New Ethanol Reality

The New Reality Of Ethanol Blending In The US

The ethanol mandate is laid out in EISA 2007, a 310 page Federal act. The applicable sections for the Renewable Fuel Standards (RFS) is Sections 201 – 248, a very small part of the act. You should be very suspicious, for it gives bounteous incentives to the oil and ethanol industry and penalizes them if they do not deliver, using something called RINS. The law is being implemented by the EPA.

By the end of 2008 the EPA has required that 9 billion gallons of ethanol be blended into gasoline across the nation. EISA is not a mandatory E10 law; in fact it is an E85 and flex-fuel car corporate welfare act. It has no requirement for the blending level percentage, only the requirement that certain amounts of ethanol be blended in every area of the country by all of the “large” oil companies in ever increasing amounts, every year until 2022, when 36 billion gallons must be blended.

The insidious parts of the act are the economic incentives, which are generous and will cause massive economic dislocations, and the economic penalties which are subtle but effective and potentially profitable to commodities brokers.

The economic incentives don’t make it clear, to the casual observer, why the act will cause economic dislocations. Perhaps what is happening in the Northwest is a good illustration though. Remember, EISA 2007 is primarily an E85 law. One state, Oregon has implemented a mandatory E10 law, another state, Washington, is implementing a bizarre sort of mandatory ethanol law and two states, Montana and Idaho have no mandatory ethanol laws as of right now. Montana has a mandatory E10 law on the books, but it has not triggered and probably never will now. However, all four states will probably be completely E10 by the end of 2009. At least that is the word I have gotten from one gasoline distributor and all of the signs are pointing that way.

Ethanol is blended at gasoline distribution terminals. It is not blended during the refining process. So far blended gasoline is not shipped through gasoline pipelines because of corrosion problems. That is the excuse given by the pipeline owners; I don’t know if it is true, but they own the pipelines and they make the rules. In order to induce terminals to install new infrastructure to blend ethanol, i.e. tanks and injection equipment, the federal government gives the blender a $0.51 / gallon of ethanol blended federal gasoline excise tax credit, as of today. (That amounts to about a $4.5 billion tax break this year.) Once the US has more than a 9 billion gallon production capacity next year, the tax break will decrease to $0.45 / gallon of ethanol blended.

Once a terminal has installed the infrastructure, it behooves the terminal economically to make as much E10 as possible and take all of the gasoline stations that they serve E10 as soon as possible. It is also economically attractive right now to blend as much ethanol as possible, because ethanol is cheaper than gasoline, but there is no guarantee that that will be the case in the future. (Update 10/24/2008, according to DTN, ethanol is now less than $0.10 / gallon cheaper than gasoline. Update 11/13/2008 according to DTN ethanol is now about $0.40 / gallon more than gasoline.) Don’t ever forget that gasoline is an international commodity that is subject to the whims of the commodities futures market, but ethanol is an agricultural commodity, subject to all the whims of mother nature and the commodities futures markets.

So far there has been no obvious economic incentive for the refinery. But it is built in, if hidden. Once all of the terminals in the geographic area served by a refinery go E10, the refinery can retune the production process to make “suboctane” blending gasoline with a lower AKI rating which costs less to refine and results in more gasoline produced. For 87 AKI regular gasoline, the refinery can make 84 AKI blending product, usually referred to as 84 RBOB. This is already happening in Oregon. Similarly the refineries in the Northwest will eventually make 89 AKI RBOB for premium unleaded blending. I doubt that the refineries pass along the savings, at least we haven’t seen it in Oregon. So far our gasoline is more expensive than Montana’s gasoline which isn’t E10 … yet.

Because of the blenders incentive and the requirement of EISA 2007 to blend ethanol into all gasoline everywhere, terminals are being forced into adding ethanol injection infrastructure. Once they do that they have a tremendous incentive to blend as much ethanol, up to 10% as they can, and the refineries are pressuring them to do it so they can change to suboctane production. Also, I’ll bet that the refineries have figured out that a large proportion of cars take a mileage hit greater than 10% when they have to use E10, and now the gasoline companies are actually selling more gasoline than before E10 was implemented. So much for energy independence.

So you can figure out why Oregon, Washington, Montana and Idaho will probably be all E10 by the end of 2009. The economic dislocation comes when all of the terminals serving the Northwest have to compete for ethanol with all of the other terminals across the nation. At present there is only 40 million gallons / yr. of ethanol production in the four NW states, an area that will need at least 550 million gallons / yr. to take all of the gasoline E10. Keep in mind that none of the corn needed by the ethanol plants that are in production or being planned is grown in the region and the shortfall in ethanol will have to be purchased on the open market in competition with all of the other terminals and gasoline producers in the country that are trying to meet, or even exceed, EISA 2007 quotas. If they don’t get enough ethanol or they don’t have the distribution infrastructure then they are penalized and must try to buy RINS from those areas that are above their EISA quota for that period, another “cap and trade” system, the darling of energy commodities marketing … and commodity traders are already trying to figure out how they can make a commodities futures market in RINS.  After what they did in the financial derivatives market, this should scare the crap out of you.