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Why is Ethanol Rela/vely Expensive in the U.S.?
Firas Abu-‐Sneneh, Colin A. Carter & Aaron Smith
University of California, Davis
7th Annual Berkeley Bioeconomy Conference, March 2014
نيدوواااالع هللا بدة عريفش
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Ethanol is typically priced above its energy content, i.e. Pethanol > 0.7*PBOB
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$ /G
allon
Gasoline Ethanol price on energy basis
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Actual Use vs. Mandated Use
• Ethanol use exceeded the mandate.
2%
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Actual Blend Rate Mandate Rate
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Poten/al Explana/ons
1. Ethanol is NOT expensive – Volumetric subs/tutes: buy ethanol as long as
Pethanol ≤ PBOB – Cheap source of octane
2. Mandate is binding
– RINs accumula/on for later years
– Switching is costly, and occurs region by region, limi/ng compe//on
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Rela/ve price in the U.S. vs. Brazil
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1.6 Jan-‐10
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Dec-‐17
Price of ethan
ol/Price of gasoline
U.S. Brazil
Perfect substitutes: energy content
Perfect substitutes: Volumetric
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Octane
• Ethanol could decrease produc/on costs by subs/tu/ng expensive inputs.
• Ethanol has high octane ra/ng (good), but also high vola/lity (bad).
• We run an LP model to es/mate demand for ethanol, given its rela/ve price and aeributes.
• Given recent prices, ethanol will not minimize produc/ons costs.
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Does ethanol in the mix reduce the price of BOB?
• If ethanol reduces produc/on cost, then introducing it should have decreased the price of BOB, once controlling for oil prices.
• Natural experiment: ethanol in mix allowed refiners to switch from 87 to 84 octane BOB.
• Regress BOB on crude price & switch dummy.
• Null hypothesis: No effect. We fail to reject.
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Switching between blends is costly
• Adjustment of BOB
• Coordina/on costs
• E10 receives a vola/lity waiver; other blends are more costly to produce
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Switching occurs regionally
• Economies of scales favors holding one blend.
– Most infrastructure designed to hold limited grades of gasoline.
– Pipeline logis/cs limits the ability to transport mul/ple BOBs to same loca/on.
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Model of blender’s choice with switching costs.
• A refiner operates in two iden/cal regions and faces the following mandate – Year 1: ethanol blend rate must be 4%
– Year 2: ethanol blend rate must be 9%
• To minimize cost and meet the mandate the refiner should either:
A. Switch one region to E10 in year 1 and switch to E10 in year 2
B. Switch both regions to E10 in year 1
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Model of blender’s choice with switching costs.
• Blending rate is thus either: – 5% in year 1 and 10% in year 2 – 10% in both years
• Giving the impression that mandate is not binding, when in fact it is.
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Should a region switch early or not?
Demand
E0 Supply
E10 Supply
$/Mile
Miles
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Should a region switch early or not?
• Demand for gasoline is extremely inelas/c.
• Producer surplus is maximized when prices are higher.
• Compe//on keeps prices down
• Mandate allows implicit collusion; sell inferior product at higher price
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Conclusion
• Mandate increase U.S. gasoline prices by raising the price of ethanol.
• Market rigidi/es result in limited compe//on between gasoline blends.
• This disconnects the rela/ve price of ethanol to gasoline from consumer preferences.
• The mandate is set at a quan/ty above equilibrium, leading to a higher ethanol price.
• It also leads to vola/le price rela/onship between ethanol and gasoline.