As opposing camps gear up for the coming war this Congress over the Renewable Fuel Standard (RFS), we should prepare ourselves for a constant bombardment of claims and accusations designed to discredit each side. Rather than present those arguments here, however, let us focus on how we ended up with the RFS in the first place.
If the American Petroleum Institute (API) is correct that the mandate needs to be repealed, then why is it unworkable now after being in law for nearly 6 years? What has changed since the RFS was first adopted – when the oil industry quietly agreed to the program’s framework?
Oil’s Political Gambit
The RFS was unquestionably a result of the country’s reflections on the causes of the Iraq War. Most Americans – regardless of political persuasion – understood that the security of Middle Eastern oil played a substantial role in the decision to topple Saddam Hussein. At the time, oil imports were at their highest levels of more than 12 million barrels per day, while economic forecasts pointed to continued growth in gasoline consumption.
Staring us in the face was thus a foreign policy dilemma, which both political parties sought to address. Few people then appreciated the importance that “tight oil” – and possibly shale oil – could play in reducing the country’s imports. Accordingly, the Bush Administration and Democratic Congress set out to send a signal to the American people that Washington was serious about reducing U.S. dependence on foreign oil, which would help us avoid further military entanglements in the Middle East.
The answer was ethanol and more ethanol. Plain and simple. From a political messaging perspective, it was incredibly effective – by 2015, America would displace 15 billion gallons of “Middle Eastern” oil with Midwestern corn. To most Americans, that number seemed incredibly ambitious – given the use of “gallons” instead of “barrels” – and thus a serious attempt to improve our energy security. Consequently, everyone gained political points, even the oil industry, which appeared willing to sacrifice profits for the national interest.
Of course, Washington is the city of smoke and mirrors – nothing appears as it seems. Few people, including our elected officials, understood what was actually happening in the fuel markets. The best-kept secret during the development of the legislation was that the government didn’t have to pass a law that required refineries to blend 15 billion gallons of corn ethanol by 2015. At the time, a majority of energy market analysts, including those who worked for the oil industry, expected that it was likely to occur regardless.
A year before the 2007 revision of the RFS, the production of MTBE (methyl tertiary butyl ether), which was widely used as an oxygen-enhancing additive to meet air quality standards, was halted because of concerns that it was a potential contaminant of underground water supplies. Because ethanol was the most competitive substitute to MTBE, its demand as a fuel additive thus skyrocketed. Refineries not only needed to blend ethanol – they wanted it.
Of course, refineries and blenders can only mix the amount of ethanol with gasoline that EPA regulation allows, and they only desire to refine the amount of fuel that is actually demanded by the marketplace, taking into consideration air quality standards. Together, these two conditions define the limit to how much ethanol can be blended in the fuel pool – policy wonks know it as the “blend wall.”
Refineries produce the fuel mix that EPA has certified and approved to power our cars and trucks. In general, that blend is an E10 ratio of ethanol-to-gasoline (10 percent ethanol, 90 percent gasoline). Although some refineries would drop ethanol completely without the RFS mandate, many of them would still blend up to 10 percent ethanol. For example, API, Chevron, and Marathon Petroleum Company told EPA last year that a one-year waiver of the RFS blending requirements would unlikely result in a “significant decrease” in their ethanol blending because it was profitable for them to continue the practice.
The Creation of Corn Ethanol’s RFS Monopoly
In their quest to gain public relations points in the face of an unpopular war linked to U.S. dependence on foreign supplies, the oil industry agreed to the RFS mandate, gambling that gasoline consumption, which at that time was 142 billion gallons per year, would continue to climb and surpass 150 billion gallons per year by 2015. And their gamble wasn’t unreasonable at the time: most analysts did not view the blending requirements benefiting corn ethanol as a major threat to the “blend wall.”
Instead, demand for gasoline dropped substantially with the recession, 6 percent from 2007 to 2011 to about 134 billion gallons. Moreover, the Obama Administration – armed with bailout leverage vis-à-vis the automakers – was able to push through another round of fuel efficiency targets under CAFE, reducing oil demand by another 2 million barrels per day by 2025.
This unanticipated decrease in the demand for gasoline changed the threat the RFS targets pose to the actual market. Now, refineries will be required to blend more ethanol in 2015 and beyond than what the market actually needs. Assuming the demand for gasoline remains stagnant and an E10 blend ratio, refineries will only mix about 13 billion gallons of ethanol with gasoline, 2 billion gallons short of the RFS mandate. Trading credits, which were earned by refineries blending more ethanol than what was initially required under the RFS, will then quickly dry up, leaving obligated parties liable for hefty fines and penalties – costs that will be passed down to you at the pump.
Political points that were viewed as costing close to nothing in 2007 have now become quite expensive to the oil and refining industry. This is why API, which certainly is suffering from regret, is now calling for repeal of the RFS. And this is why you, the consumer, should care – at the end of the day, you get stuck paying for the miscalculation of market analysts and special interest groups in Washington. You will face higher gasoline prices.
Unquestionably, many leaders in the ethanol industry would privately agree that it’s not fair that refineries face penalties and fines for not blending what isn’t demanded by the market. However, don’t expect ethanol interests to have much pity for the oil industry or for you, the consumer. They are not looking to compromise and fix the market distortion caused by the government mandate.
Instead, corn ethanol’s priority is to protect the monopoly the RFS creates for them in fuel additives – the 15 billion gallon blending requirement. Because the RFS does not give compliance credit to ethanol made from non-renewables, cheaper feedstock, such as natural gas, gets shut out. Here, consumers get hit again – without the RFS, ethanol would be cheaper, thus lowering prices at the pump.
What the oil industry probably fears the most from the RFS is the prospect that EPA will approve higher ethanol-gasoline blends solely to protect the mandate – as the Agency did with the waiver for E15 (15 percent ethanol, 85 percent gasoline).
Their fear is well founded, particularly since EPA will continue to regulate mobile source emissions. And with increased regulation, the Agency could approve and certify a higher blend of ethanol and gasoline for air quality compliance purposes, thus helping automakers develop engines with complementary fuels. If and when that happens, the RFS and its blending requirements would likely become moot. Refineries and blenders would be required to increase significantly the amount of ethanol in the fuel pool.
It’s hard to have too much sympathy for the oil industry, given their blessing of the RFS in 2007. However, the RFS status quo is unquestionably bad for consumers and the national interest. The free market should determine the amount of ethanol that is blended in our fuel pool, and corn should compete with other feedstock, such as natural gas, in making the additive. Any moves to break up oil’s domination of the transportation fuel market should be determined by the market – and not by the power of special interest groups that seek to carve out their own monopolies within monopolies.
As Milton Friedman concluded, “the first and most urgent necessity in the area of government policy is the elimination of those measures which directly support monopoly.” Accordingly, the RFS monopoly for corn needs to be abolished.