In the previous column, I described what I believe are the problems with the nation's ethanol program. In a nutshell, the U.S. government creates demand for ethanol via federal mandate. This mandate pits states, powerful public interests, and various political groups against each other. As a result, proponents and opponents fight a never-ending war around these mandates. This means there is year-to-year uncertainty that impacts ethanol producers.
The ethanol mandate is unpopular in states that don't produce much ethanol, in the refining industry, among environmental groups, and among many food manufacturers (who feel it artificially drives up the cost of corn).
Supporters of the mandate include large swaths of the Midwest, where ethanol supports numerous jobs -- both in the ethanol industry and among corn farmers. This support includes a powerful farm lobby, and a powerful bipartisan block of farm state senators that consistently supports ethanol.
The key problem is that creating demand by mandate has simply not worked to produce a self-sufficient ethanol industry. Nor has it created widespread prosperity for corn farmers. Farm bankruptcies are steadily rising. Over the past year farm bankruptcies were up 13%. The past year has seen more farm bankruptcy filings than any year since 2012.
If the ethanol mandate was suddenly removed, the ethanol industry would collapse. Thus, the industry is forced into a perpetual cycle of lobbying to ensure that the federal government keeps them in business.
I would argue that there is a far better model for the U.S. ethanol industry. In this model, the entities that control the model are the same as those that benefit from it: The Midwestern states that produce essentially all of the nation's ethanol.
The key goal here is to get the federal government out of the position of strongly impacting the market for ethanol.
The Saudi Arabia of Ethanol
Over the years, I have often referred to Iowa as "The Saudi Arabia of Ethanol." That was once a more appropriate title when Saudi Arabia was the undisputed king of global oil production, but perhaps less so with the explosion of U.S. shale oil production.
Nevertheless, there are still important elements in the comparison. At present Iowa has the capacity to produce 4.3 billion gallons of ethanol per year, which is 26% of the nation's total (Source). This is of course due to the large amount of corn production in Iowa, enabled by ample rainfall and rich topsoil.
Saudi Arabia produces 13% of the world's oil. But Saudi Arabia differs from Iowa with respect to energy production in one very important detail: Saudi Arabia satisfies its own energy needs with the oil they produce, and exports the excess. Iowa produces lots of ethanol, and exports the vast majority of it. Iowa produces no oil at all, but that makes up the vast majority of its energy consumption.
Gasoline consumption in Iowa is presently around 1.5 billion gallons per year (Source). The state consumes another 800 million gallons per year of diesel. According to the Iowa Renewable Fuels Association, gasoline blended with 10% ethanol (E10) makes up about 86% of the fuel supply. E15 and other mid-level ethanol blends (20% to 30%) currently amount to about 9 million gallons per year sold, while 85% ethanol blends (E85) make up another 13.5 million gallons per year.
Add it all up, and Iowa consumes less than 150 million gallons a year of the ethanol it produces. It exports the vast majority, but then it must import gasoline and diesel to meet its fuel needs. Can you imagine Saudi Arabia exporting essentially all of its oil, but then having to import some other fuel to meet its energy needs?
The 4.3 billion gallons per year of ethanol that Iowa produces has the energy content of about 2.6 billion gallons of diesel and gasoline. Thus, Iowa produces more than enough ethanol to be self-sufficient -- if it used the ethanol it produces. Yet, petroleum continues to supply over 90% of the fuel in Iowa, and virtually all of the fuel used in the farm equipment for growing all that corn. Meanwhile, Iowa is at the mercy of a trade war with China that is impacting its ethanol exports. Something is very wrong with this picture.
Making Iowa Self-Sufficient
If ethanol is a real alternative to gasoline, why don't Iowans consume as much as they can? Ethanol should have a greater advantage over gasoline in Iowa than probably in any other state. Ethanol should enjoy significant logistical advantages over oil in Iowa.
The problem is the price. According to data from the Energy Information Administration (EIA), the energy equivalent price of E85 is consistently 15% to 30% higher than for regular gasoline. That, in my opinion, is the single biggest factor in explaining why E85 has failed to take over the fuel market in Iowa.
Ethanol proponents will say that the oil industry keeps E85 out of the marketplace. But if the energy equivalent price for E85 is lower, they can't keep it out of the marketplace, because they can't stop people from opening their own E85 stations. Further, E85 is available across Iowa, and if the demand was higher, availability would increase.
