Is An Ethanol Compromise on the Horizon?

• The RFS ethanol mandate increasingly benefits farmers and ethanol producers at the expense of motorists, small-engine users, food producers and restaurants.
• Repeal of the RFS looks unlikely, but equitable reforms addressing the needs of all affected groups are possible, if Congress is willing to compromise.

Earlier this month, National Journal hosted an event on the “Biofuels Mandate: Defend, Reform, or Repeal” from Washington, DC. I encourage you to skim through the replay. The session highlighted a wide range of views concerning the US Renewable Fuels Standard (RFS), including those of the corn ethanol and advanced biofuels industries, poultry growers, chain restaurants, environmentalists, and small engine manufacturers. Although these broke down pretty sharply along pro- and anti-RFS lines, I thought I detected hints of the kind of compromise that might resolve this issue. I’d like to focus on the elements of such a deal, rather than rehashing the positions of all of the participants, with one necessary exception.

The most disappointing contributions to the discussion occurred during the interview with Representative Steve King (R, IA) by National Journal’s Amy Harder. If we accept Mr. King’s perspective, we should embrace the RFS as being as relevant today as when it was conceived, with no changes required. That flies in the face of the serious market distortions now manifesting in the “blend wall” at 10% ethanol content in gasoline.

Among other things, Mr. King claimed that a 2008 reduction of $0.06 per gallon in the now-expired ethanol blenders tax credit brought the expansion of the corn ethanol industry to a standstill. The industry’s own statistics tell a very different story, with US ethanol production capacity having grown by a further 86% since that point.

Rep. King also characterized “food vs. fuel” concerns as a bumper sticker issue, with no basis in fact. That issue might be controversial, but it is far too substantive to dismiss so cavalierly. The latest evidence of that is a vote by the European Parliament to cap the contribution of conventional biofuel — ethanol and biodiesel derived from food crops — at 6% of transportation energy out of a 2020 target of 10%, based on concerns about sustainability and competition with food. It seemed fairly clear that the Congressman views the RFS more as a farm support measure than an energy program.

The only one of Mr. King’s comments that seemed to find traction with the other pro-RFS panelists was his odd suggestion that without a mandate for biofuels, the only federal mandate in place would be one for petroleum-based fuels. Certainly, gasoline and diesel have advantages in terms of infrastructure, energy density and the legacy fleet, but he appeared to have something else in mind. From the way others picked up on this, perhaps it was his earlier reference to the tax benefits that conventional fuel producers have long enjoyed. This is the first and easiest element on which to compromise.

If ethanol producers and advanced biofuels developers are convinced that fossil fuels get a better deal from the federal government than the one they have under the RFS and the $1.01 per gallon producer tax credit for second-generation biofuels, it would be a simple matter to replace these programs with the same incentives received by oil and gas producers and petroleum refiners. After all, the biofuel industry already benefits from the Section 199 tax deduction that accounts for a third of budgeted federal tax benefits for the oil industry, and it shouldn’t be hard to devise an accelerated depreciation benefit analogous to “percentage depletion” and the expensing of intangible drilling expenses. Combined, the value of these tax benefits is about 1.3¢ per equivalent gallon of oil or natural gas produced this year.

Other concerns came across clearly. Despite the endorsement of 15% ethanol blends by the Environmental Protection Agency, blending more than 10% ethanol in gasoline creates serious risks for the US’s 500 million existing gasoline engines, large and small. The scale of corn diversion necessary to go beyond 10% is also distorting the US agricultural economy and food value chain, all the way to the restaurants in our communities. However, those engaged in developing new biofuels that don’t rely on edible crops, or that are fully compatible with existing infrastructure and engines, are legitimately worried that the repeal of the entire mandate would strand the significant investments in new technology that have already been made, and possibly smother their industry just as it nears its first commercial-scale deployments. All these points of view struck me as eminently reconcilable within a reformed RFS that recognizes that most of the assumptions of the 2007 mandate are no longer valid.

The starting point for reform of the RFS should be a 10% cap on ethanol from all sources in mass-market gasoline — excluding E85 — combined with measures to give ethanol from non-food sources priority within that cap over ethanol produced from corn or other food crops. The advanced biofuel targets of the RFS should also be scaled back significantly to reflect the reality that the 2007 targets were wildly optimistic. Ideally, they should be adjusted each year based on the previous year’s actual output. In return, the current producer tax credit for cellulosic and other second-generation biofuels could be extended beyond its scheduled expiration at the end of this year, and then phased out over a reasonable, predictable period, perhaps tied to cumulative output.

