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.

Ethanol Tax Credit- $4 CORN - $75 Crude

Recently, the price of unleaded 87 gasoline in the USGC and NYH has fallen below the price of ethanol in those markets. The 45 cpg ethanol tax credit (VEETC) and RFS2 mandate have now become the driving force for blending ethanol into gasoline.  The VEETC will become the primary economic driver for blending ethanol into gasoline as the ethanol/gasoline differential becomes negative.  Ethanol blending is exceeding RFS2 mandates of the obligated parties, as evidenced by very low RIN prices in the 1.0-1.25 cpg range.

Corn, at $4 per bushel with a 30 cpg crush margin, yields an ethanol price at $1.75 per gallon FOB Chicago and 180-185 cpg ($75-$78 per barrel) in the major market areas.

Crude is now in the $75 per barrel range, and gasoline cracks of $8-$10 per barrel are falling, having lowered by almost $4 per barrel to $79 per barrel last week, and continues to go lower.

Corn prices are being driven by issues in the wheat market due to the projected wheat shortfall in Europe and Russia.  China continues to be a large importer of numerous agricultural products, thereby supporting agricultural prices. Corn prices appear to have solid fundamentals that endure into 2011.

The economic drivers in the corn market (feedstock costs) do not appear to have a relationship with the price of ethanol as a transportation fuel.  The economic drivers for inputs and outputs for an ethanol plant are disconnected and headed for a possible collision.

If you take away the VEETC by not renewing it for next year, and with crude/gasoline prices deteriorating to $70 per barrel or less, the ethanol producer is going to be put into a margin squeeze.  With no VEETC to incentivize blending and lower crude/gasoline values, ethanol demand will drop sharply as non-obligated parties discontinue discretionary blending, and obligated parties minimize blending to their specific RFS2-mandated volume. The market will eventually correct itself in one of two ways: either a significant number of ethanol plants will shut down to affect corn’s supply/demand balance and drive the price of corn down, allowing ethanol production at a lower price, or, there will be a shortage of RINs, driving their price up to motivate obligated parties to pay an ethanol premium to gasoline.  RIN prices will move up accordingly, providing an incentive to blend ethanol to the obligated parties, even though the actual physical price is uneconomic.

In summary, there is a danger of a severe margin squeeze in 2011 if the VEETC is not renewed and the corn-to-crude relationship shrinks further below today’s price relationship.  This margin squeeze will result in plant capacity shutdowns to cope with the negative market signals.

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.