Most investors dream of investing in that small start-up or IPO that ultimately grows to dominate its sector. Many recent IPOs in the renewable energy space have promised to do just that—solve our energy problems and become the next ExxonMobil (NYSE: XOM). Finding such a diamond in the rough isn’t easy, but there are ways to improve your odds of doing so.

For an established company, due diligence entails looking at company financial information, business plans, competitors, and other fundamental analysis. For a company with a new technology, there is the added step of due diligence on the technology itself. Does it actually work as advertised? Can it legitimately compete?

The truth is that most good ideas die out somewhere between the drawing board and commercialization, so the financial risk in making these types of investments is high. Development of a new technology will begin as an idea, and ideally a preliminary economic evaluation. The next step would typically be to prove the concept in the laboratory. This will involve determining whether the desired products are produced, the yields of those products, and the amounts of potentially undesirable byproducts. Basic heat and material balances would be determined.

If the laboratory results are satisfactory, the process may be scaled up through a pilot facility to a demonstration facility and ultimately to a commercial facility. Each of those steps is a gate which has the potential to halt a technology from advancing to the next gate. Skipping steps—for instance, jumping from the lab to a demonstration facility—greatly lowers the probability of success while increasing the financial risk.

If we assume that each step has only a 50 percent chance of successfully meeting the desired expectations (in my experience, the probability of success is typically lower), then advancing the three steps from lab scale to pilot scale to a demonstration facility to a full-scale commercial facility has a probability of failure of nearly 90 percent. Progressing from a laboratory experiment to a commercial plant—which some companies have attempted to do—can put hundreds of millions or even billions of dollars at risk with little chance of success.

Some may question why a process that works at a small scale would fail to work at a larger scale. This behavior is really more specific to processes that involve heating and chemical reactions, and liquid-fuel processes generally fall into this category. Scale-up is less technically challenging for a technology such as solar photovoltaics, which basically scales by just adding more units.

Processes that scale by moving to larger reactors are quite different. To illustrate, consider a familiar routine for this time of year: cooking a turkey in an oven. Heating elements surround the turkey and ensure a fairly uniform temperature profile around the turkey. But now assume that you want to scale up this process to cook 100 turkeys. Further, you wish to do this every hour, 24 hours a day, year round. If you were to duplicate the single-turkey process in 100 different ovens, you would require mass production to produce very cheap ovens to keep capital costs low. This is analogous to the way solar power is scaled.

But large industrial reactors are not mass-produced, so the analog to a biomass-based process would be to cook all of the turkeys in one large oven (which should be cheaper than 100 small ovens). The challenges then are easy to imagine. How do you get the turkeys into and out of the oven? How do you prevent turkeys of different size from cooking at different rates? How do you eliminate hot and cold spots from the oven? The challenge is avoiding a process in which some turkeys are overcooked, some are just right, and some that undercooked.

Now imagine that the turkeys are instead wood chips that are being heated to produce fuel, and you have the basic business plan of a great many companies attempting to produce petroleum substitutes. Those who understand the challenge of scale-up are much more likely to be successful—or to recognize when not to proceed—than those who don’t.

As a reactor grows larger, the temperature and flow will start to deviate from the patterns seen in a smaller reactor. There may be hot spots and cold spots within the reactor, and there may be locations that are better mixed than others. Any of these factors can lead to the production of undesirable byproducts (like overcooked and undercooked turkeys) and an ultimate failure of the process at a larger scale.

This may seem like quite a digression for investors, but it is not. Whether you personally do the technical due diligence, or have someone else do it for you—it is critical that it is done. You don’t have to do technical due diligence when investing in ExxonMobil, but if you are instead investing in Solazyme or KiOR you must understand the technical challenges and risks.

Around the Portfolios

Chevron Corp. (NYSE: CVX) announced plans to boost capital expenditures by 12 percent in 2013, including higher-than-expected costs of its massive Gorgon offshore natural gas project in Australia due to a variety of factors. The Gorgon overruns were expected; the good news is that Chevron remains on pace to start production in 2015. Chevron also will invest in oil and gas projects in Africa, Kazakhstan and the Gulf of Mexico and announced major exploration projects in Kurdistan (Iraq) and off the coast of Africa. Buy Chevron on dips below 105.

Alessandro Bernini, the chief financial officer of Eni SpA (Milan: ENI, NYSE: E), resigned last week after news broke that his former employer, Saipem, is being investigated for corruption. Eni owns 43 percent of Saipem, an energy services company, but we don’t expect serious repercussions for Eni’s share price. Buy Eni below 52.

Total SA (NYSE: TOT) has discovered a significant amount of oil in in the deepwater North Platte prospect of the Gulf of Mexico. The field, of which Total owns 40 percent in partnership with Cobalt International Energy (NYSE: CIE), is the first of its kind on the Lower Tertiary Wilcox formation. Total and Cobalt will continue to explore in the area. Buy Total below 57.