How to Beat the High Cost of Gasoline. Forever!

Stop dreaming about hydrogen. Ethanol is the answer to the energy dilemma. It's clean and green and runs in today's cars. And, in a generation, it could replace gas.

By Adam Lashinsky and Nelson. D. Schwartz

February 10, 2006

[Continued, page 2]

HOW BRAZIL BEATS THE U.S.

Near the prosperous farm town of Sertãozinho, some 200 miles north of São Paulo, the fuel that will fill the tanks of nearly three million Brazilian cars in a few months is still waist-high. Lush sugar-cane fields stretch as far as the eye can see, interrupted only by the towering white mills where the stalks of the plants will be turned into ethanol when the harvest begins in March.

Brazil boasts the biggest economy south of Mexico, and with annual GDP growth of 2.6%, it is a powerhouse you might expect to consume growing amounts of oil, coal, and nuclear energy. But Brazil also happens to have the perfect geography for growing sugar cane, the most energy-rich ethanol feedstock known to science. And so, for Brazil's 16.5 million drivers, there is ready access to what's known in Portuguese as álcool at nearly all of the country's 34,000 gas stations. "Everyone talks about alternative fuels, but we're doing it," says Barry Engle, president of Ford Brazil. Ethanol accounts for more than 40% of the fuel Brazilians use in their cars.

While oil frequently has to be shipped halfway around the world before it's refined into gasoline, here the sugar cane grows right up to the gates of Sertãozinho's Santa Elisa mill, where it will be made into ethanol. There's very little waste--leftovers are burned to produce electricity for Santa Elisa and the local electrical grid. "The maximum distance from farm to mill is about 25 miles," says Fernando Ribeiro, secretary general of Unica, the trade association that represents Brazilian sugar-cane growers. "It's very, very efficient in terms of energy use."

Although Brazilians have driven some cars that run exclusively on ethanol since 1979, the introduction three years ago of new engines that let drivers switch between ethanol and gasoline has transformed what was once an economic niche into the planet's leading example of renewable fuels. Ford exhibited the first prototype of what came to be known as a flex-fuel engine in 2002; soon VW marketed a flex-fuel car. Ford's Engle says flex-fuel technology helps avoid problems that had plagued ethanol cars, such as balky starts on cold mornings, weak pickup, and corrosion.

Consumers loved flex-fuel because it meant not having to choose between ethanol and gas models--memories were still fresh of the 1990 sugar-cane shortage, when ethanol-car owners found themselves, well, out of gas. Today "nobody would buy an alcohol-only car, even with tax incentives," says sales manager Rogerio Beraldo of Green Automoveis, a sprawling dealership in São Paulo. "Brazilians are traumatized by our earlier experience, when supplies ran out. But with flex-fuel, there's no risk of that."

With Brazilian ethanol selling for 45% less per liter than gasoline in 2003 and 2004, flex-fuel cars caught on like iPods. In 2003, flex-fuel had 6% of the market for Brazilian-made cars, and automakers were expecting the technology's share to zoom to 30% in 2005. That proved wildly conservative: As of last December, 73% of cars sold in Brazil came with flex-fuel engines. There are now 1.3 million flex-fuel cars on the road. "I have never seen an automotive technology with that fast an adoption rate," says Engle.

Ethanol's rise has had far-reaching effects on the economy. Not only does Brazil no longer have to import oil but an estimated $69 billion that would have gone to the Middle East or elsewhere has stayed in the country and is revitalizing once-depressed rural areas. More than 250 mills have sprouted in southeastern Brazil, and another 50 are under construction, at a cost of about $100 million each. Driving to lunch at his local churrasco barbecue spot in Sertãozinho, the head of the local sugar-cane growers' association points to one new business after another, from farm-equipment sellers to builders of boilers and other gear for the nearby mills. "My family has been in this business for 30 years, and this is the best it's been," says Manoel Carlos Ortolan. "There's even nouveaux riches."

The key to Brazil's success is that consumers are choosing ethanol rather than being forced to buy it. Brazil's military dictators tried the latter approach in the 1970s and early 1980s, by offering tax breaks to build mills, ordering state-owned oil company Petrobras to sell ethanol at gas stations, and regulating prices at the pump. This bullying--and cheap oil in the 1990s--nearly killed the market for ethanol until flex-fuel came along. The regime wasn't good for much, says consultant Plinio Nastari, but it did create the distribution system that enables drivers to fill up on ethanol just about anywhere.

Even though the U.S. will never be a sugar-cane powerhouse like Brazil, investors now view Rio as the future of fuel. "I hate to see the U.S. ten years behind Brazil, but that's probably about where we are," says one shrewd American freethinker, Ted Turner.

ETHANOL FINDS A GODFATHER

There are venture capitalists, and then there's Vinod Khosla. A co-founder of Sun Microsystems and a partner at Kleiner Perkins, he was an early backer of Juniper Networks, whose technology helped end decades of dominance by traditional telecom manufacturers. A lean, 50-year-old native of India, Khosla says, without a hint of modesty, "I love the challenge of breaking monopolies."

