Economics Fundamentals of Ethanol Blending in the United States

economics fundamentals of Ethanol Blending us 2

In the United States, the Environmental Protection Agency (EPA) is responsible for developing and implementing the Renewable Fuel Standard (RFS), the regulation intended to ensure that transportation fuel sold contains a minimum volume of renewable fuel. This regulatory pricing component of the Ethanol is always made to look more unfavorable than it should. It is a market with highly dynamic trading fundamentals: The EPA is more of less right when saying we set rules, not PRICES.

Renewable Identification Numbers (RINs) and Renewable Volume Obligations (RVO) are the two mechanisms used by the EPA to implement the RFS program.

RVOs: It is a mandated number of RINS set for each refiner or importer of petroleum-based gasoline or diesel fuel. Obligated parties (refiners, importers, and blenders) have to acquire and submit, each year, a mandated number of RINs to the EPA. These RINs have expiration dates.  Participants must cover their RVOs by surrendering RINs within 60 days after the end of each calendar year. However up to 20% of a year’s mandate can be met with RINs generated during the previous year and delivered to the RVO.

RINs: Each Batch of Renewables fuel produced has a RIN attached is a serial number assigned to it. The value a RIN is determined in the secondary trading market, it can move higher or lower, think of it as a balancing mechanism, ensuring enough production to meet the EPA mandated Renewable Volume Obligations in any given year.  In order to acquire RINs, you have to 1) buy biofuel and blend it into regular gasoline 2) produce your own biofuel, and/or 3) buy RINs traded on the secondary market.

flows and Process Mapping

RINS are not created equal.

D-Codes (D#): they identify the renewable fuel standard category for a particular fuel based on a specific production process requirement (feedstock based). D6 category is tracking 1st generation Corn Starch based Ethanol. D6 also includes Buthanol made with Corn-starch.

D5 stands for Advanced Biofuels. It is tracking Fuels generated by sugarcane, non-cellulosic Ethanol, Cellulosic Naphtha and some Bio-mass Renewable Diesel. [1.1]

Equivalence Value (EV): is the number used to determine how many RINs shall be generated for each gallon of renewable fuel. Ethanol which is denatured shall have an equivalence value of 1.0 regardless of its sugar or corn feedstock. [1.2]

RIN Trading Phases Before and After RVOs proposals.

ethanol opisCredit: farmdoc,  University of Illinois [2]

[These are Supply and Blending and compliance issues at the tank lot size unit, they might not be the issues of a Professor of Economics University of Illinois or the issues that Big Data Providers will see]

BLENDSTOCK: The supply for blending or only minor processing into a finished output product or products.

Ethanol is a blendstock and like any blendstock it has quality grades ( acid strength, water, methanol, SO2, Sulphate, denaturant…).

Not all ethanol producers produce the same ethanol… Grading can create arbs at the product level. ( it is the traditional arbitrage business executed by simultaneously selling a finished product but simultaneously sourcing and blending high quality and cheaper/lower quality material).

The arb can be at the compliance level.

Ethanol is denatured with gasoline, natural gasoline or condensates to avoid liquor tax implications. As per RFS2 definition, any denaturant in excess of 2% can’t be treated as renewable fuel. When a denaturant test level come back at 4%, RINs can’t be generated for the entire volume. [3] [For this example, RINs can only be generated to represent 98% of the volume of denatured ethanol].

The removal of lead from gasoline during the 80s and the possible link of its replacement (MTBE) to drinking water contamination have led to increased use of ethanol as an oxygenate and octane enhancer in liquid transportation fuels in recent years. [4]

At the Blender, the Ethanol feedstock competes with ISO-Octane (aromatics).

For a gasoline blender, it is the availability to source cheaper sub-octane blendstock components to create finished gasoline with the optimal energy content who can bolster its blending margins. {a cautionary note us that ethanol is not linearly blended into gasoline and is also topped at the rack/distribution level).

e.g  Trafigura sources the cargoes from different origins to deliver it under the local gasoline 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, typically improving it with PBOB and at least 30 other feeds at our tankfarm and ship it by chartered product tankers to the U.S customers.]

