Obligation Outcomes

Curtailing ethanol blending this year may have a moderate effect on near-term corn prices, while broader, long-term consequences loom. Observers think the EPA will ultimately set the RVO above 13 billion gallons. How far above 13 no one knows.
By Tom Bryan | February 15, 2014

Considering the gale of criticism the EPA received for proposing to lower U.S. biofuels blending for 2014, it would be ironic if the federal agency’s action was intended to shield ethanol from a Congress that’s growingly indifferent to the renewable fuel standard (RFS).  

Strange as it sounds, Wally Tyner thinks it’s probably happening. “They are trying to get Congress out of it,” says the Purdue University agricultural economics professor. “They are trying to do something, administratively, that would prevent some in Congress from doing what they’d like to—and that’s kill it. I think EPA is trying to get Congress off its back and let the RFS survive.” 

With the end of the intense 60-day public comment period on the EPA’s proposed 2014 renewable volume obligations (RVOs), Tyner is among observers who partly reject the agency’s suggested reductions to this year’s biofuels blending quota. He says the EPA’s proposal to lower the entire advanced biofuels pool to compensate for absent cellulosic volumes is justified. Cutting back on corn ethanol, however, makes little sense to Tyner. In fact, he says, the severity of EPA’s advised blending ranges suggest the agency is trying to parent biofuels with tough love to keep Congress assuaged.  

Tom Buis doesn’t see it. “If they are trying to protect the RFS, they went about it wrong,” says the CEO of Growth Energy. “If they were trying to save us, I would say thanks but no thanks.”

The EPA proposed in mid-November that 2014 RFS blending requirements be set at or near 15.2 billion gallons, with roughly 2.2 billion gallons coming from advanced biofuel and the rest—about 13.1 billion gallons—coming from what’s commonly referred to as conventional biofuels, predominantly corn ethanol. The EPA published the draft proposal to the Federal Register the day after Thanksgiving, but conjecture about its impact began more than a month earlier when the proposal was leaked. At the epicenter of the RVO debate is the question of how a deferred biofuels blending schedule would check the nation’s biofuels vision and cause injury to American agriculture, which is now highly reactive to the supply and price of corn. It’s hard to disagree that less demand for corn would lower the crop’s price. What is game for speculation, then, is the depth of the EPA’s RVO reductions, the significance of the cuts on corn demand, and the downward pressure it might put on the crop’s price. 

Leading the conjecture wave, Bruce Babcock offered his opinion on the potentially lower RVO a few days before the EPA’s official proposal was released. The Iowa State economics professor, along with graduate assistant Wei Zhou, determined that limiting the requirement for ethanol blending to 13 billion gallons—rather than ramping up to the statutory 14.4 billion gallons in 2014 and then 15 billion gallons in 2015—would ultimately lower corn prices by about 5 percent, or 25 cents per bushel. That price dip is economically meaningful to corn farmers and livestock feeders, Babcock and Zhou said, but it is small compared to the price swings the market has experienced since 2006. “We wanted to know what a lower RVO would do to corn price, and it isn’t real large,” Babcock says. “It’s something, but it’s not huge.”   

Waiting for the EPA’s final RVO decision now, Babcock stands behind his predictions. He says that his November analysis assumed, for the sake of simplification, however, that ethanol exports and imports would be zero, or cancel each other out. “If we had accounted for higher demand in exports, we would have come up with an even smaller impact on corn prices,” he says. 

Breaking Down Bushels
FCStone’s Jason Sagebiel says it’s true that a sudden slack in demand would contribute to the U.S. corn carryout and draw down prices. “If you take 1.3 billion gallons of ethanol off the market, that would be equivalent to  464 million bushels of corn,” Sagebiel says, using a big number for effect and not accounting for corn-offsetting distillers grains volumes. “With a carryout of 1.6 billion bushels, that takes you up to 2 billion bushels, so it would theoretically have a negative impact on corn prices.”

Sagebiel and others say the actual reduction in market demand will probably be smaller than 464 million bushels, however. Regardless of where the EPA sets its blending requirements, the U.S. oil industry will consume no less 13.2 billion gallons of ethanol this year, says Darrel Good, a professor of agricultural and consumer economics at the University of Illinois at Urbana-Champaign. “That’s a given. No matter where the mandated amount is, we’ll blend 10 percent,” he says. 

