Are We Shocked That Wall Street Hoarded Ethanol Credits?

Source: Loren Steffy, Contributor, Forbes • Posted: Monday, October 28, 2013

Discovering that Wall Street is gaming the market for ethanol credits is about as shocking as finding gambling in Rick’s Casino. The New York Times reported that traders for large banks and other institutions hoarded the credits as new, stricter federal standards forced refiners to buy more of them. The result: a 20-fold spike in the price of the credits in six months. The only bank identified by executives in the piece, JP Morgan Chase, denied that it was stockpiling credits, yet the idea that Wall Street would game the market was a concern even before the government created ethanol credits eight years ago.

Once again, we have created a false market and then greet with surprise the notion that Wall Street would exploit it. You can’t have a free market when the basis for that market is fiction. In the article, Thomas O’Malley, chairman of PBF Energy PBF -2.58%, expressed surprise that Wall Street banks “helped transform an environmental program into a profit machine.” As he told the Times:

The justification, of course, is that Wall Street saw an chance to make money by exploiting the naiveté of environmental policy disguised as a market. Markets, after all, are driven by the desire to make money, and it seems the designers of the ethanol credit put their policy interests ahead of market fundamentals. This is the same problem with the cap-and-trade proposals to limit carbon emissions,by the way. Lawmakers, environmentalists and policy wonks keep believing that crunchy granola capitalism — environmentalism flavored with free market imitations — is a way to sell regulation across the political spectrum.

The flaw of the Renewable Fuels Standard, which created the market for ethanol credits, was that it tried to influence the market with an incentive that wasn’t economically viable. It created goals that weren’t even achievable given the limits of technology. That meant the demand — and therefore the price — for fuel credits was going to rise because refiners couldn’t function without them. Wall Street simply did what it always does: it put itself in the middle.

If ethanol made economic sense, we wouldn’t have needed the fuel standard. At the time, of course, the Bush administration was less concerned with economics than with creating an artificial means of reducing our dependence on foreign oil. The ”free market solution” of mandating that gasoline include an ethanol blend was appealing.

The fuel standard wasn’t just designed to reduce crude oil consumption or promote ethanol, but to encourage the development of the next generation of biofuels. It laid out a 15-year program, laced with incentives, all based on the assumption that cellulosic was just a few years away from being as viable as corn-based ethanol. That technology has proven elusive, and ethanol’s poor economics have made the standard a burden rather than a benefit. Essentially, refiners have been forced to buy more credits, because the fuel they need under the law simply doesn’t exist or doesn’t exist in large enough quantities to meet demand.

At this point, given the decline in U.S. oil imports thanks to the shale boom, we don’t need to be forcing more corn-based ethanol into the gasoline pool. While there’s a benefit in maintaining the ethanol infrastructure and continuing to encourage the development of next generation biofuels, the standard needs to be reworked to reflect the current abundance of domestic oil and natural gas production. As it stands now, the Renewable Fuel Standard is a piece of dinosaur legislation that is hamstringing the market. The fact that Wall Street stepped into exploit that failure shouldn’t surprise anyone.