E15 - The Politics of Implementation

As we reported in an earlier newsletter several months ago, the American Petroleum Institute (API) commissioned a study by Sierra Research, Inc., that reviewed all the state and federal regulatory changes required for the implementation of E15 in the gasoline pool.  The key point of this study is the introduction of a new transportation fuel in the United States that faces a large task of changing a labyrinth of federal and state regulations to bring new E15 fuel legally to market.  All the big hoopla about the EPA’s approval of a waiver allowing E15 to be used in automobiles model year 2001 and later is only a first step in the approval process.  Overall, Sierra Research suggests that full adoption by federal and state governments for the entire US is a 2-4 year process.  When taking a closer look at the Sierra Research report, it is interesting to note that 24% of the nation’s gasoline demand is located in states that require legislative action, and not just regulatory action.  Regulatory action is much easier in the sense that the vast majority of bureaucrats inhabiting regulatory agencies support E15, and will move quickly to change the necessary framework.  State legislators, on the other hand, with a large majority becoming Republican since the last election, are inherently hostile to ethanol subsidies unless they are from a Corn Belt state reaping the rewards of the current ethanol policy.  We think the change in the political landscape in the US after the recent election is significant in terms of potential legislative impediments to ethanol expansion via E15 gasoline.   Outside of the Corn Belt, Republicans now control both houses of state legislatures, where 45% of the gasoline demand exists.   An argument can be made that, with the mood of the country pushing back against the imposition of federal regulations, state legislatures may actually legislate proactively against the adoption of E15. 

Assuming that a large part of the country is inherently hostile to E15, how does the industry capture enough incremental ethanol demand from E15 to break through the E10 blend wall and meet the 15 billion gallons of corn based ethanol in 2015?  In addition, depending on developments in California surrounding the ability of Midwest corn-based production to meet carbon intensity reductions required by the California Air Resources Board , the corn-based ethanol industry faces the potential of losing some portion of the 1.4 billion gallons per year of California ethanol demand somewhere between 2013 and 2016.  With US gasoline demand predicted to reach 9,100,000 barrels per day by 2012, according to the EIA, 100% adoption of E10 will result in 14 billion gallons of ethanol consumption balanced against an RFS2 mandate of 13.8 billion gallons for 2013.  So, by 2014, E10 will no longer create enough demand to meet the mandated volume of 14.4 billion gallons, which is the proverbial blend wall.  We assume, for this analysis, that the “Advanced Biofuel” mandate requirements are either deferred due to lack of cellulosic ethanol production, or biodiesel usage expands to meet the “Advanced Biofuel” mandate, requiring no additional “Advanced Biofuel” ethanol to be blended into gasoline. 

Politically, there are two areas of the country that will continue to support the use of Midwest ethanol and the expansion into E15: the states in the Midwest Corn Belt, and the Northeast corridor from Boston to Washington DC.  The Midwest Corn Belt represents 15% of the gasoline consumed in the US, and moving from E10 to E15 will yield an additional 1 billion gallons of new annual demand from the region.  The Northeast corridor represents 13% of the gasoline demand in the US, and moving to E15 will yield an additional 900 million gallons of new annual demand from the region.  With the corn-based ethanol mandate growing to 1 billion gallons above the E10 blend wall, and a very large portion of California’s Midwest ethanol demand at risk, the adoption of E15 in the Midwest and the Northeast Corridor may be enough to get the corn-based industry to ts maximum mandate of 15 billion gallons in 2015 and beyond.

Future Prospect for the US Fuel Ethanol Industry

The US fuel ethanol industry exhibits the same type of boom/bust cycles as the typical commodity chemical business, characterized by overbuilding of capacity outstripping demand and causing a collapse in prices.  The collapse in prices are followed by a rationalization and consolidation phase, where weak producers that have either high production costs or weak balance sheets shut down or are absorbed by stronger industry players.  The ethanol industry experienced its overbuild bust in 2008, followed by 2009 and 2010 as years of rationalization/consolidation in the industry cycle.  There are no new greenfield plants on the drawing board for the US industry at this time, and the industry showed the ability in the last month to generate a production rate of close to 14 billion gallons per year.  This production rate may not be sustainable year-round, but, by the end of 2011, with several other plant restarts and plant modifications, it is reasonable to assume that 14 billion gallons per year will be sustainable going into 2012.

