A mess we made: The biofuels fiasco

A food versus fuel debate has raged for the past few years as ethanol consumes more and more of the U.S. corn supply. Ethanol will use about 40 percent of the U.S. corn crop this year, and for the first time ever, more corn will go into motor fuel production than into feed for livestock. As the National Cattlemen's Beef Association has pointed out, since Congress mandated the use of ethanol in the nation's fuel supply, corn use by ethanol mills has increased by 382 percent, yet with a limited supply of farmland and the need to grow other crops, plus some less than ideal weather conditions this year and last, corn production has increased only 5.4 percent over the same period.

As a result, ethanol policy has been a major contributor to reduced red meat production. Per capita beef supplies for next year are projected to be at their lowest level since 1955. Food inflation is rampant?--?especially in categories where corn is a significant input. To date, poultry prices are up 3.4 percent over last year, milk and dairy is up 9.1 percent, pork is up 7.5 percent, and hamburger is up 10.4 percent. All categories are projected to increase even more next year. Moreover, the impact is not just domestic, as more than 60 percent of the world's tradable corn supply originates in the United States.

Food versus fuel is not the only market distortion caused by the federal mandate to use ethanol in the U.S. motor fuel supply. The federal regulations and mandates of what feedstocks may be used to make which biofuels are now creating chaos within the fuel sector?--?which hits motorists and taxpayers in the pocketbook, too.

Consider that within the overall mandate that 36 billion gallons of ethanol be used for fuel by 2022, ethanol distilled from corn is limited to 15 billion gallons because of food versus fuel concerns. Despite already consuming 40 percent of the U.S. corn supply, corn ethanol has not yet hit its 15 billion gallon limit. Nonetheless, there still is more corn ethanol being produced than the market can absorb because of slackened motor fuel demand and a number of regulatory barriers.

Federal support for the ethanol industry has resulted in an excess, and thus exportable, supply of ethanol. Sold politically just four years ago in the 2007 Energy Independence and Security Act as a means to secure domestic energy independence, subsidized American ethanol is now exported to Great Britain, Finland, and the Netherlands, helping them comply with biofuel mandates issued by the European Union. Complex biofuel policy schemes are not just a U.S. mania.

While excess corn ethanol is exported, however, the U.S. market is still short of overall biofuel supply to meet the 2007 mandate. To make up the 21 billion gallons difference between corn's allotted maximum and the total biofuels mandate, so called advanced biofuels?--?which are simply those made from feedstocks other than corn?--?are also prescribed by statute.

Biodiesel is one such advanced biofuel. It is mostly made from soybean oil. The federal mandate for biodiesel use provides for one billion gallons by 2012. That is more than one-third of the country's total soybean oil supply. While blenders of corn ethanol enjoy a 45 cents per gallon tax credit, biodiesel receives a $1 per gallon tax credit. At wholesale prices above $5.50 in mid-October, even the dollar reduction provided by the tax credit still leaves biodiesel far more expensive than the $3.80 per gallon retail price of petroleum diesel.

For a time, the $1 tax credit provided a huge incentive to import soy oil from South America, blend it with a small amount of petroleum diesel to claim the U.S. tax credit?--?the blending often occurred while the tanker ship was still in port?--?and then re-export the blended fuel to Europe to further capture EU subsidies. That little scheme was known as "splash and dash," and it was a $300 million subsidy to promote domestic biofuel use that did not in fact subsidize biodiesel use in the United States.

Consider the absurdity of splash and dash at its height: According to the Department of Energy, in 2008 the United States produced 678 million gallons of biodiesel and exported 677 million gallons. We imported 315 million gallons, and domestic U.S. consumption was 316 million gallons. That particular stratagem ended in 2009, but exports haven't. Despite not meeting the mandated minimum for domestic biodiesel use last year, more than a third of the biodiesel produced in this country was exported in 2010.

Biodiesel production dropped more than 40 percent in 2010 from 2009 levels?--?down to 311 million gallons, even though there was a mandate to use 650 million gallons that year. The reason for the production shortfall was the expiration of the $1 per gallon blenders' credit. That production drop-off provides a glimpse of the economics of biodiesel. Without the tax subsidy, production was not quite half the minimum mandated consumption level. Congress then restored the tax credit for 2011?--?and did so retroactively, providing a windfall subsidy to the 2010 production, which had already occurred without the credit. The tax credit is due to expire again at the end of this year.

Another category of so-called advanced ethanol is cellulosic, made from grass, wood, and other nonstarch feedstocks. Cellulosic producers now get a net tax subsidy of 56 cents per gallon. Plus, there's a small-producers' tax credit of 10 cents per gallon for ethanol producers who make less than 60 million gallons per plant. For context, 60 million gallons is about five times the most robust market projection for total cellulosic ethanol production in 2012, so effectively all cellulosic producers qualify for the additional subsidy.

Indeed, cellulosic technology has not hit the break-even point yet. So, despite the mandate that fuel retailers use it, there is no commercial supply available. The shortfall is so acute that the prescribed 100 million gallon mandate for 2010 was reduced to 6 million gallons; the 250 million gallons mandated for 2011 were reduced to 7 million. That is a 337 million gallon shortfall in meeting the mandate.

While the cellulosic portion of the advanced biofuel mandate was waived, the overall mandate for advanced biofuels was not. So with corn-based ethanol not eligible, the difference has to be made up by a third category of advanced ethanol referred to as "undifferentiated," which includes biodiesel and imported Brazilian sugar-based ethanol.

So the United States now imports ethanol from Brazil to meet the federal mandate for ethanol use, and yet those imports are subject to a 54-cents-per-gallon tariff to protect the U.S. domestic ethanol industry. Ethanol is also imported from Canada, which is not subject to a tariff, and owing to trade agreements and foreign policy considerations, the United States is committed to importing ethanol from all Caribbean Basin countries, with special set-asides for El Salvador and Costa Rica. Remember: Despite all this import and export activity, ethanol policy was justified on grounds of U.S. energy independence.

