U.S. government mandate or no, fuel ethanol is here to stay

For the past five years, the U.S. government has paid fuel companies billions of dollars in subsidies to buy home-grown, corn-based ethanol, making it a viable part of the nation's gasoline supply.

Now you would have to pay them not to buy it.

The worst drought in half a century revived a fierce food versus fuel debate. Livestock and food producers and others are calling on President Barack Obama to abandon -- at least temporarily -- a government mandate that requires converting more than a third of the U.S. corn crop to ethanol. The president has three months to decide.

Experts say that even if he waives the Renewable Fuel Standard (RFS), that will not necessarily free up much corn for food and livestock feed. In fact, unless corn prices rise another $2 or oil prices fall sharply, it may not make a difference at all.

Even without the standard, a third of the U.S. gasoline supply must contain ethanol to meet unrelated clean air rules, mostly in California and on the East Coast. No other available substance can oxygenate gasoline as effectively, helping it burn more cleanly.

More importantly, ethanol is as much as $1 cheaper than other types of octane boosters like reformate, which refiners use to increase the efficiency of their fuel.

"Even with a reduction in the waiver, there is still economic incentive for the fuel industry to use ethanol as an oxygenate," said Maureen Cannon, a chemicals and agricultural business specialist and vice president of Valence Group, a investment bank specializing in chemicals.

Unlike five years ago, when ethanol was a marginal and relatively costly fuel that required heavy government subsidies to survive, it is now a competitive source of energy.

Food vs Fuel

The realization that ethanol won't be easily extracted from the U.S. gasoline supply is dawning just as a renewed food-or-fuel debate comes to a head. A dire drought has shriveled the corn crop, causing prices to jump more than 60 percent in just three months to a record high above $8 a bushel.

Under pressure from outraged livestock and poultry producers who have seen their feed costs surge, several state governors have applied to the Environmental Protection Agency (EPA) for waivers to the mandate. The agency, which denied a similar appeal in 2008, must decide by mid-November how to proceed.

But removing the RFS obligation won't change the fact that the 1990 Clean Air Act requires fuel companies to sell a cleaner blend of fuel, called reformulated gasoline (RFG) or RBOB, in the most populous parts of the country.

"If the EPA relaxes the standard for ethanol, refiners could produce conventional gasoline, but they would not be able to produce RFG gasoline," said Mark Routt, senior advisor for Houston-based KBC Advanced Technologies.

Originally meant as a way for nine U.S. cities with the worst smog to clean up the air, RFG is now a required fuel in about 30 percent of the country's service stations.

Producing RFG requires oxygenate, substances that allow the gasoline to burn more cleanly.

The 1990 amendment to the act did contain provisions for the use of alternate, non-petroleum oxygenates to meet air quality requirements. Oil companies and automakers offered their own alternative: methyl tertiary butyl ether or MTBE. They argued successfully that the addition of a petroleum-based oxygenate would not require a change in existing cars.

But in the 1990's, MTBE was found to be a known carcinogen. Petroleum blenders and marketers shied away from its use.

Enter ethanol. The Renewable Fuels Act of 2007 mandated use of renewable fuels, and ethanol became the oxygenate of choice -- aided by a 45 cent per gallon subsidy paid to blenders and trade tariff protection pushed by farm state legislators.

Since then, a fairly steady 300,000 barrels per day of ethanol has been used to make reformulated gasoline (RFG), according to Reuters calculations from U.S. Energy Information Administration data based on a 10 percent blend.

That is about a third of this year's ethanol output.

The Renewable Fuels Standard requires ethanol consumption of some 13.2 billion gallons in 2012 -- about 860,000 barrels of ethanol -- to improve energy independence. Production this year has averaged 885,000 bpd after fuel companies took advantage of cheaper prices in the first quarter; output is now running at around 820,000 bpd, just enough to meet the annual quota.

Discretionary Fuel

In effect, one-third of the ethanol is mandatory, but the remaining two-thirds is discretionary, blended into conventional gasoline -- or CBOB (conventional blendstock for oxygenate blending), different than RBOB -- simply to increase octane, which improves efficiency.

It is this pool that has absorbed the trebling in ethanol output since 2006, seeping into almost every filling station in the country. In May, only about 4 percent of all U.S. gasoline was ethanol-free, according to EIA data. A year ago, it was 10 percent and in 2008, it was a quarter.

"The addition of ethanol has allowed refiners to use gasoline with an octane level of 84 and then blend with ethanol to get a higher octane to reach the 87 level that we buy," said Cannon.

Ethanol has a octane rating of 113. U.S. retail gasoline octane levels range from 87, which is conventional gasoline, to 94 which is premium gasoline.

According to J.P. Morgan, the average spread between 87 and 93 octane has averaged about 13 cents over the last five years.

"This implies that, in the long term, the octane premium for ethanol is likely close to $0.63 a gallon over 84-octane gasoline," said J.P. Morgan in a note to clients.

In theory this could be curtailed if the mandate were waived. But economics say otherwise. With very few exceptions, ethanol has been much cheaper than gasoline, actually reducing the cost of gasoline at the pump.

It is 25 to 30 cents cheaper than CBOB on the spot market, according to a trader with a large U.S. gasoline blender who declined to be named.

Its appeal grows compared to other octane enhancers like alkylates, aromatics and reformates, which must be produced in costly, specialized refining equipment.

In the New York Harbor, prompt alkylates are $3.55 per gallon while reformate is $3.82 a gallon. Ethanol futures were trading at $2.63 a gallon.

Cannon reckons that corn, which hit a record high of $8.43-3/4 a bushel, would have rise to $10 a bushel and crude oil, currently trading around $97 a barrel, must drop below $70 in order to make ethanol too expensive to blend.

U.S. refiners capacity to produce alkylate is about 1.25 million bpd, according to government data -- less than 10 percent higher than two decades ago. Gasoline demand is up nearly 30 percent since then.

"We can produce and sell more octane but that comes with a cost and a change in operating rates that adds to the cost." said Tancred Lidderdale, Senior Economist with the EIA.

[Source: By Janet McGurty and Matthew Robinson, Reuters, New York, 24Aug12]

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