U.S. Gasoline Consumption Decline: Does it Affect Potential Ethanol Demand?

AgMRC Renewable Energy Newsletter
November/December 2008

Robert Wisner                                                      
Professor of Economics and Energy Economist
Ag Marketing Resources Center
Iowa State University
rwwisner@iastate.edu

 

An old rule of thumb in economics is that high prices are the best cure for high prices.  That has been proven true this year in the energy markets, at least for the short term.  Crude oil prices have recently been more than 60% below their early summer record high.  That in turn has triggered a sharp reduction in gasoline and ethanol prices.  As this is being written, gasoline with a 10% ethanol blend in some parts of Iowa is selling at less than $1.70 per gallon. Earlier in the year, the same product was priced at over $4 per gallon. 

Lower ethanol prices have been accompanied by a sharp decline in corn and soybean prices.  However, even with lower feedstock costs, many ethanol plants are struggling and a few ethanol companies are in bankruptcy. 

What’s behind the lower energy prices and how long may they continue?  Those questions are part of the focus of this article.  The answers are critically important to the renewable fuels industry, farmers, farm input manufacturers and suppliers, the livestock and poultry sectors, and almost all of agriculture as well as consumers.

The very high crude oil prices of the last 18 months and the steep increase in prices from early 2007 to mid-2008 shown in Figure 1  were due in part to supply tightness.  An increasing number of analysts also are attributing part of the increase to a large surge in purchases of commodity futures by index funds and hedge funds.  (See the article on Index Funds in our August newsletter.) 

(Click figure to enlarge.)

The high prices caused great stress on consumer budgets, not only in the U.S., but also in Europe, Asia and other areas.  For the U.S., the huge outflow of dollars to cover costs of imported oil – with about 2/3 of the nation’s crude oil supply being imported -- was a significant factor in the weakening of the U.S. dollar in foreign exchange markets.  A weak dollar pushed up costs of imported consumer goods and the impact was amplified by a sharp increase in ocean and domestic freight costs that resulted from higher fuel expenses.  These developments also worsened the balance of trade deficit.  Within a few months, this combination caused U.S. consumers to modestly reduce gasoline consumption and gasoline inventories began to rise. 

The need to cover negative returns in other financial markets as well as reduced gasoline consumption were factors encouraging investment fund traders to reduce the size of their positions in energy futures markets.  In some cases, these traders shifted from long (purchased futures) to short (selling contracts they did not previously own) positions.  Changes in positions of these traders thus contributed to the sharp decline in oil prices. 

U.S. Gasoline Use Declines for First Time in 17 Years

Figure 2 above shows the upward trend in U.S. gasoline consumption since 1945.  Except for three periods, the nation’s gasoline use has increased almost steadily over the last 63 years.  Exceptions were:

1) The 1970s when the Organization of Petroleum Exporters (OPEC) was enlarged and Middle East conflicts resulted in an extremely sharp increase in crude oil and gasoline prices,

2) Another oil crisis in the late 1970s and into the early 1980s, and

3) A modest increase in oil prices in the late 1980s and early 1990s, along with a recession. 

(Click figure to enlarge.)

These historical periods and their implications are discussed in more detail below.  The last dot on the chart is a preliminary estimate of a 4% decline in U.S. gasoline use for the 2008 calendar year.  Use in late summer and early fall was down sharply, with declines of 7% in August and preliminary estimates of a 9% decline in September. 

Figure 3 shows monthly U.S. gasoline and fuel ethanol use for the past two years and use so far in 2008.  Gasoline use was below the previous season all year, with large declines in June, July, and August and a further decline to 127 billion gallons in September.  At this writing, September and October data for 2008 have not yet been released.  High prices also encouraged increased U.S. ethanol production to replace gasoline.  Ethanol production in August was 49% above a year earlier. 

(Click figure to enlarge.)

High prices encouraged increased investments to expand oil production, but a substantial time lag is required before increased production can be expected.  The strong energy market stimulated investments in petroleum produced from Canadian tar sands.  New petroleum discoveries were reported by Brazil and Cuba, as well as elsewhere in the Gulf of Mexico, but at least 3 to 4 years will be required before production begins.

