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Now, on to why Big Oil hates ethanol.
The Energy Policy Act of 2005 created the Renewable Fuel Standard in the US, which really should be renamed as the “It Seemed like a Good Idea at the Time Energy Act.”
The Renewable Fuel Standard (RFS) established minimum volumes that increase on a yearly basis, of various renewable fuels that must be included in the supply of fuel for transportation. Ethanol currently is the most common form of renewable fuel. A fun fact you can throw out at your next dinner party is that most of the gasoline sold in the US is actually a blend called “E10,” which is composed of 10% ethanol and 90% gasoline. A blend called E85 is also available, although far less common. It is composed of 85% ethanol. Below is a graph of the minimum yearly volume that was set out as the requirement to meet the Renewable Fuel Standard. Conventional and cellulosic biofuels make up the largest portion of blending requirements with biomass and noncellulosic biofuels adding minimally in later years.
Naturally one of the main goals of the RFS is to reduce the US emissions of greenhouse gases. The issue politicians, environmentalists, and industry have battled over for decades is that most of the time, saving the environment isn’t profitable. As such, industry folk are less likely to abide by voluntary standards, as their investors would rather have their paper in a bank account than growing in a tree.
There are several serious macroeconomic problems that need to be addressed before the renewable fuels market becomes even close to a long–term, viable solution.
Now, I know most of you already know that the government really needs to get their act together on many things, but it is especially true when it comes to ethanol mandates.
The government is more than a year behind on setting the required number of RFS gallons that are to be blended. Industry has no idea what the set mandates were supposed to be in 2014, let alone 2015. There are “proposed solutions” and numbers from when the previous RFS was set, but nothing concrete. This causes all sorts of problems for the industry.
First off, without knowing the required blending requirements, both producers and refiners are scratching their heads on total ethanol required for compliance. Second, as made public by the Energy Information Administration (EIA) recently, the secondary market for credits created by producing ethanol are becoming incredibly volatile. The Renewable Identification Number, or RIN for short, is a unique identifier created through the production of each gallon of ethanol.
The RIN provides the verification that the company is blending the correct percentage of ethanol. If the company has already met blending requirements, the RIN can be sold in a secondary market to another company that needs it to meet their own yearly requirement. Therefore the only source of demand for RINs are producers and importers of transportation fuels that need to meet their obligations to use biofuels. To show the EPA that they have met the requirement, the companies give the EPA the RINs that they have accumulated. If demand for RINs is expected to increase in the future, then the current price of RINs rises as buyers try to buy inexpensive RINs today and bank them for use tomorrow. The price of RINs ran up in January from refiners banking RINs in expectation of a mandate. However, no mandate has yet been received.
Big Oil Does What Big Oil Wants
Big Oil is notorious for placing shareholder interests above those of governments and environmentalist groups. As such it should come as no surprise that the Big Oil companies are less than enthusiastic about using less oil and more ethanol in gasoline. The less oil that is used in gasoline, the lower the demand for their oil production and in turn the lower their profits.
Big Oil has made some rather humorous attempts at dissuading the public on ethanol. These include designing and funding a flawed study to demonstrate the damaging effects of higher ethanol-blended gasoline using hand-picked cars. Big Oil tried to sue the EPA over blending requirements, which was thrown out in the Washington, DC, Appeals court. Big Oil then attempted to take it to the US Supreme Court, only to have it be tossed out again.
Another interesting wrinkle is the divesting of retail gasoline divisions into their own separate entities. By doing this, Big Oil can claim to the EPA that they have no way to ensure retail distribution of higher blended ethanol gasoline.
While the above stories are rather amusing, it unfortunately drives home a serious problem. Until you get Big Oil on board, they are going to do their darndest to keep ethanol blending requirements at the current 10% level. This creates what is known as the blend wall, which currently stands at approximately 13.7 to 13.8 billion gallons of ethanol.
Big Oil wants as much oil in gasoline as possible, so why would they ever want to change the restriction to a higher blending requirement? If the total demand for gasoline is 130 billion gallons and the blending requirement is 10%, this means that 13 billion gallons of ethanol are blended with 117 billion gallons of gasoline to meet total demand. Moving this requirement up to 20% would mean 26 billion gallons of ethanol and 104 billion gallons of gasoline. The end result is a big loss to Big Oil and their shareholders.
Another issue is consumer demand. Firstly there are only 1,275 gas stations that sell E85 in the US. This might sound like a lot but in the domestic US there are over 120,000 gas stations. This means that only 1% of US gas stations sell highly concentrated ethanol-based fuel. This makes it virtually impossible to get higher ethanol-based fuels out to the mainstream. The only way to solve that would be to subsidize the retail fuel industry. But Big Oil, as we know, controls that.
Furthermore, the move toward electric and hybrid cars has been very strong in the last few years. Just look at a stock chart of Tesla Motors. The best way to see the difference is to plot the gasoline demand forecasts from the EIA. Plotting the demand forecast from 2007 along with this year’s forecast, we can see the huge difference.
Why is this an issue? Thinking back to the RFS mandates in the first chart, those are volume- not percentage-based thresholds. In 2022 the mandate calls for 36 billion gallons of renewable fuels to be blended into the gasoline stream. From the 2007 EIA forecast, gasoline demand was supposed to be approximately 165 billion gallons. This means that there would be 128 billion gallons of gasoline, along with the 36 billion gallons of ethanol, which translates to roughly 22% ethanol in the total gasoline stream. Using the 2014 EIA numbers and the current RFS mandate for ethanol, ethanol would be 31% of the total gasoline stream. This means that on a per-gallon basis, the blending mandates must be much higher in order to compensate for this lower demand.
All these demand side issues are cause for concern, but as if those weren’t enough, the supply side of the equation has its own problems. The forecasted margins for the ethanol crush spread, which is the relationship between input costs and output revenue for ethanol, is forecast to move into negative territory as the year progresses.
On the heels of this, leading ethanol refiners Valero Energy and Archer Daniels have both indicated during conference calls that they would be idling higher-cost plants to conserve costs.
This makes complete sense when we look at the chart below, compiled using data from the US Center for Agricultural and Rural Development. The return over operating costs is calculated as the difference between the revenues from ethanol plant outputs (ethanol and dried distillers grains with solubles [DDGS]) and the costs of variable production inputs (corn, natural gas, and other costs, such as enzymes, labor, electricity, and water).
As if margins were not already tight enough, there have been rumours circulating that US farmers may be backing out of leased acreage this summer. Less corn production would increase the price of corn, which would directly increase the operating costs of ethanol producers.
Compounding the problem are near record highs in ethanol inventories. With excess supply in the market place and already low gasoline and ethanol prices, this is a further warning shot across the bow for ethanol investors.
Buffettology on the US oil sector
Buffett would tell you, if you asked him, that an investor should absolutely avoid the ethanol market in the current market. Why? Because of his two rules:
- Don’t lose money.
- Don’t forget rule #1.
Even one of the largest ethanol producers stated clearly that companies will lose less money by shutting down than by trying to produce through this difficult stretch.
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