Finally, since few on the panel seemed impressed by the EPA’s exercise to date of its statutory power to adjust the RFS to fit changing circumstances, that authority should be transferred to another agency, along with clearer guidelines on when adjustments would become mandatory.

I’d be the first to admit that the reforms I’ve outlined above fall well short of the outright repeal of the RFS that many, including myself, would prefer. That’s the essence of compromise. Having just experienced a government shutdown and debt ceiling crisis brought on by the clash of two intransigent positions, this might be preferable to an impasse that leaves an unsustainable status quo untouched. And if the assessment of Representative Welch (D-VT) concerning the appetite of the Congress to take up this matter is accurate, something along these lines might just be achievable.

Reform of the RFS would leave in place for a while longer the outlines of a mechanism that one of the session's panelists accurately described as a Rube Goldberg construction. Short of a guarantee to bail out everyone who invested in biofuels production or research on the basis of the RFS that Congress put in place in 2007, should they fail in a post-repeal market, I’m not sure there’s another course that would be sufficiently equitable to all parties involved.

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

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.

It's Time To Reform US Ethanol Policy

• Virtually all of the assumptions underlying the Renewable Fuels Standard enacted in 2007 have changed, as the US emerges from energy scarcity into abundance.
• The linkage between the RFS and food prices is controversial, but a new quantitative model underscores concerns, especially for its impact on developing countries.

This April, two separate bills were introduced in the US House of Representatives to reform, or repeal, the federal Renewable Fuel Standard (RFS) that mandates how much ethanol and other biofuels must be blended into gasoline. A similar bill has just been introduced in the Senate. To understand why reform or repeal makes sense now, we should recall the factors that led Congress to enact this standard six years ago and consider how many of the basic assumptions underlying its design have changed since then.

That requires a review of US fuel consumption and import trends, commodity prices, and the impact of the RFS on food prices. After summarizing the other points I want to focus on the last one, based on an interview I conducted with Dr. Yaneer Bar-Yam, an expert on complex systems who has developed a model that explains the behavior of food prices since the introduction of the first, less ambitious RFS in 2005.
In the fall of 2007, when Congress was debating the Energy Independence and Security Act that included the current, enhanced RFS, the US energy situation looked dire. For four years oil prices had been rising more or less steadily from their historical level in the low-to-mid $20s per barrel (bbl) to around $90, on their way to an all-time nominal high of $145/bbl the following summer. US crude oil production was in its 22nd consecutive year of decline, while our crude oil imports had climbed to 10 million bbl/day, twice domestic production that year.

Even more relevant to the thinking behind the RFS, US gasoline consumption stood at a record 142 billion gallons per year and had been growing at an average of 1.6% per year for the previous 10 years–another 2 billion gallons added to demand each year. In its annual long-term forecast for 2007, the Energy Information Administration (EIA) of the US Department of Energy had projected that gasoline demand would grow to 152 billion gal/yr in 2013 and 168 billion gal/yr by 2020. Meanwhile, US net imports of finished gasoline and blending components had reached a million barrels per day in 2006, equivalent to 15 billion gal/yr–equal to the corn ethanol target set by the 2007 RFS for gasoline blending in 2015. And by the way, US corn prices for the 2006-7 market year averaged $3.04 per bushel (bu). In this environment, policy makers regarded ethanol as a crucial supplement to dwindling hydrocarbon supplies, from a feedstock that was cheap and readily expandable.

Without belaboring the events of the last five years, virtually every one of those trends has reversed course. That has occurred partly as a result of the recession and the lasting changes it produced in the US economy, and partly due to an energy revolution that was largely invisible in 2007 but had already begun.

US gasoline consumption peaked in 2007 and has since declined to 133 billion gal/yr last year. The EIA forecasts it to fall to 128 billion by 2020 and 113 billion by 2030. US crude oil output is the highest in 22 years and is set to exceed imports this year, while the US has become a net exporter of gasoline and other petroleum products. Since 2007 US ethanol production has grown from 6.5 billion gal/yr to 13.3 billion gal., and it seems more than coincidental that corn prices had doubled to an average of $6.22/bu by last year.

