Seeking Alpha
Alternative energy, long/short equity, commodities, energy
Profile| Send Message|
( followers)

This article is the second in a series on how investors can take advantage of the ethanol blend wall and subsequent attempts to surmount it. The first article is available here and includes an overview of how, just since January, corn ethanol Renewable Identification Number [RIN] prices have climbed 2700% and advanced biofuel and biomass-based diesel RIN prices have nearly tripled. This increase in RIN prices has resulted in a corresponding increase in refiners' costs of compliance under the revised Renewable Fuel Standard [RFS2]. Several methods of overcoming the blend wall and thereby reducing RIN prices have been proposed, including (1) increasing biomass-based diesel production to meet the volumetric difference between the blend wall and mandated corn ethanol production; (2) using high RIN values to offer ethanol at a discount to gasoline on an energy-equivalent basis, thereby incentivizing the vehicle and infrastructure upgrades necessary to absorb ethanol at a blend rate in excess of 10 vol%; (3) using high RIN values to spark a new wave of investment in the production of drop-in biofuels; and (4) modifying or repealing the RFS2. This article covers the second scenario.

The flex-fuel failure

From 2009 to 2011, I worked as a university postdoc, spending the first year in an agricultural economics center and the second in an energy economics center. Both centers devoted much of their time in examining the rollout of the then-new RFS2 and studying the best ways of overcoming the blend wall. The general consensus among the faculty was that the blend wall ultimately wasn't a concern because at the time U.S. gasoline consumption was projected to continue growing through 2030 (see figure). This growing consumption would give consumers several years to adopt flex-fuel vehicles [FFV] at a high enough rate to eliminate the blend wall as a hurdle. The faculty at both centers advised me to minimize the time I spent studying drop-in biofuel pathways, which are chemically identical to petroleum-based fuels, as these were ultimately "Jetsons" technologies that wouldn't reach commercial-scale production until well after FFVs had achieved the necessary U.S. market penetration to overcome the blend wall.

Projected energy consumption by transportation sector in AEO 2008, quadrillion Btus. Source: EIA (2008)

Naturally, the fact that corn ethanol RIN prices soared after the EPA set the 2013 corn ethanol volumetric mandate above the 10 vol% blend limit shows just how erroneous the FFV assumption has turned out to be. Indeed, the first commercial-scale drop-in biofuel facility (owned by KiOR (NASDAQ:KIOR)) began operating at the end of 2012. While the conventional wisdom was wrong, it made a lot of sense at the time. The blend wall was quickly overcome in Brazil not once but twice, first by very high sales of neat ethanol vehicles in the 1980s, then by very high sales of FFVs in the 2000s (see figure). All three U.S. automakers made pledges to give flex-fuel capability to up to half of their light vehicle production by 2012 during the auto bailout negotiations of 2008. Drop-in biofuels were at such an early stage of development that the initial version of the RFS2 just included a "cellulosic ethanol" category, which was only changed to "cellulosic biofuel" later. Finally, FFVs are only slightly more expensive than conventional vehicles; conversion kits are available online for $400, while researchers at General Motors (NYSE:GM) have told me that it only costs them about $100 to give a vehicle flex-fuel capability on the assembly line. In 2009 and 2010, most signs pointed to rapid FFV adoption and high future rates of E85 consumption in the U.S.

(click to enlarge)

Production of light vehicles in Brazil, 1979-2011. Source: Wikipedia

Given the favorable environment for FFVs and E85, why are we already at the blend wall in 2013? The biggest factor is falling gasoline consumption in the U.S. The federal government has taken an "all of the above" approach to reducing the country's dependence on foreign petroleum and this has included significant increases to the CAFE standards. The poor economic recovery and high petroleum prices that have followed the 2008 financial crisis have further reduced domestic consumption. The EIA, which only five years ago issued a forecast for increased transportation fuel consumption through at least 2030, now projects gasoline consumption to steadily decline until 2031 (see figure). E85 consumption has remained low, primarily because just over 1% of U.S. gas stations are equipped with E85 pumps [1]. Furthermore, these pumps are clustered in the Midwest, far from the dense population centers on the coasts. Finally, public opposition to the use of fuel ethanol following research predicting ecological and humanitarian disasters because of its production has mounted in recent years; a GM survey found that a majority of FFV owners didn't know that they could use E85, while more recently many of those with awareness have chosen not to do so (and that assumes they are even in close proximity to an E85 pump).