U.S. Ethanol Production, Consumption, and Inventories

Ethanol is a relatively small but increasing part of the nation’s motor fuel supply.  Its expansion has contributed modestly to the decrease in gasoline consumption.  The U.S. average volumetric blend of ethanol with gasoline is between 6 and 7%, but almost certainly will continue to increase in the next few years.  Figure 4 shows annual U.S. production, use and ending inventories of ethanol.  U.S. ethanol production has increased about 70% since 2005 and another increase of about 25% is anticipated in the September 2008-August 2009 corn marketing year.  Imports are a small and fluctuating part of the total U.S. ethanol supply.  Imports surged in 2006 in response to the need for more ethanol to offset the halt in production of methyl tertiary butyl ether (MTBE).  MTBE was an oxygen enhancing additive used to meet clean air standards in some states and cities.  In 2006 the petroleum industry halted production in response to concerns about contamination of ground water. 


(Click figure to enlarge.)

Some observers have been concerned that increasing ethanol inventories reported by the U.S. Department of Energy, Energy Information Agency may be a sign of slowing demand for ethanol.  Figure 5 shows end-of-month inventories in months’ supply, as well as imports in the same format.  As total ethanol production and use have expanded, larger inventories have been needed for normal merchandising activities.  Inventories through July 2008 when expressed in weeks’ supply appear to be quite modest.  Imports fluctuate, depending on relative prices of U.S. and Brazilian ethanol, exchange rates, ocean freight, Brazilian demand, and other factors.


 

(Click figure to enlarge.)

Asian Demand for Motor Fuel Grew Rapidly Until Mid-2008

China and India have been rapidly growing markets for crude oil, gasoline, diesel fuel, and other energy commodities because of their rapid economic expansions.  In fact, they have been the most rapidly growing markets for petroleum in recent years.  These two countries are the most populous in the world.  Both have experienced national economic growth rates of 7 to 10 percent annually as low labor costs and limited environmental restrictions have brought a shift of manufacturing from developed nations to these countries. 

With incomes of their consumers rising, many have purchased automobiles to replace bicycles and motorcycles.  At the same time, their governments provided generous subsidies for gasoline.  But as crude oil prices rose to previously unbelievable levels, the subsidies became expensive for these and other developing countries.  In response, the subsidies were reduced in early summer 2008 and a substantial part of the higher fuel costs was shifted to consumers.  As in the U.S., these consumers reduced their consumption.  

There is a substantial lag in obtaining crude oil and gasoline consumption data from developing countries, so information on the amount of reduction is sketchy.  A Bloomberg business news report recently indicated that South Korea’s crude oil imports declined by 1.4% in October, but did not specify whether that was from the previous month or from the year earlier.   The same report indicated that economic activity is slowing significantly throughout the region and that China Petroleum and Chemical Corporation will process less crude oil in coming months because of reduced demand.  This is the largest petroleum company in eastern Asia.  It is clear that crude oil consumption has declined at least slightly at the global level, after a long upward trend.

Previous High Oil Prices & U.S. Demand Responses

Crude oil prices have declined by more than 60% from their peak four months ago.  Factors behind the decline include the severe drop in global financial markets and the reduction in use that was triggered by unsustainably high real prices, and the rapid slowing of the global economy.  Changes in futures trading regulations a few years ago and recent market innovations that allowed investment firms to use commodity futures as long-term investment alternatives to stocks and bonds may have contributed to extreme high prices.  A decline in outstanding positions held by these firms may also have contributed to the rapid and unprecedented sharp decline in prices.

A major question now is how long will crude oil prices stay at these lower levels?  By standards of the last two decades, crude oil prices are still very high.  The average U.S. crude oil price since 1970, in inflation-adjusted 2006 dollars was $29.06 .  Current indicators suggest that the global economy may grow much slower in the next two or three years than in the recent past and that unemployment will increase in the U.S., Europe, and other areas.  These developments could weaken crude oil demand a bit more. 

After the extreme oil shock of the 1970s, it was 15 years before U.S. gasoline use recovered to its previous high.


Figure 2 shows that with the extreme oil shock of the 1970s, it was 15 years before U.S. gasoline use recovered to its previous high.  The nation’s domestic gasoline use declined for four consecutive years before reaching a bottom.  The oil shock at that time involved an approximate 213% increase in monthly average West Texas crude oil prices from January 1973 to October 1974.  The sharply higher prices resulted from the expansion of OPEC, the Yom Kippur War which reduced OPEC production and brought an embargo on its oil shipments to nations supporting Israel.  The U.S. dollar devaluation and a high-inflation environment were other factors .

Another 254% increase occurred in crude oil prices from January 1976 to April 1980. Primary causes of higher prices at that time were a disruption in Iranian production resulting from its revolution and the Iraq-Iran war. 