That brings us to the controversy that has been widely referred to as “food vs. fuel”. In the last several years I’ve read numerous papers attempting to determine by correlation or other empirical methods whether and to what extent the increase in US ethanol production from corn has affected food prices. To put this in context, since 2005 the quantity of corn used for US ethanol production has grown from 1.6 billion bu/yr to 5 billion bu/yr, or from 14% to 40% of the annual US corn crop.

Some studies, such as this 2009 analysis from the non-partisan Congressional Budget Office found a significant influence on food prices. Others, including an Iowa State study recently cited in a blog post from the Renewable Fuels Association, found a negligible influence. What differentiates the work of Dr. Bar-Yam is that he and his colleagues have developed a quantitative model based on two key factors — corn consumed for ethanol and commodity speculation — that closely fits the behavior of a global price index. Their model also accounts for the “distillers dried grain” byproduct from ethanol plants, which returns about 20% of the corn used in the form of protein-upgraded animal feed.

Before speaking with Dr. Bar-Yam, I was a bit skeptical of his results. Aside from skepticism being my default mode in such situations, I had spent a lot of time looking at claims of speculator influence on crude oil prices in the 2006-8 period and was never convinced that they were more than the “foam on the beer”, rather than a basic driver of prices. However, as I was reviewing his paper prior to our call, a light went on.

The curve his model predicted, which closely matched food price behavior, looked very much like the behavior of a process control loop responding to a ramped change in the set point–forget the jargon and think about how the temperature of your home responds to a steady increase in your thermostat setting: overshooting, then undershooting, before converging. We discussed this and he confirmed that it was effectively an "under-damped oscillator", which can be characterized the same way whether you're talking about an electrical circuit or a market. In effect, the steadily increasing corn demand from the ratcheting up of the RFS started corn prices rising, and the presence of lots of speculators, including “index fund” investors, caused the price to successively overshoot and undershoot the equilibrium price track one would expect.

Dr. Bar-Yam explained that he had arrived at these two factors by eliminating factors that other groups had investigated, but that turned out to have no predictive value. These included shifting exchange rates, drought in Australia, a dietary shift in Asia from grains to meat, and linkages between oil and food prices. In his view the focus on ethanol and speculation is validated by the shift in dialog on this issue away from other, extraneous causes.

He also emphasized that his main concern is not the price of processed foods in developed countries such as the US, for which commodity grain costs are only one input, but rather the price paid for simple foods by poor people in the developing world. From that standpoint he doesn’t just want to see the RFS reformed. ”It is important not just to repeal, but to roll back the amount of ethanol used in the US.” He would prefer not 10% ethanol in gasoline, let alone 15%, but about 5%. “The narrative has to shift,” he said, “to recognize that people are going hungry.” Those are powerful words, and I’m still thinking about them.

At current production levels ethanol from corn contributes the energy equivalent of 6% of US gasoline consumption and about 2.5% of total US liquid fuel demand. That’s not trivial, and there’s a whole domestic industry of investors, employees and suppliers who made that happen at our collective request. However, If Dr. Bar-Yam has accurately captured the relationship between ethanol and global food prices, then we urgently need to reassess what we’re doing with this fuel.

We are also in a far better position now to consider scaling back our use of ethanol produced from grain than we were when the RFS was established. With increasing production of shale gas, tight oil and various renewables, the energy scarcity that has defined our policies for the last four decades is far less relevant to our policy choices going forward. I’ll tackle the practical aspects of RFS reform, in terms of the so-called “blend wall” and its impact on gasoline prices, in a future post.

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

Ethanol's Future Without Subsidies

Given the remarkable longevity of the tax credit for ethanol blended into gasoline, it seems fitting that it would take a problem on the scale of the massive US deficit and $14 trillion federal debt to trigger its demise. Yet despite a widely-publicized Senate vote in June and the announcement of a key compromise among three Senators last week--two from the corn belt and one from the West Coast--it remains unclear just when and how the cancellation of this subsidy will become law. And because the fate of the subsidy is linked to that of the parallel tariff and duty on imported ethanol, the US ethanol industry faces not just the prospect of a more challenging market by year-end, but one that could include competition from foreign suppliers with special advantages under US renewable fuels regulations. Some producers may end up wishing they hadn't expanded output quite so fast.

