How increased renewable fuel standards could lead to less supply

Energy economist Phil Verleger’s weekly report that he sends to journalists and clients is provocative this week, as is often the case. He traces a path from the renewable fuel standards ratcheting up relentlessly, year by year, to the possibility of refiners cutting runs just to stay in compliance with the law.

His argument goes like this:

• There’s a fixed amount of gallons mandated under the Renewable Fuel Standard. That figure is expected to be close to 14 billion gallons in 2011, up about 1 billion gallons from 2010.
• But if recession and efficiency combine to reduce consumption, then that RFS standard becomes a bigger percentage of the gasoline pool. That hasn’t been an issue yet, and Verleger predicts the 2011 percentage to be blended by refiners and importers will be just shy of 8%. Given that gasoline and car engines can handle that percentage of ethanol with no difficulty, there isn’t a 2011 problem.
• But that won’t last. The outright amount needed to be blended will continue to rise in absolute numbers against a base of flat to declining consumption due to the combination of continued joblesness and automobile efficiency gains. The result? Higher average percentages of ethanol required to be blended, heading into the double digits.

Verleger notes that E15, recently approved by the EPA is not a solution. That was made clear in the wake of the EPA decision to allow 15% blends in newer cars, when many analysts pointed out that it is unlikely retailers at this point are going to have pumps of E15 for recent models and E10 or less for older jalopies, that can’t use E15 without damaging their engines.

E85, with 85% ethanol, could go a long way toward meeting the goal. But as Verleger notes, there are no figures on total E85 consumption. And while it isn’t mentioned in the piece, if E15 is an issue because it can only go into newer cars, E85 is an even bigger issue, because it can only go into flex-fuel vehicles. What percentage of cars on the road are flex-fuel vehicles and are also in areas where E85 can be purchased? A figure couldn’t be easily obtained, but it’s reasonable to assume it isn’t a big one.

So the solution?

“The alternative answer is to reduce the diesel, (non-ethanol gasoline) and E10 marketed,” Verleger writes. “A rough calculation suggests that refiners, marketers and blenders could stay in compliance if they cut volumes marketed by one millions barrels per day in 2012.” The result? A 50% increase in gasoline prices by 2013, or maybe even a doubling. “The betting here is that most firms will constrain sales to ensure compliance,” he writes. As far as buying the credits known as RINS to get into compliance, Verleger notes the obvious: if everybody’s having a tough time meeting the standards, there aren’t going to be many companies that have a lot of excess credits to sell to others also trying to meet the government mandate. (That’s not the case now, where there is an active market in RINS for 2011).

It’s an economic truism: when markets get a dose of government intervention aimed at spurring an activity that would be otherwise uneconomical, you never know what’s going to happen. However, note that projections of ethanol-induced disaster have been made previously, and while the market has done some screwy things as a result of ethanol’s exalted position, it’s hardly been a crisis.

Even if the predictions on price don’t turn out to be accurate, Verleger’s key observation here is the rigid nature of the mandate and the very variable nature of demand. Those two things may be on a collision course. That’s what’s different this time.