The rising costs of ethanol in the US

The US Federal government provides a range of subsidies, tax incentives, and regulatory mandates to promote the use of ethanol and other renewable fuels into the national gasoline pool. Until recently, ethanol use was limited by law to a maximum of 10% of the gasoline pool, or as a specialty fuel at high levels of concentration (a 70-85% blend called E85) for use only in “flex-fuel” vehicles.
Under the Renewable Fuel Standard (RFS), volumetric requirements for ethanol increase annually regardless of the growth in gasoline use. For 2011 the RFS requires the gasoline pool to reach nearly 10% of the national pool. Ten percent has historically been viewed as the limit for safe use in conventional vehicles. So called “obligated parties,” such as refiners and importers, can only market additional volumes through greater sales of E85, but E85 has met considerable consumer resistance because of its high cost at the pump and because it provides fewer miles per gallon than gasoline. E85 also requires large investments in new pumps and tanks at retail outlets. In response to concerns over the market limitations of E85, the EPA has authorized the use of a new fuel, with 15% ethanol (E15), for model year (MY) 2001 and newer cars, with certain exceptions. These initiatives to increase the blending volumes for gasoline have been sought as a means to create additional market access for the mandated volumes of ethanol as the 10% volumetric level, or “blendwall” is reached.

One of the major obstacles to rapid increases of corn ethanol into the gasoline pool is the rising cost of ethanol’s principal feedstock, corn. Domestically produced ethanol should have provided some modest constraint on the rising cost of gasoline as turmoil in the Middle East and North Africa has sent crude oil prices well above $100 per barrel (bbl). Instead, ethanol has seen its feedstock costs more than double over the past 10 months, an increase considerably greater than the rise in crude prices over the same period.

U.S. policy requiring ever larger volumes of ethanol blended into the gasoline pool is now running into two distinct and important cost realities, both of which are likely to contribute to price increases in gasoline above the rising acquisition cost for crude now faced by domestic refineries. The first is the rapidly rising cost of corn. Disappointing U.S. corn yields, loss of wheat crops worldwide, and increasing domestic and international demand for corn has pushed prices from $3.50/bushel to over $7.50/bushel since the summer of 2010, driving up ethanol prices to levels well above the cost of gasoline when adjusted on a GGE (gallon of gasoline equivalent) energy basis. Expanding access will not solve the cost problem because it cannot provide a cost competitive alternative to E10.

The second problem is the volumetric mandate on the use of ethanol in the U.S. gasoline pool which will soon cross the threshold of 10% by volume. The RFS requires the placement of greater volumes of ethanol into the gasoline pool every year. When the RFS program was implemented in EISA (Energy Independence and Security Act) 2007 it was believed that corn ethanol would be cheaper than gasoline and that U.S. gasoline consumption would continually rise, therefore avoiding a blendwall problem. However, neither assumption has proven correct. The transportation fuels sector is now left with a program that mandates the blending of a fuel regardless of cost, demand, infrastructure, or value.

The RFS mandate not only increases prices at the pump as it requires blending larger volumes of a relatively expensive fuel, but it also creates market distortions and regulatory uncertainty throughout the transportation fuels supply chain. For example, E15 is not appropriate for heavy duty vehicles or vehicles built before 2000, nor is it appropriate for boats and small engines such as lawnmowers and chainsaws. It will require special retail blender pumps and tanks costing approximately $120,000 each and yet to be determined labeling to avoid misfueling. The auto industry remains concerned over E15’s safety in vehicle engines, and the new blend level creates the potential for misfueling – all of which raises the liability to any refiner that produces E15. Most vehicles are warrantied only for E10 fuel and it is unclear who holds the liability for any damage which might be caused by E15. It is illegal to sell blends above E10 to non flex-fuel MY 2000 or older vehicles. These concerns are likely to limit E15’s introduction on a national level. In addition, production costs for E85 and E15 are not likely to be cost competitive with E10.

In a market free of volumetric mandates, costs would be the prime determinant in evaluating the appropriate mix of ethanol and gasoline sold at the pump. EPRINC’s analysis shows that the volumetric ethanol mandate for the gasoline pool is bringing a more costly product to the market. Gasoline RBOB futures have recently traded (May 2011 contracts) at $3.40/gallon and fuel ethanol futures prices (May 2011) at $2.60/gallon. But when ethanol prices are converted to a gasoline energy equivalent basis, the true price of ethanol is $3.90/gallon. Ethanol, when adjusted for BTU and MPG equivalence, consistently sells above the price of gasoline at retail outlets.

The Congressional debate over the deficit has highlighted concerns over the cost of ethanol subsidies, now estimated at nearly $6 billion per year. The true cost is much higher. Absent volumetric mandates and blending tax credits, the U.S. would consume approximately 400,000 bbls/day (barrels per day) of ethanol, half the amount of ethanol consumed today. Ethanol is highly valuable as an oxygenate, particularly since the previously used oxygenate, MTBE, was phased out of use. At current prices the natural market for ethanol is 3%-5% of the gasoline pool (see figure 5), but it could be larger under alternative pricing environments. At best, RFS is responsible only for the incremental blending of 400,000 – 500,000 bbls/d of the 800,000 bbls/d of ethanol consumed in the U.S. today. Therefore true cost of the blender’s credit is closer to $0.90/gallon rather than the nominal credit of $0.45/gallon.

The Federal government estimates that programs which reduce petroleum imports are worth approximately $14 per barrel. Using estimates routinely used by EPA, the $14 per barrel benefit for import reduction yields $2.7 billion in “import savings” benefits for 2011. These benefits must be compared to the direct and indirect costs of the program. The blender’s credit alone costs the federal government over $6 billion in lost revenue. In addition to these costs are the cost of grants, loan guarantees, loss of efficiencies in refinery and retail operations, and any impact the ethanol subsidies may have on corn prices. These additional requirements further expand the costs of the program, but even without including these additional costs of RFS, the loss of tax payer revenue alone far exceeds the benefits from the program by nearly 3 to 1.

It is not surprising that volatility in the oil market is also present in the corn market. Corn is a globally traded commodity and China, the world’s second largest corn producer, has recently become a net importer of U.S. corn for the first time in many years, slowly leaving behind a policy of grain self-sufficiency. Both the ethanol market and the gasoline market cannot be isolated from global market forces. As long as both of these commodities are locked into a regulatory environment that strictly prohibits adjustments to changes in market conditions, opportunities to temper the costs of market volatility through adjustments in the domestic fuel mix will remain limited, with corresponding and unnecessary cost increases for transportation fuels.

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