(click to enlarge)

Source: EIA (2012)

An additional factor explaining the E85/FFV disappointment is the rapid success of drop-in biofuel pathways, particularly those utilizing lignocellulose as feedstock. Virtually unknown in 2008, drop-in biofuel pathways are now expected to generate to a slight majority of cellulosic biofuel production on an energy-equivalent basis by the end of 2014. The arrival of the blend wall is certain to increase the attractiveness of drop-in biofuel pathways since they offer two major advantages over ethanol: their product fuels don't face any blend limits as biobased gasoline and diesel, and they can easily be adjusted to produce either fuel. Ethanol, on the other hand, is a mere gasoline substitute. Ethanol producers (and their investors) run the risk of being made obsolete by technologically-superior pathways in the future. More immediately, the success of drop-ins is likely to result in further questions as to whether or not the government should support the development of a fuel ethanol infrastructure.

Flex-fuel vehicles to the rescue?

With the above caveats in mind, ethanol has the advantage of being available now; corn ethanol alone was responsible for 85% of the RINs generated in 2012. The requisite feedstock supply and production capacity are present. From an infrastructure view, corn ethanol simply requires additional FFVs and E85 pumps to overcome the blend wall (or at least extend it to approximately 25 vol% of gasoline consumption based on domestic corn production). Its past failures aside, increased ethanol consumption should not be entirely discounted as an available means of surmounting the blend wall. Several developments must occur if this is to happen, however, and these will affect investors in several ways.

The first development that must occur is the use of RINs to subsidize corn ethanol consumption. This is different from using RINs to subsidize production, and it is important to distinguish between the two. RINs were initially conceived as a flexible subsidy: always valuable enough to keep producers profitable so long as production didn't exceed the mandate, but never so valuable as to provide producers with windfall profits. This was achieved by having RIN prices function as the difference between biofuel production costs and biofuel market prices; RIN prices increase when production costs increase and decrease when market prices increase. The key to this system was that the RIN value went to the producer. Those producers with the lowest production costs and/or highest market values would receive more implicit value from each RIN than those without as a means of encouraging efficiency, but the broad impact was uniform across the industry.

The arrival of the blend wall changed this equation, at least temporarily. The jump in RIN prices has occurred even as gasoline prices have increased and corn prices have decreased (see figure), which would normally result in lower RIN prices. RIN prices have increased by 2700% because ethanol consumption is capped by the blend wall to a level that is below both production capacity and the volumetric mandate for 2013. RIN prices will therefore increase until they are high enough to incentivize the consumption of the missing gallons (400 million in 2013, rising to 1.2 billion in 2014). This would most likely happen in one of two ways: (1) via the RIN value being used to discount the market price of ethanol to make it more attractive than gasoline, or (2) via refiners increasing their exports of gasoline so as to reduce their Renewable Volume Obligation under the RFS2, which can use U.S. sales as a proxy. (Non-compliance with the RFS2 isn't an option since the penalties scale according to the economic benefit gained from non-compliance, plus a fine of $37,500 per day and per violation.)

CORN Chart

CORN data by YCharts

There is already some evidence that the first option is being adopted. In late May, Absolute Energy, which produces 115 MGY of corn ethanol, took advantage of the high RIN price to sell E85 at a $0.43/gal discount to premium gasoline on a gasoline-equivalent basis. In other words, Absolute Energy used the extra value provided by the high RIN price to reduce the market price of its E85 and thereby encourage its consumption. Unfortunately, there isn't enough publicly-available data to know how widespread this practice is and whether a $0.43/gal discount on a gasoline-equivalent basis is enough to convince consumers to purchase FFVs and/or consume E85, but price theory dictates that it should have a positive effect on both. I wouldn't be surprised to see more ethanol producers adopt a similar practice in the future because the current crush spread allows most of them to operate profitably, and pushing RINs to a level at which refiners increase exports to escape the RFS2 benefits none of the involved parties.

