HOUSTON (DTN) – Investor interest in advanced second-generation biofuels is rising due to new renewable fuel standards and energy policies ushered in by the Obama administration, but these endeavors are still highly experimental and risky, according to a report from Standard and Poor's.
 

A lot of the same risks inherent in ethanol investment are also apparent in advanced biofuels investments, said Mark Habib, associate director with Standard and Poor's, who have given the ethanol industry a B rating.
 

The rating agency released the report after providing credit estimates on advanced biofuel producers for the Department of Energy.
 

A main driver of risk in biofuel investment is due to volatile feedstock prices, the report states.
 

Despite being the dominant biofuel in the U.S. and having reliable price-discovery methods for corn already in place, ethanol still lacks stable cash-flow generation for producers to service their debt obligations.
 

"With the general unavailability of long-term, fixed-price contracts for feedstocks and finished products, producers are exposed to unpredictable prices and poor commodity price correlations between ethanol and the resources necessary to produce it -- mainly corn and natural gas," the report states. "Hedging has not provided a robust alternative as it has been difficult to strike a clean and profitable long-term hedge position."
 

Meantime, advanced biofuels produce fuel from a variety of feedstocks such as woodchips, grasses, inedible plant matter and plant-based waste materials, for which there are no current price discovery methods.

"Price discovery hasn't been well developed like it has been with corn," Habib said in an interview with Telvent DTN. "There are a lot of unknowns when it comes to potential feedstocks."
 

While mainstream fuels also contend with largely unpredictable feedstock prices for crude oil and other fossil fuel feedstocks, prices for the finished products tend to correlate more closely with feedstock prices.
 

"There's no correlation between feedstocks and finished product prices for biofuels, which results in high margin volatility as either one fluctuates," Habib said. "That's been our biggest concern about credit quality."
 

That's why even producers who are able to hedge feedstock prices can still get caught holding the bag. The report cites the failure of VeraSun as an example of this. The company took a directional bet on commodity prices by locking in corn costs in mid-2008, only to wind up with overpriced contracts when commodity prices crashed later in the year, driving margins into negative territory, the report states.
 

"The problem there is that they were left with one side of exposure; they were unable to lock in ethanol prices," Habib said. "So if you hold one side fixed but the other side moves, you get caught on the wrong side."
 

Another variable is the new technology being used to produce second-generation biofuels. While the technology process for commercial corn ethanol facilities has a proven track record, second-generation biofuel facilities have only been built at a bench or test facility scale, if at all, the report states. Until a proven method is identified, construction risks will be high. For example, when ethanol processes were still being defined, Northeast Biofuels' New York plant experienced three failed startup attempts before the company filed for bankruptcy in early 2009.
 

"We currently don't have any commercial scale facilities in operation [for second-generation biofuels]," Habib said. "It hasn't yet been proven at that scale."
 

Biofuels also carry the risk of overproduction, like what happened to ethanol in late 2007, the report states. The rapid build-out in ethanol production capacity combined with limitations in infrastructure, such as transportation and terminaling, the report states. With more ethanol produced than transported to the market, ethanol was oversupplied and the pricing power shifted to the blenders, the report added.
 

Despite the risks, Habib said a number of investments have been made in second-generation biofuels over the past several months, many from major oil companies. ExxonMobil has invested in algae biofuels producer Synthetic Genomics, while Shell and Valero have also invested in a variety of biofuels companies using a variety of feedstocks, including waste fats, enzymes and plant matter, the report states.
 

"It's a different level of involvement than we had seen in biodiesel and ethanol up until last year," he said. "If these technologies are able to demonstrate reliability and the RFS mandate stays in place at its current level of second-generation biofuels quotas, then we could potentially see increased investment opportunities."

 

T.L. Hamilton can be reached at tl.hamilton@dtn.com

 

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