Brazil’s Import Barriers

Brazil made a big show of reducing their ethanol import tariff to zero earlier this year in order to spark the debate about the US ethanol import tariff that is up for renewal at the end of this year. Brazilian representatives cast themselves as supporters of free trade.

In today’s global ethanol market, Brazilian ethanol prices are very high relative to the US and Europe. Brazilian producers are holding onto inventory where in past harvest seasons they would be selling ethanol aggressively as the harvest gets into full swing. Recent consolidations in the ethanol industry, government inventory loan programs for producers and strong sugar prices all have lead to a more disciplined ethanol market in Brazil leading to the high prices.

Now that a price arbitrage is open to Brazil, US exporters are attempting to ship material to Brazil to capture these prices.

Brazil has imposed non- tariff barriers in two ways. One, the ethanol specification used for import requires that non-sugarcane produced ethanol must be 99.6% ethanol by volume while standard fuel anhydrous ethanol produced from sugarcane be 98% ethanol by volume (actual measurement is alcoholic degree of 99.3 that translates into 98% volume percent). There is no valid scientific reason to make this distinction for ethanol that is to be blended into gasoline.

Obviously, high purity(99.6%) ethanol produced in the US is a small fraction of the total ethanol produced and what is produced commands a 10-15 cpg premium over standard denatured ASTM specification ethanol.

The second non-tariff barrier has been extended bureaucratic delays in issuing import licenses. Traders trying to import ethanol into Brazil report frustrating delays in getting import licenses to take advantage of the wide open arbitrage. It is hard to determine the exact delays but with a strong price arbitrage to export to Brazil and reports of limited smaller cargos being shipped to Brazil, the bureaucratic delays are real.

Ethanol 4th Quarter 2010 – Is it a Train Wreck?

By the 4th quarter of this year, the industry is scheduled to bring on another 550 mln gallons of annual capacity. This represents another 36,000 bpd of new production. By October of this year, the driving gasoline demand bump with have dissipated reducing overall gasoline demand by 250,000 bpd resulting in the loss of another 26,000 bpd of ethanol demand. This assumes that ethanol blending penetration stays in the low 80’s% through the balance of the year. We think the blending penetration staying in this range as a good assumption based on the very low price for 2010 ethanol RINs tracking in the 1.5-2.0 cpg range.

Export opportunities will be limited because of certification requirements for renewable fuels into Europe go into effect in December and it is uncertain if US producers will go to the trouble of getting their supply chain certified. Brazil may be an export outlet, but with very strict ethanol specification for imports, it is difficult to produce and move significant quantities of this type of ethanol to Brazil to relieve length in the US ethanol market.

On the positive side, if we assume $4/bushel corn and $75/barrel crude oil, there will still be a 20-40 cpg blending incentive for ethanol even without renewal of the VEETC. The EPA will issue a ruling on some type of E12 or E15 waiver by September. This will be good news psychologically for the ethanol market but the higher blends could not be realistically implemented until the middle of 2011 offering no physical relief to the market in the 4th quarter. Renewal of the VEETC prior to its expiration again is psychological but will not affect demand in the 4th quarter.
The market is paying a 6.4 cpg premium for Q1-2011 swaps over prompt pricing. The market sees the E12/E15 waiver, the higher RFS2 mandate of 12.6 bln gallons, the elimination of the small refiner exemption as all changes that will kick in for Q1. It should be noted that during the 1st quarter of any year, gasoline demand falls another 250,000 bpd below demand levels experienced in the 4th quarter due to winter weather. Even though there is good news for the 2011 market, Q1 may be too soon for this good news to physically impact the market resulting in higher ethanol prices and plant margins.

The corn crush margins for Q4-2010 and Q1-2011 are in the 24-26 cpg range which are not sustainable for the industry.

With an industry at a nameplate capacity of 14 bln gallons in the 4th quarter and demand softening or at best staying flat, ethanol plant margins are going to come under strong pressure resulting in some temporary plant slowdowns or shutdowns to balance supply and demand.

CBO Study – BioFuel Tax Credit

The Congressional Budget Office (CBO) recently published a report entitled “Using Biofuel Tax Credits to Achieve Energy and Environmental Policy Goals” that focused on the cost to the US taxpayer of biofuels tax credits. The report focused on two policy goals: displacing the use of petroleum fuel and reducing greenhouse gas emissions. We have taken a quick look at the CBO’s analysis on the displacing of petroleum fuels by ethanol.

The CBO states that biofuels tax credits cost the US Treasury approximately $6 billion per year.

