Streetwise Professor

June 11, 2015

The Ethanol Mandate is Enough to Drive Me to Drink

Filed under: Climate Change,Commodities,Economics,Energy,Politics,Regulation — The Professor @ 6:13 pm

About 19 months ago I wrote about RINsanity, i.e., the United States’ nutty ethanol (and other biofuel) program. RINsanity has long outlived the phenomenon (Lin-sanity) that inspired the neologism. A couple of weeks ago, the EPA announced the ethanol and biodiesel quotas . . . for 2014. Who said time travel is impossible? That Einstein. What an idiot!  (The EPA also announced quotas for 2015 and 2016.)

In a nutshell, despite protestations to the contrary, the EPA largely conceded to the reality of the E10 “blend wall” (the fact that the vast bulk of auto engines are incapable of burning fuel with more than 10 percent ethanol), and announced quotas that were (a) smaller than the market expected, and (b) smaller than the statutory amounts that Congress specified in its farseeing omniscience 10 years ago. At the same time, the EPA decreed larger quotas for biodiesel.

As a result, the market did the splits. The price of ethanol RIN credits that count towards the ethanol quota plunged, while the price of biodiesel RIN credits that count towards the biodiesel quota rose. Scott Irwin and Darrell Good have all the gory details here. (Those are the guys to follow on this issue, folks. I’m just kibitzing.)

As a result, pretty much everyone is upset. The nauseating biofuel lobby is screaming bloody murder because the ethanol quota is too small, and is threatening to go to court. Those holding ethanol credits are fuming due to the forty plus percent price decline.

This all points out the dysfunctional nature of environmental markets in which the supply is set by some opaque politicized bureaucratic process unhinged from economic reality. (The European CO2 credit market is another classic example.) The Congressional mandate set quotas (supplies) years in advance based on forecasts of future fuel demand that turned out to be wildly incorrect. So the EPA played Mr. Fixit, and through some unknown process, divined what Congress meant to do-really!-and announced some surprising numbers that caused prices to plummet.

The EPA’s reaction? It is shocked! Shocked! to find gambling going on at Rick’s (ethanol served here!):

The EPA didn’t intend for the program to create a speculative market, and an agency spokesperson declined to comment on RIN price movement.

“RINs are used to demonstrate compliance under the Renewable Fuel Standard program,” the EPA said. The agency manages an electronic system that tracks the RINs, but not their prices on the open market.

Earth to EPA! Earth to EPA! (And hey-aren’t you supposed to be earth’s stewards? So what are you doing orbiting Pluto?): if you create a scarce resource (ethanol credits) a market-and yes, one with speculation!-will appear. This is inevitable as the sun rising in the east. Another unintended but metaphysically certain event.

Indeed, the kind of speculation that these markets foster is particularly bizarre, because of the necessity of speculating on the feedback between the market and the EPA’s decisions on the amount of the scarce resource it creates. A big part of the RIN prices is market participants’ expectations about what the EPA will decide. If the EPA’s decision takes the market price into account, in some unknown (and almost certainly unarticulated) way, the reasoning chain becomes mind-numbingly complex very quickly. Mr. Market guesses what the EPA will do. That affects prices. The EPA takes the price, and guesses what this says about what the market knows about fundamentals . . . and what the market thinks about what the EPA is going to do. It adjusts its decision accordingly. Market participants have to make judgments about the feedback between the price and the EPA’s decision, which can affect the EPA’s decision, and on and on, ad infinitum. (This is analogous to Keynes’s beauty contest metaphor, and Soros’s theory of market “reflexivity.” Sign of the apocalypse alert: I gave Keynes and Soros a favorable mention in a single blog post.)

That’s no way to run a market, but the alternatives are  likely worse. One alternative would be to set quotas for years far into the future, and then not adjust them based on the evolution of other fundamentals that cannot be foreseen when the quotas are set.

It’s pretty clear that events like have just rocked the biofuel world are an inherent part of the system. Somewhat arbitrary, inherently difficult to predict (in part because they are politicized), and “reflexive” decisions are a major determinant of supply. These decisions are made at discrete times. It is extremely likely that there will be disconnections between the quantity the market thinks the EPA will select and what the EPA actually chooses. Given the inelasticity of demand for energy products, these supply surprises lead to big price impacts.

All of which goes to show that a better use of ethanol is imbibing it to cope with the craziness of a faux market.

Of course it’s not just that the market is crazy: it’s crazy that there is a market. Ethanol is an economic and environmental and humanitarian monstrosity. Yes, ethanol would play a role without subsidies or mandates. But a much smaller role. Forcing and inducing its use is costly, not environmentally beneficial, and raises the price of food, which hits the poorest the hardest. So this crazy market shouldn’t exist in the first place. I think I need another drink.




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1 Comment »

  1. EPA is more or less right when saying we set rules, not PRICES ***** with the exception of the period preceding the standard compliance deadline

    e.g RIN gains in value and behaves more as insurance policy than on E100/CBOB/D6 relationships because of this increased uncertainty. ( also in part because Wall St. has quickly understood the animal)

    This recent decrease in the D6 RIN appears to be driven by the rise in gasoline price MUCH more than Quotas
    (It is my analysis when I deconstruct Figure 1.
    Phase 1. Fall 2014, rising freight cost, late harvest, rising cost prices, RIN mandate expectation D6 is up.
    Phase 2. Christmas Cliff, at the peak of congestion market has liquidated D6 RIN/ end-users no longer buying.
    Phase 3. MAY and so on… PADD V outages, D6 RIN appears to be driven by the rise in gasoline price, keep a slight pressure on the downside.
    Phase 4, MAY Cliff, quotas announcements, D6 lost forward value built into their prices however I also believe this D6 RIN had also to catch-up with rise in gasoline price since Spring. ( their was a pool of cheap D6 waiting for, Quotas uncertainties wainting only for this signal).

    Ethanol = blendstock like any Blendstock.
    The avaibility for a blender to source cheaper sub-octane blendstock components to create finished gasoline can bolster its blending margins. The most obvious relationship is CBOB Minus E100, e.g when widens E100 becomes more favorable in the gasoline blending pool.
    e.g Trafigura sources the cargoes from different origins to deliver it under the local RBOB specs at average lower-cost to exploit a locational/time arbitrage. (I have also been at a Blender in the past, what we did was importing a cargo from Macquarie in Saint-John, improving it with PBOB and at least 30 other feeds, blend it at our tankfarm and ship it by chartered product tankers to the U.S customers (a semi-arb).

    The arb between PADDs Gasoline and Exports Market has enabled the U.S to be a
    MASSIVE exporter of gasoline and blendstocks products, e.g when refiners opt for exports because of favorable economics they no longer need the D6 to comply EPA standards.

    Finally, Gasoline and Ethanol market are not always connected. The blending economics are also anchored into the freight markets.
    In addition to the surge in rail demand by the shale-oil industry, railroads generally experience peak demand during fall due to grain harvest and shipments of goods before the retail peak during holiday season causing traffic bottlenecks for corn shipments increasing the effective cost of the rail resource (delays). This is apparent in C-Town (1/3 of U.S Rail traffic) and also reflected in the E100, and even in the E85 cash and derivatives market layers…

    The Economics of Ethanol Blending are highly Dynamics. I think refiners understand them better now (Valero, the industry etc…)
    Regulatory layers, complexities and the physical constraints have incentived new trade specializations and have bolstered trade innovations.

    Simon (sent with an android somewhere between and 2 flights)

    Comment by simon jacques — June 11, 2015 @ 10:56 pm

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