Will the Drought Also Cause the Renewable Fuels Standard to Shrivel?

This post was written by James Coan, research associate at the Baker Institute Energy Forum.

In the wake of the record drought affecting much of the country, the U.S. Department of Agriculture (USDA) released on Friday an extremely pessimistic paper projecting much lower production of corn and soybeans this year. The report is sure to incite more citizens and legislators to demand that the mandate requiring ethanol consumption in the United States be temporarily relaxed or waived.

The USDA projects a corn crop of 10.8 billion bushels, or a decline of more than 12% from  last year’s crop of about 12.4 billion bushels. Unsurprisingly, given the large magnitude of this drop in production, the USDA also expects corn prices to keep rising.

At this juncture, much of the U.S. corn crop is used to make ethanol. Last year, about 28% of U.S. corn production was consumed to make ethanol (and this number jumps to about 40% if one does not account for the animal feed produced from the corn that cannot be turned into fuel).

The U.S. currently has a mandate called the Renewable Fuels Standard (RFS) that requires consumption of 15.2 billion gallons of renewable fuel. While there is no specific requirement that corn be used – in fact, there is a cap that a maximum of 13.2 billion gallons can come from domestic corn – there are very few sources to fill the immediate gap. Now that there is no longer a tariff on imported ethanol, the most plausible source for additional ethanol would be Brazil, but Brazil’s entire production in 2011 was 5.6 billion gallons, barely one-third of the U.S. mandate, and much of Brazil’s production is used for its domestic market.

Faced with the prospect of the mandate further squeezing the market and increasing the price of corn, legislators are calling for the Environmental Protection Agency (EPA) to grant a waiver to relax the ethanol standard, at least temporarily. 156 House members and 25 Senators have sent letters to EPA Administrator Lisa Jackson demanding she water down the renewable fuel mandate. They say it’s within her jurisdiction to do so. According to the Senators, “As part of EISA [the Energy Independence and Security Act, which created this RFS], the Congress included “safety valves” that enable the agency to adjust the RFS in the event of inadequate supplies or to prevent economic harm to the country, a region, or a state.”

Some of these members of Congress are also trying to pass legislation to force the EPA to weaken the RFS by up to 50%. Rather than relying on the Administrator’s discretion, the bills tie the mandate to a ratio of the stocks and total demand of corn.

Weakening the mandate should lower costs to consumers for both fuel and food – although it obviously will result in a smaller windfall for the farmers who still have crops to sell. The savings to an average household should be in the range of $100 a year, as explained below. While the savings in lower food and ethanol prices from suspending the Renewable Fuel Standard are virtually guaranteed, any increase in oil prices is very likely to be small, if it occurs at all. At present, the U.S. is enjoying a surplus of oil refining capacity, given the sluggish U.S. economy and improving car mileage efficiency.

Corn for ethanol is currently more expensive than oil, even without accounting for its lower energy content, which is about 2/3 that of gasoline. At current record corn prices ($8.29/bushel on Friday) and conversion rates (2.8 gallons/bushel), just the raw corn costs about $3/gallon of ethanol. Oil would have to be about $120 a barrel to be the same cost per gallon – or more like $180 a barrel in energy-equivalent terms!

A research economist from the USDA says that for each 50% increase in the price of corn, food prices typically climb about 1%. According to the government’s Consumer Expenditure Survey, an average American household in 2010 spent $6,129 on food and $2,132 on gasoline and motor oil. Thus, if the mandate causes corn prices to double, households would see an increase in their costs of more than $100 a year from food costs alone.

Meanwhile, the effect on world oil prices from reduced ethanol production is likely to be very modest. In energy-equivalent terms, total U.S. production last year of ethanol last year was only slightly over 600,000 barrels a day. This is less than 1% of the global market, which consumes nearly 90 million barrels a day.

The USDA seems to think that either Congress or the EPA will act and choose to weaken the mandate. It assumes that demand for corn will drop by 400 million bushels, or about 10%. If it keeps releasing frightening reports about how the drought is devastating the corn crop and causing prices to soar, the USDA may very well turn out to be right.