The CBO takes a reasoned approach in determining the cost of the tax credit per gallon of gasoline displaced by ethanol. The CBO converts the tax credit from a volumetric basis to an energy content basis. A gallon of petroleum based gasoline contains 125,000 btu/gallon and a gallon of ethanol has 85,000 btu/gallon energy content. Consequently, the 45 cpg tax credit for each gallon of ethanol is the same as paying blenders 67 cents for every 125,000 btus of ethanol blended with gasoline. Adding an addition correction for the 11,000 btus of petroleum fuels used to produce 125,000 btus of energy from ethanol yields a tax credit value of 73 cents per 125,000 btu of energy produced. This is a fair and reasoned approach to placing a value on the tax credit granted the ethanol industry.

The CBO report then attempts to assign a cause and effect relationship to the tax credit by using the results of a 2008 study by the Food and Agriculture Policy Research Institute (FAPRI) at the University of Missouri that concluded that if no other biofuels policies were in place, removing the tax credit would reduce ethanol production by 32%. The CBO then applied the entire $5.2 billion ethanol portion of the annual $6.0 billion tax credit cost and applied it to the 32% quantity identified in the FAPRI report yielding a final cost of 178 cpg. So in effect, the CBO report concludes that the government is paying $5.2 billion per year for approximately one third of US ethanol production. The size of this number is eye catching and will influence the tax credit renewal debate, but it is not an honest depiction of the regulatory landscape for ethanol in the US.

This is a faulty approach because there is a long term biofuels policy. The Energy Independence and Security Act of 2007 (EISA) with its RFS volumetric mandates will be government policy that remains in place until 2022. Congress is now questioning whether volume mandates take away the need for a tax credit by guaranteeing the industry a market for its product. The VEETC tax credit is paid to the blender of ethanol/gasoline and not paid to the ethanol producer making the effect an indirect incentive at best.

The debate is now being framed in Congress - does an industry that has a tax credit, a mandate carving out 10% of the gasoline market and a protective import tariff; does it still need this much support - or should it stand on its own or decline less government monetary support?

Proposed 2011 Renewable Fuel Standards

This week, the EPA issued a notice of proposed rule making to address Renewable Fuel Standards (RFS) for 2011 that, pursuant to RFS2 regulations, need to be determined by November of each year for the upcoming year. The table titled “Proposed Percentage Standards for 2011” indicates the percentages that obligated parties need to meet for 2011. The numbers are lower than last year due to the inclusion of small refiner volumes in 2011, even though the total mandate increases.

Cellulosic ethanol continues to be a large failure. The 2011 mandate calls for 250 million gallons, and the EPA is anticipating a range of available cellulosic ethanol of 6.5 million to 25 million gallons.

What is to be done about the shortfall, and how will both the Advanced Biofuels and Total Renewable Fuel requirements for 2011 be adjusted to address this shortfall? The EPA is proposing not reducing the totals, but just adjusting the Cellulosic mandate and anticipating that biodiesel and sugarcane ethanol will pick up the slack. The adjacent table titled “2011 EPA Proposed Rule Changes” describes the 2011 mandate. The Advanced Biofuels mandate consists of three types of biofuels based on feedstock minimum 50% GHG reduction performance: cellulosic biofuels, biodiesel, and undifferentiated advanced biofuels. A renewable fuel meeting cellulosic requirements can satisfy the cellulosic and advanced biofuels requirements, but not biodiesel. Biodiesel can satisfy the biodiesel and advanced biofuels requirements, but not cellulosic. The only approved pathway for undifferentiated advanced biofuels is sugarcane ethanol, and a gallon of this material can satisfy the advanced biofuels requirement, but cannot satisfy either the cellulosic biofuels or biodiesel requirements. One gallon of physical biodiesel generates 1.5 RINs because of biodiesel’s higher energy content.

The EPA also admits that the biodiesel industry has been struggling and is currently not producing enough biodiesel to meet the mandate. They also believe there is enough idle biodiesel capacity that can be restarted to produce a minimum of 800 million gallons in 2011. The adjacent bar chart titled “United States Biodiesel Production” indicates that the most the industry has produced in any calendar year is 670 million gallons in 2008. The EPA shrugs off the lack of a biodiesel tax credit and an industry that today is producing at a 360-million-gallons rate for 2010. The EPA blithely mentions that there are 2.2 billion gallons of capacity just ready to restart. They, however, do not address the numerous bankruptcies and facility abandonments since Congress’s failure to renew the biodiesel production tax credit; this makes estimating what capacity is left to surge production in a short time frame next to impossible. The EPA also makes no mention of the $1.00-per-gallon price premium for biodiesel over regular diesel that exists in today’s market. We are extremely skeptical that 800 million gallons of biodiesel will be produced at today’s feedstock prices without a significant change in tax policy to support the industry, which, in today’s political climate in Washington, appears to be next to impossible.