The RFS2 mandate for 2011 for corn-based ethanol is 12.6 billion gallons and grows by 600 million gallons per year until it hits a mandated ceiling of 15 billion gallons in 2015.  With the gasoline market currently structured with E10 as the maximum amount of ethanol that can be blended with gasoline, based on EIA’s latest gasoline demand estimates, the blend wall starts to arrive in 2014 when the gasoline market can only absorb 13.95 billion gallons of ethanol as E10, but the mandate for that year hits 14.4 billion gallons.  The ethanol industry has taken a two pronged approach to defeating the blend wall: E15 adoption for the bulk of the US auto fleet, and the build out via government subsidy of E85 dispensers.  The key initiative for the industry is the approval of E15 to be used by the existing automobile fleet without engine modification.  We think there is a high probability that E15 will be approved for a significant portion of the fleet, and the numerous legal and technical hurdles to implementation will be overcome by 2013.  The volumetric ethanol excise tax credit (VEETC) is going to expire, with no effect on demand sometime in the next several years.  So, by 2013, mandated demand will be 13.8 billion gallons, and E15 will be available in significant portions of the country to soak up large amounts of ethanol. 

US export demand, in terms of total industry production, is relatively small, at over 325 million gallons in 2010, but it is a key market outlet that will continue at these rates for the foreseeable future.  Both Canada and Europe do not have any new ethanol plant expansions scheduled from mid-2011 forward.  Europe’s demand will continue to grow as the expansion of E10 gasoline continues at a slow steady pace across the continent to replace E5 in the gasoline pool.  The expansion of ethanol production in Europe will be hindered by the shortage of competitively priced agricultural feedstocks to produce biofuels profitably.   Wheat and cereal grains are the feedstocks available for expansion in Europe.  The predicted expansion of demand may hit one roadblock over the Indirect Land Use Change (ILUC) debate, which is a major issue in Europe.  The results of this debate, and the potential change in biofuel sustainability requirements that could result, cast uncertainty on the EU Commission’s policy and its stated commitment to expanding the use of biofuels in transportation.  Currently, the typical US Midwest ethanol plant, based on a dry DDGS production process, can meet Europe’s GHG emission reduction requirements through 2017.

The Brazilian ethanol industry, once a major exporter to the US during the 2006 – 2008 time period, experienced the same overbuild capacity bust n 2008/2009 that pushed the country’s sugarcane-based ethanol industry into a rationalization/consolidation period at approximately the same time as it occurred in the US.  The Brazilian ethanol industry focused its expansion during the recent years in the key sugarcane production state of Sao Paulo that is located in the center-south portion of the country.  This made sense, since significant infrastructure is already in place in Sao Paulo, reducing the cost of expanding sugarcane plantations and transporting finished products, both sugar and ethanol.   Sao Paulo also has a pool of labor to support expansion of the labor intensive sugarcane growing/harvesting business.  Now that Sao Paulo is essentially built out, in terms of sugarcane production, new greenfield plants must look to states further inland that lack the same infrastructure of labor and logistics, as well as further distances to the major markets located near the coast.   Moving away from Sao Paulo makes new greenfield plants more risky because they are more expensive to build and agricultural inputs are more expensive and return lower prices for finished products due to higher logistical costs.  For these reasons, the new greenfield plants face higher investment hurdles that are hard to climb at the moment.  In terms of new sugarcane mills, 9 new plants came online in 2010, and an additional 4-5 are anticipated to come on stream for 2011.  No new plants are planned for 2012 and beyond.   The industry could show a 5%-10% growth in production of both sugar and ethanol if growing conditions are favorable, but without the expansion of sugarcane acreage, sustained production growth is not possible.   All the investment activity has been consolidation-type investment, or a financially strong company buying out financially weaker companies.  Other issues that frustrate new plant investment are the lack of fuel tax equalization for ethanol among the states of Brazil that causes undo market distortions, and the continued imposition of the US 54 cpg import tariff that eliminates any demand upside for expanded ethanol production. 

On the demand side, Brazil has created a huge demand sink in the form of the ever-growing flex-fuel vehicles (FFV), plus the development of green plastics industry in the form of ethanol feedstock from sugarcane used to produce polyethylene.  The FFV fleet grows by over 2 million units each year, and is now 50% of the overall vehicle fleet in Brazil, generating approximately 3.5 billion liters of potential new ethanol demand each year.  The FFV fleet acts as a double edged sword for potential ethanol industry investment, with fears that the state owned oil company Petrobras would control gasoline prices, holding them below market value and putting pressure on the ethanol industry, whose prices are unregulated.  In summary, Brazil for the next 3 to 4 years will not be a significant participant in the international fuel ethanol market.

