Ty Cole © Ty Cole
By Tory Newmyer
March 21, 2013

The best way to understand what’s happening out here is to follow your nose. Somewhere along the hash of giant pipes and canisters that make up this industrial plant, the sweet smell of milled pine gives way to a rotten-egg pungency. It’s crude oil. Only it hasn’t been yanked from underground reservoirs where it brewed over millions of years. For the first time ever, it’s being manufactured, in mere seconds, from trees — specifically, the pines surrounding this factory in Columbus, Miss.

The plant is the first commercial-scale facility for KiOR, a Pasadena, Texas-based startup bankrolled by Vinod Khosla, the billionaire clean-tech investor. After nearly a decade of coming up short, he’s hoping he has finally struck on an earthmoving innovation, one that will break the grip that fossil fuels hold on the transportation market. And in the process he hopes to restore rural communities across the country devastated by the decline of paper mills. “My dream would be that there are 500 communities, 15 years from now, that are all back in business using the wood chips in the forests around them, and that forestry is a lively business — not moving to Brazil,” he says.

KiOR’s success is hardly assured, but whatever the outcome, there will be widespread consequences. In a sector that seems to have gone out of its way to earn public skepticism, the company is trying to demonstrate it can turn a profit without a permanent government subsidy. “As far as I know, nobody else is even remotely close,” Khosla says. The company is fueled by a seemingly unlikely band of backers. CEO Fred Cannon, a Republican, is a Gulf Coast native who spent his career working for traditional energy companies; former Mississippi governor Haley Barbour, a backslapping Southern Republican politician, recruited the company with incentives; former Secretary of State Condoleezza Rice sits on the board.

There’s no natural reason for Republicans to oppose alternative energy sources. Khosla identifies himself as a Republican (though he wrote a $1 million check to the Super PAC supporting President Obama’s reelection), and he makes a nonsentimental case for public investment in green tech: Short-term help getting these companies started encourages competition with the oil giants, adds high-wage jobs, and promotes national security through energy independence.

That was precisely the logic George W. Bush used in his second term to enact temporary price supports for the nascent sector and start handing out loan guarantees and grants to startups. But congressional Republicans have since taken a different approach, working to make Obama’s commitment to clean energy look dippy. When the stimulus-funded solar-panel maker Solyndra collapsed in August 2011, taking $535 million in taxpayer money down with it, they appeared to be validated.

Solyndra grabbed national headlines, but plenty of other clean-energy companies have sullied the industry’s reputation by going bust and leaving taxpayers on the hook. One, Khosla-backed Range Fuels, promised to bring jobs back to rural Georgia with a plant that would convert wood chips to ethanol (sound familiar?). The technology flopped, costing taxpayers $76 million. In Mississippi, KiOR (rhymes with Eeyore, Winnie-the-Pooh’s lugubrious donkey friend) is one of a number of clean-tech investments Barbour lured with incentives — including two other Khosla-backed companies and an electric-car maker started by Democratic moneyman Terry McAuliffe. Another, solar company Twin Creeks, went belly-up in November, after the state spent $27.7 million on upgrades and equipment. Barbour insists that taxpayers will be made whole, but his Republican successor has sworn off new help for unproven technologies.

The pressure is on KiOR to reverse its predecessors’ abysmal track record. Silicon Valley (and not just Khosla) — which has poured some $15.5 billion into clean energy in the past 10 years, according to Dow Jones VentureSource — needs a winner to prove it can sprinkle its pixie dust outside the information technology sector. Washington would love to see a success story that shows that economic growth and environmental stewardship can go hand in hand. And Mississippi, with an unemployment rate hovering at 9%, could really use the jobs. If all that weren’t enough to stoke KiOR’s urgency, the company’s stock is down 60% since its June 2011 initial public offering, to about $6 a share. KiOR just booked its first revenue — a measly $87,000 — and since its inception has racked up losses totaling $226.8 million. No wonder CEO Cannon hasn’t gone on a vacation since taking the helm five years ago.

If KiOR’s technology sounds like something out of Back to the Future, that’s because it is. In 2004, Cannon was heading up the catalyst business at AkzoNobel, the Dutch chemicals giant, when he and a chemist there started musing about the scene in the movie in which Doc refuels the DeLorean with garbage. It should be possible, they thought, to design a chemical process that would convert woody biomass directly into crude oil. Such a breakthrough would solve a staggering number of problems at once: It would end-run the food vs. fuel debate souring corn-based ethanol; make use of a cheaper feedstock; and, if it worked, provide a direct petroleum substitute that could drop seamlessly into the existing fuels infrastructure. Cannon and the chemist, Paul O’Connor, pitched the idea internally but found no takers. So O’Connor left the company to try to develop it on his own. With funding scratched together from friends and family and help from a handful of university researchers, he struck on a catalyst that produced droplets of oil from wood. It was enough to encourage him to keep going, but he was running out of money. On impulse, he hopped a plane to San Francisco and managed to score a meeting with Khosla.