I've followed the ethanol subsidy for much longer than I've been blogging about it. As I was reading a two-part assessment of the changing ethanol situation in Biofuels Digest it occurred to me to take the dusty report from my long-ago M.B.A. project off the shelf. Its topic was the market for "gasohol", gasoline blended with up to 10% ethanol, on the West Coast in the early 1980s. At the time, blenders received roughly the same tax credit as today's $0.45 per gallon of ethanol blended, thanks to the 1978 Federal Energy Tax Act and the Highway Tax Act of 1983. That benefit was a lot more generous in then-current dollars than now, but much smaller in aggregate. In the intervening decades, gasoline with ethanol has expanded from around 2% of the market to nearly 100%. In much of the country it is now harder to find gasoline without ethanol than it was to find gasohol back then.

That's only one indication of the tremendous success this industry has enjoyed, due almost entirely to government policies like the Volumetric Ethanol Excise Tax Credit and the national Renewable Fuels Standard (RFS) established in 2005. In fact the eventual demise of the ethanol tax credit was virtually guaranteed by the passage of an even more ambitious RFS as part of the federal Energy Independence and Security Act of 2007. Under the RFS, blending ethanol into gasoline in steadily increasing proportions became mandatory, rendering the tax credit paid to refiners and other gasoline blenders redundant. Just as importantly, it expanded the scale of ethanol blending to such an extent that the total annual cost of the so-called blenders credit grew from roughly $1.8 billion in 2005 to a projected $6 billion this year--too big to ignore.

The deal agreed by Senators Feinstein (D-CA), Klobuchar (D-MN) and Thune (R-SD) last week would reportedly result in the early termination of both the ethanol tax credit, which was due to expire at the end of 2011 but could have been renewed, and the corresponding ethanol import tariff. It would devote $1.33 billion of the unspent funds to deficit reduction, while diverting another $668 million to extend tax credits for alternative fuel refueling (or recharging) infrastructure and cellulosic biofuel tax credits. This outcome appears to have pleased at least part of the ethanol industry. However, in order for it to become law, it must still be voted on by both houses of Congress, either by itself or as a provision within another bill, perhaps even the debt ceiling extension package that could emerge from the ongoing deliberations between the House, Senate and White House.

The ultimate effect of these changes on the ethanol industry remains somewhat uncertain, though it is hard to see them as a net positive, other than the longer-term benefit of supporting infrastructure investments that could be crucial in resolving a key bottleneck in ethanol distribution. Without much higher sales of gasoline blends containing more than 10% ethanol, the market is already nearly saturated with ethanol, and that's before factoring in the additional imports that the elimination of the tariff is likely to promote. And at least in the case of ethanol derived from sugar cane, those imports will enjoy an important advantage over ethanol derived from corn: most of them are likely to qualify for the stricter designation of "Advanced Biofuel" under the RFS, a category for which the annual quota is just starting to take off, and that cannot be satisfied by corn ethanol but also seems unlikely to be filled by domestic cellulosic ethanol any time soon.

Biofuels Digest suggested that long-dated ethanol futures have already nose-dived in anticipation of the end of the tax credit. It's true that ethanol for delivery in January 2012 is trading for around $0.35/gal. less than the August 2011 ethanol futures contract, reflecting a widening of ethanol's discount to the gasoline futures contract over that interval of around $0.11/gal. However, it also seems highly relevant that corn futures have recently retreated from their early-June peak of nearly $8/bushel to $6.80, with December corn--from which January ethanol might be produced--down at $6.20/bu. That leaves ethanol producers a small but still positive margin on that January futures price. So it is hardly certain that the end of the tax credit will, by itself, stress US corn ethanol producers. If anything, refiners and consumers--who have arguably received most of the benefit of the credit in recent years--stand to lose the most from its disappearance.

Import competition could have much more serious consequences, as the fuel ethanol industry truly begins to globalize. Brazil is the big player internationally, even if the recent rise in sugar prices and a smaller-than-expected cane crop have created the bizarre situation of Brazil actually importing corn ethanol from the US. The historically fragmented Brazilian sugar cane industry is currently both expanding and consolidating, led by companies like Raizen, the new joint venture between Shell and Cosan, which has indicated plans to double its ethanol capacity to 5 billion liters per year (1.3 billion gallons per year.) Nor is Brazil the only tropical country that can grow cane and produce sugar, ethanol and electricity from modern facilities. The Brazilian model could be replicated elsewhere in Latin America, the Caribbean, and West Africa. Not all of that extra ethanol will come here, but enough of it could, helped by the RFS, to put an effective cap on US ethanol prices. I'm not aware of a similar constraint on corn prices.

