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VG Energy and the Economics of Biofuels, by Stephen_Waite

In our initiation of coverage note on Viral Genetics (VRAL) back in February, we noted that the company created a majority-owned subsidiary called VG Energy to develop algae-based nutrient and energy technology. This technology can be used to produce diesel and jet fuel substitutes for traditional petroleum fuels. It was derived from a discovery that came out of Viral Genetics’ research in cancer treatment.

Laboratory experiments at Viral conducted by Dr. Karen Newell-Rogers and her team show that molecules which can disrupt the burning of fats (lipids) in tumor cells can also encourage algae to accumulate and secrete fats. In the lab, Dr. Newell-Rogers’ technique increased lipid production by over 300 percent. This is a potentially pioneering discovery that could radically alter the economics of future biofuel production.

Another significant finding by Dr. Newell-Rogers is that with VG Energy’s technique, the fat is stored outside the wall of the cells, thereby making it possible to extract it without killing the algae. With conventional technology, the algae cannot be reused. This finding opens up the possibility that oil can be separated and recovered from the algae in a non-destructive way, which has the potential to significantly reduce the cost of production and bring the cost into line with conventional fossil fuels.

At the time of publication of our research note, there was very little information on VG Energy and no way to gauge the value of the company in its present embryonic stage of development. We were aware that VG Energy was discussing the technology with various biofuel experts, and that some of those who examined it viewed it as a potentially important and significant development in algae-based biofuels.

Recently, biofuel expert Dr. John Sheehan published a research note titled “The potential impact of VG Energy?s lipid oxidation inhibitors on the economics of algal biofuels. Dr. Sheehan spent many years at the National Renewable Energy Laboratory (NREL) evaluating and testing alternative energy technologies. He is currently a researcher at the University of Minnesota’s Institute on the Environment and is also doing independent advisory work on biofuel technology at SheehanBoyce LLC.

Dr. Sheehan’s research is the first attempt we’ve seen to evaluate VG Energy’s technology in a rigorous manner. He evaluated several scenarios, including:

• Enhanced production of higher value oils, such as omega-3-fatty acids, in open pond algae systems

• Enhanced production of fats for oil produced as a feedstock for biofuels in open pond algae systems

• Scenarios that take advantage of observed oil secretion in VG-treated algae to permit non-destructive recovery of oil and recyclng of algae to ponds.

The enhanced production scenarios in Dr. Sheehan’s report are compared with scenarios based on values for currently achievable productivity levels of algal open pond systems that are found in the scientific literature. Sheehan’s scenarios show that VG Energy’s discovery could transform algae technology from being a negative rate of return proposition to being an attractive and profitable venture. He notes that the introduction of VG Energy’s additives offers the ability to knock down the cost of algal oil production by almost a factor of ten as a result of productivity improvements.

Sheehan also notes that if oil secretion currently observed in VG Energy’s lab can be fully demonstrated in larger scale growth systems, there is potential for further decreasing costs by another factor of roughly two. This would represent a dramatic shift in the economics of algae technology and would, as Sheehan observers, be game-changing.

Sheehan’s economic analyses, though preliminary, illustrate the promise and potential of VG Energy’s technology at a time when there is growing investor interest in algae biofuel technology. Several synthetic biology companies have came to market over the past year, including Amyris Biotechnologies (AMRS) and Gevo (GEVO). Earlier this month, Solazyme filed an S-1 and plans to raise $100 million in a public offering.

Solazyme has a unique process for creating fuel from algae. It grows its algae in dark pools and feeds them sugar. Most conventional algae processes use open sunlit ponds and rely on photosynthesis to produce the sugar needed to get the algae to produce oil. Solazyme feeds sugar directly to the algae. The oil produced by Solayzme’s sugar-fed algae is then refined into usable fuel. The U.S. Navy is a big customer of Solayzme’s biofuel today, and other companies are evaluating it for commercial use. Another emerging bioenergy company that is on our radar screen is Synthetic Genomics, which is backed by ExxonMobil. Synthetic Genomics was founded by biotech pioneer Craig Venter. Venter led the privately financed version of the Human Genome Project and is one of the world’s leading biotech visionaries. Synthetic Genomics appears to be using a more conventional open sunlit pond approach to producing fuel. That said, Venter’s vision and expertise in genomics and biology, coupled with the financial backing of the world’s largest energy company, makes Synthetic Genomics a company to watch as a source of future biofuel innovation.

As we noted, there is growing investor interest in biofuel technology. But there is also a good deal of skepticism among venture capitalists as well as in the academic community. Earlier this year we spoke with Professor James Richardson, an agricultural economics professor at Texas A&M. Professor Richardson has evaluated the economic feasibility of many conventional algae biofuel technologies in conjunction with the work he is doing with the National Alliance for Advanced Biofuels and Bioproducts consortium. The NAABB is studying over 575 strains of algae to determine which is best for lipid production.

Professor Richardson and his research team at Texas A&M have built Monte Carlo statistical models and looked at 10-year simulations of many algae-based biofuel technologies. Their research shows that most biofuel technology has negative return profiles and is unlikely to be profitable. Interestingly, Professor Richardson has done a preliminary evaluation of VG Energy’s novel biofuel technology and told us that it has a better than even odds of producing positive investor returns. While further analysis needs to be done before drawing definitive conclusions on VG Energy’s biofuel technology, the preliminary results of both Dr. Sheehan and Professor Richardson are encouraging.

At this juncture, it is still difficult to say how big an impact VG Energy will have on the value of its parent, Viral Genetics. We think the best way to view VG Energy today is as a free out-of-the-money call option on Viral Genetics. Although Viral Genetics remains in development stages and trades today at just $0.046 per share, this compares to our base case IV estimate on Viral Genetics of $0.49. That said, there is clearly more potential for value creation for Viral Genetics in the future with a successful launch and profitable build-out of VG Energy.