The evolution of the ethanol industry continues at a brisk pace. U.S. ethanol production capacity has grown tremendously over the past several years. But recent lower ethanol prices, combined with still-strong corn prices, have put a damper on continued expansion. At the beginning of 2007, the ethanol price started out at around $2.50 per gallon. But prices have backed off since then, with recent ethanol prices between $1.50 and $1.70/gal. This price drop has tightened margins at ethanol plants across the nation. But at the same time, the price drop has provided new growth opportunities in ethanol, on the blending side.

Ethanol Blends

Ethanol is blended with gasoline for a variety of reasons. It is an octane booster, it is an alternative fuel source for use in conventional fuels and it is an additive that can be used to meet Clean Air Act standards. Ethanol received a boost by means of this last reason when the additive MTBE was removed from the market. The MTBE removal occurred mostly in May 2006; ethanol blending jumped from 35% to 45% over the course of that month. Ethanol blending has exceeded 50 percent for a couple of months over the past year at times when ethanol prices have dropped. These monthly spikes are likely due to ethanol being used as a relatively cheaper alternative fuel source for conventional fuels. And given ethanol’s current pricing situation, this type of usage will continue to grow as more ethanol enters the fuel market as part of conventional gasoline.

Regional Differences

The gasoline market can be broken down into two components: the conventional and the reformulated gasoline markets. Reformulated gasoline is gasoline that is manufactured to meet Clean Air Act requirements and is mainly marketed in large urban areas on the East and West Coasts. It was in this reformulated gasoline market that ethanol replaced MTBE. In July 2007, over 11 billion gallons of gasoline were produced, and nearly half of that total was blended with ethanol. Roughly two-thirds of the ethanol-blended fuel entered the reformulated gasoline market, with the rest entering the conventional gasoline market. But when you look at various regions of the country, the blending story changes. On the coasts and in the southern U.S., nearly all of the ethanol-blended fuel is reformulated. But for the Midwest and Northern Plains, most of the ethanol-blended fuel is sold as conventional gasoline. With ethanol-blended fuel already dominating the reformulated gasoline market, the new growth area for ethanol is in the conventional gasoline market.

There are three main areas for ethanol usage: California, the upper Midwest and New York and Connecticut. The California and New York markets are the largest reformulated gasoline markets; even before the phase-out of MTBE, ethanol had captured a sizable portion of those markets. The upper Midwest market was mainly on the conventional gasoline side, with cheaper, locally sourced ethanol and state-level incentives and mandates. But ethanol usage outside of these markets was small to non-existent. In 15 states, no ethanol-blended fuel was sold. In 13 additional states, use of ethanol-blended fuel was below 5%. So ethanol has several additional markets it could potentially tap into. And the lower prices we are now seeing for ethanol provide some economic incentives for gasoline blenders to target ethanol-blended fuels in the southern U.S., New England and the Pacific Northwest, where ethanol has not traditionally been sold.

Pricing Factors

In January2007 in Omaha, NE, a gallon of gasoline was priced at $1.49, while a gallon of ethanol was $2.26/gal. At these prices, an E-10 blend cost 7.7¢/gallon more than regular unleaded before taxes. Even after accounting for the ethanol blender’s tax credit, the E-10 blend was still 2.6¢ more. In September, the price of gasoline had risen to $2.30/gal., while ethanol had fallen to $1.93/gal. With these prices, the E-10 blend is 3.7¢ less expensive before taxes and 8.8¢ less after federal taxes. This large incentive to blend ethanol has only increased with recent further declines in ethanol prices.

Ethanol Logistics, Demand, and Policy Effects

Several companies are moving to add ethanol-blending capacity and relieve what some have called a blending bottleneck. For example, Gulf Ethanol out of Houston is looking to build the first ethanol blending facility near the port of Houston, taking advantage of existing rail and barge shipping lines. And the market for ethanol through conventional gasoline continues to grow. Florida has recently allowed two E-85 pumps to be operated in the state and will likely have E-10 expansion throughout the state in the near future. Hawaii, Iowa, Louisiana, Missouri, Montana, Oregon and Washington have all followed Minnesota’s move to set renewable fuels standards or ethanol mandates. California will allow blenders to move from 5.7% blends to E-10 blends on January 1, 2010.

While most of the economic and political incentives are pointed toward increases in ethanol blending, other policy changes may come down the line in terms of government support. As part of the farm bill debate in Congress, the Senate Finance Committee has approved the Heartland, Habitat, Harvest, and Horticulture Act of 2007. The bill provides funding and budget offsets for several agricultural programs. One of the provisions of the bill is a 5¢ reduction, to 46¢/gal., in the ethanol blender’s tax credit once U.S. ethanol production exceeds 7.5 billion gallons/year. However, with ethanol being priced below gasoline, the incentives are still there to blend ethanol, even with the possible reduction in government support.¶