A Superfluous Subsidy

While listening to the podcast of a recent conference call with the President of the American Petroleum Institute, a question from one of the participating bloggers provoked one of those slap-your-forehead moments for me. Robert Rapier, who writes the R-Squared Energy Blog, asked why ethanol still needed a subsidy, since its use is now mandatory under the new Renewable Fuels Standard (RFS) regulation in the US. It bothers me that when I was dissecting the RFS the other day, this never occurred to me. Mr. Rapier's question seems highly appropriate, since ethanol is now required under not one, but two federal fuel regulations, along with various state and local rules. It's hard to avoid the conclusion that, with ethanol production booming, it doesn't require three support mechanisms, and so the subsidy should go.

As I described last week, the new national RFS sets an annual quantity of alternative fuel--which today means principally ethanol--that must be blended into gasoline, starting with 4 billion gallons in 2006 and rising each year. Anyone caught short must buy credits from another blender who used more ethanol than required. At the same time, however, most of the present ethanol supply is used to satisfy the oxygenate specification under EPA and state reformulated gasoline (RFG) regulations. So ethanol producers have a guaranteed market on two levels: the amount required for RFG and an overlapping and steadily increasing quantity set by the RFS. And that is now in addition to the 51 cent per gallon Volumetric Ethanol Excise Tax Credit, which effectively subsidizes production of fuel ethanol by enabling refiners and blenders to pay more for it than it is worth as a gasoline extender. How many other businesses would like to have the government pay them to make something, and then force their customers to buy it?

The US ethanol market would eventually look very different without the subsidy. Let's start with some numbers. Eyeballing the chart for the May ethanol contract on the Chicago Board of Trade exchange, ethanol was going for about $2.20/gallon (delivered in storage in Chicago) when the comparable wholesale gasoline futures contract for May was trading for an average of $1.92/gallon in New York. Considering that rail freight can add another 10-15 cents/gal. to the price of ethanol delivered to the blending location, incorporating 10% into gasoline raises its cost by about 4 cents/gallon, offset slightly by ethanol's higher octane rating. In today's market, the difference is covered by a 5 cent contribution from the excise tax credit.

Absent the subsidy, several things would have to happen. First, since the demand for ethanol required to meet oxygenated fuel specifications would not change, ethanol sellers into that segment should be able to hold their prices, while refiners would see their net cost of producing marketable gasoline rise. Eventually, the ethanol price for this segment would settle out at a level equivalent to the gasoline price plus the market value of the new, traded Renewable Identification Number attribute created by the RFS. Most of the resulting increase in gasoline cost would eventually be passed on to consumers.

Once the ethanol supply exceeds the quantity necessary to back out any remaining MTBE from the oxygenate requirement--somewhere around 6 billions gallons of ethanol per year--the price of any production in excess of the national RFS quota would fall toward parity with gasoline, plus a small premium for its octane value. Some of the surplus might end up in E-85, which at least for now commands a premium price, but the resulting price pressure would eventually trigger a shakeout among ethanol suppliers. Large, efficient (newer) ethanol producers would win, and some small producers with higher costs would go out of business, or have to idle their facilities until the expanding RFS quota broadened the mandated market enough to include them.

To complicate the picture further, if the subsidy were lifted, it would be hard to justify maintaining the 54 cent tariff on imported ethanol. If that were repealed, marginal US suppliers would find themselves under even more pressure, and they would lose share to imports that might come in at a low enough price to compete into gasoline on blending value alone.

But if small ethanol operators could ultimately lose from the end of the subsidy, who would win? Not the oil companies, which stand to see their blending costs increase, perhaps by more than they can recover in the marketplace. Although some foreign ethanol producers might benefit, the biggest winners would be the US economy and taxpayers. We'd get all the ethanol necessary for environmental and energy security purposes at the most efficient price, and at an immediate federal budget savings of $2.5 billion/year, and growing. At that point, the only remaining argument for continuing the subsidy would be to protect the least efficient domestic producers from competition, at a very high effective cost per gallon.