Synthetic Fuels: Investing Essentials | The Motley Fool

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Here's what you need to know about synthetic fuels.

Synthetic diesel compared to conventional diesel derived from oil. Image source: Louisiana Tech University.

We will go to great lengths to put affordable gasoline in our cars. Oil and gas producers are going to the depths of the ocean, and into almost uninhabitable lands, to secure new sources of fuel, and the cost for that oil is becoming more expensive. To combat the need for these super-expensive oil sources, there have been major strides in the development of non-crude oil-based fuels, also known as synthetic fuels.

To some, synthetic fuels are the future of how we fill up our gas tanks; but the process to develop these artificially constructed fuels has taken many years to perfect and, so far, has only been proven economical in situations where either oil is incredibly scarce, or another fossil fuel, such as natural gas or coal, is incredibly abundant. Let's take a quick look at synthetic fuels, and how you, as an investor, can invest in them.

What are synthetic fuels?

Royal Dutch Shell's synthetic fuel facility in Qatar .Photo Source: Royal Dutch Shell.

Any fuel, such as gasoline, diesel, or kerosene -- jet fuel -- that's produced through the synthesis of hydrogen gas, is considered a synthetic fuel. Synthetic fuels are produced from non-crude oil energy sources, such as coal, natural gas, or even biological sources like corn.

The most common way that we produce gasoline and diesel is by distilling crude oil into molecules of certain size and molecular weight. In the case of synthetic fuels, the source fuel is stripped of its hydrogen and carbon atoms -- normally in the form of hydrogen gas and carbon monoxide -- and then those components are formed into the desired petroleum products.

I should point out that synthetic fuels from biological sources are not necessarily the same as biological fuels like the one we most commonly know -- corn ethanol. Ethanol is produced biologically by breaking down the feedstock into sugars, and then fermenting those sugars into alcohol. Synthetic fuels from biological sources are produced chemically by stripping hydrogen and carbon monoxide from the feedstock through gasification, then reforming those components into the desired fuel.

What is the history of synthetic fuels?

It sounds like a really high-tech process, but synthetic fuels actually got their start in Germany during World War I. Germany doesn't have a lot of oil reserves, but it does have boat loads of coal. So, in order to fuel its military, scientists developed two methods to strip coal of its essential elements, and then reform it into diesel and jet fuel.

Today, the process of developing synthetic fuels is taking root in places where natural gas is in great abundance. These new gas-to-liquids facilities will be used to produce synthetic gasoline and diesel in large quantities, mostly because the value of natural gas is much greater as a petroleum product than as natural gas, itself.

How many ways are there to invest in synthetic fuels?

When compared to the total consumption of gasoline and diesel, synthetic fuels are a very small part of the market. Let's put it this way: The total amount of synthetic fuels produced today can be measured in the hundreds of thousands of barrels per day. In comparison, the entire oil and gas industry produces close to 90 million barrels of oil per day. So, we're talking about less than 1% of the entire fuel industry.

However, as the process to convert non-oil sources into synthetic fuels becomes more efficient, and the prices for non-oil feedstocks, such as natural gas and coal, remain cheap, synthetic fuel production is on the rise. A majority of synthetic fuel production is centered around a small group of very large companies -- mostly integrated oil and gas producers, as well as the national oil companies that are prevalent in places such as the Middle East. Most of these companies produce synthetic fuels from either natural gas or coal, because they are the most economical -- and most profitable -- sources of synthetic fuels today. For the most part, synthetic fuel production is a very small part of these companies' revenue streams, and normally have a negligible impact on overall earnings.

There are, however, a small set of companies that are working on producing synthetic fuels from either exclusively biological sources, or a combination of biological and fossil fuels. Most of these companies have market capitalizations of less than $200 million dollars, and some are not yet profitable.

Why invest in synthetic fuels?

Unlike ethanol produced from a biological feedstock through fermentation, synthetic fuels from any feedstock source are chemically identical to the type of fuel they're designed to replicate. This makes synthetic fuels from things such as corn, or even non-food-crop sources, much more attractive than ethanol from fermentation, because it doesn't cause some of the buildup issues that are found when too much ethanol is used in engines.

Another compelling reason to invest in synthetic fuels is because the increasing cost of oil-based fuels could make synthetic fuels much more cost competitive. Depending on the feedstock and the business environment, synthetic fuels can cost between $20 to $250 per barrel. As those costs come down, and oil, presumably, goes up over time, synthetic fuels will likely be a profitable venture worth looking into more deeply. Also, certain processes that use biologically sourced synthetic fuels are considerably less carbon intensive than traditional oil-based fuels. As we look to reduce our carbon footprint, these types of fuels could be a much more viable option.