Ethanol Blending Economics, the Expected "Blending Wall" and Government Mandates
AgMRC Renewable Energy Newsletter
Professor of Economics and Energy Economist
AgMarketing Resources Center
Iowa State University
For the past two years, ethanol market analysts have been predicting the industry would hit a “blending wall” as production expanded beyond the capacity of the transportation, blending, wholesale and retail distribution systems. There was concern that when this capacity limit is reached, ethanol prices would drop well below those for gasoline. The anticipated result was an extended period when ethanol plants would be shut down because of a lack of markets for their products. So far, that has not happened. Instead, rack (wholesale)prices for ethanol are well above those for gasoline. Ethanol’s ability to carry a sizeable price premium over gasoline indicates demand for it is still strong, despite a 31% increase in ethanol production in the past 12 months. Some ethanol plants have been shut down recently, but not because of a lack of markets for their products. The shut-downs have occurred because of challenges in managing risks of volatile corn and ethanol prices, and depressed profit margins as ethanol prices came down faster than those for corn.
In this article, we look at changing gasoline-ethanol price relationships and current ethanol blending economics in an effort to explain why spot ethanol prices are well above those for unleaded gasoline. We then look at implications of the biofuels mandates (Energy Independence and Security Act (1)) and how they relate to a very likely blending wall when cellulose ethanol production becomes widespread. The prospective blending wall is not a solid wall, but one from which ethanol prices are likely to be under more downward pressure relative to gasoline than has been seen so far.
Ethanol Price’s Relationship to Gasoline Price
Early in 2007, as well as in most of 2006,ethanol was a sellers’ market, with prices much higher than those for gasoline(see Figure 1.). The sellers’ market was created with the removal of MTBE (methyl tertiary butyl ether) from the motor fuel market. MTBE was widely used as an oxygen-enhancing additive to meet clean air standards in large U.S. urban areas. Its production was halted in 2006 because of concerns that it was carcinogenic and was a potential contaminant of underground water supplies. MTBE’s disappearance from the market created a very strong demand for ethanol to fill the void.
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By mid-2007, ethanol supplies had expanded more than enough to fill the oxygenated fuels market, and limited infrastructure capacity began to push ethanol prices below those of unleaded gasoline. In late 2007 and most of 2008, rack (wholesale) ethanol prices in the Midwest were below gasoline prices, despite a 51 cent per gallon blending credit for ethanol. In effect, the blending tax credit was not being passed on into the ethanol price because of a buyers’ market for ethanol.
However, in late 2008, conditions changed once again, leading to wholesale ethanol prices moving above gasoline. In an effort to explain this recent market change, we will review recent blending economics.
Factors contributing to the late 2008 shift of ethanol prices back to a premium over gasoline may have included the following:
- California’s announcement that in late 2009, it plans to require an average gasoline blend of 10% ethanol, up from the current 5.7% requirement (2)
- Iowa’s goal & retailer incentives that encourage the state’s average highway fuel sales by late 2009 to contain 10% renewable fuels (3)
- The emergence of transportation and marketing systems for moving ethanol to the south central U.S. market, including large cities in Texas
- Expansion of the southeastern U.S. ethanol market
- A slower expansion in ethanol production as firms with financial problems temporarily closed plants
- A 14% increase in the U.S. government mandated level of ethanol production for 2009 from the previous year’s level
- A tighter ethanol supply situation relative to the mandates than in the past. This may have caused ethanol blenders to pass a major part of their blending tax credit back to ethanol producers.
- Petroleum refiners appear to have an advantage in using ethanol to upgrade lower octane, lower-cost gasoline, thus reducing refining costs. Recent competitive conditions may have caused part of that advantage to be passed back to ethanol producers.
At this writing, Nebraska wholesale (rack) ethanol prices are about 77 cents per gallon above wholesale gasoline prices. However, the ethanol price premium is inconsistent with fuel mileage of the two fuels. A gallon of ethanol has approximately 2/3 the energy content of gasoline. Fuel blends with a high percentage of ethanol will reduce the mileage per gallon approximately in proportion to ethanol’s lower energy content.(4) Because of reduced fuel mileage, one would expect retail prices for E-85 (85% ethanol & 15% gasoline) to be at a large discount to gasoline. With E-10 (10% ethanol and 90% gasoline), it is doubtful that most consumers notice the slight decrease in mileage. Thus, when ethanol is marketed as E-10, a price discount for lower energy content generally is not needed. However, the decrease in mileage is very noticeable with E-85. So, as more ethanol is pushed into the E-85 market,a soft “blending wall” will be reached that is almost certain to bring an increasing discount of ethanol prices relative to gasoline prices due to the reduction in fuel mileage.