The profitability picture for the US ethanol industry looks very attractive for the next several years, based on the following key points:

•          US Ethanol mandate growing 600 million gallons per year
•          E15 approval and adoption anticipated for 2013 and beyond
•          No new greenfield ethanol plants for the next several years
•          Continued solid export potential to Canada and Europe
•          Brazil ability/desire to export ethanol greatly diminished
•          Crude moving to $100 per barrel

The only potential downside at the moment is a potential corn price shock that could reignite the “food vs. fuel” debate and threaten the US government mandate, which we deem as highly unlikely.  Also, a corn price shock will put significant pressure on plant margins, forcing ethanol prices to move up as quickly as corn during corn market rallies; ethanol prices have a tendency to lag surging corn prices, hurting plant margins until the market reaches equilibrium.   

In summary, based on an the lack of new plant investment on the supply side, and steady demand growth during the next three years and beyond , the profitability prospects for the US ethanol industry look very good.

Brazil's Potential Role in Ethanol Trade

This year, Brazil’s exports have tracked at a level 50% below last year’s exports.  It is our opinion that Brazil’s participation in the international fuel ethanol market is going to be very limited over the next two years.  The following is a list of factors that will contribute to keeping Brazil off the fuel ethanol export market:

•          Dry weather conditions have reduced sugarcane yields per acre by 5% or more below forecast this harvest season.
•          The poor weather conditions during the last two years have conspired to disrupt the typical replanting share of 20% of the cultivated acreage.  This has left the industry with a substantially older crop in the field that yields less cane than younger sugarcane.  It will take at least another growing season to remedy this imbalance in the sugarcane crop.
•          Sugar prices are again at record levels, and it appears that the sugar industry will not be able to replenish stocks this year, leaving the sugar market fundamentally tight for at least another year. 
•          Higher sugar prices will continue the favoring of sugar production in Brazil, where mills can swing approximately 1 billion liters of ethanol production towards sugar.
•          High sugar prices generating copious amounts of cash, coupled with the government loan program for ethanol inventory, has allowed mills to show market discipline and not dump ethanol onto the market to generate cash.  This is evidenced by the industry holding more than 2 billion liters more of inventory than last year at this point in the harvest, allowing the mills to maintain high ethanol prices.
•          The startup of significant chemical demand to produce green plastics.  Braskem’s new polyethylene facility will consume 500 million liters per year of ethanol starting next year.
•          The continued growth of the flex-fuel vehicle (FFV) fleet by 2.7 million vehicles per year.  If these FFVs shift from E25 to 100% hydrous ethanol, they have the potential to consume an additional 3.5 billion liters per year of ethanol.  FFV fuel demand is very elastic and will respond to price quickly.   Higher prices this year have reduced ethanol demand by over 1 billion liters as the FFV fleet has responded to high ethanol prices relative to gasoline.  The overall size of the FFV fleet is estimated at 11.7 million vehicles by the end of 2010.  In our opinion, this is the single largest reason why Brazil, at least for the next several years, will not be a major exporter of ethanol due to the potential for a huge surge in demand domestically when the prices are set accordingly.

EPA E15 Decision

The EPA decision on the E15 waiver came as no surprise this week.  The EPA ruled that E15 gasoline blends were okay for 2007 and later year model vehicles in the US.  As we have stated numerous times in previous reports, a bifurcated market will not work.  For example, The National Association of Convenience Stores (NACS) told its members to exercise extreme caution on whether to sell E15 gasoline.  The NACS represents convenience stores and the petroleum retailing industry that sells an estimated 80% of the motor fuels in the US.  The NACS’s key issues with the EPA waiver is that it does not address the liability of using dispensing equipment not specifically certified to handle ethanol blends in excess of E10 and the liability exposure for engine damage and Clean Air Act emission violations caused by misfueling vehicles, even with appropriate labeling in place.  An excellent study commissioned by the American Petroleum Institute that we referenced several weeks ago sums up all the other regulatory barriers that must be dealt with before E15 can enter commerce officially.  Here is the link to that study: http://www.jordan-associates.com/Sierra%20Repor%20on%20E15%20Reg%20Hurdles_080410.pdf