It's possible that the current lack of consumer acceptance of FFVs and E85 is simply one version of the Chicken and the Egg dilemma; drivers don't purchase FFVs because there aren't enough E85 pumps to merit doing so, and retailers don't install E85 pumps because there aren't enough FFVs on the road to justify the expense. If this is the case then the high RIN values and discounted E85 will only be necessary until drivers purchased FFVs in sufficient numbers to justify the installation of E85 pumps. The expenses associated with FFV purchase and the installation of E85 pumps are one-time expenses and, once made for existing equipment, need only be made again when the equipment is replaced. How many FFVs will this require? E85 is a misnomer in that it applies to ethanol blends of 51-85 vol%. If we assume that the average gallon of E85 contains 67 vol% ethanol and that the average passenger car requires 500 gallons of gasoline per year, then 2.7 million additional FFVs would be required to absorb the 1.2 billion gallon difference between the blend wall and the volumetric mandate for 2014. If we further assume that 60% of FFV owners remain ignorant of their vehicles' flex-fuel capability, then this number increases to 4.4 million additional FFVs. At present, FFVs represent just 3.4% of the light duty vehicles in the U.S. (8 million FFVs), so adding 4.4 million additional FFVs would require this figure to grow to just 5.3%.

You can lead drivers to E85...

If that last sentence leaves you puzzled as to why Congress is holding hearings over an issue requiring such a marginal solution, it's because the Chicken and the Egg dilemma probably isn't the only explanation for low E85 consumption. I've detailed in previous articles how the 2007/08 "Food Crisis" and Indirect Land-Use Change debate have affected consumer acceptance of corn ethanol in the U.S. so I won't go into too much detail, but suffice to say that the last five years have seen a major shift in the public perception of corn ethanol. Once vaunted as the solution to national security, energy security, and environmental security, corn ethanol producers have been accused of somehow managing to simultaneously starve 600 million people and destroy the Amazon. While both of these accusations have been debunked at least in the short term, corn ethanol's public image has never really recovered. One piece of evidence of this shift is found in the RFS2 itself, which caps the corn ethanol volumetric mandate at 15 billion gallons per year [BGY] in 2015 and initially imposed requirements that would have disqualified most producers from participating.

The big danger with the scenario in which the blend wall is overcome simply by selling FFVs is that it assumes that drivers are rational actors who will respond to RIN-discounted E85 by purchasing vehicles capable of utilizing this inexpensive fuel. Drivers aren't always rational, at least in a financial sense; many are willing to pay for a more expensive fuel if they believe that the cheaper alternative is responsible for ecological and humanitarian disasters. This is particularly pronounced, once political bias is accounted for. Opposition to fuel ethanol is particularly strong on the political left, what with the association of starving the poor and destroying the rainforest. As shown above, there is a dearth of E85 pumps in the "blue" high-density population centers on the U.S. coasts. The prevalence of E85 pumps in the corn-rich Midwest suggests that the low-hanging fruit has already been picked and an expansion to the coasts will be significantly more difficult. The introduction of emotion and political bias as factors greatly complicates the issue of determining the RIN price point at which East and West Coasters are willing to both purchase FFVs and begin consuming E85 to the degree necessary to overcome the blend wall.

Disparate impacts

It is easiest to begin by listing the companies that will be negatively impacted by efforts to overcome the RFS2 by increasing E85 consumption. Refiners are the obvious place to start. I've detailed earlier how their costs of compliance under the RFS2 have ballooned in the last month due to higher RIN prices, let alone since January. Any increases to the costs of both production and consumption will be borne by refiners (although one sensible school of thought believes that these will ultimately be passed onto consumers). The cost of E85 pump installation is much higher than that of FFV conversion, reaching as high as $60,000 per pump. Since refiners purchase RINs and RINs reflect the costs of ethanol production and consumption, they will ultimately pay for these costs according to their market share, regardless of if they own the gas station. Furthermore, any premium to RIN prices necessitated by a lack of consumer acceptance will also be paid for by refiners under the RFS2. It's impossible to say what RIN price level will be necessary to spur sufficient consumption of E85 and FFVs, but it will need to be sustained over a lengthy period of time if it is to do so. These costs will be borne according to each refiner's market share (see table), although refiners such as Valero that also produce biofuel won't be impacted as much.

