21 August 2012

A US Ethanol Waiver and the Price of Corn

UPDATE: At The Washington Post Brad Plumer does a fantastic job explaining the Purdue/FF paper discussed in this post.

Today's FT says this in an editorial:
Passed by Congress in 2005, the Renewable Fuel Standard mandates fuel refiners to blend rising volumes of ethanol and other biofuels. For American farmers, the RFS has been spectacularly effective. Ethanol is expected to consume about 40 per cent of this year’s US corn crop...

In the short term, the Environmental Protection Agency has the ability to issue a waiver to the RFS if implementing it would “severely harm” the economy or the environment. The present conditions amply meet that requirement.

The biofuels industry argues, rightly, that the effect of waiving the RFS might not be immediate or dramatic. Refiners will still need large volumes of ethanol to meet fuel quality standards, so production would not dry up overnight.

RFS requirements can also be met using the tradeable credits known as Renewable Identification Numbers, issued when ethanol is produced. Because there is a substantial backlog of those credits, refiners can use them to meet their obligations rather than demanding physical ethanol, again blunting the effect of an RFS waiver.

Ethanol producers also point out that if output does fall, it will cut the supply of distillers’ grains, the protein-rich byproduct used as animal feed, so increasing demand for other crops such as soya.

Nevertheless, suspending the RFS would probably help ease corn prices – next year more than this. It would also send a signal that the US is not prepared to crucify mankind upon a cross of corn.
But what effect on corn prices might be expected from a waiver of the RFS? Academics at Purdue University affiliated with the US Farm Foundation have tried to answer this in a paper just out (here in PDF).

They explain their quantitative analysis as follows:
A range of possible impacts depends on the price of oil, the price of corn, the magnitude of the drought, the economics of switching away from ethanol, and technical flexibility of refiners and blenders. First, assuming limited flexibility on the part of refiners and blenders in the near term, the impact of a waiver would be very small or nil. If refiners and blenders cannot or choose not to change their current practice of using 10% ethanol blends, then a waiver does not matter. Technical and market constraints would override the waiver.

However, refiners and blenders may have some degree of flexibility in production. This is certainly true the longer the time horizon, so the question is to what extent it is true in the confines of one year. There is not a complete answer to that question, but many of the factors that will determine it are described above.

The next question: What would be the impact of a partial waiver under the assumption that refiners and blenders do have some flexibility in reducing ethanol use and substituting other octane and oxygen additives for ethanol to meet final product specifications? For this paper, estimates were done using a partial equilibrium model developed and used for previous ethanol policy work [5-9]. The model was updated, tuned according to recent observations, and modified for this work on drought impacts. The analysis was done for several levels of partial waiver or use of available RINs in 2013. As indicated above, it is unlikely any waiver will be issued for 2012.

The model for this analysis includes expectations before the drought with a full 13.8 BG RFS for 2013. Then it assumes the drought with three alternative ethanol blending levels: 11.8 BG, 10.4 BG, and 7.75 BG. For this analysis, it does not matter whether the reduced blending levels result because of the use of RINs or a partial waiver. However, the 11.8 BG level could be seen as no waiver and the use of 2 BG of RINs. (Use of some RINs in 2012 and surplus 2013 RINs carried forward to 2014 could limit the 2013 usage to around 2 BG.) The case of 10.4 BG represents 75% of the 13.8 BG RFS and could result through any combination of waiver, use of prior RINs, or use of sugarcane ethanol. The drought may reduce corn production 25% from pre-drought expectations, so EPA might consider a case that could reduce corn ethanol use through some combination of RINs and waiver by that same fraction. Finally, the case of 7.75 BG represents a waiver of 3.45 BG (25% of RFS) plus use of all the estimated available 2.6 BG of RINs, estimated to be the maximum possible ethanol reduction level if economic and technical hurdles could be overcome.
In the graph that appears at the top of this post, I have summarized the data in the last paragraph above (and as shown in the paper's Table 2) for the case of "stronger drought."

The analysis indicates that a partial waiver coupled with use of RINS credits could have a significant impact on corn prices (a reduction of >20%). However, a reduction in corn prices due to such policy action means a cascading series of impacts in the agricultural economic system (and beyond), starting with corn farmers themselves, as as the FT notes, with downstream effects on animal feed and corn substitutes.

Policy makers are fully aware that in the political process acts of commission are sanctioned more severely than acts of omission. Thus, the chances that the US will issue a waiver of any sort in 2012 appear unlikely, though I wouldn't be surprised to see a managed use of RINs and other technical instruments. The Purdue/FF analysis is thus an academic exercise in the short term, but an interesting one nonetheless, and perhaps relevant to efforts to tinker with the RFS down the road.

13 comments:

stan said...

Assuming their assumptions assume the right facts, the right market responses, and the right elasticities, they might be right.

Sean said...

I realize that the blends for gasoline are based on a 10% ethanol content. But corn (or other food based starting materials) is not the only source of ethanol. Ethanol is essentially hydrated ethylene and I am pretty certain there are indsutrial processes for making ethanol from petroleum or natural gas based feedstocks. Perhaps its time to make this product the old fashioned way, as economically as possible.

