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Biofuels have attracted more capital than any other VCA theme since I started tracking deals in February of 2006 — $1.3 billion in venture capital financing over the last 2.25 years. Poor performance in the publicly traded ethanol stocks during this 2+ year period have not led venture capitalists to give up on the theme. There have been three new deals worth $169 million over the last three months.

The US Government continues to provide a heavy hand of support for corn-based ethanol, the largest and most fully developed of the biofuel industries. Here are the Renewable Fuels Standards (RFS) from the recently published 2007 Energy Independence and Security Act, mandating the amount of biofuels US refiners must mix into motor gasoline over the next several years:

20.5 billion barrels of biofuels, the total quantity mandated for 2015, would be 15% of the 137 billion gallons of motor fuels consumed in the US during 2007. 15.0 billion of those 20.5 billion gallons are mandated to come from “First Generation Renewable Fuels” - ie. corn-based ethanol.

The plan for biofuels from the US Department of Energy is clear. We are using corn-based ethanol to build a large scale biofuel industry over the next five years. This industrial base will be leveraged with cellulosic ethanol thereafter. Cellulosic ethanol is made from biomass including wood chips, algae, rice straw, corn stalks, and “energy crops” such as fast-growing trees and grasses. Cellulosic ethanol is the second stage of the DOE’s plan:

• “Producing ethanol from cellulose promises to greatly increase the volume of fuel ethanol that can be produced in the U.S. and abroad. A recent report found the land resources in the U.S. are capable of producing a sustainable supply of 1.3 billion tons per year of biomass, and that 1 billion tons of biomass would be sufficient to displace 30 percent or more of the country’s present petroleum consumption.”

Looking out beyond five years, cellulosic ethanol is expected to bear the brunt of expanded biofuel production. The more recent venture capital investments have all been in promising cellulosic ethanol or biodiesel ventures. For the next five years, however, corn-based ethanol will remain king.

The Fuel for Food Controversy

Right now, agricultural product prices are going through the roof, and people are panicking. William Tucker’s “Food Riots Made in the USA” is one of the more lucid recent articles accusing the ethanol industry of causing an increase in global hunger.

• “True, the rising cost of energy and the perennial defects of Third World food markets are partly to blame. But the International Food Policy Research Institute in Washington says biofuel conversion accounts for at least a fourth of this increase… C. Ford Runge and Benjamin Senauer, two agricultural experts at the University of Minnesota, predict that by 2025 bio-fuels will be responsible for 600 million more chronically hungry people. Jean Ziegler, a U.N. food expert, labeled biofuels a “crime against humanity” and called for a five-year moratorium.”

For an even more incendiary argument, read Christopher Calder’s “The biofuel hoax is causing a world food crisis!” After reading Mr. Calder’s piece, I wanted to track down my congressman and protest the recent doubling in Renewable Fuel Standards.

The only problem is that the basic argument is false. Ethanol production is not driving up the price of agricultural commodities. Rather, an increasingly affluent global populace is demanding a higher caloric intake as part of a better lifestyle. The proof of this statement is in the numbers.

Since the start of 2007, corn prices have gone up less than any other grain-based commodity and considerably less than the price of oil. The biggest increase has been in rice, the king of consumable agricultural products (globally, rice provides more than one-fifth of all calories people consume). Corn has the lowest increase of any of the commodities listed in the table below:

Is the US substituting fuel for food with our Biofuel strategy? Yes, we are. But this is a rational strategy for the United States given our dependence on foreign oil, the probability of sharply decreasing availabilities of crude oil in ten years, and our strength in agricultural production. This strategy is not causing global hunger — the rise in corn prices has actually been less than the increase in other agricultural commodities.

There are limits to our ability to rationally substitute ethanol for corn, and we will probably bump up against those limits during the 2009 growing season. The DOE know this, and that is why RFS 2007 has ethanol mandates dropping to low single digit growth beyond 2010. Increases of that magnitude should be obtainable through increased crop yields rather than increased acreage.

Ethanol Producers Provide a Classic Deep Cyclical Opportunity

So, we are left with a classic cyclical investment story in the ethanol producers. The sector is hated, it has underperformed for years, the companies are going through margin compression, there is tremendous new supply coming on the market near term, and the short sellers are swarming. We could see negative earnings this quarter and next.

But the five year outlook is terrific. The DOE — and members of Congress — are supporting the buildout of our corn-based ethanol industry as a hedge against the possible onslaught of Peak Oil.

The ethanol producers could be sitting there in 2012 with an end product (ethanol) whose price is skyrocketing due to the effects of peak oil, while their feedstock (corn) benefits from continuing productivity improvements. We could see margins for the ethanol producers expand to record levels, and Verasun Energy Corp. (VSE) in particular could have explosive earnings.

If Verasun returns to the 35% gross margins it enjoyed in 2006, for example, 2012 earnings would be over $5 per share. Let me take you through the numbers behind that $5+ in earnings.

Peak Earnings for Verasun Energy Could be Over $5

Verasun completed their acquisition of US BioEnergy Corporation on April 1st of 2008. The combined companies, along with the new plants Verasun will be opening this year, make Verasun one of the three largest ethanol producers in the United States, along with privately held POET Energy and Archer Daniels Midland (ADM). All three of these big ethanol producers are expected to have around 1.5 billion gallons of ethanol capacity by the end of 2008. Together, by the end of this year, they will have 50% of the ethanol market.

Here are Verasun’s combined financials, using their 2007 Annual Report and their recent post-merger roadshow presentation. I show their 2006 actuals, their proforma 2007 numbers, consensus expectations for 2008, and 2012 projections assuming Verasun grows in line with the 2007 RFS mandates. I show two scenarios for 2012, one showing trough earnings using 10% gross margins and one showing peak earnings using 34.5% gross margins.

Trough margins deliver $1.08 in 2012 earnings per shares, and peak margins deliver $5.23 in 2012 earnings per share.

View the spreadsheet used for this valuation analysis.

All of the ethanol stocks popped on Friday, driven by Oppenheimer & Co. analyst Joseph A. Gomes’ optimistic view on ethanol margins by the end of this summer. In my opinion, Verasun Energy is the one to own for long term gains. I would buy Verasun up to $14 (current price is $7), with a long term target of $32.