The new economics of ethanol

On November 18, the U.S. Environmental Protection Agency (EPA) issued a proposed rulemaking on ethanol that is having shattering repercussions throughout the energy world. The agency will be holding a public hearing on December 5 next week to discuss the merits of the proposal, which many have described as an about-face in policy by the Obama administration.

At the same time, Congress is considering another proposal—importing massive amounts of ethanol derived from cane sugar—that would result in creating a huge energy windfall for Brazil at the expense of the United States and undermining current efforts at curbing energy dependence from foreign sources.

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The EPA has been a strong backer of biofuels designed to replace oil and gas—hydrocarbon molecules from fossil sources—with similar molecules derived from plant life and renewable sources. The best-known biofuel is corn ethanol, but there are many more—plant-derived oils and fats that are made into biodiesel; algae-based fuels; woody plant materials that become cellulosic ethanol; and cane-sugar ethanol. Right now, Brazil is the leading country producing sugar cane for ethanol, though at a production cost not nearly as cost-effective as corn-based ethanol produced domestically here in the U.S.

The first hint of a bombshell from the EPA was a leaked draft document that appeared in the press last month. In it, the EPA proposed for the first time to roll back the ethanol mandate created by Congress, called the Renewable Fuel Standard, also known as the “RFS.” Since its inception, the RFS has required refiners to add an ever-increasing amount of ethanol to the gasoline pool each year. 

Hence the surprise in the energy world. If EPA follows through on its proposal, it will be taking unprecedented unilateral action to avert a market crisis.

This ethanol mandate no longer works, and it has reached its natural limit. Refiners today blend into the fuel supply literally as much ethanol into the fuel supply as vehicle engines can handle. If refiners cannot blend more and more ethanol into their product to meet their federal quota, they must either pay huge fines or stop producing gasoline altogether.

Both Congress and the White House are alarmed by the EPA’s recent move. The fear is that the breakdown in the ethanol mandate may force consumers to pay higher— perhaps sharply higher— prices at the pump for retail gasoline in 2014, which just so happens to be an election year.

Congress, regrettably, has the wrong idea. They think the problem is not just too much ethanol in general, but too much ethanol from corn. So there is movement in Congress to mandate “advanced biofuels” instead of corn ethanol. In practice, this will mean importing sugar ethanol from Brazil because this is the only fuel available in the needed amounts that meets the technical definition of an advanced fuel.

But it bears repeating why there’s more than one downside to importing sugar ethanol. First, it is not made here.  Second, it is more expensive than corn ethanol. Third, shipping ethanol from Brazil consumes energy—in the form of diesel fuel—instead of conserving it. Finally and most interesting of all, Brazil needs fuel for its vehicles too. Brazil can only produce so much ethanol in the near-term. 

The reality is that we don’t need an RFS mandate any more. Oil was about $50 per barrel when the ethanol mandate was created. Today, it trades around $100 per barrel. Ethanol is usually cheaper than gasoline on a gallon-for-gallon basis. And at current prices, ethanol is an inexpensive (and EPA-approved) octane boost for gasoline that helps today’s light, clean automobile engines meet federal meet Corporate Average Fuel Economy (CAFE) standards.

The answer to our ethanol problem is not to switch from corn to sugar. The answer is not a mandate either, because force-feeding isn’t necessary.

Without a mandate, ethanol consumption will not decline and will likely increase over time, exactly in the volume needed.

In the near term, refiners will voluntarily use ethanol as they have been doing all along. But, as the vehicle fleet turns over to include more vehicles that can run on blends higher than the 10 percent limit for older cars, market demand will pull more ethanol into the gasoline pool. Automakers will support the trend, but because it helps their engines meet the higher standards.

The current mandate requires too much ethanol too soon, poses big legal penalties for refiners that will be passed on to the public if the target is missed, and will result in a management headache for the EPA.

Both President Obama and Congress want to sweeten the driving public prior to Election Day 2014. The way to do this is not with sugar. They should just let the markets work.

Lucier is managing director of Capital Alpha Partners, a research firm in Washington, DC.

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