After the relatively mild oil price shock of the late 1980s, it took five years for the nation’s gasoline consumption to recover.


In the relatively mild oil price shock of the late 1980s (rising from $13.80 to $22.64 per barrel), it took five years for the nation’s gasoline consumption to recover to the pre-shock level.  During that period, domestic gasoline use declined for three consecutive years.  Undeflated oil prices at their peak in July of this year were 640% above the level of early 2002 and 382% above late 2003.  These increases compare with a 345% increase in monthly average crude oil prices from July 1973 to January 1979.  Prices increased by another 166% from January 1979 to July 1980.  From July 1973 to July 1980, crude oil prices rose by 1,010% in undeflated dollars.  The total oil price shock of the 1970s and early 1980s was approximately the same as the 1,011% increase in crude oil prices from February 1999 to July 2008.  After reaching a peak in early 1980, crude oil prices declined for the next eight years, to a low point 65% below the previous record high.

Implications for Biofuels

History suggests more time may be needed for gasoline demand to stabilize.  In the global supply picture, if OPEC is successful in enforcing its intended 1.5 million barrels per day reduction in output, the reduced supply would partially offset reduced global demand.  OPEC accounts for about 40% of world crude oil production.  New production is expected to come on line soon in Nigeria and some former Soviet republics, although production appears to be poised to begin a decline in some older foreign fields.  Stability in gasoline demand and crude oil prices would be stabilizing influences on corn prices, although weather and planted acreage would still be important market influences affecting biofuels profitability. 

As long as there is no major crisis in the Middle East, a quick return to crude oil and corn prices of early summer 2008 should not be expected.

Long-term history of the oil industry and the global economic down-turn suggest that, as long as there is no major crisis in the Middle East, a quick return to crude oil and corn prices of early summer 2008 should not be expected.

Ethanol Mandate Concerns With Declining Demand

For ethanol, there is another important issue.  The corn starch-based ethanol mandates in the December 2007 Energy Security and Independence Act were developed with the presumption that demand for U.S. gasoline would continue its long-term upward trend.  Table 1 shows the mandates in billions of gallons of corn starch-based ethanol to be blended with U.S. gasoline annually.  If U.S. gasoline use would stabilize for the next few years at the August percentage decline from a year earlier, it would translate into annual gasoline use of about 135 billion gallons.  A 10% national average blend of ethanol into gasoline would then create a market for 13.5 billion gallons of ethanol, a billion and a half gallons below the 2015 mandate. 

Table 1. Ethanol Mandates

Year Blending Requirements (billion gallons)
2009 10.0
2010 11.4
2011 11.8
2012 12.2
2013 13.8
2014 14.4
2015 15.0


That would mean at least 11% of the ethanol production would need to go into the E-85 market unless the Environmental Protection Agency (EPA) permits lower levels of blends than E-85 but higher than E-10.  By 2015 there may be enough flex fuel vehicles available in the U.S. to easily absorb this extra ethanol, although additional investment in E-85 facilities at retail outlets would be needed.  If adequate profit potential is available, the investments will be made.  However, marketing the extra ethanol as E-85 would require it to be priced about 25% lower than regular grade gasoline to compensate for the lower fuel mileage and to entice consumers to use it.  The lower ethanol prices would put pressure on margins of ethanol producers and also on corn prices. 

One solution for avoiding the severe drop in ethanol prices would be to allow slightly higher blends than E-10.  An E-12 or E-15 blend likely would solve the problem of absorbing the additional mandated supply with much less downward pressure on ethanol prices than moving the excess entirely into the E-85 market.  These higher blends may also be needed to absorb the mandated cellulose ethanol production that will be required beginning in 2012.  We will look at these issues in more detail in an article next month.

References

1 All data for charts is from the Energy Information Agency, U.S. Department of Energy.
2 Alexander Kwiatkowski and Christian Schmollinger, Bloomberg Business News, November 6, 2008,  “Oil Falls, Tracking Shares, on Concern Slump Is Hurting Demand”  and  Felicia Loo, Reuters News Service (Singapore), November 7, 2008,  “Diesel imports into China come to a halt, price cuts eyed, plus Zero gasoline imports for second straight month” ;  “World financial crisis reins in Chinese oil demand growth”, Reuters (Singapore)
3 Ibid. All data for charts comes from the Energy Information Agency, U.S. Department of Energy.
4 From an historical review and analysis of the oil industry in James L. Williams, Oil Price History and Analysis by WTGR Economics.
5 Based on data from EconMagic.com, and James L. Williams, Ibid.