DESPITE claims to the contrary from opponents of the federal renewable fuel standard (RFS), a report from the Federal Reserve Bank of Kansas City says markets -- not mandates -- shape ethanol production.
Analyzing the factors involved in the biofuel supply/demand equation, the bank issued a report by economist Nathan Kauffman concluding that the ethanol industry has become market driven, regardless of RFS mandates.
Kauffman outlined essentially three reasons why the mandates have little to do with the current ethanol marketplace:
1. Production has exceeded RFS mandates in recent years.
2. Energy prices have risen faster than agricultural commodity prices.
3. Ethanol has become the primary octane enhancer and fuel oxygenate.
When the RFS was established in 2005 under the Energy Policy Act, what was known as "RFS1" called for blending 7.5 billion gal. of ethanol by 2012. "RFS2," established by the Energy Independence & Security Act in 2007, required 9 billion gal. by 2008 and ramped up to a peak of 15 billion gal. in 2015.
While ethanol production grew an average of only 14% from 1980 to 2005, production surged nearly 30% each year from 2005 to 2010, according to data from the Renewable Fuels Assn. (RFA).
Because of market factors, production capacity in 2012 actually slipped, with an analysis from Kansas State University economist Dan O'Brien suggesting that at least 9% of U.S. ethanol production capacity was idle by early November (Figure 1).
One reason those gallons are temporarily out of the equation highlights one of Kauffman's arguments: basic profitability.
According to Kansas State, on average, the U.S. ethanol industry either broke even or lost money since January 2012, based on Iowa State University ethanol plant model calculations. Since the beginning of 2012, average monthly losses have been 8 cents/gal. of ethanol produced (Figure 2). This compares to six months of losses at an average of 5 cents/gal. of ethanol produced from December 2008 to May 2009.
Basic economic theory suggests that there is a shutdown point at which margins dictate that a product can no longer be produced. For some 9% of the industry's productive capacity, losing 8 cents/gal. was roughly that point.
"Crude oil and corn are the fundamental determinants of ethanol profitability, which drives ethanol production," Kauffman wrote. "Corn is the dominant input to ethanol production, accounting for approximately 90% of variable costs at an average Midwest ethanol plant. Likewise, the price of crude oil is the key factor driving wholesale gasoline prices."
Kauffman noted that the corn-to-crude oil price ratio is a good indicator of the prices at which fuel blenders are indifferent to using ethanol and gasoline, on a volumetric basis, in consumer transportation fuel. For 2005-06, crude oil prices climbed faster than corn prices, so as the ratio fell, ethanol profits soared and production expanded. On the other hand, for 2008-09, the ratio rose as crude oil prices plummeted, and some ethanol plants went out of business altogether.
This past summer, corn prices spiked in response to the worst drought in nearly six decades. The ratio of corn to crude oil appreciated, ethanol profits deteriorated and production fell.
"Current commodity prices suggest that economic conditions may favor continued ethanol production," Kauffman predicted. "With Brent crude currently at $115 per barrel, it would take a corn price of approximately $8.90/bu., likely with some persistence, to activate substantial contraction in the ethanol industry."
One other factor keeping mandates out of the equation, at least at this point, is the importance of ethanol as an oxygenate and octane enhancer. Due to environmental concerns over the use of methyl tertiary butyl ether, blenders have largely opted to instead use ethanol, with estimates suggesting that at least 5 billion gal. of ethanol are required specifically for this purpose, underpinning ethanol demand and production.
The Kansas City Fed analysis suggested that the RFS could play an indirect role in supporting ethanol production, however. Because the mandate for 15 billion gal. in 2015 exceeds production capacity -- and, in fact, exceeds what is known as the "blend wall" -- producers may be stockpiling RFS credits known as renewable identification numbers (RINs) to apply to future years.
RINs are essentially vouchers generated with each gallon of ethanol produced. The Environmental Protection Agency allows up to 20% of one year's RFS mandate to be fulfilled through RINs generated in previous years. In other words, by producing more ethanol now, producers can essentially stockpile RINs, allowing them to produce less in the future, most likely when the RFS exceeds the blend wall.
Determined more or less by U.S. gasoline use, the blend wall is essentially at 10% of consumption because that is the most common blend of ethanol used in the fuel market today. With increasingly fuel-efficient automobiles and recession-trimmed disposable income, consumers are using less gasoline and, thus, using less ethanol, keeping the blend wall around 13 billion gal. based on projected gasoline usage.