Only Thing Clear in Corn Ethanol Mandate Debate: RFS Language Needs Changing

August 27, 2012 05:28 AM

Via a special arrangement with Informa Economics, Inc.

NOTE: This column is copyrighted material, therefore reproduction or retransmission is prohibited under U.S. copyright laws.

Flaw in RFS mandated amounts started with initial inflexibility

RFS impacts come from no impact analysis. When the Renewable Fuels Standard (RFS) mandate for corn-based ethanol first surfaced in 2005 legislation and when the mandate amount virtually doubled via 2007 legislation, not much if any impact analysis surfaced, especially from sectors like the U.S. animal industry that has been one of the most impacted by those mandated levels. That lack of economic analysis at the time the energy legislation was written continues to bite the industry most impacted by the mandate law.

Background on RFS. Congress first established an RFS with the enactment of the Energy Policy Act of 2005 (EPAct, P.L. 109-58). This initial RFS (referred to as RFS1) mandated that a minimum of 4 billion gallons be used in 2006, and that this minimum usage volume rise to 7.5 billion gallons by 2012. Two years later, the Energy Independence and Security Act of 2007 (EISA, P.L. 110-140) superseded and greatly expanded the biofuels blending mandate. The expanded RFS (referred to as RFS2) required the annual use of 9 billion gallons of biofuels in 2008 and expanded the mandate to 36 billion gallons annually in 2022, of which no more than 15 billion gallons can be ethanol from corn starch, and no less than 16 billion must be from cellulosic biofuels. In addition, EISA carved out specific requirements for "other advanced biofuels" and biomass-based biodiesel. (See table below for volume details.)

Cause and effect. When corn prices have rallied in recent years, livestock interests and governors from states housing those animals have been quick to propose a waiver of the Renewable Fuels Standard (RFS), as in the case in recent months.

Ethanol lobby groups have been just as quick to say hands off - no matter what the corn carryover and price level. A National Pork Producer Council official summed up the latest frustration with the no-change crowd as, "If not now, when?" in commenting on the meager pipeline corn carryover level projected for the 2012/13 marketing year. Remember that quote because some say it is the key to eventual legislative changes needed ahead.

The worst drought in half a century has brought another food-versus-fuel debate. Livestock and food producers and others are calling on the Environmental Protection Agency (EPA) to make a change. But insiders know full well it will be President Barack Obama and his top officials and not EPA administrator Lisa P. Jackson along with consultation from Energy and USDA that will make any decision to waive the RFS.

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The Obama administration has until Nov. 13 - after the Nov. 6 elections - to decide on the waiver petition requests. The EPA announced Aug. 24 that the Aug. 27 Federal Register will officially publish the EPA's call for 30 days of public comments on the matter. Link to public inspection notice. However, it was not in Monday's Federal Register.

Point, counter-point on analysis reports. In recent weeks, several analyses have concluded that even if the RFS is waived, it would not generate much corn for food and livestock feed. But others say any RFS waiver would likely have at least a psychological short-term bearish impact in the marketplace, as index fund traders and others race to take profits ahead of any potential further changes in the mandate.

The fear of additional changes beyond any initial, even temporary waiver is why some veteran traders predict a potential $1 plunge in corn futures - until the marketplace sees any such price drop would prompt buying by not only livestock feeders but also by ethanol processors who would very likely extend their coverage for months ahead. (The irony of course is that any corn price plunge would have corn users scrambling to get coverage for the months ahead, thereby limiting any short-term plunge and perhaps resulting in the need for accelerated price rationing that would likely lead to more significant demand destruction and political pressure to "do something.")

Others note that even if the RFS is waived, a third of the U.S. gasoline supply must contain ethanol to meet unrelated clean air rules, mostly in California and on the East Coast. Reason: no other available substance in any quantity like corn can oxygenate gasoline as effectively, helping it burn more cleanly.

Besides, others note, ethanol is as much as $1 cheaper than other types of octane boosters like reformates, alkylates, and aromatics.

U.S. ethanol production recovers. Over the last four weeks, ethanol production has modestly recovered from 796,000 barrels per day to 823,000 barrels. According to Informa analysts, USDA's current forecast for 4,500 million bushels of corn used in ethanol for 2012/13 would necessitate a season-average production rate of only 809,000 barrels per day. Although July production was near that level, reported ethanol stocks were declining, suggesting little, if any, slowdown in ongoing ethanol usage. Thus, according to Informa, it seems unrealistic to expect production to remain that low as production seasonally increases amid favorable economics to produce and use ethanol.

The following chart shows that blenders currently have no incentive to reduce blend rates as ethanol futures are below gasoline futures and, at the same time, ethanol production margins are modestly positive over variable costs.

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Another key factor in the use of corn-based ethanol is the rising margins processors are receiving for a major byproduct - DDGs. In fact, some ethanol plants that had previously been shut down were recently reopened once their owners saw that customers (feedlots and livestock producers) were willing to pay premium prices for the much-needed byproduct.

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The growing pressure in Washington. Under pressure from outraged livestock and poultry producers who have seen their feed costs surge, several state governors have petitioned the EPA for waivers of the mandate.