The US ethanol industry has matured in the last three decades. Today's ethanol plants are much more efficient than the ones supplying the small quantities used for gasohol in the early 1980s, and they now consume around 40% of the US corn crop. The industry has expanded on a scale that would have seemed nearly impossible thirty years ago, though in my view it has in the process fallen into the classic overcapacity trap of commodity manufacturers. Whether that situation is temporary or permanent depends on the success of blends containing more than 10% ethanol--blends that the market has so far treated with indifference. But either way, when the training wheels finally come off with the end of the blenders credit and import tariff, we shouldn't be surprised to see more of the small and higher-cost producers fall by the wayside. That will have local consequences, but the ethanol industry will survive, just as it survived the bankruptcies of some ethanol producers during the financial crisis. Ethanol is here to stay, and it is about to embark on a new career as a more normal commodity.

Will Oil Prices Rescue Ethanol?

Time is running out for the ethanol blenders credit and the matching ethanol import tariff, which at least one industry publication suggests are likely to survive, but at "sharply reduced rates." Although I'm among those who suspect that the blenders credit probably benefits consumers more than ethanol producers, as long as the national Renewable Fuel Standard is binding on blenders, it seems fortunate for the US ethanol industry that this situation is playing out when crude and gasoline prices have risen to levels we haven't seen since spring, and could go higher if current economic indicators hold up.

The US benchmark futures price for crude oil is suddenly flirting with $90/bbl again, and UK Brent crude, a better gauge of world oil prices whenever WTI inventories at Cushing, OK are this high, has already surpassed that mark. Even if oil's move is at least partly the result of recent currency fluctuations, it is supported by fundamentals in the form of gasoline and distillate inventories that for the first time in months are back within their normal seasonal ranges. Crack spreads, an indicator of refining margins, look strong, reflecting solid demand. All of that suggests that if crude prices move higher, increases will be passed on in product prices, rather than being absorbed partly by refiners. That doesn't sound like good news for motorists, but how could it help compensate the ethanol industry for the potential loss of some or all of the $0.45 /gal. blenders credit?

It helps in two ways. First, by pushing wholesale gasoline prices above those for prompt ethanol even without factoring in the credit, this gives refiners more incentive to add as much ethanol to gasoline as they can, to increase their profit margins. That should put positive pressure on ethanol prices, even as blenders approach the 10% "blend wall" that the recent EPA decision on E15 hasn't yet affected. That opens up headroom for ethanol producers who have recently seen their margins, or "crush spreads", squeezed by strong corn prices. And it's especially crucial for those producers who only recently emerged from Chapter 11 protection after a protracted margin squeeze in late 2008 though mid-2009. This is an industry that spent the last five years in a frenzy of capacity building, and that only escaped creating a severe and persistent glut of ethanol because some of the marginal operators couldn't afford to run their plants. If gasoline prices fell while corn prices remain high, losing the blenders credit could put a number of plants back into bankruptcy; rising gasoline prices constitute a lucky break.

It's anyone's guess whether the present configuration of markets will remain in place long enough to ease the ethanol industry through the transition it faces after December 31, if the Congress cuts the blenders credit and tariff or allows them to lapse. After all, Europe has just dodged another bullet with Ireland, and the Euro could come under renewed threat from Portugal, Spain or Italy at any time. If recent shopping results are any indication, the US economy is looking healthier, although joblessness remains high and unemployment benefits for millions are set to end before the holiday bills come due. If oil prices swooned in the next few weeks, consumers might be relieved, but ethanol producers would see it as another lump of coal in their stocking.

Building a Market for Biofuels

For the first time in many years I find myself in general agreement with one of the major ethanol trade associations on a key matter of energy policy. Last week Growth Energy, which represents a significant portion of the US ethanol and biofuels industry, announced its support for a phase-out of the federal Volumetric Ethanol Excise Tax Credit, or "blender's credit", in preference to using these funds to provide incentives for constructing the infrastructure needed to offer ethanol at every gas station, and to promote vehicles that can safely burn higher-percentage ethanol blends. This looks like a prudent shift for several reasons, and I hope that the Congress is paying close attention.

