GoodFuels

A New Argument for Cutting Ethanol Mandate Surfaces

Energy economist Philip Verleger has a new contention that U.S. refiners are producing less gasoline thus less diesel due to increased ethanol demand. “Demand for diesel is rising in the U.S. and Europe, and its price has been shooting up much faster than that of petrol [gasoline],” he said recently.  Here is his argument and why it doesn’t stand.

Verleger said refinery operators were responding to the rapid increase in diesel prices by bidding more and more for light, low-sulfur crude. The U.S. could increase the light-crude supply — thus reducing the quantum of the price hikes — by putting some of its reserves on the market.

“Most crude, when refined, produces diesel and petrol; the lighter the crude, the bigger the share of diesel. Refinery upgrades to get more diesel from heavier crudes could take two years to relieve the pinch,” Mr Verleger said.

“Until then, refiners don’t want to produce more diesel from cheaper heavier crude because that would mean producing more petrol — sales of which have dropped,” he added.

Here’s the good part.

“The U.S. could also ease the diesel squeeze by adjusting the federal requirement that 9 billion gallons of ethanol be blended with US petrol supplies this year.

“The ethanol mandate is reducing the amount of petrol used. And so are petrol prices in excess of $4 a gallon. The side effect of less petrol use is less production of diesel — and more pressure on crude oil prices.

“Easing the ethanol mandate would also slow the increase in food prices. Ethanol, a biofuel, is made mostly from corn, the cost of which has also been soaring,” Verleger contends.

His remarks about food prices will have to wait. There’s plenty of evidence that corn is not the primary driver of higher food costs. That has much more to do with oil prices.

Verleger’s obsession with diesel demand and production is rooted in a recent paper where he seeks to explain the real story behind soaring crude oil prices this year. The paper, titled “Explaining the 2008 Crude Oil Price Rise” can be found here. In it he predicts that crude oil prices could reach $200 per barrel, but does not offer a timeline.

The U.S. slate of crude oil is a mixture of light and heavy crudes, low and high sulfur grades. In fact many U.S. refineries are well equipped to process heavier crudes, and have been for years. Worldwide and domestically, all available “sweet” crudes are most likely sold out as they are produced. It is true that the U.S. and the IEA hold vast quantities of “sweet” or light crudes in reserve, but it is clear neither is willing to offer the barrels on the market.

Verleger’s contention that this is the primary reason, along with ethanol mandates in the U.S., for rising crude oil prices borders on the absurd. The fact of the matter is U.S. and probably most European refiners are maximizing distillates this summer, more than at any time in the last ten years. Additionally, gasoline demand is falling and diesel demand is falling, albeit, at a slower rate.

Diesel demand is not as elastic as gasoline demand. Consumers find ways to cut back, while business and agriculture, the largest consumers of diesel and jet fuel worldwide, cut back reluctantly. Nevertheless, it is happening as the global economy slows down.

In his essay on why crude oil prices soared this year, Verleger says “Europe, for example, has become a large importer of the fuel, while the U.S. has become a significant exporter for the first time in years. Traders report that the United States will export perhaps 400,000 barrels per day to Europe in July. A year ago, no diesel exports were going from the U.S. to Europe.”

That is blatantly false as last fall we confirmed the movement of at least 13 to 15 cargoes of diesel to Europe, or between 4 and 5 million barrels. It was one of the reasons U.S. distillate inventories took so long to catch up this year. In the most recent EIA weekly statistical report, distillate inventories are now ahead of 2007. So much for a diesel shortage.  He is correct that diesel supplies were tight, with demand coming from Germany, China, India and South America specifically over the past 11 months. That tightness has now eased.

As we noted in an earlier post, and contrary to Verleger’s contention, a reduction in the ethanol mandate would jettison not just gasoline prices, but crude oil and therefore diesel prices as well. His notion that cutting the mandate will force refiners to ramp up production is true, but to suggest that as refiners ramp up, producing more gasoline, and diesel will lower crude oil prices is unjustifiable. Frankly, refiners are not interested in producing more gasoline.

In a table we prepared, we measure how U.S. refiners would replace the estimated 350,000 barrel per day of ethanol in the motor fuel pool in the event the mandate is reduced. We allow for a 3% mileage discrepancy between gasoline and ethanol.

We then measured several supply categories such as crude inputs to refineries, gasoline imports, crude oil imports and gasoline production. In addition we measured the average “Implied Demand” as reported by the EIA weekly.

The time period used was from the week ending June 7 through July 18 (seven weeks, or 49 days) in 2008 and compared the data to the average over the same time period in 2006 and 2007. Obviously, all categories were lower in 2008.

Over that period, we estimate that a total, over the 49 day period, of 16.6 million barrels of gasoline would be required. Of that, we estimate about 3.0 million barrels of gasoline would be imported as part of the solution to replace the lost ethanol. That would leave an estimated 13.635 million barrels (278,300 bpd) required through gasoline production in U.S. refineries.

Based on our assessment that U.S. refiners are producing more diesel (overall distillate) due to export opportunities, we cannot justify using the typical 3-2-1 crack spread, which implies 3 barrels of crude oil to produce 2 barrels of gasoline and 1 distillate. Therefore we would use a gasoline yield of 1.8 barrels per 3 barrels of crude oil.

By our calculations, it would require an additional 463,333 barrels per day of crude oil. The “impact numbers” of an increase on this scale: It would require that refinery utilization increases to 15.822 million barrels per day, from the current average of 15.358 million bpd, or an increase of 3.0%. Crude oil imports would have to increase by 463,333 barrels per day, representing a 4.6% increase in the amount of crude oil the U.S. imports currently.

This crude oil total is key to understanding what the reaction would be to cutting the ethanol mandate in half. The increase in U.S. crude oil demand would all but counter the increase that Saudi Arabia implemented when they added 500,000 bpd to the market in recent months. It is also more than the expected annual increase in Chinese demand in 2008.

To suggest that cutting the mandate would bring down prices of oil is ludicrous. Therefore it naturally follows that cutting the ethanol mandate would not bring down food prices. To the contrary, food prices would rise as oil prices soared.

You can call this a pre-emptive strike against a new argument that is about to surface. It is unclear how “big oil” can possibly spin Verleger’s suppositions, as it is all too aware of what the market would do if the ethanol mandate is cut in half.