Frustrated that Kleiner Perkins wasn't taking enough risks after the dot-com crash, Khosla opted out of Kleiner's most recent fund and started his own group, Khosla Ventures. He'd been dabbling in environmentalism but never expected to become an investor. Brazil's success, however, made him wonder about ethanol's U.S. potential. "I spent two years trying to convince myself that this was never going to be more than another minor alternative fuel," he says. "What I discovered was that ethanol might completely replace petroleum in this country. And a lot of countries. This was a great shock to me."

Pretty soon Khosla was surprising plenty of others. He put together a PowerPoint presentation, "Biofuels: Think Outside the Barrel," which he fires up on a moment's notice. He has made the pitch on ethanol to the President's Council of Advisors on Science and Technology and elsewhere in the White House. He is also behind California's upcoming ballot initiative to fund a subsidy for gasoline retailers that add E85 fuel pumps. "Getting distribution going is the real problem," says Khosla. "We need to increase blending and then introduce E85 pumps, and the possible will become the probable."

His conversion to energy investing is part of a Silicon Valley trend, as VCs seek the rapid growth and giant markets that computers once offered. VantagePoint Venture Partners in San Bruno, for instance, established a fund called New Energy Capital that invests in ethanol, wind power, and other energy projects. Nth Power, a San Francisco energy-investment firm, estimates that $700 million of the $21 billion flowing into venture funds last year were earmarked for "clean technology" startups.

CELLULOSE NIRVANA

No one, not even a professionally optimistic VC, thinks we're anywhere near getting rid of gasoline. The oil superstructure is simply too efficient and too entrenched to just go away. Nor could corn ethanol generate enough fuel to run America's cars, pickups, and SUVs. Already ethanol gobbles up 14% of the country's corn production. Converting a bigger share into fuel would pinch the world's food supply--a favorite objection of skeptics. Critics also contend that producing fuel from crops consumes more energy than it yields. On this topic of endless Internet bickering, the Energy Department recently reported, "In terms of key energy and environmental benefits, cornstarch ethanol comes out clearly ahead of petroleum-based fuels, and tomorrow's cellulosic-based ethanol would do even better."

Because cellulosic ethanol comes from cornstalks, grasses, tree bark--fibrous stuff that humans can't digest--it doesn't threaten the food supply at all. Cellulose is the carbohydrate that makes up the walls of plant cells. Researchers have figured out how to unlock the energy in such biomass by devising enzymes that convert cellulose into simpler sugars. Cellulose is abundant; ethanol from it is clean and can power an engine as effectively as gasoline. Plus, you don't have to reinvent cars. Ratcheting up production of cellulosic ethanol, however, is a gnarly engineering problem.

The onus now is on companies like Genencor, a Palo Alto biotech. Its biological enzymes are used to break down stains in Tide detergent and achieve just the right distressed look in blue jeans. But making underpants whiter and denim bluer is nothing compared with breaking America's longstanding addiction to gasoline. The best way to do this would be to bring down the cost of ethanol to the point where consumers clamor for it. Before flex-fuel engines came along, Brazilians would mix their own rabo de galo (cocktail) of ethanol and gasoline when filling up, simply because it was cheaper than straight gas. Genencor says its enzymes have cut the cost of making a gallon of cellulosic ethanol from $5 five years ago to 20 cents today. Now refiners have to learn how to scale up production. Canada's Iogen is the furthest along in commercialization; another hopeful is BC International, a Dedham, Mass., company that's building a cellulosic ethanol plant in Louisiana.

There's still a role for government--and we don't mean more handouts for corn growers or distillers. The recently enacted energy bill takes steps in the right direction, like mandating the use of 250 million gallons of cellulosic ethanol a year by 2013, but much more can be done. Easing the tariff of 54 cents per gallon on imports of ethanol from Brazil and other countries would certainly help. Because sugar cane generates far more ethanol per acre than corn, Brazil can produce ethanol more cheaply than the U.S. Not only would importing more of it broaden access to ethanol for U.S. buyers, but it would also make it cheaper for the ultimate consumers--us. That in turn would spur demand at the pump and encourage service station owners to offer ethanol more widely. What's also needed is for someone big--like Shell or BP, which tout themselves as green companies--to commit to cellulosic ethanol on a commercial scale. Shell's bet on Iogen is minuscule compared with the $20 billion it plans to spend on producing oil and gas off Russia's Sakhalin Island.

Of course, the timing of when ethanol goes from dream to reality isn't just a matter of an investment here or a subsidy there. It took decades of ferment in Brazil before serendipity in the form of high gas prices and flex-fuel engines made ethanol an everyday choice for consumers. But the sooner we start, the greater our ability to shape a future that's not centered on increasingly expensive oil and gas. It's not as if gasoline demand is going to go down: As long as the Chinese and the Indians want our lifestyle--and they do--you can forget about oil at $10 or even $20 a barrel. Whatever the technological challenges, a world of abundant, clean ethanol is suddenly looking a lot more realistic than a return to the days of cheap, inexhaustible oil.

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