KC Fed: Ethanol Markets Shape Production

Report outlines key factors in this summer's debate over the RFS; market's role in ethanol production

Published on: Dec 10, 2012

The persistent drought has yet to let up in many parts of the country, and though the corn crop used for ethanol is out of the ground, there's still concern about short supplies and high prices.

Those concerns are the focus of a new Kansas City Federal Reserve report that points to the markets, not mandates, as the primary driver behind corn ethanol production.

"Although mandates were key in supporting biofuel expansion several years ago, the ethanol industry is increasingly market driven," report author Nathan Kauffman writes. "Accordingly, market-based incentives emerging from crude oil and corn markets will stake the path forward. "

Kauffman's report finds that though a U.S. grain shortage had an impact on the food and ethanol sectors, much of the hoopla surrounding the Renewable Fuels Standard – an Environmental Protection Agency-mandated production level for ethanol – was unwarranted.

Report outlines key factors in this summers debate over the RFS; markets role in ethanol
Report outlines key factors in this summer's debate over the RFS; market's role in ethanol

Many livestock groups were unhappy with the RFS mandates this summer over concern of short crops and high demand. Though the EPA entertained comments for and against a temporary waiver of the RFS, a waiver was denied. Kauffman writes that ethanol production may not have declined significantly, even if the mandates were waived.

"A temporary waiver would not relieve the pressure on current production to build credits to satisfy future mandates. In addition, the ethanol industry has become more market-based as production has exceeded the mandates in recent years. If energy prices rise faster than agricultural commodity prices, ethanol profits could expand and production soar regardless of mandated levels," Kauffman asserts.

Also, Kauffman says, ethanol is a primary octane enhancer and fuel oxygenate, a purpose few other products serve – another factor that points to markets, not mandates, as a driving factor behind the scale of ethanol production.

The blend wall

Kauffman continues to note that the RFS, while a building block of the U.S. ethanol industry, has been "largely irrelevant" since 2010, due to high ethanol demand consistently pushing production over mandated levels.~~~PAGE_BREAK_HERE~~~

In contrast, Kauffman writes, hitting the ethanol "blend wall" – a virtual restriction on the volume of ethanol the market will take due to blending limits – is approaching quickly.

"Historically, this blend wall has been above the mandate, allowing the industry to satisfy rising mandates by increasing production. Under current policy, however, the ethanol industry may face the challenge to satisfy future mandates as they rise above the blend wall," Kauffman notes.

Right now, ethanol can contribute approximately 10% of a gallon of gasoline, what most consumers understand as the E10 blend. This composition creates the blend wall.

Another factor to consider, Kauffman points out, is this summer's EPA approval of E15 for the commercial marketplace. Though it may have an effect on increased ethanol use, many hypothesize that it will be slow to catch on due to high costs of installing blender pumps and the perceived anxiety expressed by automakers and consumers.

RINs play a part, too

Kauffman insists the market is still the driving force behind production, noting that any gap between the blend wall and mandated production could be filled using RINs, or credits that account for each gallon of ethanol produced. The RINS may either be used to fulfill current-year mandates or saved for another year, allowing up to 20% of the current-year mandate to be satisfied with RINs.

Kauffman says these RINs may dwindle in the future, signaling need for increased ethanol production and fueling the market.

"In the future, RIN prices could climb if the mandate rises above the blend wall and stored RINs are needed to fulfill RFS mandates. RIN prices could also jump if corn prices rise further or if crude oil prices fall significantly and slash ethanol profits. In this scenario, ethanol producers could choose to cut ethanol production and rely on stored RINs to fulfill RFS mandates. A run-up in RIN prices would indicate strong demand for RINs, strengthening the incentive for more ethanol and RIN production," Kauffman notes.~~~PAGE_BREAK_HERE~~~

Further, Kauffman says if a waiver were thrown in, RIN prices would drop to zero, possibly ensuring ethanol would be produced only to the blend wall.

Commodity Prices

Commodity prices, logically, have an effect on ethanol. Kauffman notes that crude oil prices also determine ethanol profitability. Current prices favor steady production.

"With Brent crude oil currently about $115 per barrel, it would take a corn price of approximately $8.90 per bushel, likely with some persistence, to activate substantial contraction in the ethanol industry," Kauffman writes.

Though high corn prices have softened exports and feed demand, Kauffman says further rationing will be necessary. However, the ethanol industry appears to be "unlikely to curtail its corn use much further. In fact, ethanol production has steadied since its summer slowdown," Kauffman writes. "Accordingly, market-based incentives emerging from crude oil and corn markets will stake the path forward."

Click here for the full report.