Source: Morgan Stanley • Posted: Tuesday, August 14, 2012

A new report by Morgan Stanley analysts finds that ethanol demand is a function of economics and not the renewable fuels standard (RFS2).

“Just as ethanol demand did not decline when the $0.45 blenders’ tax credit expired, so long as ethanol remains economically attractive to blend, any change to the RFS is unlikely to impact demand,” Morgan Stanley analyst Vincent Andrews, along with several colleagues, wrote today. “Further, significant structural constraints also make moving away from ethanol challenging,” the report noted.

The report comes as the RFS has been under attack in recent weeks, with calls by some to reduce this year’s conventional biofuel requirement (mostly comprised of corn-based ethanol) of the provision, citing the current drought situation.

Last week, a handful of meat and poultry groups filed the second formal request to waive the RFS, asking EPA for a waiver “in whole or in substantial part” of the amount of renewable fuel that must be produced under RFS for the remainder of this year and for the portion of 2013 that is one year from the time the waiver becomes effective. The first waiver, filed by Texas Gov. Rick Perry (R) in 2008, was denied by the agency.

“It is hard for us to believe the mandate [RFS2] would be repealed, as such an action would set a very negative precedent for future government endeavors that required side-by-side private sector investment (i.e., the U.S. would walk away just a few years into the program, leaving private investors in a lurch),”

The report explained. “This is not to mention that ethanol plants have been an incremental source of employment and there is no obvious place for those workers to go should their plant shutdown. Further, gasoline prices would go up as a consequence if less ethanol were used. Finally, 2012 is an election year and after the election, the country likely has larger scale issues on hand.”

As the report explained, “[e]conomics, not politics, drives ethanol use today. Other than an outright ban of ethanol use, we do not believe that any policy change will materially impact ethanol demand (and therefore corn prices), as regardless of the RFS mandate, U.S. blenders have an undeniable economic incentive to maximize the amount of ethanol in U.S. gasoline (ethanol costs $0.35 per gallon less than RBOB gasoline). Further, the corn, ethanol and gasoline futures curves all suggest that blending will remain profitable well into the future,” the report noted.

Meanwhile, “[t]here are significant structural impediments to moving away from ethanol,” the report continued. “First, blenders cannot simply switch to using more gasoline blendstock, as this would not meet industry octane/oxygenate requirements. At present, ethanol is the most available and least expensive source of both. Switching from ethanol blending to conventional gas requires retooling refineries and finding cost competitive alternative octane/oxygenate sources, which we believe would be challenging given the sheer size of the ethanol market vs. alternatives markets such as toluene,” the report noted. “This is not to mention that the cost of substitutes is already in excess of ethanol. Finally, we believe that at least 34% of U.S. gasoline runs through common pipelines/terminals with a standard ethanol blend percentage. In the absence of the RFS, a blender is likely to blend ethanol simply from a logistics cost perspective, even if the underlying ethanol blending economics are negative,” the analysts wrote.