Crashing into the Ethanol Blend Wall

• The long-anticipated arrival of the ethanol "blend wall" for gasoline is the inevitable result of a federal policy designed for a world of expanding gasoline sales that no longer exists.
• This is not just another arbitrary crisis; it is already costing consumers at the pump, and those costs will increase unless the Renewable Fuel Standard is reformed or repealed.

The Energy and Commerce Committee of the US House of Representatives held hearings late last month on the Renewable Fuel Standard (RFS). It’s otherwise known as the ethanol mandate, although it covers biodiesel, as well. The hearings were timely, since at least two bills have been introduced to reform or repeal the RFS.  During the session on July 23rd, Rep. Waxman (D-CA) referred to the “gasoline blend wall, which may be around the corner.” In fact, a review of current gasoline sales and this year’s final ethanol target--just issued yesterday!--confirms that the ethanol “blend wall” has arrived, at least for some of the nation’s refiners. That explains the urgency of the debate about the future of the RFS.

The blend wall is simply the threshold at which the RFS requires more ethanol to be blended into US gasoline than the quantity necessary to dose essentially all of it with the maximum 10% ethanol content for which most cars on the road were designed. Because the Environmental Protection Agency, which administers the RFS, has been unwilling to exercise its flexibility under existing law, the fuels industry must now choose from a set of unattractive options: It can limit mainstream gasoline to 10% ethanol content and absorb substantial RIN costs (see below) or statutory penalties for failing to blend the required volumes of biofuel. It can produce less gasoline than the country needs, or export more of its production, to reduce its renewable fuel obligations. Or it can produce higher-ethanol blends such as E15 and risk the integrity of millions of cars and large portions of the country’s fuels infrastructure, including all but the newest gas station pumps and tanks. All of these choices affect the price consumers pay at the pump.

In order to understand why the blend wall is a serious problem, rather than another arbitrary crisis, we need to examine its two main elements. The first is fairly straightforward, relating to the mechanical integrity of the pumps and seals in automobile engines and fuel systems, as well as refueling infrastructure. While most of these function acceptably with blends of up to 10% ethanol in gasoline, there’s significant controversy about what happens above that threshold. As I noted in June, this issue has become relevant much sooner than the 2007 law anticipated, because US gasoline sales have declined instead of continuing to grow by 1-2% per year, while sales of E85 remain small and mainly regional.

As the head of the American Automobile Association (AAA) indicated in his testimony before Congress, any new product like E15, which consists of 15% ethanol and 85% petroleum gasoline, should have been tested thoroughly before release. Although the EPA conducted extensive testing before certifying E15 for use in 2001 and later model cars, as best I could tell their focus was on vehicle emissions systems, rather than mechanical integrity. Other tests conducted at the behest of the fuels industry identified problems with higher ethanol blends in vehicles not specifically designed as “flexible fuel vehicles” (FFVs) which can use up to 85% ethanol. UL previously tested existing service station product dispensers (gas pumps) and observed leaks and other failures above 10% ethanol. The uncertainties that have been raised by independent testing may not be conclusive, but they can only be resolved by a lot more testing on actual vehicles, not by rhetoric. The bottom line for consumers is that most carmakers won’t warrant any but their latest models for use with E15.

Another important but more obscure aspect of the blend wall relates to a feature of the RFS called Renewable Identification Numbers, or “RINs”. The RFS regulations created RINs for tracking purposes, to provide “the basic framework for ensuring that the statutorily required volumes of renewable fuel are used as transportation fuel in the U.S.” But they also have another purpose. RINs can be separated from the physical gallons of renewable fuel and traded in the market, effectively becoming paper ethanol. Enabling this RIN market, which includes both “obligated parties” — mainly refiners and importers of finished gasoline — and non-obligated parties such as gasoline blenders and traders, provides some flexibility in the RFS compliance system. It allows refiners that cannot blend any more ethanol into their direct fuel sales — or cover their typically larger sales of pre-ethanol product — to satisfy their legal obligations under the RFS by presenting a certificate, instead.

This worked reasonably well when the annual blending target was lower and refiners and marketers could bank RINs for future use by blending more ethanol than required, while remaining under the 10% limit. However, only 20% of the RINs generated in that manner last year could be carried over into 2013, restricting the supply just when the market approached the overall 10% blend wall. My understanding from those who follow this market is that this “bank” will become insolvent sometime next year, limiting new RINs largely to those generated from sales of E85 in the Midwest.

Now, with the blend wall a reality, the limited stock of RINs from past blending is being drawn down at prices that have spiked from a few cents per gallon-equivalent at the start of the year to well over $1.00 recently. Some refiners are spending hundreds of millions of dollars on RINs. It’s hard to determine how much of that is being passed on to consumers in fuel prices, because of the complexities of the RIN market and the agreements that various participants have made concerning the allocation of RINs. If 100% of their cost were passed on, then RINs at $1.00 would add $0.10 per gallon to the price of gasoline at the pump. The higher the annual RFS target ratchets, the higher RIN prices could go, with a recent estimate setting the potential impact on gasoline prices in 2014 at $0.19/gal, with the possibility of even larger increases in diesel prices.

Another potential outcome mirrors a comment made the hearings by the CEO of Cumberland Gulf Group, a large gasoline distributor. He characterized the functioning of the RFS and its RIN provisions as “subsidizing exports and taxing imports.” Refiners that don’t have enough RINs to cover their gasoline production will weigh current RIN prices against the profit they could generate by exporting more of their output to other countries, thus reducing the volume that must be covered by RINs. This could have an even bigger impact on the US gasoline market than merely passing through the cost of RINs. That's because gasoline prices are set by the last increments of supply and demand, and small shortfalls can translate into large price increases. That’s exactly what seems to be happening now in the artificial market the EPA has created in RINs.

The original purpose of the RFS and the law that established it was to reduce US reliance on imported oil, along with reducing greenhouse gas emissions. Because of its lower energy content the ethanol blended into US gasoline this year displaces about 540,000 barrels per day of gasoline produced from petroleum, though with questionable environmental benefits. That’s almost exactly the average quantity of finished gasoline and gasoline blending components exported from the US in the last 12 months reported.  Although that might be at least partly coincidental, it’s a further indication of just how much our national energy situation has changed since the legislation establishing the current RFS was passed in 2007.

One of the experts appearing before Congress characterized ethanol as an additive, rather than a replacement fuel. Until and unless E85 sales grow dramatically, that seems apt. Our elected representatives should now be asking themselves whether it makes sense — in light of altered circumstances and the EPA's decision to defer any administrative adjustments in the RFS until next year — to subject the US motor fuels market and consumers to a new and entirely artificial source of price volatility for the sake of an additive that the CEO of Growth Energy, a major ethanol trade association, testified would continue to be produced and sold in the absence of the mandate. When considered together with serious questions about its impact on food supplies and prices, the case for at least reform of the Renewable Fuel Standard is compelling.

A different version of this posting was previously published on Energy Trends Insider.