Analysis: As corn burns, excess ethanol credits help dampen demand

NEW YORK Fri Jul 20, 2012 8:49am EDT

Corn plants struggle to survive in a drought-stricken farm field near Evansville, Indiana, July 18, 2012. REUTERS/John Sommers II

Corn plants struggle to survive in a drought-stricken farm field near Evansville, Indiana, July 18, 2012.

Credit: Reuters/John Sommers II

NEW YORK (Reuters) - As drought devastates the U.S. corn crop, relief from near-record prices may come from an unexpected quarter: oil companies, which may buy less ethanol than their government mandate suggests.

With a 50 percent surge in corn prices stirring fears of global food inflation and threatening to revive the debate over using crops for fuel, traders are zeroing in on a little-known niche of the ethanol business known as Renewable Identification Numbers (RINs) that may help ease the pressure on corn.

In essence, RINs are certificates used by refiners or fuel companies to demonstrate they are meeting their government mandate to use a set amount of renewable fuel every year.

Each RIN is a unique 38-character code that is assigned by an ethanol producer to each gallon or batch of fuel. When the fuel is sold to an oil company that blends the ethanol with gasoline, the RIN can then be "retired" to regulators, or sold on the market.

But they also serve a second function as a kind of relief valve in the event of a one-off crop crisis or price spike: if an oil company buys more ethanol than its minimum quota, it can keep about a fifth of those credits to use the next year.

While the mechanics of the RIN market can be dizzyingly complex, the upshot is simple: Oil firms with surplus RINs could use those paper credits in lieu of buying physical ethanol next year, ultimately reducing demand for corn to make the fuel.

Because the role of RINs is not widely appreciated, some say the U.S. Department of Agriculture (USDA) may be overestimating corn-for-ethanol demand by as much as 10 percent.

"The general view is that there is a floor, or a minimum, for demand for corn for ethanol," says Nick Paulson, an assistant professor in the University of Illinois' agriculture and consumer economics department, who wrote a paper on RINs in March that has become required reading for grain traders.

"We wanted to show that there's this bank of RINs that has been building up so that if we got into a situation in which blending became unprofitable, these companies could meet a portion of their mandate through RINs. This will come into play in a major way for 2013."

That "floor" is now the topic of intense debate in the grains market as traders look for signs that near-record prices are slowing demand for corn. Weekly ethanol production has dropped by more than 9 percent since mid-June to the lowest in more than two years, according to data released on Wednesday.

BULLISH CORN, BUY RINS?

The Renewable Fuel Standard (RFS2) that establishes annual U.S. biofuel use quotas is the last vestige of a once sizeable scheme that was meant to support the development of a home-grown ethanol sector, supporting farmers and curbing oil imports.

While blender credits and import tariffs have fallen away, the RSF2 still creates a base line of demand for an industry that in most other ways runs on an economic model -- one that is now suffering the greatest strain since the 2008 financial crisis, when a wave of bankruptcy decimated the sector.

RINs were intended to create a degree of flexibility within the system, allowing companies from giants like ExxonMobil (XOM.N) to small fuel importers to meet as much as a fifth of their ethanol quota using surplus RINs from the previous year, or borrow the same amount against the coming year. Firms can also trade RINs on a secondary market if they need more.

In recent years, ethanol blending has been running in excess of the RFS2 quota because ethanol has been cheaper than gasoline, making it profitable to blend the maximum. Nearly 3.5 billion gallons worth of 2011 RINs have not yet been used, Environmental Protection Agency data shows.

Of those, some 2.6 billion are eligible for use against this year's 13.2 billion gallon renewable fuel target. Converted into corn, that's 1 billion bushels that oil companies would not need to buy this year if they choose to use up their stockpiled RINs.

With first-half ethanol output strong and inventories high, few expect them to erode that paper surplus this year, even with some producers now closing plants and cutting output.

But the scenario for next year is far different.

In just weeks, the worst drought since 1956 has decimated what was expected to be a record corn harvest, extending what some ethanol producers had hoped would be just a short-term supply squeeze deep into 2013. The U.S. government has already cut its corn crop estimate by 12 percent, with more losses likely.

Prices for 2012 RINs have surged this month as blenders scrambled to ensure they maintained a healthy ending stock for next year. Prices trebled to some 4 cents a gallon over the past three weeks as corn prices surged toward a record $8 a bushel.

