Kansas fed economist says markets, not mandates, drive ethanol

By Susanne Retka Schill | December 11, 2012

Markets shape ethanol production, Nathan Kauffman, an economist with the Federal Reserve Bank of Kansas City, argues in the most recent issue of the Main Street Economist. In a seven-page analysis, Kauffman takes a look at the mandates in the renewable fuel standard (RFS), the ethanol blend wall and market incentives to examine the concerns raised in the recent requests for a waiver of the RFS.

In “Markets, Not Mandates, Shape Ethanol Production,” Kauffman concludes a temporary waiver would not relieve the pressure on current ethanol production needed to build credits to satisfy future mandates. “In addition, the ethanol industry has become more market-based as production has exceeded the mandates in recent years. If energy prices rise faster than agricultural commodity prices, ethanol profits could expand and production soar regardless of mandated levels,” he writes. “Finally, ethanol is the primary octane enhancer and fuel oxygenate, and there are few alternatives for U.S. oxygenate blends. Thus, it is markets, not mandates, that ultimately will determine the scale of ethanol production and its use of scarce corn.”

In his discussion on the blend wall, Kauffman points out that in 2007, when the current RFS was passed, the Energy Information Administration was forecasting U.S. gasoline consumption to reach 150 billion gallons by 2015, and the 15 billion gallon ethanol mandate set for 2015 would have been 10 percent of that. “Since then, U.S. residents are driving fewer miles with more fuel-efficient vehicles,” he writes. “In 2012, EIA projected U.S. gasoline consumption to reach approximately 130 billion gallons by 2015, which would cut the blend wall to 13 billion gallons, 2 billion gallons below the mandate.” The gap between blend level and mandate in the RFS will be filled by using renewable identification numbers (RINs) from previous years, he suggests, and evidence that it is happening is seen in the rise of ethanol RINs values in recent months.

In evaluating market corn and crude oil market factors, he writes, “Current commodity prices suggest that economic conditions may favor continued ethanol production.”  Futures prices for 2013 March and July contracts of crude oil and corn fall in a price ratio that supports relatively steady ethanol production. “With Brent crude oil currently about $114 per barrel, it would take a corn price of approximately $8.90 per bushel, likely with some persistence, to activate substantial contraction in the ethanol industry,” he adds.

Though mandates were important to the industry several years ago, Kauffman concludes the ethanol industry is increasingly market driven. “High crude oil prices relative to corn prices and the use of ethanol as an octane-enhancing fuel oxygenate should drive ethanol production going forward. The RFS mandates, or a temporary EPA waiver, may not be as important to ethanol production in the future.”