With most of fuel ethanol blended in gasoline, there is high substitutability between these two markets. For the sake of simplicity, we will modelize CBOB Minus E100 as the implied feedstock demand for ethanol with the lower bound determined by the EPA minimum volume and its upper bound determined the blending wall (gasoline blends with more than 10% ethanol). It is obvious that when this relationship widens, E100 blendstock becomes more favorable in the gasoline blending pool.

top tier

EXPORT Margins

At the Refining level, the arb between PADDs Gasoline and Export Markets has enabled the U.S to be a MASSIVE exporter of gasoline and blendstock components and these CPP exports have been a crack-margins-booster for USG and USAC Refiners. RVOs are covering imports and domestics gasoline/diesel fuel sales. When U.S refiners opt for exports they no longer need the D6 to comply the RVOs. RVOs will be considered when U.S Refiners import products.

At the merchandising level, TOP-TIER Ethanol Merchants and Volcker-Rule Trading Desks maintain a global market coverage. It is a cargo market where the equilibrium is determined by freight volatility, tariffs, delivery timing and gasoline/feedstocks pricing factors rather than AGs pricing factors linked to corn/sugar productions and stock levels.

copy-edim2.png

Recently, a solid MISPRICING has appeared in the Ethanol/RIN market.

The RIN for advanced cellulosic Ethanol, has become expansive vs E100 and Gasoline( shortly after the EPA ruling) and a major U.S IB has originated Brazil Ethanol for blending in the U.S, in order to generate the RIN, stripping it to cash-out the credit attached. [However unlike what was reported in this Media, Ethanol from Brazil is brought into the U.S for ETBE(RFG) processing, the processed blend is then re-export to South America. It’s not a product import, and the arb is not at the product level].

It is a striking example of Commodity Trading doesn’t works like a script. **

“BLENDING ECONOMICS are also entrenched 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.

Traffic bottlenecks for corn shipments increasing the effective cost of the rail resource for the Ethanol producer and the merchant trader. [This is apparent in Chicago (1/3 of U.S Rail traffic]. Gasoline and Ethanol Markets can stay disconnected because Gasoline relies mostly on pipeline transportation. This is reflected in the RINS prices, E100, E85 cash prices and their derivatives market layers.

Complexities and physical constraints along the supply chain have created volatility in the pricing factors and price patterns that have bolstered innovations and incentived a new trade specialization.

The Ethanol Blendstock Market have highly dynamic economics fundamentals and Refiners and Ethanol Merchants understand them quite well now.

This also underscored that EPA is more of less right  when saying we set rules, not PRICES. It is NOT Regulations that are making these Economics: =­> it’s always the regulations with traders and within the economics context ” that are drawing the contours in this market.

© 2015 Navigating the commodity markets with Freight and Spreads

Sources:

1.1 40 CFR 80.1415 – How are equivalence values assigned to renewable fuel? https://www.law.cornell.edu/cfr/text/40/80.1415 and

1.2 How are RINs generated and assigned to batches of renewable fuel by renewable fuel producers or importers?40 CFR 80.1426  https://www.law.cornell.edu/cfr/text/40/80.1426

2. Chart from Irwin, S. and D. Good “The EPA’s Proposed Ethanol Mandates for 2014, 2015, and 2016: Is There a ‘Push’ or Not?farmdoc daily (5):102, Department of Agricultural and Consumer Economics, University of Illinois at Urbana-Champaign

3. EPA, frequent questions.

4. Ethanol Blending Models for Improved Fuel and Vehicle Performance & Lower Costs, Dr Andrew Rudge, UoM Commercial Ltd

**The real world is seldom like a textbook.

Commodity Merchant Trading and Shipping Advisory Services covers the mispricings/arbs in the Cash/D-Codes in details.

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