NEW YORK (Reuters) - The price of corn ethanol, the main renewable fuel mixed into gasoline in the United States, has surged 10 percent since last week, reaching a two-year high near $2.22 a gallon on Friday.
Corn futures also rose to two-year highs in the week since the U.S. Department of Agriculture (USDA) forecast a smaller-than-expected corn harvest and the tightest supplies in 15 years.
Also boosting share prices for U.S. ethanol makers, the Environmental Protection Agency on Wednesday approved lifting maximum ethanol content in gasoline to 15 percent from 10 percent, a measure known in the industry as E-15..
Decatur, Illinois-based Archer Daniels Midland, the top publicly-traded ethanol maker, is supportive of higher ethanol blends, and its shares rose to near a record high on Thursday.
Is the smaller corn crop projection and the E15 measure reason enough for investors to load up on ethanol futures and biofuels shares? Or is ethanol ripe for a fall due to the rare premiums to gasoline futures, which traded at $2.14 a gallon on Friday -- 7 cents a gallon cheaper than ethanol futures?
Some analysts and traders see room for a further rally.
"It is a good time to buy ethanol forward since corn is going to be in short supply and E15 is bullish," said Peter Covella, a trader for Noble Energy, which expects an even smaller U.S. corn crop than USDA's 12.664 billion-bushel estimate.
Morgan Stanley analysts said in a note this week that ethanol may cost as much as $2.59 a gallon on average next year, and corn prices may also rise if the White House approves planned subsidy changes to encourage higher blend rates.
EPA approval of higher blends does not make them obligatory, and it could take months or years before E15 gasoline catches on at filling stations. But even the existing 10 percent U.S. blending mandate should lift ethanol prices any time corn is in short supply, especially when fuel demand is rising, Swiss-based ethanol and sugar consultant Jonathan Kingsman told Reuters this week.
"Ethanol prices are likely to continue to move in line with corn demand, because demand for ethanol is inelastic due to the mandate," Kingsman said.
U.S. consumption of liquid fuels including gasoline and ethanol should rise modestly this year and next, when it's projected to top 19 million barrels a day, according to the Energy Information Administration (EIA).
But the share of ethanol in the mix is surging. U.S. renewable fuel standards call for ethanol use of 15 billion gallons by 2015, up from 12 billion gallons this year. EIA sees domestically produced ethanol use growing nearly 19 percent this year from 2009, and another 3 percent in 2011.
Brazil, the largest ethanol exporter, is unlikely to provide U.S. blenders with more supplies this year. Made from sugarcane, Brazilian ethanol is in tight supply, with domestic demand growing more than 15 percent a year. U.S.-bound shipments are also discouraged by steep ethanol import tarrifs, likely to be renewed for next year.
"Ethanol prices in Brazil are currently even higher than in the U.S., so we won't see exports from there," said Covella.
While EPA has approved E15 for use only in cars built from 2007 on, it is soon expected to approve it for cars up to 10 years old, raising demand further.
Not all experts see ethanol as a sure bet, and even those bullish on the fuel's long-term prospects see factors that may cause prices to tumble from current highs.
One of the world's top corn processors sees a good chance U.S. corn crop yields will exceed the USDA's reduced estimate that sparked the latest rally in corn and ethanol prices.
"We still think there's a lot of room for the crop to grow. Grain yields are growing over time," Jeff Broin, CEO of privately-held POET, the largest U.S. ethanol producer, told Reuters this week.
Broin declined to forecast ethanol prices, but does expect them to revert to a discount to gasoline, giving ethanol back a competitive advantage at the pump.
Ethanol's current high price deters "discretionary" blenders from using more of it. Some can opt for other fuel additives, known as oxigenates, while others buy credits known as RINS (renewable identification numbers), allowing them to blend less than 10 percent ethanol. When ethanol prices surged last week, the cost of RINS doubled.
Meanwhile, the E15 faces opposition from the automotive, oil and food sectors. The biggest hurdle may be convincing service stations to adopt it at all, given potential liabilities.
"The main issue that has not been addressed by the EPA and needs further legislation is auto warranties. Currently driving on a higher ethanol blend than 10 percent invalidates auto warranties," Credit Suisse analysts said in a note on Thursday.
The top independent U.S. oil refiner Valero Inc, which is also a major ethanol producer, this week balked at introducing higher blends at service stations.
"It's hard to imagine any retailer, including Valero, selling the E15 blend at its sites without liability or warranty protection," Valero's Bill Day said.
Some also have doubts about US ethanol subsidies. Some Republican lawmakers oppose generous blender credits and steep ethanol import tarriffs. Republicans are expected to gain congressional seats in November 2 midterm elections, potentially winning a majority in the House of Representatives. Some have pledged to work on repealing ethanol mandates or subsidies encouraging its use.
Finally, economic woes are still hitting U.S. fuel demand. Gasoline demand -- the main driver for a lift in ethanol consumption -- has been anemic. EIA data last showed it down last week from year-ago levels.
Additional reporting: Inae Riveras, Jeff Kerr, Janet McGurty, K.T. Arasu and David Brough; Editing by David Gregorio