Another Bubble Bursts

I think a lot of people, except some commodity bulls, knew this was coming. I guess we can officially conclude that the ethanol bubble has burst now than Verasun, one of the leading ethanol producers, is filing for bankruptcy protection. This is one of the few bubbles identified in advance by market consensus.

Bankruptcy, though widely expected, caps a swift reversal of fortune for the seven-year old company, which has been one of the key beneficiaries of U.S. policies designed to encourage the use of fossil-fuel alternatives.

As investors clamored for stock plays on alternative energy, VeraSun shares made a stunning debut at more than $30 a share in 2006, helping fund the company's rapid expansion. Its 16 production facilities are scheduled to have production capacity of 1.64 billion gallons of ethanol by the end of this year.

Unprecedented moves in corn prices and a global credit tightening proved the company's undoing. A run-up in corn prices earlier this year, in part due to increased demand from ethanol makers, squeezed margins for VeraSun and other ethanol producers.


This shows the risk with investing in commodity businesses, especially these producers who don't own the commodity source. These companies live on thin margins and wild fluctuations in the underlying commodity, which is the norm in commodities, can bankrupt them. Companies can use hedging but I view that as a short-term/intermediate-term tactic and don't believe it's sustainable (it's also confusing to investors since it's never clear how good the business is.) In the case of Verasun, their hedges seemed to have backfired, with them locking up prices at a high level while the source commodity price collapsed subsequently.


A similar outcome can result if the government pushes alternative energy. I am not a fan of the government trying to pick the correct, sustainable, industries that won't blow up when business slows during economically weak periods. Having said that, if the goal is not to build a sustainable industry but rather to protect the environment, then it's ok in my eyes.

If you are a value investor, you need to clearly understand if the business is sustainable on its own during weak periods; if you are a growth investor or a macro investor then it isn't so important as long as you "catch the wave" and get out while the masses are piling on. Someone like Boone Pickens, whom I view as a macro speculator, will still do ok if the oil market doesn't recover. But anyone that bought oil or oil stocks in the last year will post losses similar to those, including yours truly, who bought companies owning/insuring toxic mortgages (note that I'm not making a call on oil and am simply using a hypothetical example.)

Comments

  1. The problem is that corn ethanol isn't the best or most efficient crop and the whole industry grew on government subsidies.

    Ethanol can work efficiently with the correct crops, and without any government subsidies. I'd only invest in ethanol companies that are going to use more efficient crops and new technology. There are plenty of good choices... algae, sorghum, nipa palm, cassava, cattails, fodder beats, sugarcane, buffalo gourd, and about a few dozen other crop,s are all more efficient than corn. Even potatoes are more efficient than corn in terms of yield per acre. We can also look to the new cellulosic ethanol for some big changes too.

    ReplyDelete
  2. I think some of what you are suggesting is uneconomic (I think it's even more costly than solar.) My impression is that the only one that is economic and doable on a mass scale is sugarcane (as Brazil does.)

    ReplyDelete

Post a Comment

Popular Posts

Thoughts on the stock market - March 2020

Warren Buffett's Evolution and his Three Investment Styles

"The Markets They Are A-Changin'"