The huge sticking point that is evident in the proposed rulemaking is that the 1.0 psi RVP waiver granted for E10 cannot be extended to E15 by agency rulemaking.  In 40 CFR 80.27, the law limits the waiver to gasoline containing between 9%-10% ethanol with no exception.  It can only be changed with an act of Congress.  In this week’s proposed rulemaking (here is the link - http://www.jordan-associates.com/e15-labeling-nprm.pdf), the EPA is proposing that E15-blended gasoline will not  be granted this RVP waiver, forcing the blendstock that 15% ethanol is blended with to have a reduced vapor pressure and allowing the finished blend to meet summertime gasoline RVP without a waiver.  This means a refiner will be required to produce both an E10 blendstock and an E15 blendstock.  The rulemaking goes through an elaborate process to prevent comingling of E10 blendstock with E15 blendstock in order not to violate the RVP waiver language.  It is absurd to think the gasoline industry is going to go through these contortions to deliver E15 to the consumer.  There is no economic incentive for a refiner to produce a more expensive blendstock to accommodate E15.  In our opinion, these rules are completely unworkable, and it is going to take an act of Congress (hopefully with more input from industry) to clean up this mess. 

Ethanol Tax Credit Renewal

The impressive juggernaut called the ethanol lobby seems to be losing their grip on the political landscape – at least for the moment.  After spending almost the entire year staking out the position that renewal of the VEETC (Volumetric Ethanol Excise Tax Credit) and import tariff were a must-have from the US government, with no compromise, the ethanol lobby received little to no traction on this position.  In response to no movement by lawmakers on renewing ethanol’s tax credit, the key lobbying groups - RFA, Growth Energy and ACE - are now floating a compromise position.  The form of the compromise is outlined as follows:

· Reduce the existing 45 cpg blending tax credit by up to 50% for 2011

· Create a refundable producer tax credit to start in 2012 to last four years – there are no details available on how this would be calculated

· Reward ethanol producers who reduce their carbon footprint with higher producer credit levels – there are no details available on how this would be calculated

· Eliminate the import tariff, starting in 2012

· Accelerate deployment of flex-fuel vehicles by mandate and provide government grants for blender pumps at fueling stations

· Allow cornstarch ethanol to be considered for “Advanced Biofuels” status

· Suppress indirect land use penalties on cornstarch ethanol

Being a keen observer of today’s political environment, it is becoming highly unlikely that a lame duck session of the US Congress is going to deal with the ethanol industry tax credit issues.  A new Republican-controlled Congress in 2011 has the potential to be politically hostile to any attempt for an ethanol tax credit renewal.  We think our subscribers should at least prepare for expiration of the VEETC and the import tariff moving into 2011. 

The key impact will be pressure on discretionary ethanol blending that depends on ethanol/gasoline economics, and not mandated volumes.  We can estimate discretionary ethanol blending by calculating how much ethanol is used to produce ethanol-blended gasoline from the EIA, and compare that to a simple 12 billion gallons mandate divided by 365.  Using last week’s EIA production figures, 34 million gallons of ethanol were blended into gasoline.  This compares to the daily average the RFS2 mandates requires of 32.8 million gallons per day, which means only 1.2 million gallons per day of ethanol are discretionary.  The chart titled “Ethanol Blended vs Mandate” below uses this analysis and calculates the amount of ethanol blended into gasoline that is discretionary, i.e. more than mandated through September of 2010.  The total amount blended exceeding the mandate is 142 million gallons through September.  These numbers would suggest that losing the VEETC will have little impact, if any at all, on ethanol prices for next year.  A negative impact assumes that ethanol prices are higher than gasoline prices as they are today.  In addition, the mandate increases to 12.6 billion gallons, or 34.5 million gallons per day, of ethanol blending next year, and expands the available gasoline pool to include all the gasoline blended by small refiners that lose their exemption from RFS2 mandates starting in 2011. 

The expiration of the import tariff will have little or no effect, particularly due to the high prices in Brazil.  The LCFS in California may create demand for sugarcane-based ethanol, but that remains to be seen, and market participants do not anticipate any action until 2012 if the LCFS is still in place.