In proposing no change to the total Advanced Biofuels mandate, the EPA is also assuming that sugarcane-based ethanol, essentially from Brazil, will be available to fill the gap left unfilled by cellulosic biofuels and biodiesel. The EPA assumes 144 million gallons, or 544 million liters, of ethanol will be available for export to the US in 2011. They further point out, more specifically, that the California Low Carbon Fuel Standard (LCFS), which begins in 2011, should attract sugarcane-based ethanol, and that can be applied to the Advanced Biofuels mandate. With government regulators in the US, California, Europe, and Japan all wanting to use sugarcane-based ethanol to meet their GHG reduction goals, colliding with the hard facts of weather-related negative pressure on Brazil’s sugarcane production and expanding Brazilian domestic demand, will force importers to bid ethanol away from Brazil’s domestic market. So far this year, Brazilian exports are 665 million liters, which are 50% below previous year’s exports, and the outlook for 2011 is not any better for material available for export. None of Brazil’s exports this year have come to the US for use in the transportation fuels market. If the import tariff on Brazilian material is left in place, CBI hydrous ethanol dehydration plants may start processing again by being able to offer a 10-20 cpg discount to direct shipped anhydrous ethanol from Brazil.

In summary, the Advanced Biofuels portion of the RFS2 is struggling. The hard taskmaster of economics is proving to be a difficult hurdle. With a highly efficient cornstarch ethanol industry producing cost-competitive ethanol, it will require strong government support and a long-term financial incentive to bring high-cost cellulosic ethanol to market. The biodiesel industry is in the same situation, with a product that is not cost competitive. We question the ability of the government to follow through with the needed financial and market support to make cellulosic ethanol a reality. The EPA is counting on imported sugarcane ethanol to meet a portion of the US renewable fuels mandates, even when there are significant quantities of US-produced cornstarch ethanol available. It appears that US environmental policy is promoting the importation of transportation fuels, which is diametrically opposed to stated policies of promoting energy independence. Conflicting government policy on Brazilian sugarcane ethanol has the EPA promoting the importation to meet renewable fuels goals, while the same US government continues to impose a 54 cpg import tariff on Brazilian ethanol to protect the US cornstarch ethanol industry in the name of energy independence.

More E15 News

The EPA confirmed in a status update, hidden on their website on Friday afternoon before a three-day weekend, (brave bureaucrats) that an E15 waiver for 2007 model cars and younger would be decided on in late September. For automobiles in the 2001-2006 model years, a decision will be issued in November. Assuming that, at some point in the future, some portion of the automobile fleet in the US will be able to use E15, let’s consider the confusion at the pump for the average consumer. The consumer will approach a fuel dispenser and be faced with a big ugly label indicating that it is unsafe to use E15 in cars in the appropriate model years. The consumer will then think that if E15 is unsafe for some cars, why take the risk and will decide not to use E15, even if the car in question is actually compatible with E15. The price differential will be minimal at best, so an economic incentive will not exist to motivate the consumer to make the choice of filling up with E15. A bifurcated E10/E15 gasoline market will not work. With no economic incentive to purchase E15 while E10 sits next to E15 at the same gasoline pump, E15 is going nowhere. As we suggested in last week’s newsletter, getting full E10 penetration in the gasoline market and pushing FFV’s, along with E85, is going to be the route to expanding ethanol demand. E85 will work for the consumer when he sees the lower cpg price, even though, on a miles per gallon basis, it won’t be any better; consumer self-interest will kick in. The FFV/E85 strategy faces a density of demand issue, with FFV’s scattered across the US and not concentrated enough in one area to support numerous E85 station conversions. Look for lobbying to kick into high gear to expand FFV production, as well as government (federal and state) monetary support to install E85 dispensers.

E15 Update

The EPA announced last week that the agency was delaying the decision on whether to grant a waiver to allow E15 in gasoline, citing the agency’s desire to wait until the DOE has completed its engine testing in September. The DOE engine testing is focused on late model Tier II emission control vehicles that went into production in 2007. In announcing this delay, the EPA intimated that it may only approve a waiver for these types of vehicles, and older vehicles may not be part of the waiver. The ethanol industry was hoping for a minimum waiver that included vehicles 2001 or younger that would have made more than half the existing fleet eligible for E15. Backing up the waiver to 2007 or younger will shrink the available vehicles to approximately 20% of the fleet. This type of waiver will do little for the ethanol industry. As we have discussed previously, a bifurcated market will have gas station liability issues, product labeling issues, and distribution issues for the gasoline marketer offering clear unleaded 87, E10, E15, E85, and premium gasoline.

