Fuel vs. Biofuel

Yesterday's New York Times carried an interesting article examining the conflict between biofuels and conventional fuels from a different angle. This isn't about resistance to E85, or the growing food vs. fuel problem manifesting at grocery stores around the world. Rather, it's a simple question of competing future fuel supplies that domestic refinery owners must factor into their expansion plans. As the article explains, industry analysts and company officials are starting to express concern that expanding biofuels production, driven by a new federal standard, will put a cap on plans to increase refinery capacity.

I raised this issue in an energy blogger conference call hosted by the American Petroleum Institute last week, and I've been thinking about it ever since. Ethanol production in the US last year stood at 4.9 billion gallons. 15 billion gallons per year--still well short of the President's target of 35 billion gallons--is a reasonable expectation for 2012, but it's also the magic level at which the combination of corn supply curves and the ability to blend ethanol into conventional gasoline hit natural limits, using current technology. In five years the output of any refinery expansions begun this year or next would be competing with an extra 10+ billion gallons/year of biofuel. That incremental ethanol is the equivalent of 460,000 barrels per day (bpd) of gasoline, adjusted for energy content.

A company planning a refinery expansion would have to consider the future market in which its project would operate, when estimating its financial returns. Between now and 2012, the US gasoline market could expand by 570,000 bpd, if it grew at a typical 1%/year over the 2006 average. However, mandated ethanol expansion would leave only 110,000 bpd of that market growth for refinery expansions to cover. At an average gasoline yield of 55%, that equates to 200,000 bpd of integrated refining capacity, or roughly one new refinery. Bear in mind that the industry has been talking about adding the equivalent of six new refineries over that period.

There's another piece of the market that our hypothetical company project manager couldn't ignore: imports. Gasoline imports have ranged from as little as about 600,000 bpd to as much as 1.6 million bpd in the last three years, averaging 1.1 million last year. Even on the minimum side of that range, there's plenty of scope for backing out imports with new US capacity. To proceed on that basis, however, a US refiner would have to feel confident in bringing an expansion on-stream at a combined capital and operating cost lower than that for a new offshore refinery, adjusted for freight. Given the higher construction, permitting and labor costs in the US, compared to, say, the Middle East, that looks like a risky bet. Even if the expansion would compete with an existing refinery in Europe, rather than a start-up elsewhere, it's still a shaky proposition, because of the difference between incremental and full-cost economics. And if higher gas prices finally slowed the growth of the US gasoline market, the whole thing looks like a loser.

The expansion of US ethanol blending to 15 billion gallons or more over the next five years has a direct impact on the headroom for refinery capacity additions. No one should expect oil companies to make multi-billion dollar investments that don't offer the prospect of attractive returns, especially considering the risks that go along with these facilities. Nor could canceling previously announced projects be fairly characterized as keeping supply off the market, since these companies are not regulated utilities, which get a guaranteed return on new capacity. Unless I've missed something significant, any supply-based price relief for gasoline may have to come from ethanol producers, rather than new refining capacity not already in the works.

Please note: Energy Outlook will be on vacation next week, with regular postings resuming on June 4.