Good is among academics who say lowering the nation’s ethanol blending requirement in 2014 would not significantly threaten corn prices. He says it was never likely that liquid gallons of corn ethanol would, alone, be used to meet the 14.4-billion-gallon conventional biofuels blending floor in 2014. Rather, obligated parties would have filled the billion-plus-gallon gap with a combination of higher ethanol blends, biodiesel and the utilization of amassed renewable identification numbers (RINs). “We wouldn’t have blended 14.4 billion gallons of ethanol in 2014,” he says. “We would have used a combination of alternatives. So what you’re doing by rolling back the mandate is taking away a little bit of the market that [higher ethanol blends] would have gotten. And in terms of ethanol, you’re not losing 1.2 billion gallons, but rather a small portion of that.”

Good says the decrease in corn demand should correspond to the volume of E85 blending that would occur this year if the 14.4-billion-gallon RVO were preserved. “In terms of the corn market, what’s lost is the difference between what we will do and what we would have done on E85,” he says. “Let’s say 250 million gallons of ethanol for E85 could have been mustered up. That’s about 90 million bushels of corn. That’s not a big number. However, it could become a big number moving forward because we wouldn’t be pushing higher blends like we would if RVOs were maintained.” 

Babcock estimates a slightly higher number. “It’s about 135 million bushels,” he says, explaining that the hit to the ethanol market could equal less than 1 percent of the current 13.9 billion bushel corn crop. 

Additional ethanol volume support will come from exports, Good says, explaining that ethanol is experiencing an improved trade balance because corn and ethanol prices are low. The combination of cheap corn and a curtailed RVO also discourages imports of ethanol into the U.S. “Under the scenario we are facing, it would be a pretty expensive alternative to import Brazilian ethanol,” Good says, referencing a year-end USDA report that virtually disregarded the EPA’s probable RVO curtailment and pegged corn for ethanol at a record 5 billion bushels in 2014. 

 

Babcock also expects export demand to soak up some of the excess ethanol capacity on the market in 2014. “It just goes to figure when you have such a spread between gasoline and ethanol prices,” he explains.  

Buis readily admits that the impact of spinning back the RFS is uncertain. “The result could range from tremendous to minimal,” he says. “But either way, it’s not going to be favorable to the American farmer.” The record 2013-’14 corn crop was produced under mediocre conditions with delayed plantings. Ordinary growing conditions in 2014 could lead to a megabumper crop, Buis says. “With the productivity of today’s farmer, and with normal weather, we will have an even greater supply of corn,” he says. “That supply builds up over time, and the larger the carryover gets, the lower price becomes, unless you have demand out there to take care of it.” 

New Normal Questioned 
Whether U.S. farmers can make a profit growing corn when the crop’s price is at or below $4 a bushel is debatable, but it’s a fact that the crop’s production costs have risen dramatically in the past five years. According to the USDA, the average American farmer now spends $655 per acre, factoring in the cost of land, to produce corn. That suggests growing corn barely makes economic sense at today’s prices. Babcock and Good caution, however, that some corn production costs are coming down. “[$655 an acre] is only true if land rents and other farming costs stay high,” Babcock says, explaining that any land rents renegotiated this winter were probably lowered.   

Good agrees that land costs should be dropping. “If we see corn prices maintain in the $4 or less range, it will pull land down,” he says, adding that fertilizer costs should be lower this year, too, while the price of seed may stay fixed.

Sagebiel says sub-$4 corn in 2014 is a possibility, but he thinks the trading community’s reaction to the EPA’s initial RVO proposal was more negative than the prolonged market response may be. Good agrees that the response to a lower ethanol blending requirement may not be severe because it is generally assumed that 5 billion bushels of U.S. corn will be used for the production of ethanol and ethanol coproducts in 2014. “Beyond the initial knee-jerk market reaction, I think the market understands that we’re not going to use less ethanol this year,” Good says.  

Longer-term, corn should stay in the “new normal” price range of $4 to $4.50 per bushel, Tyner and Good agree. “The default expectation is that corn will hover in that low to mid-$4 range. We’ll see deviation from that—up or down—on the supply side. Bumper crops will drag prices below that level, and production problems will pull prices above that level.” 

Buis isn’t so sure. He says a curtailed RFS will put downward pressure not just on corn, but other crops as well. “If a rising tide lifts all boats, a sinking tide also brings them down,” he says. “High corn prices bring all commodities up, but if farmers start to back off corn and switch to other crops due to excess supply, you’ll see overproduction in other areas. The key is to establish consistent domestic demand.”

Babcock agrees that $4 to $4.50 corn only makes sense when there is strong government support for ethanol production. “You need that bright signal,” he says. “The opportunity to turn cheap corn into ethanol as a substitute for gasoline makes sense at $4.25, but if the government isn’t [consistent in its support], you can get oversupplied with corn fairly quickly. There’s nothing to keep corn at $4.25 other than ethanol. I don’t know what else is out there. You can clearly oversupply the food and feed market, and if ethanol is frozen, the price of corn could go down dramatically.” 

