Monday, January 07, 2008

The Biofuel Gap

When I was writing last Wednesday's posting on the year ahead, I was tempted to call 2008 the Year of Biofuel. That's wasn't because I think biofuel will necessarily be the most important energy development of the year, but because, of all of the provisions of the recently-enacted Energy Bill, its greatly expanded renewable fuel standard (RFS) will have the most immediate impact on domestic energy markets, and not all of it good. The new standard requires an increase in ethanol use in 2008 that could not be met by the domestic production facilities existing at the time of the bill's passage, or with current levels of imports, which already face a substantial tariff barrier. So while some ethanol producers struggled in 2007, with margins squeezed between rising corn prices and flat wholesale prices to blenders, it's hard to see how their fortunes could fail to improve this year.

The phase-in of the RFS in the Energy Bill instantaneously increased the size of the US ethanol market, starting on 1/1/08. The RFS previously in effect called for 5.4 billion gallons of renewable fuel to be used in 2008--well below the 6.4 billion gallons of ethanol the industry was on track to deliver in 2007. The new law hiked that to 9 billion gallons per year (GPY) of "conventional biofuel"--mostly corn ethanol--this year and 10.5 billion next year, increasing to 15 billion by 2015. With domestic production running at just over 7 billion GPY in October, the last month for which data is available, and imports contributing perhaps another half billion GPY, meeting the federal target this year will require a lot of new facilities to start up, or a lot more imports. In other words, demand suddenly exceeds supply, by mandate, and that ought to translate into a healthy increase in ethanol margins, once the EPA gears up to administer the new standard.

On the surface, this doesn't sound like much of a problem. After all, doesn't every additional gallon of ethanol reduce the amount of foreign energy we have to import and benefit the environment by reducing greenhouse gas emissions and local pollution? For a thorough answer to that question, I refer to you the excellent article on biofuels in the current issue of MIT's Technology Review, available in three parts on the Internet. But even if ethanol were as beneficial as its most ardent advocates claim, the Congress and President cannot sweep away with the stroke of a pen the logistical bottlenecks involved in getting ethanol from distilleries to gasoline blending terminals all over the country. Those problems helped depress ethanol prices last year and will have to be overcome on the ground, in order to expand the use of ethanol beyond the oxygenated fuel markets from which it has successfully displaced MTBE, which has fallen out of favor due to product liability concerns, or where its supply has been cheap and reliable enough to compete as a separate product, in the form of E-85 for "flexible-fuel vehicles."

As I understand it, companies unable to secure enough ethanol to meet their new quotas would have to purchase blending credits from other companies that blended in excess of their quotas--something that would only be possible if shortages were local, rather than national, and that could run afoul of the current 10% upper limit (E-10) on ethanol/gasoline blends into conventional cars. That would also increase the cost of fuel in areas that can't easily be supplied with ethanol. The alternative would be to apply for a waiver of the portion of the RFS that couldn't be filled practically. That could prove controversial, if the production from new ethanol facilities--however remote from the actual demand--were going begging. When I ponder what this is likely to mean for the business of getting motor fuel reliably to over 100,000 retail sites, I don't envy my former colleagues in the supply and distribution segment of the oil industry.

However unenthusiastic many of us are about corn ethanol, the new RFS is a fact, and our focus should be on minimizing the disruptions it could create in fuel markets. At least until the logistical problems can be addressed by new infrastructure, the best outcome would probably be for as much as possible of the incremental ethanol requirement to be consumed in the form of E-85 in the Midwest, where most corn ethanol will continue to be produced, thus minimizing the cost and constraints associated with distributing it to the most remote corners of the country for E-10 blending. One can only hope that the painful experience gained from this exercise will be useful in smoothing the way for the eventual introduction of cellulosic ethanol, which should be more economical and environmentally-beneficial, and for which a separate RFS quota starts to ramp up in 2010.

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