No, I haven't suddenly abandoned my aversion to ethanol subsidies that have dragged on for more than three decades and are now long overdue for full retirement, at least for ethanol derived from corn and other food crops. The Congressional Budget Office just released a study on these subsidies showing that when applied to volumes of biofuel equivalent to a gallon of gasoline, the current $0.45 per gallon ethanol blenders' credit equates to $0.73/gal., and the full cost to taxpayers of displacing a gallon of petroleum gasoline with ethanol works out to $1.78/gal. That doesn't count any of the actual production costs of the fuel, either. US ethanol output may thus displace roughly 500,000 barrels per day of imported gasoline (or the imported oil from which to refine it) but it's hardly a bargain. However, I'm also aware that the US has made an enormous policy--and political--commitment to biofuels, including advanced biofuels from cellulosic biomass.

We've done this for reasons that transcend economics. But unless we invest smartly to create a bigger market for these biofuels, the Renewable Fuel Standard will shortly collide with the "blend wall", and US biofuels policy will be stymied. That will happen sooner than might otherwise have been expected, because instead of growing at a steady 1-2% per year as they had prior to the enactment of this policy, US gasoline sales have actually shrunk since then. Trying to cram additional amounts of ethanol into this market--and into cars that weren't designed to use more than 10% of it without damage to engines, fuel systems, and emissions equipment--is a dead end. In order to keep growing, ethanol--including cellulosic ethanol--requires an independent outlet. That's where E85, the 85% ethanol/15% gasoline mix that's as close to straight ethanol as can effectively be delivered to the gas station and used in flex-fuel cars, comes in. So far, though, E85 occupies a tiny niche market mainly in the corn states of the Midwest.

Growth Energy appears to have assessed the longer-term environment for their fuel and reached a similar conclusion: paying refiners to blend ethanol into the shrinking space left in each gallon of ordinary gasoline--which is what the current VEETC does--now makes a lot less sense than helping the nation's 100,000-plus service stations (most independently owned) to adapt their forecourts to deliver a wider mix of products. Promoting flexible fuel vehicles--including wider awareness of which cars are already capable of safely using higher ethanol blends--is also an important element of creating a market for these fuels, though to some degree this is already underway through the government's Corporate Average Fuel Economy regulations and voluntary manufacturer initiatives.

This won't be easy. Growth Energy expresses confidence that ethanol can compete against gasoline without a per-gallon subsidy, as long as it's widely available and most cars are equipped to burn it. However, the industry must somehow overcome the fact that each gallon of pure ethanol contains just 66% of the energy of a gallon of petroleum gasoline. Most drivers don't notice the impact of this when they use gasoline blended with 10% ethanol, but at 85% ethanol and just 15% gasoline, this effect becomes impossible to ignore. Beyond those customers willing to absorb that hit for reasons of perceived patriotism or environmentalism, E85 must ultimately be priced at a discount that reflects the reality that a tank of it won't take you nearly as far.

As of last Friday, ethanol for August delivery traded for $1.61/gal on the Chicago exchange. (That doesn't include freight to market, mainly by rail, which can easily add another dime.) That works out to $2.46 per gasoline-equivalent gallon. Meanwhile Unleaded Regular without ethanol was worth $2.05/gal on the New York exchange (pre-tax.) Nor is this difference anomalous; over the last year wholesale gasoline was consistently cheaper than its energy equivalent in wholesale ethanol, to the tune of roughly $0.90/gal. Unless the ethanol industry figures out how to produce its product at a lower cost, or gasoline prices go up without ethanol prices following, as they did in 2008, then tax credits for distribution and sales infrastructure may not foster as big a market for ethanol as Growth Energy expects, or as profitable a market as I'm sure they'd like. Yet as a matter of policy equity, and from the standpoint of what taxpayers are getting for their money, guaranteeing access for ethanol looks like a better approach than guaranteeing sales, as we do now. It also has the additional benefit of having a logical end-point, instead of the open-ended support we've effectively provided ethanol since 1978.

The current ethanol blenders' credit expires at the end of 2010. The announcement by Growth Energy is even more notable because the Renewable Fuels Association, which represents a larger slice of the industry, has come out in favor of an extension of existing policy through 2015, when the subsidy in question would likely approach $7 billion per year. If this divergence within the ethanol industry is reflected among its supporters in Congress, we could see a surprisingly lively--and fruitful--debate over how best to integrate support for ethanol into a more cohesive national energy framework. Compared to continuing the status quo, Growth Energy's idea of investing to create a mass biofuels market, rather than just paying for space in gasoline, has considerable merit. This approach could also be done for a lot less than the current subsidy, because it wouldn't be necessary to install E85 pumps in every service station in the country. Most of the benefit could be achieved by focusing incentives on strategically-located high-volume outlets, and the rest of the money could go back into the Treasury, where it belongs.