High Blends Hit Hardest  
Babcock says everyone should stop worrying about the near-term price of corn and, instead, focus on the broader implications of curtailing the RFS. He says keeping the ethanol blending requirement low cuts the legs out from under next-generation biofuels. “If EPA’s decision stands, and you don’t push through the blend wall, where’s cellulosic ethanol going to go?” Babcock asks. 

Tyner, Good and Babcock all agree that a lower 2014 RVO will also harm higher ethanol blends, E85 in particular. “The real impact of a 13-billion-gallon RVO is that it kills any incentive to blend more E85,” Tyner says. “They’re going to blend E10 up to the max because they have an economic incentive to do so, but they don’t necessarily have an incentive to grow the E85 market.”

The probability of RFS curtailment will slow or stop new E85 infrastructure development. But even if flex-fuel vehicle production and E85 pump installation halted completely, Tyner says, there is enough infrastructure in place today to meet a 15-billion-gallon ethanol RVO with E10 and E85 alone. “With the 70-cent-per-gallon difference between ethanol and gasoline, and with 30-cent RINs, there is enough wiggle room to grow the E85 market,” he says. “But it won’t happen if this 13-billion-gallon RVO holds. I think 14.4 was a bit high, but something higher than 13 is needed.”

Babcock agrees that higher ethanol blends are in immediate jeopardy under a reduced RVO scenario. “What we will lose in 2014 and beyond is the push for E85,” he says. “That may be a small impact in 2014, but it becomes a growing impact as you go forward.” Babcock believes that the statutory 14.4 billion-gallon conventional biofuel blending requirement could have been met in 2014 by using carryover RINs and increasing E85 consumption. “You could meet 14.4,” he says. “13.8 is easy. But if EPA stays behind 13, there’s no incentive to use flex-fuel vehicles, there’s no incentive to push E85, and there’s no growth potential for renewable fuels at all.”

Buis, of course, believes the EPA should stand by the statutory schedule of the RFS and require 14.4 billion gallons. “We can produce it,” he says. “There is plenty of room for it in the marketplace. There is an excess of RINs and we’re on the cusp of getting more and more retailers to move to E15.”

The academics are less bullish. Tyner, for one, says he’d like to see the EPA place the ethanol blending floor at 13.8 billion gallons. “At 13.8, E85 use would happen in greater volumes and you could overcome the blend wall.” 

Tyner adds that he is perplexed by the EPA’s proposed 2014 ethanol RVO range of 12.7 billion gallons to 13.1 billion gallons because the number is so unforceful that it defies the role of a government mandate. “The EPA is basically ratifying what the market has already done, rather than pushing industry to work more renewable fuels into the mix,” he says.  “If they keep the number at 13 billion gallons, they kill any incentive to grow [higher blends]. That’s the biggest concern I have with this proposal.”    

Wait and See Time
The EPA’s public comment period on the RVO proposal ended Jan. 28. It’s not clear how long the agency will take to digest industry feedback and make its decision. “I think they genuinely want to get it out as soon as possible because they’re beyond the deadline,” Buis says, “But we really have no idea how long it will take.” 

In the meantime, the experts can only guess where the EPA will land. “There is still a lot of uncertainty about what the EPA will do, but I think the uncertainty ranges between 13 billion gallons and 13.8 billion gallons,” Babcock says. “I don’t think they’ll go above 13.8, so that’s an 800-million-gallon degree of uncertainty—just for the domestic market—which is about 1 percent or 2 percent of the corn crop.”

Good says he is “optimistic” about what the EPA might decide this spring. “Gas consumption is on the rise,” he says. “That may not affect the EPA’s decision, but it creates an opportunity for ethanol. I wouldn’t be surprised if the EPA rolls its numbers up somewhat to, if nothing else, just reflect that more gas is being used.” In addition, Good says, the threat of legal challenges might dissuade the EPA from overstepping. “If you’re going to curtail the mandate, at what level would the reductions be legally challenged by the ethanol industry?” he wonders. “Would there be a point where all the parties say, ‘That’s not what we wanted, and we don’t think EPA has the authority to do this, but it’s large enough where we’re not going to press on with a legal challenge?’”  

In addition to increased gas consumption, Tyner says, there is reason to believe the EPA will raise RVOs to acknowledge the potential for higher level blends. “I think they’ll consider the comments everyone put in,” he says. “I think they really do want to get this right. They just went a little too far with the draft. It’s a draft. I think they’ll respond to comments and end up higher than 13.”

Author: Tom Bryan
Editor in Chief, Ethanol Producer Magazine
701-738-4916
tbryan@bbiinternational.com