ADM has petitioned the EPA to consider an E12 waiver based on the “substantially similar” concept that bypasses any engine testing by deeming the product substantially similar. This approach appears to be a long shot. The year and half delay in making any type of decision by the EPA is indicative of the difficulty in moving the gasoline market past E10 with the existing fleet of vehicles. Always keep in mind that when a difficult decision is required by a government bureaucrat that involves risk, the “make no decision” reflex will win out, as evidenced by the long delay on this E15 decision.

We believe the clear path to large ethanol consumption is to focus on moving the fleet towards E85-capable vehicles. In order to achieve the desired amount of renewable ethanol in the US gasoline pool, the solution that Brazil has embraced is the Flex-Fuel Vehicle (FFV). The FFV in Brazil has been tremendously successful in developing the ethanol fuel market in that country. It is very inexpensive to produce an FFV versus a non-FFV, so that is not an impediment. The key to unlocking the E85 market is getting the fuel dispenser infrastructure in place. There is proposed legislation to mandate the auto manufacturers to produce 90% of the fleet as FFV’s by 2013, and the legislation offers substantial federal grants for blender pump installation at gas stations.

Looking forward into 2011, the RFS mandate increases by 600 million gallons, and the small refiner exemption will be removed. These two actions will be enough to complete 100% penetration of E10 into the gasoline pool and consume all the production scheduled to come online by the end of this year. E15 is not necessary to consume all the domestically produced ethanol over the next 18 months, but the delay is having a negative impact in market psychology.

Global Ethanol Trade Flows

Global Ethanol Trade Flows

Ethanol trade has started to slow down for many producing and consuming countries.  The table on the right titled “Global Ethanol Trade Flows” examines trade flows between various regions around the world comparing year to date April of 2010 versus year to date April of 2009.  The six key trade flows that have shown significant year over year changes are evaluated as follows:

· USA => CANADA

Looking at the table on the right, according to the US Census Bureau, exports of ethanol from the US to Canada have almost doubled this year compared to the same time frame last year.  This is due to provincial ethanol blending mandates in Canada taking effect within the last year, as well as preparation for the national E5 mandate that is set to be implemented at the end of the year.  There is one new plant expansion scheduled in Canada by Suncor of 200 mln liters in Q1 2011.  With no other new capacity on the drawing board beyond the Suncor plant, this level of Canadian imports will continue into next year.

· Brazil => CBI  => USA

Brazil’s exports to the CBI nations are down 76% of what they were a year ago.  CBI nations enjoy duty-free access to the US market.  The CBI countries have essentially no indengious ethanol production and rely solely on the dehydration of Brazilian ethanol.  The dehydration arbitrage of Brazilian hydrous ethanol is closed and we expect the arbitrage to remain closed for the foreseeable future reducing this trade flow to zero.

· Brazil => USA

Due to feedstock prices in their respective countries, imports of ethanol into the US from Brazil have diminished during the last two years.  Brazil’s poor harvest last year and substantial growth in Brazil’s domestic ethanol demand by the burgeoning FFV fleet has maintained strong domestic prices reducing the incentive to export. The US import tariff of $0.54-per-gallon tariff is also a strong barrier to open trade.  Although corn prices are rising in the US at the moment and pushing ethanol with them, it is remains uneconomical to bring material in from Brazil, especially with the added tariff.

· Brazil => Asia/Pacific

Brazilian ethanol exports to Asia are somewhat lower this year compared to the same time last year.  This market represents a potential growth opportunity for Brazil.  Other than China, there are no substantial producers of ethanol in Asia, especially for export, and countries such as Japan and India have invested in sugar mills and ethanol technologies in Brazil, leading to a natural trade flow between Brazil and these countries.  South Korea is a major recipient of ethanol from Brazil, but much of this volume is for beverage-grade consumption since  South Korea does not have a fuel ethanol blending mandate.

· Brazil => EU

Exports of ethanol from Brazil to the EU have fallen by almost half of what they were last year during the same time period.  This has been due to abundant T2 ethanol supply in Europe, as well as a function of price; when adding the EU import ethanol tariff, it simply has been largely uneconomical to send undenatured EN spec ethanol from Brazil to the EU.    We expect ethanol demand to grow in Europe with increased blending penetration percentages kicking in the second half of the year.  With this increased demand, regional price spreads will widened at some point to draw in the necessary volume to cover demand.

· USA => EU

Exports of ethanol to the EU from the US have increased substantially.  This change in trade flow has been a function of price.  Ethanol prices in the US have been low relative to EU and Brazilian prices prompting the surge in exports.  Export volumes have receded recently with the narrowing of regional prices.  This week’s strengthening in corn prices due to changes supply fundamentals will keep US ethanol prices too high for further sustained exports to the EU.