Yet, just as the shortfall of advanced biofuels has created a new demand for Brazilian sugar ethanol imports, Brazil has reduced its ethanol production. In fact, Brazil has even begun to import ethanol to meet its own biofuel mandates. Imports into Brazil so far in 2011 include corn ethanol from the United States. Before long, ships carrying U.S. corn ethanol southbound could regularly pass ships carrying Brazilian sugar ethanol northbound?--?a sort of splash and dash part two, driven by the U.S. mandate for "advanced" biofuels rather than by a tax credit.

On top of all the complexity of the tax credits, tariffs, and the import quotas, the federal mandate by feedstock category creates an intricate compliance system. Energy companies who comply with blending regulations to meet the mandate are issued a "renewable identification number," known as a RIN. These are 38-character numeric codes to trace the transfer of biofuels. Even the National Biodiesel Board itself confesses that "a RIN may look, at first glance, like a wicked advanced algebra problem," but "in reality, it is the basic currency for . . . credits, trading, and use by obligated parties and renewable fuel exporters to demonstrate compliance, as well as track the volumes of renewable fuels."

There is a sophisticated secondary market for RINs among "obligated parties"?--?i.e., energy companies who must blend biofuels into petroleum-based fuels to meet the standards. Companies who earn RINs may sell them to companies who don't. It is a miniature cap and trade regime.

Energy companies who cannot procure advanced biofuels on the market because supplies are not available are forced to buy RINs. Given the production situation?--?overproduction of corn ethanol combined with severe underproduction of advanced bio-fuels--it came as no surprise to industry observers when a Maryland biodiesel producer was indicted for fraudulently selling counterfeit RINs.

Yet, to effectively maintain the overall biofuels mandate imposed in 2007, the Obama EPA recently proposed to increase the 2013 biodiesel mandate above the statutory level of 1 billion gallons to 1.28 billion gallons. There can only be one outcome: U.S. diesel users will pay more for fuel in order to offset the cost of imported sugar ethanol from Brazil and the lack of viable commercial cellulosic production technology. This was foreseeable when President Bush proposed, and Congress adopted, the mandate for cellulosic ethanol back in 2007. For all intents and purposes cellulosic fuel did not exist at the time. Nonetheless, its use was mandated.

If cellulosic ethanol were to reach the market, on top of the excess corn ethanol supply, there would have to be higher concentrations of ethanol in retail fuel blends?--?which is the ethanol industry's primary policy goal now as they keep fingers crossed for a cellulosic breakthrough. But there are a few problems with increasing the blends. First, cars get lower mileage when fueled by the blends. This puts the ethanol mandate in tension with the federal mandate for the auto fleet to achieve higher fuel efficiency.

Second, there is the issue of damage to engines from burning ethanol blends. The ethanol content in fuel is currently limited to 10 percent. The Environmental Protection Agency is finalizing a regulation to allow 15 percent blends (so-called e-15), but even the EPA has admitted this can harm engines, issuing a statement warning that "all motorcycles, all vehicles with heavy-duty engines, such as school buses, transit buses, and delivery trucks, all off-road vehicles, such as boats and snowmobiles, all engines in off-road equipment, such as lawnmowers and chain saws, and all model year 2000 and older cars, light-duty trucks, and medium-duty passenger vehicles (SUVs)" are prohibited from using e-15. Needless to say, this will cause chaos at the gasoline pumps.

Finally, as if that weren't enough, in the offing lurks another compliance challenge. The 2007 energy statute limits the production of crops for biofuels mainly to land that was "existing agricultural land" at the enactment of the bill. Specifically, that means land that was cleared or cultivated prior to December 19, 2007, and since that time has been in continuous agricultural use. While the fuel market is a little more than halfway to its ultimate 36 billion gallon goal for biofuel use by 2022, land use is already at 98 percent of that cap. Once the cap is met, each gallon of biofuel will have to be classified by its feedstock and also certified to have originated on preexisting farmland. More regulation, more record keeping, more costs.

Ethanol started out as the quintessential subsidy program back in the 1970s. It cost a large number of taxpayers a relatively small amount of money apiece to provide a large benefit to a relatively small number of beneficiaries. It didn't hurt that most of the beneficiaries were?--?and still are?--?in Iowa, where 25 percent of all ethanol is produced. Average farmland prices in the Hawkeye State have grown from about $2,600 per acre to $6,400 per acre since 2004, the year before the latest mandate was put in place. In 2004, owning 385 acres of typical Iowa farmland made you a millionaire. Today 160 acres will do the trick.

If politicians had set out to cater to and enrich some of the most influential voters in our presidential primaries every four years, they could scarcely have come up with a more ingeniously targeted policy. But the program is now starting to collapse under the weight of its own complexity and market distortion. Indeed, biofuels policy is now recognized by many of those same politicians as a program of dubious if not harmful environmental impact that imposes major costs on taxpayers and food consumers?--?with additional costs to motorists soon to come.

There are proposals in Congress to establish a trigger based on corn stocks to waive the corn ethanol mandate temporarily, to let states opt out of the federal mandate, and to deny the tax credits afforded biofuels. Those proposals are intended to address the budgetary costs and the now-widely recognized food versus fuel impact of biofuel -policy. But, even if they are adopted, a mind-numbingly convoluted regulatory regime will be left in place. As long as Iowa looms large in our -quadrennial selection of presidential candidates, don't look for leadership on the issue to arise in this White House, or its successors.

Dave Juday is an agricultural commodity market analyst. The opinions expressed in this commentary are solely those of the author.