Who should pay for our corn ethanol policy – Big Oil or gas stations?

Ethanol made from corn goes into our gas tanks. Now refiners who pay for the subsidy are complaining of rising costs. armydre2008/flickr, CC BY

When most of us refuel our car or truck with gas, we’re also filling up with ethanol – the E10 label on many gas pumps indicates that 10 percent of the fuel is ethanol.

The reason we run our vehicles partially on biofuel goes back to a federal mandate to blend ethanol with gasoline prior to it being pumped into your tank. The mandate, which is backed by subsidies, was put in place to reduce dependence on foreign oil and cut vehicle pollution.

The subsidy for blending the ethanol and gasoline together isn’t free, however, and now a debate has broken out over who should be required to pay for it. It’s an argument that could be felt by consumers if higher refining costs increase prices at the pump.

In recent weeks, oil refiners and some gas station owners have complained about rising prices associated with blending ethanol into gas. The country’s oil refiners are on track to spend in total more than US$2 billion on meeting the mandate this year. A refining trade group has argued that the mandate, which uses credits that can be bought and sold, is unnecessarily imposing higher fuel costs on drivers.

Is the system of subsidizing corn ethanol blending actually broken and, if so, how should it be fixed?

How the biofuels mandate works

In 2007 Congress created the revised Renewable Fuel Standard (RFS2). This legislation mandates that a certain volume of biofuels be blended with fossil fuels such as gasoline. The corn ethanol industry was already established in 2007, and its fuel was set as the largest blending category (as opposed to biofuels from other sources, such as wood chips) until 2022.

Annual blending requirements under the RFS2 through 2022. Schnepf (2013)

Oil refiners process crude oil to make finished products, such as fuels or plastics. The RFS2 requires oil refiners to blend sufficient biofuels with their refined fuels to meet the mandated volumes. Each refiner’s individual obligation is determined by its U.S. market share.

The mandate is enforced through the use of blending credits named Renewable Identification Numbers (RIN). RINs are credits that represent the attributes of ethanol and act as the form of compliance to show that refiners and blenders have met the federal biofuel mandate.

A RIN is created when a gallon of biofuel is produced. Once a refiner or gas station purchases a gallon of biofuel and blends it with petroleum fuel, the RIN can then be submitted to the federal government to demonstrate compliance with the mandate. Alternatively, if the blender has more RINs than it is required to submit by the mandate, it can sell the excess to another company at a market price.

Surging RIN prices

This system worked well during the mandate’s early years. Some refiners owned sufficient blending capacity to meet their annual RIN obligations. Those who did not were able to purchase the balance for about $0.02 per RIN for the corn ethanol category.

This situation changed rapidly in early 2013. Corn ethanol RIN prices surged, from $0.05 at the beginning of the year to $1.45 by the following July, an increase of 2,800 percent. Those refiners that relied on RIN purchases to meet their obligations saw their expenses move sharply higher. RIN prices fell below $0.20 by November, but not before U.S. refiners and importers spent a total of $1.3 billion on them in that year alone.

2013’s “RINsanity” was attributed to the arrival of the ethanol “blend wall.” The blend wall is the maximum volume of ethanol that can be blended with gasoline, which was put into place for technical reasons.

The primary intent behind U.S. biofuel policy was to promote a domestic fuel made from corn. iowacorn/flickr, CC BY-NC-SA

Unlike gasoline, ethanol attracts water into the fuel infrastructure, such as pipelines and storage tanks. This isn’t a problem when only a small amount of ethanol equal to less than 10 percent of gasoline by volume is blended. However, blending more than this can cause corrosion in older or unmodified pipelines, storage tanks and vehicles.

Gasoline consumption was steadily rising when the mandate was created, so Congress did not expect the blend wall to be a problem. High oil prices and improved vehicle fuel economy caused U.S. gasoline consumption to decline after 2009, however, and the mandate breached the blend wall in 2013, meaning more than 10 percent of the U.S. fuel mix was ethanol.

Most blenders were unable to handle the higher rate, and refiners became dependent on purchasing credits from other companies to generate the needed RINs. RIN prices declined only after the federal government proposed to reduce the mandate below 10 percent of gasoline consumption in recognition of the problem.

A broken market?

Rebounding gasoline demand more recently has prompted the federal government to raise the blending mandate.

So this year RIN prices have returned to levels not seen since 2013 despite higher gasoline demand. They have remained so high that U.S. refiners have reported spending nearly as much on RINs in the first half of 2016 as they did in all of 2013. My analysis of refiners’ financial statements suggests that their total RIN costs this year will be 46 percent higher than in 2013 and 134% higher than last year based on current prices.

Combined annual RIN costs for publicly traded U.S. independent refiners based on data from quarterly earnings calls, annual 10-K filings. Author

This year’s high prices have coincided with refiners’ accusations of RIN market manipulation by other companies in the fuel supply chain.

Refiners transport and sell their fuels to fuel terminals that then distribute them to gas stations. Restrictions on the transport of ethanol through pipelines mean that terminals are frequently the point at which the blending occurs, rather than centralized refining plants.

These terminals and fuel retailers (the two operations are frequently, but not always, owned by the same company) thus control more blending capacity than many refiners despite not falling under the blending mandate. Any company that blends a gallon of biofuel produces a credit, but only refiners are legally obligated to submit their credits to the government. The terminals and retailers instead sell their credits to the highest bidder.

One of the largest “nonobligated blenders,” retailer Murphy USA, is on pace to earn $165 million from its RIN sales this year. Many additional small entities, such as terminal owners and fuel truck drivers, also generate RINs for resale. This is such a lucrative source of small business income that individual states have in the past considered laws banning biofuel blending by refiners.

Shifting the cost?

The American Fuel and Petrochemical Manufacturers (AFPM), a trade group, recently petitioned the federal government to change the mandate so that terminal owners in addition to refiners are required to blend biofuels or buy RINs under it. The group claims that nonobligated blenders are holding onto RINs to create artificial scarcity and higher prices refiners, as a captive market, are forced to pay.

The group argues that expanding the obligation of purchasing ethanol credits to include companies further along the distribution network would cause RIN prices to become cheaper and less volatile. It would also reflect limitations in the refining and transport infrastructure on how much biofuel can be blended.

This position is supported by researchers at Columbia University and former Special Assistant to the President for Energy and Environment Ron Minsk on the grounds that it would also increase the incentive to blend higher volumes of biofuels by reducing RIN hoarding. Finally, an analysis led by a MIT researcher finds that high RIN prices are passed through to fuel prices, in which case the proposal could result in lower prices at the pump for drivers.

A downside to this proposal is that, by requiring terminals and retailers to blend or purchase blending credits as refiners are, these smaller businesses would lose out on an important source of income. Instead of being able to sell their credits, they would be given to the government to show compliance with the biofuel mandate.

The effect on prices at the pump is unclear. Refiners argue that obliging terminals and retailers to pay would reduce refining costs and increase supply, pushing prices lower. Retailers argue that they already pass the increased income to drivers in the form of lower prices, and that removing the income would cause prices to move higher.

In effect, this proposal could be presented as transferring wealth from smaller business owners to “Big Oil” – namely, the big national refiners. That could be a hard sell in a presidential election year even if it benefits drivers too. The federal government has pledged to listen to both sides before making its decision. In the meantime, expect the debate over who pays for our corn ethanol subsidy to continue as we wait to see if higher prices will be passed down to consumers.

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