No need to rush to more ethanol

Dave Juday Contributor
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One of the best economic performances of the past year can be attributed to the ethanol industry. Indeed, ethanol has been profitable for the past 12 months, based on stabilized corn prices and natural gas prices. It is one of the few industries that has been expanding.

The only bad news for the sector is that in this economy Americans motorists are driving less, which means that ethanol will hit its ceiling of an allowable 10 percent blend in motor fuel more quickly than it had anticipated. This shrinking market for motor fuel can be considered the dark cloud that surrounds what otherwise is ethanol’s silver lining.

What is behind this expansion? In part, ethanol is expanding because Congress mandated it to. Back in 2007, before the 2008-2009 recession, Congress and the Bush Administration passed an energy bill that provided for a steady increase of ethanol use through 2020 under a scheme known as the renewable fuel schedule (RFS). Moreover, with moderated corn and natural gas prices—two key inputs into ethanol production—current profit margins are large enough to encourage growth in the supply capacity. The industry trade association, the Renewable Fuels Association (RFA), reports that there are 12.8 billion gallons’ capacity existing. Then, there is another 1.3 billion gallons of ethanol capacity under construction.

Not surprisingly, with fuel demand down, and ethanol supply up, the ethanol industry is looking for a home for its production—especially that additional 10 percent which is about to come on-line. Therefore, one approach the sector is taking is to push the US Environmental Protection Agency (EPA) to approve a higher blend limit. Indeed, the 2007 energy bill that created the mandate for ethanol use in motor fuel also capped the blend at 10 percent ethanol.

With a higher limit, ethanol could rely on federal regulations to further ensconce itself with a bigger share of the shrinking fuel market by squeezing out gasoline, so last year, the ethanol industry petitioned EPA to allow a 15 percent ethanol (e-15) blend motor fuel. The problem, however, is that tests on the impact on engines that 15 percent blends are not complete. The early indications are that some engines like late model cars could handle e-15, others like older cars, off road vehicles, and small engines could not. This would create what the industry is calling a bifurcated market—two types of fuel, two sets of pumps, two sets of rules, etc.

Indeed, how to segregate the market and enforce the proper distribution is a major enforcement conundrum for EPA. Based on EPA’s past experience with the changeover from leaded to unleaded gasoline, significant amounts of “misfueling” would occur if EPA just relies on a label to keep e-15 fuel out of older cars and small-engines that could be damaged by E-15. Moreover, even by using E-15 in the newer cars which EPA says are safe for e-15 could give legal standing to void manufacturer’s warranties.

In lieu of the e-15 for which they petitioned last year, the ethanol lobby has come up with the idea of a 12 percent blend—not because there has been conclusive testing on e-12, or that warranties allow for it, but just because it sounds like a reasonable compromise and from their perspective, a quick, much-needed first step on the way to a e-15 or higher blend in subsequent years. That is their government regulatory strategy.

Meanwhile, in the marketplace, another strategy has been taking place. Ethanol mills are exporting ethanol in lieu of mixing higher blends in the US. Making ethanol is just too profitable—given tax credits, tariffs against imports, grants, loans, and a federal mandate guaranteeing a domestic market—to slow down production. So the growing production is being shipped internationally. In the first quarter of 2010 about 83 million gallons were exported; more than half of that was in March alone.

These export statistics are only estimates, but very educated guessed to be sure. Technically fuel ethanol shipments have no specific statistical breakout. The Census Bureau has always maintained that up until now there was no reason to track ethanol exports because they were somewhere between non-existent to extraordinarily small. But the US has now subsidized the industry to the point that the Census Bureau will have to re-think that view.

Even RFA itself recognizes the exports are a result of what it notes as “current prices show Iowa ethanol plant-gate ethanol prices are 50 cents per gallon lower than Brazilian ethanol prices.” According to RFA statistics for the first two months of 2010, monthly production averaged 1.025 bln gals, so first quarter ethanol exports equaled about 2.7 percent of all US production.

Which brings us back to the baseline ethanol subsidy scheme. Subsidies for ethanol have been justified as necessary for a fledgling industry that can’t compete. Moreover, the benefits of the grants, loans, tax credits, and ethanol mandate, have been argued to accrue to domestic energy security. That line of reasoning is now compromised. Moreover, the rush to approve e-15 or e-12 or any other higher than e-10 blend seems misplaced. The ethanol industry is surviving—indeed, thriving and expanding, without e-15.

Before rushing into a higher ethanol blend rate—and especially before doing it piecemeal, like an e-12 to e-15 to possibly higher blends—consideration should be given to some long range planning on how to handle more corn, less oil, double tanks, and other infrastructure issues beyond any questions of engine damage. Then there are health and safety issues. Will the fire extinguishing equipment work the same with different belnds of ethyl alcohol? Will storage tanks have the same safety features with various blends? After all, it wasn’t until after methyl tertiary butyl ether (MTBE) was mandated in certain gasoline blends that it was found to contaminate ground water.

In sum, ethanol mills are making money. Taxpayer subsidies are starting to flow overseas. The impact of a bigger blend of ethanol has a lot of as of yet unanswered questions—the biggest of which, given the economic standing of the industry is, what’s the rush?

Dave Juday is a commodity market analyst and principal of The Juday Group.