To determine the source of the premium for wholesale or rack prices for ethanol,Table 1 illustrates the approximate ethanol blending economics with E-10 in central Iowa and northern Illinois in early December and possible blending economics in early 2009 with the lower blending tax credit if wholesale price relationships remain unchanged. For 2009, the blending credit has been reduced to 47 cents per gallon from its previous 51 cents. (5) The 51 cents ethanol blending tax credit per gallon of ethanol created a 5.1 cents tax credit per gallon of E-10. In 2009, it translates into 4.7 cents per gallon.
The smaller tax credit for ethanol blending in 2009 likely will be passed on to consumers in slightly higher E-10 and E-85 retail prices than would have occurred without the reduction. For E-10, the change amounts to slightly less than one-half cent per gallon at the pump. For E-85, it is approximately 3.4cents per gallon.
Calculating Distribution and Merchandising Margins
The total merchandising margin for blenders,distributors and retailers of ethanol is the retail pump price minus various taxes and credits and the rack price for ethanol. In Table 1, the cost of E-10to the retailer, with an adjustment for the ethanol tax credit, is calculated as((0.9 x gasoline price) + (0.1 x ethanol rack price less the blending tax credit)). The industry determines the retail price through competitive pressures and by adding motor fuel taxes to this price along with the gross merchandising margin that covers all distribution and retailing costs and profits.
Using these calculations, recent retail prices imply that the merchandising margin on E-10is less than half as much as for gasoline in Iowa and Illinois. However, that much difference in actual margins is unlikely since gasoline and E-10 require the same facilities and transportation to make the product available to consumers. We conclude that the main reason for the lower E-10 price than for gasoline is that it allows the petroleum industry to use ethanol to upgrade lower octane (and lower cost) gasoline to the octane level needed for the regular grade. That would allow the oil refining industry to reduce its cost of producing gasoline. A portion of that cost saving can then be bid into ethanol prices. Conversely, if government mandates were the main factor pushing wholesale ethanol prices above those for gasoline, we would expect the higher ethanol price to be passed on to the consumer, but in fact the opposite is happening.
|The main reason for the lower E-10 price than for gasoline is that it allows the petroleum industry to use ethanol to upgrade lower octane (and lower cost) gasoline to the octane level needed for the regular grade.|
Variations among States
Blending economics vary from state to state, depending on local wholesale gasoline and ethanol prices and state motor fuel taxes for ethanol blends. Iowa has a two cents lower state tax per gallon of ethanol blend than for gasoline. It also has a volume-related incentive of up to 6.5 cents per gallon for fuel station retailers. (6) Illinois, on the other hand, applies the same state tax to both ethanol blends and gasoline and adds different sales taxes to ethanol blends versus gasoline.
Ethanol prices vary by state, depending on local supply and demand conditions. At this writing, states to the west of Iowa have a higher ethanol price than in Iowa. That may be due partly to California’s plan to nearly double its average ethanol content in gasoline-ethanol blends late next year. (7) California is the nation’s largest user of gasoline. The state uses about 15.5 billion gallons of gasoline annually. (8) Increasing its average ethanol blend from 5.7% to 10% has the potential to create a demand for an additional 665 million gallons of ethanol and 238 million bushels of corn to be processed into ethanol. Its motor fuel industry may be building stocks in preparation for the sharp increase in demand for ethanol.
E-85 Blending Economics
Table 2 shows early December 2008 costs, estimated merchandising and distribution margins, taxes,and prices for E-85. The margins are calculated in the same way as for E-10,although the blenders tax credit has a much larger impact for E-85. E-85 is a blend of 15% gasoline and 85% ethanol that can be used only in flex-fuel vehicles.
Note the implied negative blending, distribution and merchandising margin for E-85 and the positive margin for unleaded gasoline. As with E-10, the calculations suggest that E-85 may provide significant advantage to the petroleum industry in upgrading low-octane gasoline to meet needed motor fuel levels. The advantage varies from one region to another. If the ethanol premium over gasoline increases in the months ahead, it will reduce this incentive.
Blending economics and incentives for upgrading low-octane gasoline also vary geographically. In areas that are close to the coast and petroleum refining but long distances from ethanol production, ethanol prices are higher and reduce the advantage. Also, the ability to provide retail E-10 prices below those of gasoline may be partly due to forward purchases of ethanol at lower prices than are currently available. In addition, other subsidies beyond the blending tax credit may contribute to the industry’s ability to have a wholesale price well above gasoline but a retail price substantially below that of unleaded gasoline.
The Mandates and the Future Blending Wall
If you wonder why analysts talk about a forthcoming blending wall for ethanol, three reasons stand out:
- When the national average ethanol blend starts to approach or exceed 10%,more of the supply has to be channeled into the E-85 market. That market currently is limited by a relatively small number of retailers that offer E-85,as well as by a limited number of flex-fuel vehicles that are permitted to run on E-85. The 2007 energy legislation and some states provide incentives for retailers to add E-85 facilities.