Ethanol and the Gulf Spill

The implications for the oil industry from the ongoing Gulf of Mexico oil spill are already taking shape, with the administration calling for a Challenger-style investigation and rewriting the playbook for oil & gas leasing and the issuance of safety and environmental permits for offshore drilling. It's less clear how the spill might affect other aspects of energy, beyond boosting the public's interest in pursuing clean energy options. However, it would be ironic if a problem perceived to have arisen because of a "cozy relationship" between oil companies and regulators resulted in an even cozier relationship between the government and the ethanol industry that depends on it for both financial support and the rules that mandate the use of its product. Yet that's exactly what could happen as the administration decides whether to increase the allowable percentage of ethanol in gasoline.

Perhaps you've seen the new ads from Growth Energy, an ethanol trade association: "No beaches have been closed due to _____ spills", with the word "ethanol" fading slowly into view. Then there's "We won't have to wait millions of years to replenish our _____ reserves," and other statements emphasizing ethanol's employment and energy security benefits. It's a clever campaign, and well-timed. On one level, using more ethanol in gasoline seems an obvious response to concerns about our dependence on oil. For all its many shortcomings, ethanol remains the most successful oil substitute in the US market, thanks to the combination of a $0.45 per gallon blenders' tax credit and the steady ratcheting-up of the annual federal renewable fuels standard. Ethanol currently displaces the equivalent of approximately 500,000 barrels per day of gasoline that would otherwise be imported or refined here from imported crude oil. The problem is that the market penetration of ethanol is rapidly approaching the 10% blending limit that has been approved as safe for use in engines that haven't been modified to run on higher-percentage ethanol blends, such as E85. And because E85 has so far failed dismally to take off--accounting for just 0.01% of US gasoline sales in 2008, based on EPA's analysis--any additional ethanol would have to be squeezed into ordinary gasoline, at least in the near term.

Our proximity to this threshold, referred to as the "blend wall", is determined by two factors, in addition to the federally-mandated ethanol blending volume: total US gasoline sales and US ethanol output. Last year Americans bought just under 138 billion gallons of gasoline (including the ethanol blended into it), a reduction of about 3% from the 2007 peak. Without further growth in demand, 10% of that would be 13.8 billion gallons per year (gpy). According to the Renewable Fuels Association, another ethanol trade association, the capacity of existing US ethanol facilities plus those under construction already totals 14.7 billion gpy. In other words, once all the ethanol plants now being built are finished, the industry could supply more than 10% of US gasoline demand without breaking a sweat. But without either a higher blending limit in gasoline or a sudden, unexpected surge in E85 sales, any additional ethanol beyond that level would have no home in the US fuels market. Nor is it obvious that corn ethanol exports represent a viable long-term outlet. Left unresolved, this is a guaranteed train-wreck.

Under the circumstances, it's natural for the ethanol industry to ask its patron for help, in the form of a request for a waiver to blend more than 10% ethanol into each gallon of gas. Last winter, the Environmental Protection Agency told Growth Energy that it was studying their request and would respond by mid-2010. That deadline is nearly upon us, and with more oil spilling into the Gulf of Mexico every day, the pressure on EPA to agree must be mounting. This can't be an easy call to make, especially with the auto makers citing test results indicating that ethanol blends above 10% could harm some car engines. Saying no would call into question the nation's entire long-term renewable fuels strategy, at a time when green jobs and green energy are being widely promoted as the key to a new, more competitive economy. Yet granting that request, either as a favor to the ethanol industry or as a hasty response to the Gulf Coast oil spill would be a mistake that could have serious repercussions, both for consumers and for the administration making such a call. Stay tuned.

Update as of 6/18/10: EPA delays its decision on E15 until the fall.

