What a Waste! The EPA’s Biofuel Boondoggle

When we set unrealistic goals and fail to achieve them, we pay the price in wasted time and effort. But when the government mistakes the desirable for the possible, the price is all too often paid by someone else, and sometimes by innocent bystanders.

That’s been the case with the cellulosic fuels mandate foisted on the refining industry by Congress in 2007.

That legislation targeted production of 1 billion gallons of fuel from cellulose this year. Now the Environmental Protection Agency (EPA), the mandate’s administrator, is demanding a mere 14 million gallons. And when that arbitrary quota once again goes unmet it could face another lawsuit from the refining industry stuck with an unjust bill for Washington’s wish fulfillment.

Some background on this episode in misgovernment. Between 1978 and 2005, the US government supported the ethanol industry with various tax credits. The industry grew very slowly, but by 2005 ethanol output had reached 3.9 billion gallons annually, produced almost exclusively from corn.

Then came the Energy Policy Act of 2005, which imposed a Renewable Fuel Standard (RFS) requiring 7.5 billion gallons of renewable fuel — primarily ethanol — to be blended into the fuel supply by 2012.

The ethanol industry soon found itself in financial trouble because capacity was overbuilt in the rush to cash in on the mandates. Margins suffered as supply exceeded the quotas. But the government came to the rescue by expanding the ethanol mandate with the Energy Independence and Security Act (EISA) of 2007. The new Renewable Fuel Standard — the RFS2 — accelerated the quotas for renewable fuel. Instead of 7.5 billion gallons by 2012, the new law required 9 billion gallons by 2008, soaring to 36 billion gallons by 2022.

Biofuels mandate chart
The RFS2 also established new categories of renewable fuel, and set separate blending requirements for each. One was for cellulosic biofuel.

Cellulose is the structural material of cell walls composed of linear chains of sugars. There are various ways to break these chains into individual sugars, which can then be converted into fuel such as ethanol. But Mother Nature didn’t design cellulose to break down easily, and therein lies the big challenge.

Yet Congress mandated 100 million gallons of cellulosic biofuel in 2010, increasing to 250 million gallons the next year, 500 million gallons in 2012, and finally 1 billion gallons in 2013. If the mandated volumes were not met by gasoline blenders — primarily oil refiners — the blenders were required to buy credits based on their shortfall.   

Congress did allow the EPA to lower the biofuel quotas in the event of a production shortfall, or if the agency found that required volumes would severely harm the economy or the environment. For instance, when the drought last summer reduced the corn supply, the EPA was petitioned to waive part of the ethanol mandate. (It refused.)

But how did Congress come up with the mandated volume? Why did lawmakers require 100 million gallons in 2010, for instance? Funny story. Since the onus for meeting the mandates was on the gasoline blender, there was absolutely no accountability demanded from would-be cellulosic biofuel producers who over-promised what they could deliver. In fact, the more they promised, the higher the mandate was likely to be. So they assured Congress that this industry could be created and scaled rapidly — as long as taxpayers generously funded the venture.

In 2009, the EPA did an assessment of the expected contributions from prospective biofuel producers, and concluded that the 100 million gallon mandate for 2010 could be met. The EPA noted that “the largest volume contributions were expected to come from Cello Energy and Range Fuels” (Source).

These two companies were backed by billionaire venture capitalist turned green energy entrepreneur Vinod Khosla. Despite taking hundreds of millions in taxpayer and investor dollars, neither company ever produced a single qualifying gallon of cellulosic biofuel, and both companies soon went out of business. In fact, no company produced any qualifying cellulosic fuel in 2010. Or 2011.

In 2012 the first batch of qualifying cellulosic fuel was produced by Blue Sugars Corporation (previously KL Energy). Blue Sugars received the first cellulosic ethanol tax credits under the RFS2 for a 20,069-gallon batch of cellulosic ethanol produced from bagasse — waste plant matter from the sugar industry — in April 2012 and then exported to Brazil as a demonstration. The EPA shows no other cellulosic ethanol produced in 2012, but does show that 1,074 gallons of cellulosic diesel was produced in November 2012. It probably came from KiOR (NasdaqGS: KIOR).

When it became obvious that the mandates could not be met, the EPA did in fact reduce them. In 2010, EPA rolled the 100 million gallon cellulosic fuel mandate back to 6.5 million gallons. That lowered mandate wasn’t met either; as noted above there was zero production in 2010 or 2011 (when the 250 million gallon mandate was reduced to 6.6 million gallons).

Because there was no commercial production in those years, the fact that EPA didn’t reduce the mandates to zero meant that gasoline blenders were fined for not buying product that didn’t exist. The American Petroleum Institute (API), an energy industry group including the refiners, sued the EPA over the issue. On Jan. 25, the United States Court of Appeals for the District of Columbia ruled that the EPA had based even its reduced cellulosic fuel quotas on wishful thinking rather than on sound analysis, and invalidated the cellulosic biofuel mandate for 2012.  (See the court decision here.)

Some excerpts from the ruling:

…we are not convinced that Congress meant for EPA to let that intent color its work as a predictor, to let the wish be father to the thought.

We do not think the text or the general structure of the RFS program supports EPA’s decision to adopt a methodology in which the risk of overestimation is set deliberately to outweigh the risk of underestimation.

EPA points to no instance in which the term “projected” is used to allow the projector to let its aspirations for a self-fulfilling prophecy divert it from a neutral methodology.

…the most natural reading of the provision is to call for a projection that aims at accuracy, not at deliberately indulging a greater risk of overshooting than undershooting.

Apart from their role as captive consumers, the refiners are in no position to ensure, or even contribute to, growth in the cellulosic biofuel industry. “Do a good job, cellulosic fuel producers.  If you fail, we’ll fine your customers.”