Top 10 U.S. Publicly-Traded Refiners by Capacity

RefinerMillion bbl/day% of U.S. total2012 operating income (billion)
Valero (NYSE:VLO)
1.863
10.5%
$4.0
Exxon Mobil (NYSE:XOM)
1.856
10.4%
$64.0
Phillips 66 (NYSE:PSX)
1.594
8.9%
$6.6
BP (NYSE:BP)
1.341
7.5%
$19.7
Marathon Petroleum (NYSE:MPC)
1.248
7.0%
$5.3
Chevron (NYSE:CVX)
0.943
5.3%
$46.3
Tesoro (NYSE:TSO)
0.674
3.8%
$1.4
PBF Energy (NYSE:PBF)
0.502
2.8%
$0.9
HollyFrontier (NYSE:HFC)
0.47
2.6%
$2.9
Royal Dutch Shell (NYSE:RDS.A)
0.426
2.4%
$46.4
U.S. Total
17.824
75.4%
N/A

Sources: EIA, Google Finance

Counterintuitively, dedicated ethanol producers such as Biofuel Energy (NASDAQ:BIOF), Green Plains Renewable Energy (NASDAQ:GPRE), Pacific Ethanol (NASDAQ:PEIX), and Rex American Resources (NYSE:REX) are unlikely to directly benefit under this scenario, though that's not to say that they will be negatively impacted. While high RIN prices subsidize ethanol producers, the RFS2 is designed to prevent windfall profits. Furthermore, this scenario will likely require ethanol producers to pass at least part of the RIN value onto consumers in the form of discounted E85 prices relative to gasoline, as the high RIN prices are the result of consumption costs rather than production costs. The implicit value of the RINs to ethanol producers would therefore be less than the RIN price. It should be noted that sufficient E85 consumption would increase the size of the corn ethanol market to at least the 15 billion gallon annual cap designated by the RFS2, which is a marginal increase from current capacity.

The greatest beneficiary under this scenario would be General Motors (GM), which accounted for 67% of U.S. FFVs as of 2010. While Chrysler and Ford (NYSE:F) have also pledged to give flex-fuel capability to half of their light vehicles by 2012, GM is in the best position to take advantage of a surge in FFV demand resulting from E85 being offered at a significant discount to gasoline on a gasoline-equivalent basis. Again due to the way in which the RFS2 is designed, refiners would indirectly shoulder the extra costs incurred by FFV production (which are admittedly very marginal) and GM would simply benefit from the increased demand for a segment of the automobile market that it dominates.

Conclusion

The arrival of the ethanol blend wall and subsequent increase in RIN prices has created a situation in which one of four scenarios for surmounting the wall is likely to be implemented in coming months. This article examines the second scenario, in which high RIN prices are passed onto consumers in the form of lower E85 prices relative to gasoline. This in turn sparks sufficient demand for FFVs for the blend wall to be overcome in the U.S. Refiners would once again bear the costs under this scenario due to the design of the RFS2. Corn ethanol producers would not benefit directly since at least part of the RIN price would be passed onto consumers, although the maximum size of the corn ethanol market in the U.S. would increase to at least 15 billion gallons per year. Finally, U.S. automakers would benefit from increased demand for FFVs resulting from low E85 prices, especially since refiners would pay for the increased costs of FFV production. Of the three main U.S. automakers, GM is in the best position to take advantage of increased FFV demand due to its large market share.

[1] E15, which was expected to garner greater acceptance following its approval by the EPA in 2011, has fallen flat in the face of opposition from automakers, refiners, and drivers concerned about damage to fuel systems resulting from its use.

Disclosure: I have no positions in any stocks mentioned, but may initiate a long position in PEIX over the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

Source: Can Ethanol Overcome The Blend Wall?