This has been a tough year for the U.S. biofuels industry: drought curtailed corn starch ethanol production and investment in the industry shrank to its lowest level in nearly a decade.  Headed into 2013, though, industry momentum appears to be regaining steam.  Led by advanced biofuels, the potential for expanding biofuels production has improved dramatically as Washington offers clarity on key policy issues.

Last week, in a vote on partisan lines, the U.S. Senate extended support for the military’s efforts to scale up advanced biofuels production.  As reported in Biofuels Digest, it approved an amendment offered by Senator Kay Hagan of North Carolina to repeal a section of the annual Defense appropriations bill that would have prohibited “the Secretary of Defense or any other official from the Department of Defense (DoD) from entering into a contract to plan, design, refurbish, or construct a biofuels refinery or any other facility or infrastructure used to refine biofuels unless such planning, design, refurbishment, or construction is specifically authorized by law.”

Over the past year, the U.S. military has emerged as a key torchbearer leading the commercialization of advanced biofuels.  Spearheaded by the Navy, which signed a Memorandum of Understanding (MOU) with the U.S. Department of Agriculture (USDA) and Department of Energy (DOE) to develop cost-competitive advanced biofuels, the DoD has been a lone bright spot for an industry that has suffered from press blowback and investor retrenchment in recent years.

Only $84 Billion to Go

Prior to the Hagan amendment, the Senate approved another amendment, offered by Senator Mark Udall of Colorado, to repeal section 313 of the annual Defense appropriations bill.  Offered by Republican Senator James Inhofe of Oklahoma, Section 313 would have prohibited the DoD from procuring alternative fuels if they cost more than their conventional counterparts.  The section was introduced in response to the U.S. Navy’s highly criticized purchase of advanced biofuels from firms like Solazyme and Dynamic Fuels for its “Great Green Fleet” exercises off the coast of Hawaii, at an estimated price-tag of $15 per gallon.

These bills are expected to facilitate public-private partnerships and funnel much-needed capital to support advanced biorefinery construction within the United States.  In our Industrial Biorefineries report, Pike Research forecasts that at least 13 billion gallons of advanced biorefinery production capacity will come online over the next decade in the United States.  Although that falls short of the 21 billion gallons of advanced biofuels carved out under the EPA’s Renewable Fuel Standard (RFS), more than $60 billion will be invested over that same period.

With the minimum cost of scale-up to meet RFS’s advanced biofuel production mandate estimated at $84 billion, the industry still has significant ground to make up.  Although continued federal support will help assuage investor fears, uncertainties around feedstock supply and production profitability persist, translating into high levels of risk for investors.

Advanced biofuels, which address these concerns at least in part, have enjoyed a rising tide of policy support in recent months from Washington.  In August, Congress allocated $170 million to support the development of military biofuels and other defense initiatives, voted to extend key tax credits for advanced biofuel producers, and granted algae producers tax credit parity with other feedstock pathways.  Meanwhile, the recent commissioning of first-of-kind facilities from advanced biofuel producers KiOR and INEOS Bio are strong indicators of a maturing cellulosic biofuels industry.

Europe is leading the world in production of biomethane vehicles, which run on methane generated from digesters of waste products.  Germany has jumped into the market in a big way, with Hamburg Wasser shifting its fleet of vehicles to run on biomethane and the opening of the 100^th all-biomethane refueling station.  Biomethane (also called biogas or renewable methane) is often mentioned as a way to move to CO2-neutral driving.  The German energy agency, DENA, found that mixing 20% biomethane has the possibility of reducing GHG emissions by up to 39% over gasoline and 36% over new clean diesels, and that using 100% biomethane would be as clean as driving an electric car using 100% wind electricity generation.

Well-to-Wheel Greenhouse Gas Emissions for Various Fuel

(Source: DENA German Energy Agency GmbH)

A new study from Dr. Frank Rijnsoever of Utrecht University in the Netherlands shows that Netherland government fleet managers will value biomethane-fueled vehicles as much as electric vehicles.  The research shows that fleet managers are willing to pay a premium for both biomethane and electric vehicles over traditional gasoline vehicles.  However, similar to what we see here in the the United States, the lack of refueling infrastructure for biomethane limits interest.

Interest in biomethane is particularly strong in Northern Europe (the Nordic countries, the Netherlands, and Germany).  However, the overall market for natural gas vehicles in these countries remains small in comparison to Western Europe’s largest market, Italy, with 159,578 NGV sales anticipated this year, compared to 29,849 in Sweden, the second largest market in Western Europe.  While Italy is in the throes of sorting out the biomethane industy, Sweden has a strong market for biomethane, with about 58% of NG used for transportation coming from biomethane in 2008 (latest data available).