O’Connor was convinced that Khosla had the singular combination of bankroll and vision to bring his idea out of the lab. He decided to go bold with his pitch, declaring that his technology trumped Khosla’s ethanol bets. “I thought that was a pretty arrogant view,” Khosla says. Yet O’Connor not only persuaded Khosla to back him but also talked the financier into hiring Cannon as CEO. “Fred is not one of these Wall Street blah, blah, blah guys,” O’Connor says. Indeed, in Cannon’s reedy drawl, “oil” comes out sounding like “awl.” He’s so soft-spoken his sentences can end in a mumble somewhere behind his trim white moustache. But his low-key mien belies a razor-sharp canniness: He first learned how to commercialize biomass as a 12-year-old, when he turned a summer gig selling watermelons on a Pascagoula, Miss., roadside into a multi-unit operation that even Whole Foods might admire. Cannon wanted a deeper understanding of how the world fit together, so he followed his father, a career Chevron engineer, into the energy industry.

After 30 years at AkzoNobel, Cannon was looking for a new challenge when O’Connor called. Cannon, who clicked instantly with Khosla and general partner Samir Kaul, didn’t hesitate to ask for a big commitment. Khosla Ventures ponied up $10 million for a demonstration plant and bestowed on the company one of the many four-letter names the venture firm has trademarked. (Vinod Khosla says two-syllable names are easy to remember — think “Sony” — and four letters allow the company to use its name as its ticker symbol.)

While Cannon tuned up the technology, Khosla made an improbable connection that would secure the company’s next chapter. In September 2008 he was talking up KiOR’s potential at the late private-equity guru Teddy Forstmann’s annual Aspen conference when he was introduced to Barbour, then a year into his second term as Mississippi governor. Barbour was in the midst of aggressively recruiting new energy projects to his state. His hope was they would put people back to work in the short term and lay the foundation for a longer-term manufacturing revival. It didn’t much matter that Khosla is motivated by a belief that climate change poses a graver threat than terrorism or nuclear proliferation, while Barbour isn’t convinced it’s happening at all. KiOR was offering to patch the open wound in the state’s economy left by the paper industry’s decline. Since 1990, Mississippi has lost 10 of its 21 pulp and paper mills. Employment in the sector over that period is down by 63%, or roughly 6,100 jobs. The ripple effects have been far worse. The timber producers, loggers, and truckers who supplied the plants got hit too, multiplying the economic pain by a factor of four, according to research by the Forest and Wildlife Research Center at Mississippi State University. “We’re in it for the improvement of the quality of life for our people,” Barbour says. “That’s where Vinod Khosla’s and my views intersect. He wants economic success. I want it here.”

If the KiOR team has its way, the startup won’t just replace logging jobs in Mississippi; it will turn Columbus and the next plant in Natchez — which will be three times the capacity of the Columbus facility — into mini-Houstons. He jokes that the Columbus plant is the “world’s smallest integrated oil company,” because it’s not just creating the crude oil, but also refining it into gas and diesel and then marketing it. As KiOR expands across the Southeast, the plan is to build identical wood-to-oil converters near shuttered paper mills and ship the crude back to a refinery in Natchez, the same hub-and-spoke model the big guys use for pulling petroleum from the ground and processing it centrally. Eventually Cannon wants to accelerate expansion by finding joint-venture partners to put up the capital for new plants while KiOR supplies the technology and facility design. Cannon even talks of a network of filling stations — big dreams for a small company.

KiOR’s process is indeed amazing, but how do the economics of oil from wood stack up against the traditional model? It’s impossible to determine at the moment, in part because the company won’t disclose its current production costs. KiOR will say it expects to be making its renewable crude for $69 a barrel when it achieves full scale at the Natchez plant. That would compare favorably with the $69.43 a barrel the supermajors reported spending on average to recover petroleum last year. As KiOR seeks to raise $600 million from the capital markets for its expansion, it contends that an apples-to-apples comparison also obscures the longer-term advantages of its approach: Its source material can be replanted; the company can translate investment into production faster; and while yield from any oil well inevitably diminishes over time, KiOR should be able to squeeze ever more out of its feedstock as it perfects its process. Its gas also reduces greenhouse gas emissions by more than 80%. (One critic charges that KiOR’s refining actually depends on natural gas, diminishing its “renewable” sheen.)

The company is benefiting from some key public-policy boosts. It built the Columbus plant with the help of a $75 million interest-free loan Barbour steered through the legislature over a single week in late summer 2010. And it signed up two of its first three customers — Hunt Refining and Catchlight Energy, a joint venture between Chevron and Weyerhaeuser — thanks to a Bush-signed law designed to get the industry on its feet by requiring refiners to buy increasing amounts of renewable fuel through 2022. That mandate generates a tradable credit, now worth $2.12, that attaches to each gallon KiOR produces — allowing the company to charge refiners $5.13 per diesel gallon.

The oil industry is putting its considerable political muscle behind dismantling the law. Even Barbour, now back at his Washington lobbying firm and on the Chevron payroll, calls the mandate bad policy: “Let the market decide!” It’s a refrain with easy appeal in light of the taxpayer-funded failures so far. Khosla counters that government’s role is to subsidize the development of promising alternatives until it’s clear whether they will be able to compete with traditional sources on a global scale. KiOR board member Condoleezza Rice agrees: “We have to get this balance right between energy and the economy and the environment,” Rice tells Fortune. “KiOR can be a real contribution to that kind of equation.” With Rice’s help, KiOR hopes its combination of connected backers, passionate founders, and science will all add up.

This story is from the April 08, 2013 issue of Fortune.


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