The Midwestern drought has gone from bad to worse in just over a month. Predictions in May of a bumper crop now look like a cruel joke as the region is experiencing the worst drought conditions in decades, causing corn and soybean prices to jump sharply:
In a case of history repeating itself, U.S. corn ethanol production in general and the revised Renewable Fuel Standard (RFS2) biofuels mandate specifically have once again been trotted out as the culprits behind hunger in the developing world. For the sake of this discussion, we'll ignore the fact that the last time U.S. biofuels policy was accused of causing millions of poor people to go hungry, cases of chronic hunger in the developing world actually fell by 60 million to 250 million [pdf] (never let the evidence get in the way of a good headline!). The UN has responded to the rise in food prices by calling for an immediate waiver of the RFS2 mandate (at least the organization hasn't reached the point of accusing U.S. ethanol producers of committing crimes against humanity yet) and pressure is ramping up on President Obama to do just that.
From a political standpoint, a waiver of the corn ethanol mandate is unlikely to occur this year. Of the Ten Commandments of U.S. presidential politics, the first is "never anger voters in Midwestern swing states close to an election." Rural Corn Belt states have an outsized number of electoral votes relative to their size and are generally considered to be "swing states" where margins of victory have been historically slim for both Democrats and Republicans. Corn Belt states have greatly benefited from the rise of corn ethanol and a waiver would be viewed very negatively by the powerful corn grower lobby. That said, there are a few unlikely scenarios in which a waiver could be considered feasible. For example: President Obama, having written off the Midwestern swing states as losses, makes an attempt to appease both the environmental groups and the petroleum lobby by waiving the corn ethanol mandate. While unlikely, such a scenario cannot be entirely discounted as impossible and commodity investors should be aware of a waiver's ramifications in the event that one does occur.
This article, the first in a two-part series on waiving the biofuels mandate, reviews the RFS2 and discusses the potential impact on corn prices of a waiver of the corn ethanol mandate. The second article will discuss the impact on soybean prices of a waiver of the biomass-based diesel mandate.
Waiving the corn ethanol mandate
The RFS2 consists of four separate yet nested biofuels categories, each with its own specific definitions. The RFS2 mandate operates as a carrot for biofuel producers and a stick for refiners. Refiners are required to purchase from biofuels producers a certain volume of biofuels each year in proportion to their market size; failure to do so incurs a stiff penalty (the stick). Each gallon of biofuel is tracked by compliance commodities in the form of Renewable Identification Numbers (RINs) (the carrot), which are attached to a gallon of biofuel after production and used by refiners to demonstrate their compliance with the mandate to the EPA.
The largest of the biofuels categories is the total renewable fuels category, which covers all biofuels but has the lowest RIN value because total production is currently in excess of the mandated volume. Corn ethanol is the only commercialized pathway that doesn't qualify for the other, more valuable RIN categories, so the total renewable fuels category is effectively the corn ethanol category. The core RIN value for any category is the amount established by the market as being necessary to incentivize sufficient biofuel production to meet the mandated volume; this increases when feedstock prices are high and decreases when petroleum prices are high.
The RIN mechanism is one reason that corn ethanol production is accused of causing sharp increases in corn prices: whereas high corn prices would normally discourage corn ethanol production, RIN values increase in response to higher feedstock prices (other things being equal), thereby shielding corn ethanol producers from the higher input costs and encouraging more production than would otherwise occur. While technically correct, this reasoning ignores the fact that corn ethanol production currently exceeds the mandated volume. RIN values for the total renewable fuels category (and corn ethanol) scarcely exceed transaction costs as a result. In other words, the mandate isn't driving corn ethanol production at present. Waiving the total renewable fuels mandate (and thereby driving the core RIN value to 0) therefore shouldn't affect corn ethanol production.
As agricultural economist Bruce Babcock points out in a recent policy brief, the corn ethanol production surplus is actually even greater than the above paragraph assumes. RINs for a given year can be "banked," or carried over, to the following year (i.e., if a refiner blends more biofuel than it is required to in a given year, it can use the excess RINs to demonstrate compliance with the following year's mandated volume). It is estimated that 2.6 billion RINs (representing 2.6 billion gallons of corn ethanol) are currently "in the bank," further pushing down RIN values for the total renewable fuels category. Assuming that 2.4 billion of the "banked" RINs will be submitted to the EPA for the 2012 and 2013 mandates, Dr. Babcock modeled the impact of a waiver of the total renewable fuels category on corn prices. The results show a 7% drop in corn prices, or $0.58/bu. This would bring the corn price down to $7.49/bu; an improvement, but still substantially higher than the prices seen during the peak of the last "food crisis," let alone before the current drought (see chart). In fact, the only scenario analyzed by Dr. Babcock in which corn prices fall to pre-drought levels is one in which the federal government bans corn ethanol production entirely. Suffice to say that the legal and political hurdles to such a ban in the time frame considered would be insurmountable, eliminating its consideration as a feasible scenario.
Finally, Dr. Babcock's results indicate that the ratio of ethanol price to gasoline price has more influence on ethanol production than the RFS2 at present. For example, based on the U.S. market demand curve for fuel ethanol, an increase in the ratio from 0.5 to 1.1 results in a 33% decrease in ethanol production (from 15 billion gallons per year [BGY] to 10 BGY). This is in stark contrast to the 0.5 BGY fall in ethanol production under the modeled total renewable fuels mandate waiver scenario.
