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Wishes and Hopes Are Not Enough to Recommend Syntroleum

Syntroleum (SYNM) is a fuel technology company. The company has developed 3 technologies:

SyntroleumŪ: The process of converting natural gas stock into Fischer-Tropsch (FT) wax. FT has a variety of industrial uses, including in the rubber, cosmetics, ink, and coatings industries. Additionally, FT wax is used as a feed product for...

SynfiningŪ: The Synfining process is used to convert FT wax into synthetic diesel, naphtha, and liquefied petroleum gases (LPG - think propane or butane).

Bio-SynfiningŪ: A process used to convert biomass such as recycled vegetable cooking oil (e.g., from restaurants), animal waste fats, soybean and algal oil, etc., to synthetic diesel, naphtha, and LPGs.

I believe the best way to think of Syntroleum is as an intellectual property (IP) development firm. The business model is to license the above technologies to partners that wish to construct plants to produce synthetic fuels, earning an up-front technology licensing fee and collecting both royalties and service support revenues from their licensees.

The only technology in production is Bio-Synfining, with which Syntroleum partnered with Tyson Foods (TSN) in 2007 to create Dynamic Fuels LLC. The partnership successfully opened their Geismar, Louisiana plant in 2010. At present, this plant is churning out synthetic diesel which has been used by Royal Dutch Airlines (KLMR), Alaska Air (ALK), and the U.S. Navy. Syntroleum owns an equity stake in Dynamic Fuels, earns royalties from it, and collects technical service fees from it as well. In fact, the vast majority of Syntroleum's cash flows are dependent on revenues from Dynamic Fuels.

An analysis of Syntroleum as an investment opportunity is not real positive. Synthetic diesel demand is largely government-driven, stemming from the Energy Policy Act of 2005 where the EPA sets annual quotas on what percentage of fuel sold must be blended biofuel. The market has had little trouble meeting these quotas - indeed, over 100% of the mandate was fulfilled in the first 9 months of 2012. As a result, demand plummeted, and the price for RIN (Renewable Identification Number, basically a unit of biofuel) crashed from an average of $1.30 to currently about $0.50. While the EPA is set to raise the mandate by about 30% next year, it looks to me like the market is having no trouble keeping up with the demand. That will keep prices low.

The fact is problematic when you understand that Dynamic Fuels' Geismar plant is deeply unprofitable even with over-$1 RIN costs. Since launching in late 2010, Syntroleum has swallowed over $21 million in equity-accounted losses in the joint venture. The plant has not operated anywhere near efficiency, consistently producing at only about 55% of capacity. When I see yearly mandates being met in 9 months, plummeting RIN prices, and low factory utilization, that screams over-supply to me. And in a commodity market, over-supply is bad, bad news for producers.

There are a few additional concerns aside from Dynamic Fuels. First, Syntroleum has been unable to find partners to commercialize the Syntroleum or Synfining processes, making me question to viability to commercialize them - ever. Second, the stock has traded well under $1 for most of the year, triggering a NASDAQ de-listing notice. While the company has recently applied for an extension, it seems likely to me that an already-approved (and embarrassing) reverse split may have to take place to save the listing.

The bull case for Syntroleum is one of wishes and hopes. Of course it would be great if we could take waste products and turn them into clean biodiesel, but organic demand just isn't happening right now. And, given the ever-expanding oil reserves being uncovered in the U.S., my feeling is that demand is unlikely to explode any time soon. Therefore, I recommend MFI investors step away from Syntroleum and look elsewhere.

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