In the United States, biomethane remains a very small part of the overall gas market.  As a transportation fuel it’s almost entirely relegated to fueling garbage trucks and a few other demonstration fleets.  That may change in time, as the California Air Resources Board has published a proposal for a new Low Carbon Fuel Standard (LCFS), which includes a “pathway” to biomethane production.  This was followed by the announcement that three companies have been selected by the California Energy Commission to receive grants for biomethane production.  Whether these grants will ultimately be awarded is still very much up in the air, but the momentum is growing.

If emissions were the deciding factor then biomethane would be the clear, hands-down, winner.  However, production costs of biomethane range from $5.90 to $9.00 per million British thermal units (MMBtu), according to Calstart, for midsize to small production facilities.  Non-renewable natural gas is very cheap at the moment ($3.43/MMBtu), so the economic motivation is not there.  This will relegate the biomethane market to small projects targeted at specific fleets or geographic areas.  This, combined with the small size of the NGV market in the United States (20,381 vehicles in 2012), makes it hard to see biomethane having a significant impact on the U.S. transportation market.  For the foreseeable future, most biomethane investment will remain focused in Europe.

Biodiesel production in the United States fell 61% from its 2008 high of 678 million gallons per year (MGY) to 263 MGY by January 2010.  Precipitated by the lapse of a key $1 per gallon producer’s tax credit that had enabled biodiesel producers to recoup the cost of production and offset feedstock costs, this drop forced producers to idle capacity and set off a wave of bankruptcies across the country.  Amidst the doom and gloom, the industry was largely written off as a peripheral player in EPA’s rejiggered Renewable Fuel Standard (RFS2).

Today, with the producer’s tax credit reinstated, biodiesel has become a lone bright spot under RFS2 and an early success among advanced biofuels.  Production capacity is expected to expand over the next few years. U.S. biodiesel production currently exceeds 1 billion gallons per year (BGY), thanks in part to expanding production of renewable diesel.  Assuming adequate feedstock access, Pike Research’s forecasts suggest that renewable diesel production could continue to surge in the United States over the near-term.

A Crude Replacement

To understand renewable diesel’s surge, it is important to note the difference between conventional biodiesel and renewable diesel.  Solazyme explains:

The molecules in biodiesel are primarily FAMEs (fatty acid methyl ester), usually obtained by transesterification. Renewable diesel is hydrocracked and refined, and is nearly molecularly indistinguishable from standard diesel that comes out of the pump.

A superior product to conventional biodiesel, renewable diesel is fully fungible with existing diesel infrastructure.  This means that it can be used in place of crude oil-based diesel without any corrosion of pipelines or loss of performance in existing engines.  This makes renewable diesel particularly attractive.  For investors and project developers, it means end-market access while sidestepping many of the regulations and approvals that have confined conventional biodiesel to “cottage” status in the United States.

Meanwhile, biodiesel’s past troubles demonstrate that subsidies matter in commodity-dependent industries.  In the high-volume fuel business, scale and low-cost production drive success.  Consumers have proven unwilling to pay premiums for “green” or “renewable” fuels, forcing producers to compete with petroleum-based diesel on price.  Biodiesel production collapsed in 2008 and 2009 – not because of any inherent technological shortcomings, but because it was crippled by wildly fluctuating feedstock costs and a simultaneous loss of subsidy support.

Largely dependent on soy and canola as feedstocks, North American producers manage thin profit margins while competing for these soft commodities on the open market.  Dramatic price increases are the industry’s Achilles heel.  Since tax credits help offset price surges, a lack of financial support can leave biodiesel producers with excess supply on the market and no way to recoup production costs.

This partly explains why fats, oils, and greases (FOGs) have been such a hot feedstock in recent years.  A waste byproduct of restaurants and animal processing, FOGs offer producers a relatively price-stable alternative insulated from the demand pressures of vegetable oils and other food-based feedstocks.  Although collecting used cooking grease from restaurants has proven logistically difficult at scale, chicken fat, pork lard, and beef tallow from the food processing industry have driven a mini-renaissance in renewable diesel production.  Dynamic Fuels, a joint venture between food processing giant, Tyson Foods, and Syntroleum, has demonstrated the efficacy of this approach at its 75 MGY capacity Geismar Plant in Louisiana.

Renewable Diesel Comes Cheap

Superior performance and FOGs are only part of renewable diesel’s recent success.  Renewable diesel has also led among peer advanced biofuel production pathways with competitive capital costs.  Based on public data, renewable diesel facilities are currently being built at between $2 and $4 per gallon, compared to more than $10 per gallon for many cellulosic and thermochemical-based pathways.  With petroleum refineries being sold for less than $0.10 per gallon, lower capital expense matters.