Half a Loaf

When I wrote Monday's posting mentioning the impending conflict between the government's requirement to increase the volume of biofuels blended into gasoline and the current approved maximum ethanol blending limit of 10%, I was unaware that the EPA was about to issue a response to the industry group that had requested a waiver to increase that limit to 15%. But while the letter the agency sent to Growth Energy yesterday deferred any ruling until mid-2010, it gave a clear indication that the EPA is considering splitting the baby, in the form of an increase for part of the fleet: those cars built in 2001 or later. Sometimes such a quasi-Solomonic decision reflects wisdom and flexibility; at other times it elevates compromise above common sense. I'm sure you won't be surprised to learn that I suspect this case falls into the latter category.

First, we should applaud the EPA for declining to be stampeded by an interest group into making a decision before its own test results are all in, particularly concerning the impact of blends containing higher proportions of ethanol on the durability and emissions (air pollutants, not CO2) of a representative cross-section of the US vehicle fleet, which numbers roughly 240 million passenger cars and light trucks/SUVs. The agency is right to insist that the science should be clear before the blending limit is increased. Unfortunately, there's more than science involved.

If any group outside the energy industry ought to have a clear understanding of the consequences of fragmenting the marketplace through the creation of Balkanized environmental specifications for fuels, it ought to be the EPA, since they and their state regulatory counterparts have presided over just such a system in the last couple of decades. This is why gasoline blended for use in Oregon or Washington can't be sold in California, and gasoline blended for rural areas can't be sold in metropolitan areas that have been designated as "non-attainment" areas for ozone and other pollutants. This has a direct impact on consumers by raising the cost of suppliers' inventories and deliveries to areas with divergent specifications, and more significantly by delaying the response to local supply outages. If the EPA is seriously considering establishing two blending standards for ethanol, it would further fragment the fuels market, not along geographic lines, but down to individual service stations, because the likelihood of them all carrying Unleaded Regular (E10), Unleaded Regular (E15), Mid-grade (E10), Mid-grade (E15), and so on, in addition to diesel and eventually E85 and whatever else they dream up is essentially zero.

Let's rewind the tape for a moment to recall how the situation the EPA is attempting to address arose in the first place. When the Congress set the new Renewable Fuel Standard as part of the Energy Independence and Security Act of 2007, it was obvious to all involved that even if US gasoline sales had continued to grow at 1-2% per year, as they consistently had prior to the Great Recession, we would rapidly reach the point at which the quantity of ethanol mandated for use would exceed 10% of our annual motor fuel use--long before the mandate reached its 36 billion gallons per year (gpy) target in 2022, including a billion gpy for biodiesel. That wasn't deemed to be a problem, since E85 sales were expected to take off in a big way, soaking up all that extra ethanol. In fact, before it started to shrink the gasoline pool looked like it could accommodate the entire 35 billion gpy of ethanol with an E85 sales percentage as low as around 18%. Today you'd probably have to bump that up to nearly 25%. Unfortunately for this scenario, E85 sales are not on any kind of trajectory to reach that threshold.

One E85 website reports that 2,211 gas stations around the US sell E85. Finding reliable statistics on actual E85 sales is time-consuming, but if all these stations sold at the current Minnesota average of around 4,000 gallons per month, then total US E85 sales are just over 100 million gpy. That's less than 0.1% of US gasoline sales, or just about enough to absorb the output of one typical ethanol plant. These figures also suggest that the roughly 6 million "flexible fuel vehicles" apparently on the road today are consuming E85 less than 10% of the time, either because of availability, or because the average discount between E85 and gasoline is typically much less than the 25% or so necessary to compensate for its lower energy content. And availability is a function of the significant expenses involved for service stations in either converting an existing tank and pumps for a higher-volume product to E85, or investing in additional tanks and pumps--including the downtime involved in such a project.

In other words, the ethanol industry (and the EPA) are in a bind now because the strategy for increasing ethanol use hinged on the expansion of sales for a new blend of ethanol and gasoline that is incompatible with existing service station infrastructure and with most vehicles on the road, and their best solution to the breakdown of that strategy appears to involve introducing yet another new blend of ethanol and gasoline that is incompatible with existing service station infrastructure and many cars on the road. Using this logic, the answer to the financial crisis would have been to launch another wave of new financial derivatives and sub-prime loans. Perhaps it's time for a simpler answer: If the tests by the EPA and DOE indicate that a significant number of vehicles could be harmed by a 15% blend of ethanol in gasoline, or that such a blend would increase local air pollution, then surely it is time to call a halt to the annual increases in mandated ethanol use until a more practical solution can be found.