Brazil's Inventory Bubble

As we noted in last week’s newsletter, the increase of ethanol inventory in Brazil this harvest season is surpassing last season’s inventory build substantially.  The following chart clearly illustrates the dramatic change in the inventory profile between the two harvest seasons:

  

How much inventory does the Brazilian ethanol market need to cover the inter-harvest period when sugarcane processing and ethanol production are at minimums?  To determine the answer, we have forecasted monthly consumption for the inter-harvest period as follows:

                   Monthly Consumption

Fuel Use                 1,875

Non-Fuel Use             210

Exports                  __150

Total                      2,235 million liters

Fuel use is based on average consumption this year, according to data published by the National Petroleum Agency (ANP).  Fuel demand is lower than last year’s consumption by 160 million liters per month.  Non-fuel use is predicted to be approximately 50 million liters per month higher than last year due to the startup of new chemical (non-fuel) demand for ethanol.  This new demand is anticipated to come on line in the 4^th quarter.  Exports are forecast to follow last season’s pattern. 

With the drier harvest season this year, December ethanol production will fall off to inter-harvest levels due to the poor quality of the late harvest sugarcane, which was impacted by dry weather.  This results in an estimated ethanol production of 400 million liters per month for the period of December of 2010 through March of 2011. 

These numbers indicate a market that is short by 1,835 million liters per month for the December 2009 - March 2010 time period, yielding a total shortfall of 7,340 million liters leading up to the start of the 2011 harvest.  As of August 15, Brazil’s physical inventory was 5,673 million liters and building monthly by 1,500 million liters.  Assuming this inventory build rate continues through October, and the carryout inventory at the end of the harvest season is 1,000 million liters, the Brazilian ethanol industry will meet this inventory level by mid-October.  If nothing changes in the supply/demand balance, inventory levels by the end of November could reach 10,000 million liters, assuming the industry has the storage capacity to hold this quantity.

Brazil’s ethanol prices have been remarkably stable this harvest season, due in large part to the industry’s ability to finance the increased inventory.  The ethanol market in Brazil is moving into some uncharted waters as this inventory level continues to reach new heights.  Going into October, it would not be surprising to see weaker prices in Brazil that would stimulate demand to slow down the inventory growth.  A countervailing force for lower prices is the anticipated increase in European ethanol prices.  The European ethanol market is suffering significantly from higher feedstock costs due to the poor wheat harvest, which could result in sizeable export demand for Brazilian ethanol.

E85 - Is It the Solution?

During the last several months, the key advocacy groups for ethanol have been split on the long term policy they want to advocate for ethanol in the face of the looming expiration of the tax credit and import tariff.  Growth Energy took the lead and changed directions from the drum beat of tax credit renewal exclusively to advocate Flex Fuel Vehicles (FFV) and the construction of E85 fueling stations.  The argument is that the ethanol industry, once provided its own fuels market via E85 that is not controlled by the US refining industry, will then control its own destiny and profitability.

On the surface, this idea has substantial appeal in that it gives the ethanol industry the opportunity to compete with hydrocarbon gasoline on an equal playing field.  In our opinion, for E85 to be successful long term, it must be cost competitive to the consumer on an energy-delivered basis compared to gasoline.  The simple facts are that a gallon of ethanol contains 75,700 btu/gallon, whereas hydrocarbon gasoline contains 115,000 btu/gallon, which calculates as a 35% disadvantage for ethanol.

The three keys to E85’s success are:

•          Expand the FFV fleet substantially to create demand density

o   Legislation has been introduced to force the auto industry to produce more FFVs

•          Build E85 Fueling stations

o   The industry estimates that it needs 200,000-300,000  stations

o   Currently, there are 2,500 stations

o   Legislation has been introduced to provide tax credits to build E85 fueling stations

•          E85 price meets or beats gasoline parity

o   This is the issue

 

The price parity issue is the one piece of the E85 puzzle that is not falling into place. We have analyzed the price parity issue from two perspectives using Chicago physical prices for gasoline and ethanol.  This analysis assumes no ethanol tax credit is available.  The first perspective is comparing gasoline prices to market ethanol prices and plotting them against the hypothetical E85 energy content parity price.  The following graph shows that the price of ethanol has never dropped low enough to value E85 below the energy parity line during the last 2 ½ years.

The second perspective is to see if E85 can be competitive from a cost-of-production basis, which removes ethanol market influences. The value of ethanol in this analysis is based on CBOT corn plus 30 cpg.  We used this value for ethanol in the following graph and, once again, E85, using this ethanol value, is never less expensive than the E85 parity line.

These results are startling from the perspective that ethanol is unable to compete against hydrocarbon gasoline on an energy content basis without government incentives.  The difficulty is the relationship between agricultural prices and crude oil prices. The question becomes, will the corn price versus crude price separate enough in the future to overcome this differential?  In the near term, the differential is actually going in the opposite direction, with a corn/crude margin squeeze that we will discuss in our next segment.