% of total biofuel production. Biodiesel is derived from reacting fats like vegetable oil with an alcohol like methanol. The products of the reaction are biodiesel and glycerin.

The chemical structure of biodiesel is distinctly different from that of petroleum diesel. Petroleum diesel is composed of only hydrogen and carbon (hydrocarbons), but biodiesel also contains oxygen. This gives biodiesel somewhat inferior physical and chemical properties compared with petroleum diesel.

A key difference is that biodiesel will gel and freeze at higher temperatures than petroleum diesel. This can cause fuel filters to plug if the biodiesel concentration is too high in cold weather conditions. Thus, biodiesel tends to be blended at much lower levels with petroleum diesel in cold weather, and is unsuitable for aircraft that fly at high altitudes.

On the other hand, biodiesel is relatively easy to produce. Unlike many alternative fuel technologies, biodiesel can be made in a garage from widely available waste cooking grease with minimal equipment or training. Most alternative fuel technologies have much larger capital expenditure and expertise requirements.

Biodiesel is produced and used in numerous countries around the world, and is the most commonly used biofuel in the European Union. The EU produced 2.8 billion gallons of biodiesel in 2013, 40% of the global total. Many EU countries have biofuel mandates that encourage the use of biodiesel, although some countries have weakened their mandates in recent years over concerns that cultivation of certain biodiesel feedstocks was encouraging deforestation.

As with ethanol, the US was the largest national producer of biodiesel in 2013. US production in 2013 was 1.4 billion gallons, produced primarily from soybeans. Production exceeded the mandate from the RFS, which covers ethanol, biodiesel, and advanced biofuels, and which called for inclusion of 1.28 billion gallons of biodiesel in diesel fuel markets in 2013.

Behind the US in biodiesel production were Germany and Brazil, which increased production by by 16% and 5% respectively in 2013, to 820 million gallons and 766 million gallons. Argentina was the fourth largest producer with 608 million gallons. France was the world’s fifth largest biodiesel producer, but is moving toward reducing its biofuel mandates.

Most of the major biodiesel producers consumed what they produced. China, on the other hand, is a significant consumer of biodiesel, but satisfies most of its demand by importing biodiesel from Southeast Asian producers like Malaysia and Indonesia. In fact, I visited Malaysia several years ago and asked a palm oil producer if the EU’s concerns about the sustainability of palm oil (production of which has caused deforestation in Malaysia and Indonesia) might affect their growth, and I was told that China had no such concerns and would buy every drop they could produce.

Texas has the most biodiesel production capacity in the US with 414 million gallons per year spread across 10 plants. Iowa is second with 290 million gallons of annual capacity among its 10 plants. Investors looking for exposure to US biodiesel production have few options, as most of the producers are privately held (e.g., Cargill). Renewable Energy Group (NASDAQ: REGI) is one of the few publicly traded options. The company has 10 working biorefineries across the US and is one of the country’s leading biodiesel producers.

Hydrotreated Vegetable Oil

Hydrotreated vegetable oil (HVO) has emerged as an attractive alternative to biodiesel in recent years. With this process the same kinds of vegetable oil feedstocks that are used in biodiesel production are reacted with hydrogen in a process called hydrotreating — a common process in the petroleum industry. The products of this reaction are diesel-length hydrocarbons (also known as “green diesel”), with propane produced as a byproduct.

The primary advantage of hydrotreated green diesel over biodiesel is that the product is chemically equivalent to petroleum diesel, so it can be used in diesel engines in any concentration with no modifications. The disadvantage is that the capital costs of hydrotreating equipment are much higher than for the equipment required to produce biodiesel, and thus the process requires larger scale to be economical.

HVO accounted for only 2.7% of global biofuel production (820 million gallons), but grew by 16% in 2013. In 2013 HVO production took place primarily in Europe (475 million gallons), Singapore (238 million gallons) and the US (80 million gallons).

The HVO space is dominated by Finland’s Neste Oil (Helsinki: NES1V, OTC: NTOIY). Neste began developing its hydrotreating technology — called NEXBTL — in 2002, and in May 2007 started up a plant at its Porvoo refinery outside Helsinki, Finland with an initial capacity of 55 million gallons per year of HVO. The feedstock for the HVO refinery is vegetable oil and animal fat, and in 2009 the capacity was doubled to 110 million gallons. In November 2010, Neste commissioned the largest HVO plant in the world in Singapore with a capacity of 245 million gallons per year (800,000 metric tons), and in 2011 started up another 245 million gallon per year HVO refinery in Rotterdam. The Rotterdam facility is Europe’s largest renewable diesel refinery, and to my knowledge this facility and the Singapore plant are the two largest biofuel plants of any kind in the world.

Besides Neste, HVO processes have been developed by Honeywell (NYSE: HON) subsidiary UOP, Syntroleum (recently purchased by Renewable Energy Group), ConocoPhillips (NYSE: COP) and Petrobras (NYSE: PBR). Syntroleum formed a joint venture with Tyson Foods (NYSE: TSN) called Dynamic Fuels LLC, which opened a $150 million facility in Geismar, Louisiana in 2010 with an annual HVO capacity of 40 million gallons per year.

Conclusions

Global biofuel production continues to be dominated by ethanol, and the US is the world’s dominant biofuel producer — leading in both ethanol and biodiesel. HVO is the world’s third largest volume biofuel and its production is growing at a faster pace than the more mature ethanol and biodiesel industries.

Biofuel volumes will continue to be heavily influenced by government policies and subsidies, and some weakening of these policies has hurt both the ethanol and biodiesel industries in several countries. There are opportunities for investors wishing to place their bets on the future of biofuels, but you have to be comfortable with the role that governments will play in the future success of these fuels.

(Follow Robert Rapier on Twitter, LinkedIn, or Facebook.)