Say what you want about renewable fuels, but the policies jointly enacted by Congress and the U.S. Environmental Protection Agency in 2005 and 2008 were wildly successful in creating globally competitive ethanol and biodiesel industries. Since the Renewable Fuel Standard was established in 2005 the United States has increased annual ethanol and biodiesel production 263% and 1,375%, respectively. Is it even possible to argue the successfulness of the endeavour?
Unfortunately, the policies may have been a little too successful in some aspects (and failures in others). The EPA knows it's time to overhaul and update mandates, but has been slow to act. Very slow. The agency hasn't even decided the volume of biofuels required to be blended into petroleum fuels for, ahem, 2014. That has left the renewable fuels businesses of leading ethanol and biodiesel producers such as Archer Daniels Midland (NYSE:ADM), Valero (NYSE:VLO), Darling Ingredients (NYSE:DAR), and Renewable Energy Group (NASDAQ:REGI) in a rut of volatility.
The uncertainty created by outdated legislation hasn't been kind to producers, has made creative business strategies a necessity, and has scared away many investors from what could (and has been) a lucrative opportunity. Dear EPA, please fix biofuels in 2015. Here are some obvious problems with a relatively simple solution to get you started.
Artificial demand: The 800-pound gorilla in the room
Archer Daniels Midland, the nation's largest ethanol producer, generated $697 million in operating profits from its ethanol business in 2014 and accounted for 43% of the total companywide year-over-year improvement. Historically low corn prices pushed down production costs, while strong demand home and abroad increased selling prices. The resulting high margins encouraged many producers to operate at full-throttle in recent months to maximize profits.
Profit-boosting production races sound great, but there's one problem. Today the United States is swimming in excess ethanol and biodiesel capacity amounting to roughly 2,000 million gallons (or 15% of domestic demand) and 820 million gallons (or 64% of domestic demand), respectively. When an entire industry suffering from excess capacity operates at full production, there are bound to be consequences. The result? Soaring stockpiles and plunging oil prices have slashed selling prices, which forced Archer Daniels Midland to limit shareholder expectations for its bottom-line-driving ethanol business in 2015.
While excess production capacity would appear to be the ethanol industry's problem, not that of the EPA, the agency actually deserves much of the blame. The long-term plan announced in 2008 -- when oil prices hit all-time highs -- called for the United States to produce 31 billion gallons of ethanol annually by 2022. Corn ethanol would provide 15 billion gallons (the industry's current capacity), while cellulosic ethanol would provide the remaining 16 billion gallons.
However, regulates state that we can only blend about 10% ethanol into its gasoline supply, and it's highly unlikely there will ever be that much demand for ethanol fuel. Consider that annual gasoline consumption reached 134 billion gallons in 2013, pegging real annual domestic demand for ethanol fuel from any source at roughly 13.4 billion gallons -- a level well below current production capacity. It gets worse when you consider that gasoline consumption has been in decline thanks to the improving fuel economy of the nation's automobile fleet.
Keeping the unrealistic mandates brings a flurry of unanswered questions to the surface. Is the industry expected to export 20 billion gallons of ethanol each year? Should corn ethanol production gradually be replaced with cellulosic ethanol? Or perhaps a more valuable fuel such as butanol? If so, how will the transition work? The longer the EPA takes to update its expectations, the longer America's ethanol industry will be mired in uncertainty, which runs the risk of losing its global competitiveness.
The, um, negative 800 pound gorilla in the room?
The biodiesel industry faces similar frustrations at the other end of the spectrum. The EPA has set annual biodiesel blending targets at 1.28 billion gallons. But the United States can blend about 7% biodiesel into its petroleum-based diesel supply. Considering that consumption of on-highway diesel reached 37.3 billion gallons in 2013, the market could have a real annual domestic demand of 2.6 billion gallons of biodiesel. If consumption of nontransportation uses of diesel fuel are included, such as heating oil, then potential annual demand for biodiesel could top 4 billion gallons.
Underselling biodiesel's potential has capped growth for the industry and resulted in the adoption of creative strategies. Renewable Energy Group, the nation's largest biodiesel producer, has been forced to halt construction at four production facilities with a combined annual production of 150 million gallons. To put that in perspective, the company currently has active biodiesel production totaling 257 million gallons per year.
To better cope with the market environment, Renewable Energy Group has invested in lowering production costs at existing facilities and a 75-mgy renewable hydrocarbon diesel facility that produces fuel identical to petroleum-based diesel. Better yet, the fact that renewable diesel qualifies as an advanced fuel yields a key advantage: Production generates tax credits that can be applied to meet a refiner's annual blending requirements for any renewable fuel, including ethanol and biodiesel (hey, I didn't make the rules).
That makes renewable diesel, the most mature advanced fuel, the best near-term hedge against market uncertainty. Indeed, Valero and Darling Ingredients constructed a 147-mgy renewable diesel facility to offer the refiner relief when attempting to satisfy EPA blending mandates for petroleum-based fuels it produces. When Valero, the third largest ethanol producer in the United States, has to hedge against its own renewable fuels production in such creative ways, that's a pretty good hint that the system isn't optimized.
What do producers and investors need?
Let's be honest, the EPA finds itself in a less-than-envious position. Many factors affect renewable fuels markets, and there is no shortage of problems that can be addressed, which makes it unrealistic to expect a quick or simple fix for all problems facing the ethanol or biodiesel industries. Therefore, the agency should start with the lowest hanging fruit, that is, the simplest changes that will have the largest effects, and work its way up.
That being said, the biggest problem is that demand for high-volume renewable fuels isn't fully determined by the market. When the EPA sets annual blending targets, it creates artificial demand that doesn't always match up with real demand in real markets. Judging by the fast rise of ethanol and biodiesel, that practice appears to work for seeding demand of and encouraging investment in less developed renewable fuel industries. But it also appears to do more harm than good for more mature industries such as ethanol and biodiesel.
It's time to develop a flexible, long-term plan to guide investment and development and respond to changes in both the domestic and global marketplace. When the EPA makes its much-anticipated decision on renewable fuel targets for 2014 and 2015 in the weeks ahead, it needs to address the inefficiencies of previous mandates. The future of renewable fuels in America depends on it.
Maxx Chatsko owns shares of Renewable Energy Group. Check out his personal portfolio, CAPS page, previous writing for The Motley Fool, and follow him on Twitter to keep up with developments in the synthetic biology field.
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