海角大神

US Ethanol Policy Should Reflect Circumstances and Consequences

This April, two separate bills were introduced in the US House of Representatives to聽reform, or聽repeal, the federal聽Renewable Fuel Standard聽(RFS) that mandates how much ethanol and other biofuels must be blended into gasoline.

To understand why reform or repeal makes sense now, we should recall the factors that led Congress to enact聽this standard six years ago and聽consider how many of the basic assumptions underlying its design have changed since then. That requires a review of US fuel consumption and import trends, commodity prices, and the impact of the RFS on food prices. After summarizing the other points I want to focus on the last one, based on an interview I conducted with聽Dr. Yaneer Bar-Yam, an expert on complex systems who has developed a model that explains the behavior of food prices since the introduction of the first,聽less ambitious聽RFS聽in 2005.

Origins of the RFS

In the fall of 2007, when Congress was debating the聽Energy Independence and Security Act聽that included the current, enhanced聽RFS, the US energy situation looked dire. For four years oil prices had been聽rising more or less steadily聽from their historical level in the low-to-mid $20s per barrel (bbl) to around $90, on their way to an all-time nominal high聽of $145/bbl the following summer.聽US聽crude oil production聽was in its 22nd consecutive year of decline, while our crude oil imports had climbed to聽10 million bbl/day, twice domestic production that year.聽

Even more relevant to the thinking behind the RFS, US聽gasoline consumption聽stood at a record 142 billion gallons per year and had been growing at an average of 1.6% per year for the previous 10 years鈥揳nother 2 billion gallons added to demand each year.聽In its annual long-term forecast for 2007, the Energy Information Administration (EIA) of the US Department of Energy had projected that gasoline demand would grow to聽152 billion gal/yr in 2013 and 168 billion gal/yr by 2020.聽Meanwhile, US net imports of聽finished gasoline聽and聽blending components聽had reached a million barrels per day in 2006, equivalent to 15 billion gal/yr鈥揺qual to the corn ethanol target set by the 2007 RFS for gasoline blending in 2015.聽And by the way,聽US corn prices聽for the 2006-7 market year averaged $3.04 per bushel (bu). In this environment, policy makers regarded聽ethanol as a crucial supplement to dwindling hydrocarbon supplies, from a feedstock that was cheap and readily expandable.聽

Trend Reversal

Without belaboring the events of the last five years, virtually every one of those trends has reversed course. That has occurred partly聽as a result of the recession and the lasting changes it produced in the US economy, and partly due to an energy revolution that was largely聽invisible in 2007 but had already begun.

US gasoline consumption peaked in 2007 and has since declined to聽133 billion gal/yr聽last year. The EIA forecasts聽it聽to fall to聽128 billion by 2020 and 113 billion by 2030. US crude oil聽output聽is the highest in 22 years and is set to exceed imports this year, while the US has become a net exporter of gasoline and other petroleum products.聽Since 2007 US ethanol production has grown from聽6.5 billion gal/yr聽to 13.3 billion gal., and聽it seems more than聽coincidental that corn prices had doubled to an average of $6.22/bu by last year.

Food vs. Fuel

That brings us to the controversy that has been widely referred to as 鈥渇ood vs. fuel鈥�. In the last several years I鈥檝e read numerous papers attempting to determine by correlation or other empirical methods whether and to what extent the increase in US ethanol production from corn has affected food prices.聽To put this in context, since 2005 the quantity of corn used for US ethanol production has grown from聽1.6 billion bu/yr聽to 5 billion bu/yr, or from 14% to 40% of the聽annual US corn crop.

Some studies, such as this聽2009 analysis聽from the non-partisan Congressional Budget Office found a significant influence on food prices.聽Others, including an聽Iowa State study聽recently cited in a聽blog post聽from the Renewable Fuels Association, found a negligible influence.聽What differentiates the work of Dr. Bar-Yam is that he and his colleagues have聽developed a quantitative model聽based on two key factors 鈥� corn consumed for ethanol and commodity speculation 鈥� that closely fits the behavior of聽a global price index.聽Their model also accounts for the 鈥渄istillers dried grain鈥澛燽yproduct from ethanol plants, which returns about 20% of the corn used in the form of protein-upgraded animal feed.

Before speaking with Dr. Bar-Yam last week, I was a bit skeptical of his results.聽Aside from skepticism being my default mode in such situations, I had spent a lot of time looking at claims of speculator influence on crude oil prices in the 2006-8 period and was never convinced that they were more than the 鈥渇oam on the beer鈥�, rather than a basic driver of prices.聽However, as I was reviewing his paper prior to our call, a light went on.

Rising Corn Demand Spurs Increased Speculator Activity

The curve his model predicted, which closely matched food price behavior, looked very much like the behavior of a process control loop responding to a ramped change in the set point鈥揻orget the jargon and think about how the temperature of your home responds to a steady increase in your thermostat setting: overshooting, then undershooting, before converging.聽We discussed this analogy聽and he confirmed that the聽effect could聽be characterized the same way whether it related to聽an electrical circuit or a market.聽In effect, the steadily increasing corn demand from the ratcheting up of the RFS started corn prices rising, and the presence of lots of speculators, including 鈥渋ndex fund鈥� investors, caused the price to successively overshoot and undershoot the equilibrium price track聽one would expect.

Dr. Bar-Yam explained that he had arrived at these two factors by eliminating factors that other groups聽had investigated, but that turned out to have no predictive value.聽These included聽shifting exchange rates, drought in Australia, a dietary shift in Asia from grains to meat, and linkages between oil and food prices.聽In his view the focus on ethanol聽and speculation聽is validated by the shift in dialog on this issue away from other, extraneous causes.

He also emphasized that his main concern is not the price of processed foods in developed countries such as the US, for which commodity grain costs are only one input, but rather the price paid for simple foods by poor people in the developing world.聽From that standpoint he doesn鈥檛 just want to see the RFS reformed.聽鈥滻t is important not just to repeal, but to roll back the amount of ethanol used in the US.鈥澛燞e would prefer not 10% ethanol in gasoline, let alone 15%, but about 5%. 鈥淭he narrative has to shift,鈥� he said, 鈥渢o recognize that people are going hungry.鈥� Those are powerful words, and I鈥檓 still thinking about them.

Conclusion: Timing is Right for RFS Reassessment

At current聽production levels聽ethanol from corn contributes聽the energy equivalent of 6% of US gasoline consumption and about 2.5% of total US聽liquid fuel demand. That鈥檚 not trivial, and there鈥檚 a whole domestic聽industry of investors, employees and聽suppliers聽who made that happen at our collective request.

However,聽If Dr. Bar-Yam has accurately captured the relationship between ethanol and global food prices, then we urgently need to reassess what we鈥檙e doing with this fuel.聽We are also in a far better position now聽to consider scaling back our use of ethanol produced from grain than we were聽when the RFS was established. With increasing production聽of shale gas, tight oil and various renewables, the energy scarcity that has defined our policies for the last four decades is far less relevant to our policy聽choices聽going forward. I鈥檒l tackle the practical aspects of RFS reform, in terms of the so-called 鈥渂lend wall鈥� and its impact on gasoline prices, in a future post.

Source:聽Why the Timing is Ripe for Ethanol Policy Reform