With corn prices racing higher and output falling, ethanol futures prices have risen 30 percent over the past four weeks while New York gasoline futures have climbed only 12 percent -- reducing the economic incentive to blend fuel. Ethanol prices are now only about 25 cents less than gasoline, down from a more than $1 discount in April.

"Part of the problem for (ethanol) margins is that there is not that much demand but plenty of supply," said Bill Day, spokesman for Valero, which owns both ethanol plants and refineries. Valero is one of several companies that has shut some ethanol production.

The last time ethanol was significantly more costly than gasoline was in late 2008 and early 2009 -- a period in which RIN prices surged to more than 16 cents as blenders scrambled to buy coverage for a production shortfall.

"If you want to be bullish on corn, go out and buy RINs," said one trader, who declined to be named.

BLEND WALL LOOMS

Oil companies also have a second reason for wanting to maintain a maximum suplus of RINs for 2013: as the fuel blending mandate rises another 5 percent, many fear they won't be able to sell enough ethanol-blended gasoline to meet their target.

Most service stations are already pumping out E10 (10 percent ethanol), and are unwilling to sell a higher blend for fear of lawsuits from car makers or drivers -- despite EPA assurances that E15 blend is safe for most modern cars.

Without some accord to cover engine warranties, a practical "blend wall" at the 10 percent threshold threatens to prevent companies from injecting more ethanol -- in which case stockpiled RINs may be the only way to satisfy the RSF2. Those who don't meet it face penalties of up to $37,500 per day.

"There's an incentive now for companies to carry forward RINs into the coming years in order to cover themselves when the blend wall comes into play," said Pat Westhoff, director of the Food and Agricultural Policy Research Institute (FAPRI) at the University of Missouri.

"The market would not be happy if we ran out of RINs."

But neither can companies cut ethanol use too deeply.

Sean Hill, an economist with the U.S. Energy Information Administration, said he expects demand for ethanol would be about the same as it is now even without the EPA renewable fuel rules, thanks to the Clean Air Act which requires the use of oxygenate to reduce carbon monoxide in gasoline.

After Methyl Tertiary Butyl Ether was banned in 2005, ethanol became the cheapest and most widely used oxygenate.

PRODUCER PAIN EQUALS LIVESTOCK GAIN

Now the trick is calculating just how much ethanol the blenders will buy -- or, rather, how much they won't buy, opting instead to draw upon the previous year's RINs.

It is not a simple matter.

For one thing, the surprisingly rapid decline in U.S. gasoline demand has a direct effect on ethanol demand.

Each blender's quota is equivalent to a proportion of its overall fuel sales, not an absolute volume. In 2012, renewable fuel -- primarily ethanol -- must comprise 9.23 percent of an company's gasoline sales. The EPA establishes that percentage by dividing the target volume -- established by law -- by the estimated motor fuel consumption for a given year.

With gasoline demand this year down as much as 5 percent from last year, the oil firms need to buy less ethanol.

The picture is further complicated by ethanol trade. Exports boomed last year and earlier this year, but now look to dry up as Brazil's output of ethanol made from sugar becomes more competitive with the U.S. corn-based fuel.

What is clear to some observers, however, is that the U.S. Department of Agriculture's estimates on the amount of corn to be used to produce ethanol look too high.

From September 2012 to August 2013, the corn crop year, the USDA estimates that 4.9 billion bushels will be consumed by ethanol plants, enough to make about 13.2 billion gallons -- identical to the minimum quota for this year, in fact.

That figure was revised down from 5 billion bushels last week, but to many it still appears unrealistically high.

"I can't see using more than 4.5 billion," said the RIN trader, who declined to be named.

Others disagree, saying livestock companies and importers are more likely to cut back quickly in the face of corn prices that are just 15 cents away from a record high.

"To me, it will be very hard for them to trim a good 100 million bushels out of new crop corn for ethanol," says Rich Nelson, director of research at Allendale Inc, an agricultural advisory firm. "The real demand destruction comes from exports and corn for feed."

What is clear to most, however, is that RINs have become a critical new piece of the puzzle.

"In recent years RINs have been viewed as a hassle and transaction cost. It was profitable to blend so the fuel companies generated more than they needed," said the University of Illinois' Paulson. "That's changing. I think RINs are going to be approached in a very different way in the coming months."

(This story removes reference to 2011 RINs, corrects contract year for 2012 in paragraph 19)

(Reporting By Jonathan Leff and Janet McGurty; editing by Jim Marshall)

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