But modifying the RFS obligation would not alter the 1990 Clean Air Act which requires fuel companies to sell a cleaner blend of fuel, called reformulated gasoline (RFG), in the most populous parts of the country. Methyl tertiary butyl ether or MTBE was initially used as a petroleum-based oxygenate because it did not require a change in existing cars. But in the 1990s, MTBE was found to be a known carcinogen. Petroleum blenders and marketer rush to an alternative due to court threats and other reasons. That is when corn-based ethanol went into overdrive.

Enter the 2005 and 2007 energy legislation which mandated certain corn-based ethanol levels. Corn was not only available in quantity, it was also aided at the time by a tax incentive (now no longer available) and import tariff on imported ethanol (now no longer in effect).

The RFS requires ethanol consumption of 13.2 billion gallons in 2012, and 13.8 billion gallons in 2013.

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Don't forget those DDGs. When one counts corn used for ethanol as a share of all corn, around 40 percent is used to make ethanol. However, it's really 25 percent when you count the distillers grains remaining from making ethanol because that adds to the net overall supply of corn. Because DDGs have 120 percent of the nutrition value of corn, that means 37 percent of the corn used in the ethanol-producing process comes back as feed for livestock. Thus, ethanol's net share is 25 percent of U.S. corn.

Acreage planted to corn started to surge in 2007 - a fact some ethanol opponents do not point out.

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A major use of ethanol in the retail business is to increase octane, which improves efficiency. Reuters recently reported that in May, only about 4 percent of all U.S. gasoline was ethanol-free, citing Energy Information Agency (EIA) data. A year ago it was 10 percent, and in 2008 it was one-quarter.

Of note, ethanol blenders figure corn futures could rise to over $9 and possibly as high as $10 a bushel to make ethanol too expensive to blend. This depends in part on the price of crude oil and gasoline.

So what's going to happen? As you can see, both sides have arguments. The solution, as usual, is not an easy one. And this at a time when most of Washington's favorite "solution" is to do nothing, or at best kick the can down the road.

Some observers laugh at suggestions from some ethanol proponents, including USDA Secretary Tom Vilsack, who say let the market work. This in an area that forces consumption of a mandated product. When confronted, those ethanol proponents quickly note the national security, energy independence and/or job-generating roles that ethanol plays. Vilsack earlier this month said he is concerned that investment in ethanol production would drop if the mandate was modified. And, ethanol producers say they have had to make their own adjustments to higher corn prices.

But veteran observers of the issue say the solution is to go back to the initial legislation and rather than use a static level of mandated levels, base such volumes on forecast gasoline consumption, and review that calculation on an annual basis. With the increasing miles per gallon being generated by new cars, and the lower gasoline consumption caused in part by a tepid U.S. economy, those observers say the true "market" aspect should be a more flexible mandate table for the years ahead.

Observers say there is a need to look closer at the accuracy of the Dept. of Energy forecast on which the framework for the policy was set, as the graphic below illustrates.

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And, using information on gasoline consumption from the August 2012 STEO from EIA (link), the estimate for fuel consumption keeps dropping, which means the blend wall will likely remain in the 13.2-13.4 billion gallon range through 2013 (and possibly longer).

In other words, the RFS mandated amounts were flawed from the get-go. As the pork producer said, "If not now (for changes), when?"

The Obama administration could have an easy way out on this matter: Reject the waiver requests, but note it will work with Congress in coming up with a more flexible RFS mandate. A perfect solution that would likely please no one at the present time, but would serve as a far better "market solution" than the existing non-market-oriented mandate.

More trouble ahead. The advanced biofuels and the cellulosic mandates may be an even bigger problem going forward given the growing annual mandates as compared to actual commercial production. This reality is perhaps the most important driver of reviewing the mandate - EPA simply can't make the mandates work for these categories.

A coming EPA decision could offer a partial corn RFS solution. Normally, EPA issues its decisions on the level of the RFS in November of the year before the RFS is applied. If EPA sticks with that timeline, the agency would have until October to gather information on the extent of "economic harm" done by the originally stipulated RFS level and to decide whether to issue a partial waiver to reduce the 2013 mandate. Most observers do not think EPA will issue a waiver for 2012.

According to a recent Purdue University analysis (link),
"one possibility would be for EPA to totally waive the "other advanced" mandate, which is 0.75 BG for 2013. Sugarcane ethanol is included in that category. If that mandate were waived, all the sugarcane-based ethanol would move into the conventional category with lower RIN prices. It would then be counted toward meeting the implied mandate, which could reduce corn ethanol production. This would only represent about 275 million bushels of corn. But the sum of the other advanced mandate plus carry-forward RINs could potentially be about 1.2 billion bushels of corn. That represents about 24 percent of the effective corn mandate, which is roughly the size of the projected corn crop shortfall. With the higher corn ethanol price, more sugarcane ethanol would be imported, which also effectively lowers the demand for corn ethanol."

Bottom line: As with a lot of legislation, Congress' inability to get it right the first time (or the second), has produced unintended consequences. Just ask the U.S. animal industry and food processors.

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