So you want to be a biofuels investing Rock Star?

The good news? The Biofuels Digest Index gained 39.8 percent, year on year. The bad news? It’s a volatile, stock-by-stock sector where the tide may be rising but not lifting all the boats.

By most conventional measures, biofuels had a vintage year in 2010 and into early 2011 – industry revenues up sharply, oil price rises driving public interest, government support continuing behind the move towards advanced fuels, “name-brand” strategic partners diving in by the bushel-load, and the IPO market opening up to companies like Codexis, Amyris and Gevo.

The bumper crop of good news drove the Biofuels Digest Index, a basket of thirty biofuels-related public stocks, up 39.8 percent for the year, compared to a 14 percent jump in the Dow Jones Industrial Index for the same period.

So, investors who had the nerve and capital to bet big broadly on biofuels stocks back in, say, the spring of 2009 or 2010 – have had a very good run, and with companies like Solazyme and KiOR testing the IPO waters in 2011, there are plenty of stocks to get excited about.

High risk, high reward

Biofuels investing is not for the faint of heart – even high-flyers like Gevo, up more than 33 percent since its debut earlier this year, have been volatile – and a number of small-cap advanced biofuels stocks struggle to communicate a degree of certainty in a sector so influenced by government policies.

In this week’s Digest, we look at biofuels from the retail investor’s point of view.

In Part I, today, we offer 8 Caveat Emptors worth thinking about when investing in biofuels. In Part II, tomorrow, we take a look at the 30 stocks in our Biofuels Digest Index – why they are there, how they are doing, where they may be going.

Eight Think-About-This for budding Biofuels Investing Rock Stars

1. Your friend, the government. When you are investing in biofuels, you are investing in the government policies of the US, EU, Brazil and China, to name a few. US policy has become notoriously short-term and unreliable, EU policy on biofuels has not been a shining example of consistency either, and “what does China want?” is the question of the day. Broadly put, governments like biofuels as a downstream set of alternative fuels, are decidedly iffy about feedstocks like field corn, and have a very hard time establishing policy consistency over the ten-year cycles in which biotechnologies are brought from pilot to player.

2. Portfolio theory is a good idea. It’s tough to pick individual winners over the long term, and enough companies like VeraSun, Aventine Renewables or Verenium have struggled as public stocks to suggest that the better way to invest is across a portfolio of technologies, feedstocks and fuels. Easier said than done. There aren’t so many pure-plays in advanced feedstocks or drop-in fuels – but there are a lot of options to cover in the processing technologies, from starch fermentation to transesterification, and on to more exotic technologies like pyrolysis, gasification, gas-phase fermentation and enzymatic hydrolysis. More on navigating the biofuels realm in “The Biofuels Technology Square Dance”, here.

3. The long and short of it. There’s hype in any emerging sector, and investors should always be on guard from the enthusiasm generated by those engaging in some sort of pump-and-dump activity in biofuels. On the other hand, consider that  there are short-sellers in advanced biofuels, especially in the small-caps, and they have an equally compelling interest in driving the stock price down by feeding investors a steady diet of fear, uncertainty and doubt. Complainers are usually long, just in something else – consider everyone’s motivation, not just the motivations of supporters.

4. It’s the feedstock, baby. Bottom line, if you are investing in a technology that needs a given feedstock, you are investing in the feedstock anyway, and you might as well invest directly so that you own something of value even if the technology caves or the feedstock price makes biofuels processing unaffordable. On the other hand, long-term, scalable, fixed-price feedstock contracts (as in the case of municipal solid waste), or technologies that work with multiple feedstocks – well, that’s a different matter. Also, feedstock that is easy to aggregate, or grown in high density, has added value.

5. TRY, TRY again. With any fermentation technology – and there are a bunch coming forward – success depends not only on the “crush spread” between the price of the feedstock and the price of the fuel, but the titer, rate and yield (TRY) associated with the process. That’s the concentration of fuel in the broth, the rate at which the magic bug is doing its conversion work, and the amount of fuel from a given amount of feedstock. Those control the capital and operating costs of the technology. Know them!

6. Externalities. Feedstock prices are an externality that are generally hard to control, government policy is too. But also there is the availability of vehicles, pumps and pipelines, interest rates, availability of private equity or venture capital, the development timelines of other substitutes for petroleum, the price of oil and natural gas, and so on. For all these reasons, technologies that develop quickly and have the least number of externalities have a lot of reasons to be considered attractive, above and beyond their basic value proposition.  God speed the plough, as it were.

7. Freedom to operate. Oops, that’s a legal term with specific definitions in the law – in our case, we mean FTO not only in the narrow legal sense of having a technology that can be protected and used in a given market – we mean the geography of a given processing technology, feedstock or fuel. For example, consider where and when alternative vehicles, pumps and pipelines will be available for a given technology. Or what limitations there are on a given feedstock – both the growing, and the aggregation – to what extent is it sustainable, affordable, reliable and available, and to what extent can agricultural practice or genetics change and extend the geography of viability. The bigger the world, the richer the treasures.

8. High value co-products. Offtake, offtake, offtake. No matter how great the technology, high-margin contracts to sell stuff are the mother of all enduring value. Policy makers like to talk about replacing “the whole barrel of oil” – referring to the chemicals, plastics, aviation fuels and diesel that comes out of a given barrel, in addition to gasoline. Maximizing the value of feedstock, by pursuing high-value co-products – those are winning strategies in the short terms (offering a faster path to break even) and in the long term (higher margins).