Will Soaring Ethanol Credits Cost You at the Pump?

Refiners have crushed the market in the past two years, thanks to a favorable margin in crude oil benchmarks, and look to continue their upward trajectory in 2013. However, an unfolding development surrounding the federal ethanol mandate has refining companies going toe-to-toe with ethanol producers and the EPA. The value of ethanol credits known as renewable identification numbers, or RINs, has grown more than 1,000% since December.

Executives at some of the nation's largest refiners have seized the opportunity to publicly deride the mandates, with CEO Jack Lipinski of CVR Energy (CVI -1.68%) saying the "unintended consequences are frightening." Some have called for the mandate to be reduced in 2013, arguing that it now threatens profit margins for refiners and retail gasoline prices for consumers. 

Will the rising values end up costing you the next time you fill up the tank? Who's to blame? The answer isn't as clear-cut as it seems.

The RIN market
Ethanol producers assign RINs to blocks of ethanol -- usually between 1 million and 5 million gallons -- which are then sold to blenders alongside the physical product. For example, if ethanol sells for $2.00 per gallon and RINs are valued at $0.50 per gallon, the blender must pay a total of $2.50 per gallon of ethanol. The market system was designed in 2005 with the Renewable Fuel Standard, or RFS, to accomplish two things: (1) to provide an added incentive for renewable fuel production, and (2) to keep track of the volumes of biofuels that refiners blended into the nation's gasoline.

Source: EIA.

Since it was implemented, the market for RINs has worked as intended in a supply-and-demand relationship. In the early years of the industry, RINs produced a sizable chunk of sales for biorefineries. Credits fell precipitously as the industry matured and ethanol production soared, pushing weaker producers out and leaving only the most efficient standing. Nonetheless, the mandate did its job to spur the American ethanol industry.

Hitting a wall
Which brings us to the issue at hand: From early 2010 to the end of 2012, ethanol credits never broke $0.10 per gallon. Something changed a few weeks ago, as secondary RINs were trading hands for $0.75 per gallon:

What's behind it all? The long-term problem facing the industry has little to do with RIN values and everything to do with the dreaded blend wall -- the limit of how much ethanol can be blended into a gallon of gasoline. Refiners have maintained that the blend wall will be reached at 10% ethanol mixtures, or E10, while the EPA has stated that it's E15 for cars built after 2001. Who's right?

Although blenders cite car manufacturers as the de facto source for their concerns, several studies suggest that E10 isn't really where the blend wall begins. A study released last year showed the potential benefit of using higher ethanol blends in terms of octane ratings for E15 to E30 fuels. The report states: "Higher octane ratings would enable greater thermal efficiency in future engines through higher compression ratio (CR) and/or more aggressive turbocharging and downsizing, and in current engines on the road today through more aggressive spark timing under some driving conditions."

It goes on to conclude that "substantial societal benefits may be associated with capitalizing on the inherent high-octane rating of ethanol in future higher-octane number ethanol-gasoline blends."

Who wrote the study? A little-known group called Ford (F -1.15%).

Blenders have a point
You can't blame refiners for attempting to defend their turf. Raising the mandated ethanol blend from E10 to E15 displaces an additional 5% of gasoline from the market and results in a loss of market share. And to be fair, they do have a point in their scuffle with the EPA. The agency's unwillingness to break from its original fuel guidelines in light of changing market forces is worrisome. For instance, RFS calls for nearly 1 billion gallons of cellulosic ethanol in 2013 despite the country's lack of capacity.

The bigger problem is the ever-increasing mandates for ethanol in the face of falling gasoline consumption. The mandates push the effective ethanol blend in the nation's gasoline tantalizingly close to the E10 blend wall:

Source: EIA.
Note: Fuel ethanol sold equals production less net imports.  

Given the 15 billion-gallon cap on corn ethanol in RFS and a rough target of 10% ethanol blends, we can assume that the agency figured ethanol production would top off when gasoline consumption hit 150 billion gallons. Oops.

This is the root of the problem. Refiners such as Valero and Marathon Petroleum are making a short-term push to buy RINs on the secondary market -- without equivalent volumes of ethanol -- to combat the blend wall. Doing this allows blenders to have enough credits to meet their renewable-fuel requirements without exceeding 10% blends.

What's the rush? In April, the EPA is expected to announce the 2013 ethanol mandate calling for 14 billion gallons of corn ethanol. Continually increasing engine efficiency could lower total gasoline consumption to around 130 billion gallons for the year, resulting in a national ethanol blend just above the line refiners have drawn in the sand. 

Foolish bottom line
Will rising RIN values affect gasoline prices? Assuming the credits remain at current prices of $0.70 per gallon and a 10% ethanol blend for 2013, RINs will add $0.07 to a gallon of gasoline. Consider that gasoline prices last week were $0.12 below last year's prices. Therefore, it seems unlikely that ethanol will make a major impact on your budget.

As for the larger problem at hand, I find it difficult to show compassion for refiners complaining about skyrocketing RIN prices when they're the ones buying certificates on the open market. Furthermore, refiners can increase exports of non-blended gasoline to countries that don't have ethanol mandates, so it may actually increase margins even further.

That doesn't mean the EPA gets off the hook. The agency urgently needs to address its plans for the future of renewable fuels. When 2022 rolls around, it will be impossible to blend the required 31 billion gallons of ethanol (16 billion gallons of cellulosic) into our fuel. The market needs to be reassured by the EPA and car manufacturers such as Ford that the country's infrastructure and automobile engines can handle higher blends of ethanol without significant modifications (where possible). Many see E15 blends as an inevitable reality in the next several years, but that won't solve the problems we'll face in 2022. And it's much closer than you think.