Renewable diesel facilities also boast larger average capacities, taking better advantage of economies of scale.  Neste Oil led the way globally with 200-plus MGY facilities in Rotterdam and Singapore.  Emerald Biofuels and Diamond Green Diesel are expected to join Dynamic Fuels with 85 MGY and 136 MGY capacity plants under construction, forming a renewable diesel corridor along the Mississippi River in Louisiana.

Although Pike Research’s report, Clean Diesel Vehicles, forecasts that clean diesel vehicles will capture a slightly higher percentage of new light and medium duty U.S. vehicle sales than hybrids, even with sustained growth in renewable diesel production, volumes are likely to still be a drop in the overall fuel bucket.  With diesel confined to niche vehicle fuel status, renewable diesel producers’ future is likely to be in the heavy duty vehicle and aviation biofuel markets.  As conversion technologies developed by Honeywell’s UOP and Eni have demonstrated, hydrotreatment of traditional biodiesel feedstocks like fat can produce a range of distillates like renewable diesel and aviation biofuels at competitive costs.  With costs and performance competitive for these applications, feedstock access will dictate how long the industry can replicate its early success.

The worst drought in half a century across the U.S. Midwest is having a devastating impact on agricultural production.  Conditions have deteriorated such that the USDA is forecasting the 2012-2013 harvest to be the lowest in 17 years, with corn prices up by more than 60% over the past two months.

Rising corn costs, a key ingredient in animal feed in the U.S., are expected to drive up the cost of meat, dairy, and eggs.  As a result, the corn starch ethanol industry – a favorite punching bag for just about everyone who doesn’t make a living off of it – finds itself in the crosshairs, with opposition building amongst a diverse group of domestic and international stakeholders.

Admittedly, all this seems to paint a grim picture for biofuels.  In our forthcoming Biorefinery report, Pike Research has slashed its U.S. corn starch ethanol production forecasts for 2012 and 2013.  At the same time, we maintained a strong growth projection for the industry in the U.S. and abroad over the next decade.  The drought matters, but its long-lasting effects will be small.

Corn Starch Ethanol Growth Plateaus

Long before the drought, momentum behind corn starch ethanol had deteriorated in the United States.  Currently accounting for more than 46% of global biofuels production, the industry expanded rapidly over the last decade, due in part to an annual subsidy worth $6 billion.  That subsidy was scrapped at the close of 2011, as industry proponents shifted their focus to expanding end-market access.

What’s more, under the EPA’s revised Renewable Fuel Standard (RFS2), the volume of ethanol derived from corn starch that can be blended into existing gasoline supplies is capped at 15 billion gallons starting in 2015.  This policy has already sent a clear market signal that corn starch ethanol’s future will be significantly restrained, thus diverting industry investment to advanced alternatives over the last few years.

As a result, the corn starch ethanol boom of the 2000s has given way to a next wave of advanced conversion technologies.  In our forthcoming Biorefinery report, we project that 50+ new advanced biorefineries – using non-food feedstocks – will be built annually in the U.S. by 2022.

Regulatory Backlash to Nowhere

Fearing a global food crisis caused by the U.S. drought, the United Nations called for an immediate cessation of government-mandated U.S. ethanol production, a directive that is likely to be repeated many times throughout the next decade.  On the domestic front, decreasing corn supplies have stoked debate about whether the RFS2 corn starch ethanol mandate should be scaled back.

Backlash in the U.S. and abroad is unlikely to materialize into regulatory action, though.  International organizations like the U.N. have no legal authority to compel the United States to adopt or abandon specific policies; meanwhile, the ethanol industry annually contributes more than $45 billion to U.S. GDP and helps ensure some semblance of global equilibrium between liquid fuel supply and demand.  Despite its shortcomings, corn starch ethanol is a mature industry with steel in the ground and an established track record of revenue generation.  Although RFS2 may be up against the ropes, Big Corn is a heavyweight in the Washington political arena, and ethanol is a primary beneficiary.

Consolidation Improves Industry Health

Ultimately, as my colleague, Alex Lauderbaugh, commented earlier on this blog, industry consolidation bodes well for advanced biofuels.  Companies like Gevo and Butamax, which are currently embroiled in a contentious patent dispute, are among those next generation biofuel companies particularly advantaged by the troubles of the first-generation ethanol industry.  These companies aim to retrofit existing biorefineries to produce isobutanol, a molecule that qualifies as an advanced biofuel under RFS2.

While the current drought will put a dent in U.S. ethanol production for 2012 and 2013, the biofuels industry will emerge leaner and better-positioned to expand both conventional and advanced production capacity over the next decade.  Although our recent forecasts show U.S. biorefinery infrastructure attracting nearly $60 billion over the next decade, only a fraction of this total is expected to be the result of new corn starch ethanol capacity.