- The automobile industry is committed to greatly increasing the production of flex-fuel vehicles but several years will be required before a large percentage of the U.S. auto fleet has flex-fuel capability.
- As more ethanol is forced into the E-85 market, the ethanol price will need to decline relative to gasoline in order to compensate consumers for its lower fuel mileage as shown in Table 3. Because of its high ethanol content and the lower energy content of ethanol than gasoline, EPA studies and antidotal evidence indicate a typical flex-fuel vehicle will have about 25% to 29% lower fuel mileage per gallon with E-85 than with gasoline . Table 3 also shows the approximate minimum price needed for E-85 to be competitive with gasoline with this fuel mileage differential. Lower ethanol prices are likely to put additional pressure on profit margins of ethanol producers. A secondary effect will be lower prices for corn and for producers of cellulose feedstock for ethanol plants. These price pressures from E-85 should be a major concern to the renewable fuels industry. Reduced prices for these feedstocks translate into reductions in farmer incentives to expand production of feedstocks to meet the government mandates.
Blending Wall versus Government Mandates
The volumes of ethanol that will be forced into the E-85 market by mandates from the 2007 energy legislation(unless regulations are changed to allow intermediate levels of ethanol blends) are shown in Table 4. Beginning in 2013, the mandated excess ethanol supply begins to rapidly exceed the E-10 market, thus setting the stage for an increasing and potentially large future discount of ethanol prices below those of unleaded gasoline.
Mandated volumes of ethanol to be blended with U.S. gasoline increase from 9 billion gallons in 2008to 15.6 billion in 2013, and then on up to 35 billion gallons by 2022. In this assessment of the point where a “blending wall” begins to show up in a large way, we use an assumed 5% decrease in U.S. gasoline use from the level of recent years. That puts annual gasoline use at 133 billion gallons.
|The 10 percent limit on ethanol content of motor fuels will impose a“blending wall” on ethanol usage. Although excess ethanol supplies can be used in the E-85 market, the severe discount in ethanol price needed to compensate for ethanol’s lower energy content will be a major disadvantage.|
Alternatives for Reducing the Blending Wall Impact
Part of the anticipated “blending wall” is due to infrastructure limitations such as transportation equipment and facilities,wholesale and distribution systems as well as availability of flex-fuel vehicles. The 2007 energy bill and other legislation provide support for dealing with these limitations. However, the challenge that has not been dealt with so far is the downward pressure on ethanol prices (relative to gasoline)that is virtually certain to occur if efforts to develop large-scale production of cellulosic ethanol materialize.
- Possible new technology for producing butanol (which has no mileage reduction vs. gasoline and no need for engine or infrastructure modifications),
- Possible development of thermo-chemical processes that produce other renewable fuels without the mileage disadvantage,
- Possible new automotive technology to reduce the ethanol mileage disadvantage, or
- Allowing intermediate ethanol blends such as E-12, E-15, and E-20. Brazil has used such blends successfully for years. At the 2022 mandated ethanol production levels, these blends would temper but probably not completely reduce the negative pressure on ethanol prices, ethanol profitability, and feedstock prices.
Of the above four alternatives, the last one (allowing intermediate blends)would be the easiest to implement and would buy time to develop technology needed for the other alternatives. The EPA and auto industries will be important participants in deciding whether this is feasible.
1 Energy Independence and Security Act of 2007, PL 110-140, December 19,2007
2 Jeff St. John, Tesor oCorp. Sues State of California on Ethanol Blending Mandate, October 8,2008
3 American Coalition for Ethanol, Iowa Ethanol Profile, 2007
4 Joanna Franco, “U.S.DOE Unveils Preliminary Test Results of Mid-Level Ethanol Blends”,Biofuels Business.Com, reporting on an Oak Ridge National Laboratory study with varying fuel percentages, and EPA mileage by vehicle make.
5 Energy Independence and Security Act of 2007, Op. Cit.
6 Iowa Legislature, AN ACT RELATING TO RENEWABLE FUEL AND ENERGY, PROVIDING INCENTIVES FOR INFRASTRUCTURE USED TO STORE AND DISPENSE RENEWABLE FUEL, PROVIDING FOR INCOME TAX CREDITS, PROVIDING FOR PENALTIES, AND PROVIDING EFFECTIVE AND APPLICABILITY DATES, INCLUDING RETROACTIVE APPLICABILITY, House Bill 2754, May 2006.
7Jeff St. John, op. cit.
8 California State Board of Equalization, Annual Gasoline Consumption Report
9 U.S. Environmental Protection Agency, “Fuel Economy Guide- Alternative Fuel Vehicles”