The objective for Iowa -- and by extension all of the Midwestern ethanol-producing states -- should be to undercut the price of gasoline. There are several ways to accomplish this, albeit at a cost. Currently, the cost of our ethanol mandate is borne by refiners, and subsequently consumers across the country. The benefit flows from around the country into the Midwest. That is a nice arrangement for the Midwest, but not as good for the states that don't produce ethanol. Hence, the constant battles over the RFS.
If I was the governor of Iowa, my top priority would be to seize control of the state's ethanol destiny. I would do that by first estimating the overall benefit to the state from the ethanol industry. This would include all of the tax revenues associated with the industry, as well as those derived from corn farming.
I would then set out to provide a substantial fraction of those revenues as incentives for using E85. I would consider this an investment into building an E85 corridor across the Midwest. The objective would be to make the energy equivalent price of E85 consistently and appreciably less than the price of gasoline. (This could also be accomplished by additional taxes on gasoline, but incentives are an easier path).
I would also provide incentives designed to increase the usage of ethanol in farm equipment. Ethanol's high octane means it is resistant to preignition during compression. That means it can operate in engines with higher compression ratios than typical gasoline engines. (For example, see the Cummins ETHOS engine). It could also be used in farm equipment with modified diesel engines. But given the cost of diesel versus ethanol, farmers haven't shown much interest in ethanol-powered farm equipment.
Iowa does have some incentives in place, but they haven't been sufficient to kick-start the E85 industry. In order to ensure the future of Iowa's ethanol industry, they need to be increased.
Adopting these incentives would cause ethanol usage to climb, and gasoline and diesel consumption to decline. But, what are the trade-offs? Most importantly, Iowa could control its own destiny when it comes to one of its most important industries. Other states have done this. California has its own fuel standards. It has its own carbon markets. There is no reason Iowa couldn't do the same thing.
The downside for Iowa is that it would be less lucrative than the current arrangement. Presently, Iowa's ethanol industry is supported across the entire country, but it's a conditional support. The rest of the country doesn't see the same benefits, and thus unless something changes there will continue to be annual fights over the RFS. And some day, the RFS may be abolished. But, if Iowa has seized its own destiny, that's irrelevant.
Iowa is really just a case study for the top ethanol-producing state. But things get even more interesting if the entire Midwest used such a model.
Fuel Demand in the Midwest
The United States is divided into five Petroleum Administration for Defense Districts (PADDs). PADD 2 encompasses most of the Midwest. The states in PADD 2 are Illinois, Indiana, Iowa, Kansas, Kentucky, Michigan, Minnesota, Missouri, Nebraska, North Dakota, Ohio, Oklahoma, South Dakota, Tennessee, and Wisconsin.
According to the EIA, PADD 2 presently consumes about 5 million barrels per day (BPD) of petroleum products. Two of those states -- North Dakota and Oklahoma -- are also major oil producers. Overall, PADD 2 produces about 2 million BPD of oil. But PADD 2 is also responsible for nearly all U.S. ethanol production (~1.o million BPD).
Given the 3 million BPD shortfall between PADD 2's oil demand and its oil production, wouldn't it make sense to fill a larger portion of this demand with locally-produced ethanol? The energy content of 3 million BPD of oil products is equal to nearly 5 million BPD of ethanol. If E85 were to step up and fill that void, it would require nearly five times the nation's current ethanol production. That's probably not possible, but there is more than enough potential demand there to make the RFS entirely irrelevant. The ethanol industry would forever race to catch up to demand, instead of perpetually fighting over the mandate.
Conclusions
This week, ethanol futures plunged to a five-year low. Ethanol inventories are rising. The consulting group IHS Markit recently said that China, which had looked like a growing export market for U.S. ethanol producers, is now expected to turn to countries like Brazil in light of the ongoing trade war.
Thus, the U.S. ethanol industry continues to suffer from problems outside of its control.
Ultimately, building up an E85 market across the Midwest could fix the ethanol industry. If the Midwest adopted E85 as its flagship fuel, there would be no blend wall to be concerned about, nor would an expensive ethanol pipeline be needed to export ethanol out of the region. The potential market across the Midwest is far beyond the nation's current ethanol production, giving ethanol producers an ample opportunity to grow without constantly worrying about how they will be impacted by federal policies.
