Dakota Beacon

Since 1978, in order to support and promote the consumption of ethanol in the United States, Congress has granted generous tax preferences to ethanol production.   The current tax preference is known as the Volumetric Ethanol Excise Tax Credit (VEETC), which provides a $.45 credit per gallon credit for the blending of ethanol into motor fuel.  This credit is applied against the blenders’ federal excise tax obligation.
Recent studies, however, have shown that the VEETC is extravagantly redundant.  Indeed, the credit is applied on top of a federal mandate that requires by law the use of ethanol in the nation’s motor fuel supply, therefore the benefits from the credit are a windfall to the ethanol industry.  Consider the conclusions of a report commissioned by the Grocery Manufacturers Association, conducted by the firm Advanced Economic Solutions of Omaha.   According to the report:

“… removal of the tax credit would reduce federal tax expenditures by over $6 billion, but would only decrease US ethanol production by three percent. This reflects the redundancy of the tax credits and the federal mandates for incorporation of ethanol into the US fuel supply. The results also suggest that under the baseline scenario $6.95 billion would be spent during 2015 in order to incent an additional .45 billion gallons of production – equal to $15.45 per gallon. …. (Moreover) the $6.95 billion tax expenditure would add only 353 additional ethanol manufacturing jobs – an annual cost of $19.68 million per job”.

That – and the dire need to reduce federal spending - is why Congress is likely to let the excise tax credit expire at the end of this year.  However, the ethanol industry is pushing for a significant part of the tax credit to be extended to be used to fund infrastructure expansion for biofuels.  The rational is that such infrastructure subsidy spending is necessary to scale what the biofuel industry has deemed the blend wall.

The blend wall is a combination of regulatory and physical factors that put a limit on the amount of ethanol that can be absorbed into the nation’s motor fuel supply.  First of all, vehicle engines are meant to run on 10 percent ethanol blends; higher blends could cause engine damage and void manufacturer warranties.  While EPA has proposed raising the allowable blend to 15 percent, there are still large numbers of vehicles and off-road engines that could not use higher ethanol blend fuels.   A complete and expensive revamping of the nation’s auto and light truck fleet would be necessary to create new so called flexible fuel vehicles. 

Moreover, there are storage and delivery issues.  There is a lack of pumps, pipelines, and storage tanks suitable for high ethanol blends – all to be built at a considerable cost.  In 2009, to address the potential need to raise the level of ethanol in gasoline, DOE’s National Renewable Energy Laboratory (NREL) with Underwriters Laboratories (UL) and Oak Ridge National Laboratory (ORNL) began testing fuel retail station equipment and materials to determine how the most common equipment in the existing fuel infrastructure would perform with 15 percent ethanol blends.  Late in 2010, UL released the results of their work for NREL and, in March 2011, ORNL released their report.  The results of NREL’s research indicated that 70% of the used equipment tested and 40% of the new equipment tested yielded non-compliant or inconclusive test results.  ORNL’s testing showed that seals and gaskets will be impacted the most by the switch to E15 and may eventually develop leaks. 

That is why the biofuels industry is seeking billions in subsidies to retrofit the nation’s fuel infrastructure.  Consider, the US biofuel supply today is only about 40 percent of the total mandated level of 36 billion gallons to be used by 2022, and we are already experiencing blend wall issues.  Indeed, the US is now exporting ethanol that cannot be absorbed into the US fuel supply, and in the next 10 years the supply of biofuels under the federal mandate will more than double.

Of course, biofuels were mandated back in 2007 as a means to reduce the nation’s reliance on imported oil, establish energy independence, and to be a catalyst to economic growth in the farm belt.  Ironically, though, we are starting to export our domestic biofuels and much of the oil to be displaced by an expanding biofuels supply would otherwise come from North Dakota, where new oil finds since the biofuels mandate was put in place have exceeded expectations.

In 2008, the US Geological Survey conducted an assessment of recoverable oil in North Dakota in the Bakken shale formation (which extends into Montana and Canada), reassessing their original 1995 evaluation and increasing their projection by a factor of 25 fold.  Now with evidence that the formation is even larger, USGS is now conducting yet a third survey this fall.  For a benchmark comparison, by 2015, the Bakken shale formation will provide about 700,000 barrels per day of oil; total U.S. production of ethanol is about 880,000 barrels per day.  By 2015, however, with car fuel efficiency standards and ethanol subsidies and mandates, gasoline demand could begin to incrementally decline. 

Thus, from North Dakota’s perspective, the most critical fuel infrastructure problem is not the lack of blender pumps nor flexible fuel vehicles. It is, however, the lack of infrastructure to ship out the oil and natural gas production in the state that has tripled from 2005 to 2010, has increased another 20 percent this year, and is expected to more than double within five to seven years.  That is why North Dakota crude oil currently trades at a discount to West Texas Intermediate (WTI) crude prices in Cushing, Oklahoma.  The WTI/Cushing price is the benchmark for the petroleum futures contact. 

According to experts, the lack of “take away” capacity (now pegged at 189,000 barrels per day, with a 360,000 barrels per day production) will only get worse as production continues on this pace.  Indeed, North Dakota is the fastest growing oil producing state, and will soon surpass all other states expect for Texas.  North Dakota in 2009 surpassed Lousiana as the nation’s fourth largest oil producing state, and since 2008, North Dakota oil has been shipped by rail to Lousiana to earn a premium price.

From a policy perspective, the question is whether to let market forces dictate the pace of private sector investment in additional infrastructure capacity to move this fungible supply of oil from the US northern plains, or to maintain expensive subsidies to create a market for an additional supply of biofuels that itself is a reaction to federal intervention into the market and that will increasingly displace US domestically produced oil that is trading at a discount to the market.  Subsidies for biofuel infrastructure will only make the investment in North Dakota oil less attractive – and it won’t make US energy independence any more tangible.

 

Dave Juday is a commodity market analyst and principal of The Juday Group