Joshua said...

Interesting.


Skimming thought the paper, looks like a complicated mix that goes into the relationship between ethanol production and corn prices. Lots of factors. Weather is a factor. Price of oil is a factor. Flexibility of various industries is a factor. Production of corn for other purposes is a factor. So it isn't just that as the ethanol mandate increases, so does the cost of corn.

And this:

==>> Purdue/NFF study says reduce mandated ethanol production by 45% and corn prices drop 23-28%, from Table 2 in the study: <<==

Seems rather simplistic.

Anyway, it seems like a flexible ethanol policy is the best option, as opposed to just assuming that the mandate itself is the problem.

MattL said...

-3- Joshua,

Anyway, it seems like a flexible ethanol policy is the best option, as opposed to just assuming that the mandate itself is the problem.

Why do we even need an "ethanol policy?" What are the benefits? Didn't most of the presumed benefits (lower carbon footprint, increased independence) turn out to be bogus? It seems like the only actual beneficiaries are the corn farmers and ethanol distillers.

Joshua said...

Matt -

I don't really think we need an ethanol policy.

Yes, my sense is that some of the ostensible benefits have turned out to be bogus. I'm not sure that the primary rationale that was offered (by the Bush administration) in support of the governmental mandate - energy independence - is completely bogus, but it certainly seems to me that there is no valid justification from an ACO2 emissions standpoint.

It is unfortunate that it has become such a weapon in climate debate food fight. Also unfortunate that it has become a political boondoggle in an industry/politician circle jerk.

I do give some Republicans credit for trying to deal with the problems directly. Their efforts have been undermined by the cheap exploitation of the problems used for political expediency.

I guess the problem is that now there are vested interests that will be significantly hurt by a removal of a mandate - which may ironically have unintended consequences just as did the initial implementation of the mandate.

Hopefully, all the politically expedient exploitation of the issue won't limit flexibility in policy adoption going forward.

I'm not terribly optimistic in that regard. My Magic 8 ball says "Outlook not so good."

stan said...

Ethanol policy -- negative for the environment, negative for taxpayers, negative for gas prices, negative for car engines, negative (as in bad) for food prices, negative for the world's poor. Totally bogus program which harms everyone and everything except corn farmers.

And we can't get rid of the program. When a govt program is so blatant a disaster and still untouchable, it proves that wise people should be very, very, very slow to advocate new govt programs. Govt programs are forever.

Jonathon Rauch (liberal) as quoted here http://blogs.the-american-interest.com/wrm/2012/08/18/miracles-and-politics/

"If the business of America is business, the business of government programs and their clients is to stay in business. And after a while, as the programs and the clients and their political protectors adapt to nourish and protect each other, government and its universe of groups reach a turning point—or, perhaps more accurately, a point from which there is no turning back. That point has arrived. Government has become what it is and will remain: a large, incoherent, often incomprehensible mass that is solicitous of its clients but impervious to any broad, coherent program of reform. And this evolution cannot be reversed."

Joshua said...

- 6 - stan -

I presented the following issue to my Magic 8 ball again:

"Hopefully, all the politically expedient exploitation of the issue won't limit flexibility in policy adoption going forward. What do you think?"

Subsequent to your post, my Magic 8 ball switched from "Outlook not so good" to "Very doubtful."

I wonder if there's a connection.

Marlowe Johnson said...

"The next question: What would be the impact of a partial waiver under the assumption that refiners and blenders do have some flexibility in reducing ethanol use and substituting other octane and oxygen additives for ethanol to meet final product specifications?"

there are a couple of issues here. First, refiners can typically adjust the butane and pentane %s to meet octane requirements, so in most cases this is a non-issue. Right now, butane content is reduced to lower the summertime volatility of the blendstock (i.e. Reformulated Blendstock for Oxygenate Blending aka RBOB). So the practical effect of a waiver would be a tighter butane market.

The oxygenate requirements are also a non-issue. The 2% federal requirement was waived with the passage of the energy security act in 2006. In any case, such a requirement is now redundant now that virtually all vehicles have on-board oxygen sensors that can adjust the air intake ratio.

In fact, many people argued years ago that the advent of oxygen sensors was the primary reason that the ethanol industry decided to market their product in terms of the GHG benefits rather air quality benefits.

Mark B. said...

The ethanol program was put in place to buy votes in corn states. It is being kept in place by politicians from corn states. Nothing else matters. YOU many think there's some policy issue to debate, but this is an income redistribution/power politics matter, plain and simple.

jgdes said...

I understood that ethanol can be bought cheaper from Brazil than it can be made in the US.

Marlowe Johnson said...

@10
which is why the u.s. had a pretty hefty tariff on brazilian ethanol and subsidies for u.s. ethanol until earlier this year...

Shadeburst said...

The inability of players to determine the effect of a waiver illustrates that economics is not a science.

Joshua said...

==]] Why is corn so expensive? The answer does not seem difficult to understand. [[==

Say, Roger - maybe, in the name of being an "honest broker," you might want to update this post?

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