Summary
Ethanol production capacity continues to rise. With a current capacity of 7.9 BG/yr, refiners and blenders need the timely completion of projects under construction to meet the 2008 mandate of 9 BG/yr. With another 5.4 BG/yr under construction this seems assured. However it seems to me the Table is missing at least 15 other projects that are well under construction totalling over 800 MMG/yr capacity and another 600MMG that have recently broken ground. Although logistics and distribution are impediments to increased use of ethanol throughout the country, the number one problem is state motor fuel quality regulations that prevent the addition of 10% ethanol to the finished gasoline sitting in the terminal. For example, the ethanol distirbution system is in place in Las Vegas for winter blending, why is it not used in the summer?
Analysis
In the spring of 2006, refiners began phasing out the use of MTBE in the production of approximately 3 million barrels per day of reformulated gasoline and switched to ethanol. The price of ethanol spiked to over $5 per gallon on a spot basis, imports soared and as new capacity came on line, the price of ethanol dropped precipitously.
The Renewable Fuels mandate required the use of 4.7 billion gallons per year of renewable fuels in 2007, that will easily be surpassed with refiners and blenders using over 6 billion gallons. However the enactment of the Energy Independence and Security Act in December of 2007 raised the renewable fuels mandate from 5.4 BG in 2008 to 9.0 BG. As 2008 started, the RFA lshowed 7.5 BG/yr of domestic ethanol capacity on line, Reuters now has this rising to 7.9 BG/yr which is well under the new mandated level.
However, with many ethanol plants still under construction, adequate capacity will exist in 2008 to easlity meet the new standard. In fact, by the middle of the year, I expect well over 10 BG of capacity to exist and over 13 BG by the end of 2008. That is about equal to the amount that both the RFS and the Reuters article indicate currently exist and are under construction.
But beyond that, there are at least 15 or so plants under construction that are not on either of these lists representing over 800MMG/yr capacity. Take Liberty Renewable Fuels in Gratiot, MI. Expected on stream summer to fall of 2008, the web site contains pictures of a facility well under construction. The same may be said for Altra Biofuels plants in Carleton NE (113MMG) and Cloverdale IN (92 MMG). Other companies are indicating construction plans with imminent start up dates in their SEC 10K filings such as Little Sioux Corn Processors in Iowa, Husker Ag in Nebraska, Show Me Ethanol in Missouri.
There are another half dozen or so plants that recently broke ground such as E-85 in IA or Everton Energy in KS, but if the economics substantially change it is possible to see these projects cancelled as well.
One question is, when will all the additional capacity come on line and begin to impact the price of ethanol? The distribution system will struggle to keep up with the supply. I expect ethanol producer margins to decline substantially in the second half of 2008.
Although many feel that ethanol should price at 51 cents per gallon over the price of gasoline, this is predicated on its use as a volume extender offset by the blender tax credit. This relationship need not hold. When supply outstrips demand, the price will go to a marginal production cost type of level. In fact as more ethanol capacity comes on line, the raw material price of corn is likely to see upward pressure. In 2007 approximately 17% of the corn crop was used in ethanol product. The production of 9 BG ethanol will use nearly 25% of the crop and 11 BG production levels use close to 30%. Increasing corn supply will require either more acreage or better yields per acre.
The most affected companies are Pacific Ethanol, Aventine, Verasun who are dependent on the ethanol refining margin. On the other hand, the integrated ethanol refiners who also own farmland and produce corn will be big winners. Corn at $5/bushel is much better than the $2 it was 2 years ago.
I earlier mentioned the limitations of the distribution and logistics system. As ethanol prices declined last year, the economics for blending into gasoline improved. Now ethanol is already used in the metro areas of the country in reformualted gasoline, so it is the less populated areas that use conventional gasoline where more blending can take place: The southeastern USA for instance or places like Oklahoma, Maine, Vermont, Idaho, Montana.
However the biggest limitation is state motor fuel quality specifications. What do I mean by that? The federal government does not regulate motor fuel quality per se, the EPA regulates gasoline qualities that affect air quality. These are such things as sulfur, benzene, pollution emissions and vapor pressure. there is no federal regulation on octane.
At the state level, some states like California have very restrictive motor fuel quality specifications, other have no state specification at all, for example Pennsylvania or Maine. Many states adopt what is known as ASTM International Specification D4814.
Ethanol has very good octane qualities, but very poor volatily qualities. ASTM International has specifications regarding volatility and in the trade the ones that matter are Reid Vapor Pressure (RVP), the distillation or T50 and finally the V/L or vapor liquid ratio. Each of these qualities is important in regards to how the fuel burns from a cold start, through warm up to smooth burning as well as preventing vapor lock.
The problem with the state regulations is that in many instances they require both gasoline and gasoline/ethanol mixtures to meet the ASTM specifications. Practically speaking, if one adds 10% ethanol to 90% gasoline, the vapor pressure is raised by 1 psi, the T50 is reduced and the V/L is reduced.
During the summertime, the EPA grants a "waiver" for the increase in RVP. The EPA does not regulate T50 or V/L. Many states do. So in order to accomodate ethanol blending, states must legislatively address the quality change for RVP, T50 and V/L otherwise refiners would have to make a new boutique fuel.
One might say, how come the midwest has been able to blend ethanol for decades and a place like Florida can not? States in the Midwest like Minnesota, Iowa or Nebraska simply say in their standards that if the base gasoline blend meets the ASTM standard one can simply add ethanol on top, make a 10% blend and sell it. Oregon and Washington have similarly worded regulations.
On the other hand, Florida currently requires that the before and after blends meet ASTM specifications. They do not even grant an RVP waiver like the EPA although changes are afoot. Recently states like Tennessee and Idaho have modified their regulations to accomodate ethanol blending and new regulations are working through the legislative process in the Carolinas.
In Las Vegas, during the winter season, refiners are required to produce a fuel that is then blended with 10% ethanol for retail sales. This is due to the designation by the EPA that Las Vegas is a CO non-attainment area. So the distribution facilities are already in place. Why not blend in the summer? Nevada must modify its fuel quality regulations which are guided by ASTM to accomodate changes in T50 and V/L.
In summary, ethanol production is rising, the supply will be more than adequate to meet demand. Ethanol producer margins are likely to get squeezed. Widespread distribution of ethanol is occurring, it is being slowed down until infrastructure investments are in place along with changes state regulations.
Ethanol producers will see deteriorating margins. Farmers are big winners. Railroads and terminal operators stand to benefit immensely from the increased use of ethanol. Refiners may see a bit of pressure on gasoline margins by the second half of the year.
