Date: February 4, 2008

Author: Peter Guest

Source: Financial Times

When President George W. Bush announced last January that his government saw increased use of ethanol as a mechanism for partially decoupling his country's economy from its oil dependency, it marked another milestone in the development of a fuel that is undergoing a renaissance. For investors it marks a return to thematic investing that taps into a complex blend of social and market trends.

The biofuels boom is not a fad, according to Jeffry Kuijpers, associate director, commodities products and services, EMEA at CME Group.

"Ethanol has been produced for a long time," he says. "It seems as though when other fuels become expensive, people go back to the old methods of making fuel by fermenting agricultural products."

The underlying commodities used in the manufacture of ethanol - largely maize in the US and sugar in South America - have seen enormous growth, with the former hitting a 12-year high this year, and the other being 2008's leading commodity performer. Wheat, used in Europe to produce ethanol, has followed a similar curve, as have the feed commodities for the bio-diesel industry: soyabeans, canola oil and palm oil.

However, the correlations between fuel and food stocks are a reminder of the potential for conflict arising over the use of farmland, particularly in areas suffering from food shortages. While there is currently an oversupply of sugar, current demand growth suggests this will not persist past the early part of the next decade.

Gaining exposure to bio-fuels is to gain exposure to the enormous, global underlying trends of resource security, according to Steve Goldin, vice-president at Standard & Poor's. "What's different about these trends is that they cross over geo-graphies and industry classifications, so in order to capture these trends within an investment product you need new tools," he says. Older methodologies, such as screening by region or industry code, are not sufficient to build a portfolio.

For an institutional or individual investor, the question is whether to access these trends passively or actively. S&P produces thematic indices, including a global clean energy index, which use a multidimensional "clustering system" to rate companies relative to their exposure. Several products, including BGI's iShares S&P Global Clean Energy ETF, look to tap into the huge growth across all green energyrelated sectors, and offer beta exposure to the biofuels market.

Mr Goldin believes structured products - ETFs, ETNs and certificates - will be the predominant mechanism for accessing the themes. Many asset managers were burnt in the last big thematic investing spree during the dotcom boom. "Now that there's an interest in thematics, they have a reluctance to be launching products because of last time," he says.

Those looking for either pure plays on the biofuels boom or alpha opportunities across all related areas may look for direct investment in the platform, ie the farmland. But the development of land-based products, such as agricultural real estate investment trusts, may prove an easier access point, according to Henry Boucher, deputy chief investment officer of Sarasin & Partners, which manages about $6bn across its thematic funds.

There is also significant potential in longer-term plays on regulation and technology, says Mr Boucher. Nascent products, such as cellulosic ethanol, which can be produced by enzyme action from the inedible parts of crops, or companies working with plants that can grow in marginal or otherwise unusable farmland, could tap into the sustain-ability issues that may influence future subsidy and investment. Mr Boucher believes this could be a five-year play while subsidy regimes rationalise globally and the science catches up with the growth.

In the interim, arguments over the sustainability of biofuels continue. Lifecycle analysis of "phase one" biofuels demonstrate that their green credentials are less than secure. Riots in Mexico over point-of-sale cornflour prices last year demonstrated the social effects of diverting yields to more profitable enterprises and were widely interpreted as being a direct result of increased appetite for ethanol in the US.

The European Union is re-examining its biofuel targets following criticism of the deforestation caused by elements of the growing palm oil biodiesel industry in south-east Asia. Continued investment remains principally influenced by current high oil prices and, as Mr Boucher notes: "Climate impact itself is an issue. We've seen droughts in Australia and Texas and China. It's hard to measure, but we've seen the impacts of major climate events on agriculture."