Last week the U.S. Environmental Protection Agency (EPA) announced that just over 1 million gallons of cellulosic ethanol was produced during the first quarter of 2016. In fact, production for the month of March jumped 64% from February to 446,000 gallons, a record. Production is well ahead of the pace in 2015, when 2.2 million gallons of cellulosic ethanol were produced during the entire year.   

This sort of rapid production growth is sure to catch the attention of investors, who will wonder whether there is an opportunity to make money. I am often asked about investment opportunities in the renewable fuel industry, and in particular the advanced biofuel area. So let’s do a quick primer, and put everything into proper perspective.

First, let’s define a couple of terms. For the purpose of this discussion a renewable fuel is considered to be one that is derived from recently living plants, commonly referred to as biomass. First generation renewable fuels (aka “biofuels”) are those made in large volume today, which includes ethanol produced from corn and sugarcane and biodiesel made from vegetable oils. Of the 127.7 billion liters (34 billion gallons) of biofuel produced in 2014, 97% was from conventional ethanol (74%) or biodiesel (23%) processes:

Second generation biofuels, also commonly known as “advanced biofuels,” generally fall into one of two categories. Hydrotreated vegetable oil (HVO), also known as “green diesel,” is produced from hydrotreating technology using the same feedstocks as conventional biodiesel. Instead of reacting the feedstocks with methanol as in the conventional biodiesel process, they are reacted with hydrogen. The products of this reaction are diesel-length hydrocarbons — green diesel — and propane (instead of the glycerin byproduct in conventional biodiesel production).

The technology hurdle for green diesel is higher than for biodiesel, and as a result there are fewer players. The global leader is Finland’s Neste Oil (HEL: NESTE), although there are a handful of other competitors. The most popular feedstock for this process to date  has been palm oil, but this feedstock has also been highly criticized for environmental reasons.

The second category of advanced biofuel is the one presently of greatest interest in the U.S., and that is cellulosic ethanol. Conventional ethanol production uses a fermentation process to convert starches or simple sugars to ethanol. Cellulose is an important structural material for plants, and it is made up of many repeating sugar units. These repeating sugar units can be broken down by various processes into the component sugars, which can then be fermented into ethanol. This is the process typically referred to as “cellulosic ethanol,” resulting in the one million gallons of cellulosic ethanol produced thus far in 2016.

To this point, the advanced biofuel sector has been a money pit for investors. While there aren’t any publicly traded companies whose focus is primarily cellulosic ethanol, there are a number that have already gone bankrupt or are in the process of doing so by trying to produce an advanced biofuel that can compete with oil. KiOR is probably the most famous publicly traded example, going from an IPO that valued the company at $1.5 billion in 2011 to bankruptcy in 2014. Other companies that have competed in the advanced renewable hydrocarbon space have seen 90% or greater losses since their IPO (e.g., Solazyme, Gevo, Amyris).

The explanation is pretty simple. Advanced biofuel proponents will point fingers in many directions, but imagine for a moment what they are attempting to replicate. With petroleum, which is just ancient biomass, nobody had to plant or harvest or apply the heat and pressure to convert the biomass into an energy-dense liquid fuel. With biofuels, you have inputs of energy and manpower at every step — and the cost of those inputs adds up. That’s why petroleum made from ancient algae can be produced for a couple of dollars per gallon, while renewable fuel produced from recently living algae can cost 10 times more.

Circling back to cellulosic ethanol, which companies are responsible for this year’s production jump? Over the past couple of years, several have announced the startup of plants. The key players have been:

• INEOS – Startup of its Indian River BioEnergy Center in Florida was announced in 2012 with nameplate capacity of 8 million gallons per year.

• Quad County Corn Processors – Announced first production in July 2014; claims its process is producing 2 million gallons per year from corn kernel fiber.

• POET – Project LIBERTY plant in Emmetsburg, Iowa startup was announced in September 2014. Capacity was announced at 25 million gallons per year, and later downgraded to 20 million gallons with the potential for 25.

• Abengoa Bioenergy – Announced startup in October 2014 of its 25 million gallon per year plant in Hugoton, Kansas.

• DuPont – Announced startup in October 2015 of its $225 million plant in Nevada, Iowa with a nameplate capacity of 30 million gallons per year.

 From published reports, it appears that the INEOS facility isn’t producing any ethanol, and Abengoa shut down its plant last December and then declared bankruptcy. Quad County is sort of a wild card, as its potential seems to be limited to a small amount of residual cellulosic ethanol production at conventional corn ethanol plants.

It would appear that most of the current cellulosic ethanol production is coming from POET and DuPont (NYSE: DD). I suspect that the jump in production in March was DuPont working out some of the kinks in its process. Still, even if one assumes that the entirety of the recent production was from those two companies, March’s record output only amounts to about 10% of the combined nameplate capacity of the plants.

While POET is privately held, investors can get tiny exposure to the cellulosic ethanol business by buying DuPont. In my opinion, cellulosic ethanol is still a money-losing proposition at this stage, but I will watch with interest to see if companies like DuPont announce new cellulosic ethanol plants following their experience with the first one. If anyone can do it DuPont can, but don’t place any bets just yet.

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

Portfolio Update

Capital Products Chops Dividend  

The unitholders always come first, when it comes to paying the price for failed management forecasts. The 69% distribution cut announced Tuesday by Capital Products Partners (NASDAQ: CPLP) proved no exception.

It will not affect management that repeatedly assured investors the prior distribution was sustainable, nor the sponsor, which will keep collecting as before on its special class of units, as it is entitled. These are the sordid realities of far too many yield vehicles and other equities on land and sea.

But since the market was already widely discounting the likelihood of a distribution cut, it also seems wrong to argue that biting the bullet now was irresponsible. Irresponsible was people well versed in realities of the shipping business forecasting nothing but clear sailing ahead in past conference calls and presentations.

In any case, the distribution cut anticipates a multitude of possible future hardships, including the loss of Hyundai Merchant Marine (HMM) container ship charters accounting for 20% of recent revenue in the event that ailing customer files for bankruptcy. CPLP and HMM have been discussing HMM’s requests for discounts on its way-above-market charter obligations, reportedly of up to 30%,

Also baked in is the likelihood that CPLP has to repay $175 million in bank debt over the next two years if it can’t refinance, and its unwillingness to issue equity at anywhere near the current valuation.

The reduced distribution is warrantied by management to hold up under the worst-case scenario through 2018, for whatever that’s worth at this point. After a 30% decline since the announcement, CPLP units now yield 11% based on the lowered payout, with 1.7x distribution coverage even after reserving nearly half of the available cash for the rainy day.

CPLP’s concentration in the currently healthy markets for products and crude tankers gives those numbers some credibility even though management has little at this point.

Aggressive pick CPLP remains a Hold, and it’s a weak hold at that. We wouldn’t blame anyone for abandoning this ship.

— Igor Greenwald