— John Kemp is a Reuters columnist. The opinions expressed are his own —



Despite a promising start, the U.S. experiment with renewable fuels is facing a serious challenge next year. Falling gasoline consumption, lower pump prices and contradictions within the federal government program are intensifying existing pressures on ethanol distillers and farmers already struggling to cope with over-capacity and collapsing margins.

ETHANOL ENTHUSIASM

Between 2000 and 2007, production of fuel ethanol quadrupled from 1.6 billion to 6.5 billion gallons, and the industry is on course to distill a record 9.3 billion gallons in 2008.

Ethanol production is not really economic at oil prices below about $60-70 per barrel (prices of grains and fats for ethanol conversion and processing costs are too high relative to oil). So the original boost to ethanol came from its use as an oxygenating additive in reformulated gasoline, rather than as fuel in its own right, when a number of states banned the use of MTBE.

As oil prices breached $50 in late 2004 and continued to climb steadily higher over the next four years, ethanol’s properties as a fuel suddenly became more attractive. Blenders began to use ethanol as a cheaper (partial) substitute for conventional oil-derived blendstocks in making gasoline.

Prompted by national security concerns and encouraged by lobbyists for the farm sector, U.S. legislators tried to accelerate the use of ethanol by mandating a minimum ethanol content for all gasoline produced or imported into the United States.

The centerpiece of the government’s intervention is the Renewable Fuel Standard (RFS) which sets a steadily increasing minimum volume of ethanol that must be blended into the nationwide gasoline supply each year.

The original RFS set out in the 2005 Energy Policy Act was relatively modest — requiring blenders to incorporate 4 billion gallons of ethanol into the fuel supply in 2006, rising to 5.4 billion gallons in 2008 and 7.5 billion gallons by 2012.

But as soaring crude oil prices intensified concerns about energy dependence, the 2007 Energy Security and Independence Act imposed a set of much more ambitious targets. The RFS blending target for 2008 was almost doubled to 9 billion gallons, rising to almost 13 billion gallons in 2010 and to an extraordinary 36 billion gallons in 2022 (see chart https://customers.reuters.com/d/graphics/US_ETH1108.gif).

WORSENING ECONOMICS

Most attention has focused on the role of the RFS, but surging oil prices were probably more important in supporting ethanol.

RFS is designed to stimulate investment in the production facilities and distribution infrastructure needed for ethanol by guaranteeing a minimum level of demand for the fuel irrespective of oil prices. But over the last three years, RFS has never been binding.

On a purely voluntary basis, gasoline blenders have always used more ethanol than the required minimum because increasingly high oil prices made ethanol an attractive fuel in its own right.

RFS mandated 4 billion gallons of ethanol in 2006, but blenders actually used 4.9 billion. It mandated 4.7 billion in 2007, when blenders actually used 5.7 billion (an extra billion gallons or 22 percent).

The apparent success of the ethanol industry on a voluntary basis because of favorable economics was one reason why legislators felt comfortable about amending the RFS to include more ambitious targets in 2007.

But as oil has tumbled below $70 per barrel, ethanol no longer looks competitive. On current trends, blenders will use 9.26 billion gallons of ethanol in 2008, just 260 million gallons or 3 percent above the RFS-mandated minimum of 9 billion gallons.

Unless oil prices rise substantially from current levels, the RFS is set to become binding for the first time in 2009. Gasoline blenders will have to use 11.1 billion gallons of ethanol because that is what the law tells them, not because it makes economic sense.

OBLIGATIONS AND CREDITS

In practice, RFS is expressed as a percentage requirement imposed on each gasoline refiner and importer to buy a specified volume of ethanol (or tradable credits) in proportion to their production/import volume – thereby ensuring the total quantity of ethanol used each year meets the mandated target.

The Environmental Protection Agency (EPA) uses total forecast gasoline consumption in the United States for the coming year (sourced from the October edition of the Energy Information Administration’s Short Term Energy Outlook) and adjusts it for gasoline consumption in Alaska (not currently included in the RFS requirement); production by small refineries and refiners (not subject to RFS until 2011); and the quantity of ethanol that has to be incorporated into the gasoline mix (there is no requirement to blend ethanol into itself).

EPA divides the total mandated ethanol volume into the adjusted gasoline supply to publish the percentage RFS requirement for the coming year. Each gasoline refiner and importer must purchase sufficient ethanol (or tradable credits from others blending more than the minimum) to meet this ratio.

So far, ethanol credits have been cheap (trading at around 3-6 cents per gallon in 2008). However, if oil prices fall further, and RFS becomes binding, the price of credits will have to rise to give blenders an incentive to use at least the mandated minimum volume.

THE BLENDING WALL

Ethanol is a good but not perfect substitute for gasoline.

It has around 66 percent of the energy content of regular gasoline. Almost all ethanol is sold is sold in a 90-10 gasoline-ethanol blend known as E10 and is the limit that can be used in regular motor vehicles under existing manufacturer warranties. A tiny percentage is sold in a 15-85 blend known as E85 that can only be used in vehicles with specially designed engines.

As a practical matter, the amount of ethanol that can be blended into the general gasoline supply is capped at around 10 percent of the total or about 10-14 billion gallons per year – known as the “blending wall”.

For 2008, EPA set the RFS obligation for refiners and importers at 7.76 percent, based on the need to blend 9 billion gallons of ethanol into forecast gasoline consumption of 144.5 billion gallons or 116 billion gallons after adjustments.

In the event, gasoline demand has proved much weaker than forecast. Without voluntary blending above the required amount in the first half of the year owing to high oil prices, the 7.76 percent blending requirement would not have been high enough to ensure 9 billion gallons were used.

On Nov. 14, EPA published an RFS for 2009 of 10.21 percent, based on the need to blend an even higher volume of ethanol (11.1 billion gallons) into a diminished amount of gasoline consumption (139 billion gallons, or 109 billion gallons after adjustments).

The industry is now very close to hitting the blending wall.

This was always going to happen, given the much more ambitious RFS volume obligations in the 2007 law. It was never going to be possible to blend 20.5 billion gallons into the gasoline supply by 2015 without much wider uptake of E85 vehicles or other modifications of the U.S car fleet. But the unprecedented cyclical reduction in gasoline demand has brought the blending wall much closer.

CONSTRAINTS BITE

In fact, the gasoline industry is now trapped in a vice.

Low oil prices are discouraging ethanol blending (RFS becomes binding) while slumping gasoline demand is tightening the technological constraints (the blending wall approaches faster).

Blending credits look set to become more expensive, as gasoline refiners and importers have to start paying far more to make it worthwhile to blend 11.1 billion gallons into the fuel supply next year at low oil prices.

Meanwhile, the limits of the system could prevent any more ethanol being blended for technological reasons. The RFS requirement for 2009 looks achievable, but 13 billion gallons in 2010 and 14 billion gallons in 2011 may be impractical unless the car fleet changes.

The looming wall explains why ethanol advocates are pushing the incoming Obama administration to set a much higher blend rate than E10, reaching E15 or E20, and require motor manufacturers to start redesigning cars to take much higher blends and produce a higher proportion of E85-enabled Flex Fuel Vehicles (FFVs) as a condition of any financial rescue package.

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