Another paper [pdf] from a group of Purdue economists led by Wallace Tyner concludes that the price of petroleum will play a large role in determining whether a waiver would have any effect. As previously stated, core RIN values decrease when petroleum prices increase so as to prevent biofuel producers from receiving a windfall via RINs when high petroleum prices already incentivize biofuel production. A combination of low petroleum prices and continued high corn prices would cause RIN values to appreciate, at which point a waiver could actually affect corn ethanol production. As Dr. Tyner et al. point out, however, such a scenario would also depend on a willingness by refiners to undergo a 3-6 month retooling process (based on the difference in octane levels between gasoline and gasohol) and continue holding "banked" RINs until 2013. Based on current RIN values, however, a waiver would have relatively little effect on corn ethanol production, as there is very little room for the core RIN value to fall. Furthermore, renewed optimism regarding U.S. economic prospects has caused petroleum prices to rally since June, further reducing the impact that a RFS2 waiver would have on corn ethanol production.
Both papers illustrate an important point that is not being considered by those calling for a waiver of the total renewable fuels mandate: while corn ethanol production was unable to compete on an unsubsidized basis with petroleum when petroleum prices were low, the sustained high petroleum prices that have been a characteristic of the "recovery" from the Great Recession have incentivized continued production. This is despite the expiration of the blender's credit last year and the current virtually non-existent RIN values. Demand for corn ethanol will remain strong so long as petroleum prices remain high and total ethanol production doesn't exceed the limit imposed by the so-called "blend wall." While U.S. biofuels policy has played a crucial role in getting corn ethanol to its current production level, the fuel has attained commercial viability and macroeconomic forces will now determine its production rate.
Possible investment plays
There are a few possible methods for investors to take advantage of a waiver of the total renewable fuels mandate category. The first employs the Teucrium Corn ETF (NYSEARCA:CORN), which tracks corn futures. A drop of greater than 7% in the ETF's price immediately following a waiver should be bought, as the market will be overestimating the waiver's impact on corn prices and these will rebound in the short-term as the waiver's actual effects are accounted for (long-term corn prices will be determined by actual supply and demand of the commodity). The above trade should not be entered into, however, if the price of petroleum falls significantly below current levels before the waiver, as this will increase the RIN value and thereby allow the waiver to affect corn prices.
Ironically (especially in light of my long-term bearishness on the corn ethanol industry), another trade is to buy shares of dedicated corn ethanol companies such as BioFuel Energy (NASDAQ:BIOF), Green Plains Renewable Energy (NASDAQ:GPRE), Pacific Ethanol (NASDAQ:PEIX), and Rex American Resources (NYSE:REX) following a waiver. A temporary waiver of the type being pushed would only affect the mandate for 2012 and/or 2013. The mandated volumes of total renewable fuel increase through 2015, however, so under the waiver scenario ethanol demand will be at an historical high after the temporary waiver expires. This will cause RIN values to rapidly increase from zero to the level needed to satisfy the mandate in the year following the waiver. Mandated volumes are due to increase to 13.8 billion gallons per year [BGY] in 2013 and 14.4 BGY in 2014. Whereas the mandate is currently designed to gradually increase and thereby prevent shocks to RIN values from mandated demand growth, a waiver would have the effect of increasing mandated volumes from a level that is currently several hundred million gallons below actual production to one that is several hundred million gallons above production. Dedicated corn ethanol producers will experience in the waiver scenario a period of strong profit margins per gallon so long as total production falls significantly below the mandated volume.
It is possible (albeit improbable) that a combination of U.S. election year politics and international pressure will prompt the EPA to waive the total renewable fuels category of the RFS2. Such a waiver would have relatively little impact on corn prices this year due to the current low RIN value for corn ethanol production, which has removed the primary RFS2 mechanism for incentivizing corn ethanol production. Furthermore, the recent rebound in petroleum prices will further incentivize corn ethanol production regardless of the RFS2. As Dr. Babcock points out, the only scenario in which corn commodity prices would fall to their pre-drought levels is one in which corn ethanol production is banned; this can be completely disregarded, however, as a scenario that has no basis in legal and political reality. In the event of a waiver, commodity investors should not expect to see corn and soybean prices quickly return to their pre-drought levels.
The results of the studies by Dr. Babcock and Dr. Tyner suggest that the federal government can more effectively reduce the price of corn by instituting policies that encourage low petroleum prices (NYSEARCA:USO). Policymakers could do so by encouraging increased utilization of a variety of domestic transportation fuel feedstocks, thereby making the economy less reliant on corn ethanol as the sole large-scale substitute to imported petroleum. For example, it could ease the regulatory hurdles faced by giant natural gas-to-liquid projects such as that being proposed by Sasol (NYSE:SSL) in Louisiana to utilize inexpensive U.S. natural gas reserves (NYSEARCA:UNG), or expand advanced biofuels incentive programs to include synthetic fuels as part of a broader "alternative fuels" program. While an "all of the above" approach to energy policy has become political code for "I can't come up with any new ideas," investors in particular can appreciate the benefits of portfolio diversification.
While recent media attention has largely focused on high corn prices, concerns are growing that soybeans will be the next commodity victim of the Midwestern drought. The second article in this series will examine the impact of a waiver of the biomass-based diesel RFS2 category on soybean prices.