A full reading of the court decision makes it clear that the EPA was chastised for its methodology in setting cellulosic biofuel quotas. Even though the EPA rolled the 500-million-gallon mandate for 2012 back to 8.65 million gallons of cellulosic fuel, only about 20,000 gallons of qualifying cellulosic fuel was produced (about 0.2% of the mandated volume.)

Yet, amazingly, just days after the court ruling debunking its methodology, the EPA set the 2013 cellulosic ethanol mandate at 14 million gallons. While this is a tiny fraction of the original 1-billion-gallon mandate legislated in 2007, it is still 60% higher than last year’s round of wishful thinking. I suspect that EPA is going to lose another lawsuit this year.

Where did the EPA come up with 14 million gallons? The Washington Post reported that the agency expects to get a lot of it from Vinod Khosla, the same person whose companies failed them so miserably in 2010:

The agency’s new projection of 14 million gallons of cellulosic ethanol matches the amount that venture capital investor Vinod Khosla, in an interview in October, said would be produced this year at a small commercial plant in Mississippi by Kior, a company he is backing. Another company, Ineos, expects to produce some, too. And POET, one of the world’s largest corn-based ethanol producers, is constructing a cellulosic-based plant that might be done this year.

I went on record in 2007 predicting that the initial RFS mandates couldn’t possibly be met. In a 2008 article, I predicted that companies like Cello and Range Fuels would soon begin to fail:

The next few years will see a record amount of backpedaling from most of the companies trying to establish a foothold in this space – and overpromising on their technology to do so. There will be the normal litany of excuses – such as ‘the oil companies are suppressing the technology’ – but in the end the chemistry, physics, and most importantly the capital costs and logistical challenges will catch up with them. Yes, excuses will be made, but those who know a little about the technology will know what really happened.

Today I will go on record and predict that actual qualifying production of cellulosic biofuels this year will be less than a quarter of the EPA’s 14 million gallon projection. In fact, I expect it to be less than one-tenth of its projection, but I do expect some cellulosic fuel will be made. It will be very expensive to produce, and every gallon will be produced at a loss. The production volumes will ultimately depend on the amount of investor and tax dollars these companies can continue to pull in.

Some will argue that this is to be expected with new technology. However, most people don’t realize that cellulosic ethanol isn’t new technology. The Germans first commercialized cellulosic ethanol from wood in 1898. Commercialization first took place in the US in 1910. The Standard Alcohol Company built a cellulosic ethanol plant in South Carolina to process waste wood from a lumber mill. Standard Alcohol later built a second plant in Louisiana. Each plant produced 5,000 to 7,000 gallons of ethanol per day from wood waste, and both were in production for several years before they were shut down due to poor economics. Since then, there have been many attempts around the world to commercialize cellulosic ethanol, and all have failed for straightforward reasons of physics and chemistry.

So we have the US government mandating a technology that has already proven to be a commercial failure. Congress attempted to mandate an industry into existence. Of course, any time the government is handing out “free money” there will be those who attempt to tell a convincing story of how they can succeed so they can get their hands on that money. And that has taken place over the past half dozen years. Lots of money has been lost by fast-talking promoters, but almost zero fuel has been produced.

My recommendation to investors would be to avoid the entire biofuel sector. There may be some companies that survive, but they won’t have high profit margins. The vast majority of companies in this sector will ultimately go bankrupt (just as many already have), and the rest will depend on government support for the foreseeable future. This sort of artificial industry is not one in which I would put my money.

The episode demonstrates the folly of the government attempting to pick technology winners. Government was convinced that cellulosic fuels were the way to go, and tried to mandate an industry into existence. Can you imagine if it took the same approach to curing the common cold? Just mandate a cure within five years, and then levy fines if that goal isn’t met. Congress would probably think that was a silly idea, and yet they happily spent our tax money on another silly idea.

To conclude, I want to make it clear that I do not oppose biofuels. Certain biofuels and certain approaches will ultimately be successful, and in fact will be needed in some situations. Rather, I oppose the method by which Congress and the EPA have attempted to mandate specific technologies into existence. There are far more effective ways of incentivizing the production of alternative fuels without picking technology winners and wasting tax dollars.   

Around the Portfolios

Sandridge Mississippian Trust II (NYSE: SDR)
Shares of the Growth Portfolio holding were dragged through the mud and discounted  nearly 15 perfcent Friday after the trust announced a disappointing quarterly distribution. Sandridge will pay just over 53 cents a share to holders of record as of Feb. 14, down from nearly 60 cents a share the prior quarter and 11 percent shy of its targeted distribution. Those distribution targets were set last spring based on Sandridge’s evaluation of reserves on trust properties as well as actual output during the first three months of last year. Raymond James downgraded the trust from Outperform to Underperform after the miss and drew a troubling inference about the future. The analyst noted that production declined 7 percent, and more than that for crude oil, despite a big increase in drilling by Sandridge. “We can only conclude that these wells are either not achieving the initial production results that we were expecting or are declining at a much faster clip than previously anticipated,” the analyst wrote. We have changed our rating on the trust to Hold and will have a further update shortly.       

Oasis Petroleum (NYSE: OAS)
The Aggressive Portfolio holding had much better production news, reporting that output more than doubled in 2012 and forecasting an increase of at least 33% for 2013. At the same time, capital spending on wells is forecast to drop, Wunderlich raised its target on the stock to $60 a share, praising the reduced costs as well as the shrinking discount of the Bakken crude Oasis sells relative to the West Texas Intermediate. At this pace, the comoany could be self-funding this year, noted the analyst.

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