U.S. Ethanol Market: MTBE Ban in California (27-FEB-02, 	 
GAO-02-440R).							 
								 
The 1990 Amendments to the Clean Air Act (CAA) requires that an  
additive (oxygenate) be added to the gasoline used in areas with 
excessive carbon monoxide or ozone pollution. The CAA		 
specifically requires those areas with "severe" ozone pollution  
to use reformulated gasoline, which contains at least two percent
oxygen by weight. In California, as in other areas of the	 
country, oil refining companies predominantly use the oxygenate  
methyl tertiary butyl ether (MTBE) to meet the CAA requirement.  
Because MTBE has been detected in ground water, the governor of  
California issued an executive order in March 1999 to ban MTBE in
the state's gasoline by the end of 2002. If California decides to
use ethanol to replace MTBE, ethanol production capacity from	 
2003 through 2005 could likely satisfy U.S. consumption. However,
if other states also banned MRBE and moved to ethanol,		 
consumption could increase and affect the industry's ability to  
meet demand. Moreover, production capacity projections may be	 
overstated because they include not only existing plants and	 
plants under construction, but also new plants being planned,	 
which may not materialize. Although prices have been relatively  
stable to this point, ethanol price spikes could occur in	 
California if supplies were disrupted by either production or	 
distribution problems.						 
-------------------------Indexing Terms------------------------- 
REPORTNUM:   GAO-02-440R					        
    ACCNO:   A02837						        
  TITLE:     U.S. Ethanol Market: MTBE Ban in California	      
     DATE:   02/27/2002 
  SUBJECT:   Alternative energy sources 			 
	     Energy consumption 				 
	     Energy industry					 
	     Fuel prices					 
	     Pollution control					 

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GAO-02-440R
     

United States General Accounting Office Washington, DC 20548

February 27, 2002

The Honorable Dianne Feinstein United States Senate

Subject: U.S. Ethanol Market: MTBE Ban in California 
Dear Senator Feinstein:

In response to your request, we obtained information on (1) U.S. ethanol
consumption, supply, and prices, as well as factors that could potentially
contribute to ethanol price spikes in California, and (2) the structure of
the U.S. ethanol market and conditions that could conceptually affect
competition. On February 22, 2002, we briefed your staff on the results of
our analysis. The enclosed slides formed the basis of the briefing we
presented.

The 1990 amendments to the Clean Air Act (CAA) requires that an additive
(oxygenate) be added to the gasoline used in areas with excessive carbon
monoxide or ozone pollution to help mitigate these conditions. The CAA
specifically requires those areas with "severe" ozone pollution to use
reformulated gasoline, which contains at least 2 percent oxygen by weight.
In California, like most other areas of the country, oil refining companies
predominantly use the oxygenate methyl tertiary butyl ether (MTBE) to meet
the CAA requirement. However, because MTBE has been detected in ground
water, the governor of California issued an executive order in March 1999 to
ban MTBE in the state's gasoline by the end of 2002.

In summary, if California decides to use ethanol to replace MTBE, ethanol
production capacity from 2003 through 2005 could likely satisfy U.S.
consumption, according to available ethanol industry projections. However,
if other states also banned MTBE and moved to ethanol, consumption could
increase significantly and potentially affect the industry's ability to meet
demand. Moreover, production capacity projections could be overstated
because they include not only existing plants and plants under construction,
but also new plants being planned, which may or may not materialize.
According to our analysis of average monthly data from 1993 through May 1998
(the latest data available), U.S. ethanol prices generally ranged from $1 to
$1.20 per gallon. While prices have been relatively stable to this point,
ethanol price spikes could occur in California if supplies were disrupted by
either production or distribution problems. Structurally, the U.S. ethanol
industry is currently highly concentrated, as measured by the
Herfindahl-Hirschman Index (HHI), a standard measure of market
concentration. According to the guidelines of the Federal Trade Commission
and the

U.S. Department of Justice, an HHI above 1800 is highly concentrated. Our
analysis of January 2002 data from the Renewable Fuels Association shows
that the U.S. ethanol industry's HHI is 1866. According to economic theory,
while high market concentration could conceptually limit competition in an
industry, this factor alone is not necessarily sufficient to determine
competitiveness of an industry. In addition to market concentration,
competition in the ethanol market could conceptually be affected by the
interaction of a variety of other factors, including the cost of initial
investment and the availability of substitute products.

Please note that information on future ethanol consumption and supply
contained in this report reflects the potential implications of the proposed
ban on MTBE in California by the end of 2002. We did not examine the
potential impacts of switching to ethanol on California's gasoline market or
on U.S. corn prices, both of which could ultimately be affected by the MTBE
ban.

This quick snapshot of the industry, based largely on data from other
federal agencies and industry sources, does not allow us to draw conclusions
or predict with accuracy the ethanol industry's capability to meet changing
demands. As agreed earlier, we will work with your staff to address any
remaining questions you may have.

We discuss our methodology in the enclosed slides. We provided portions of
the statistical information to the relevant federal agencies from which we
obtained data and they reviewed and verified the data. We performed our work
in February 2002 in accordance with generally accepted government auditing
standards.

As agreed with your office, unless you publicly announce its contents
earlier, we plan no further distribution of this report until 7 days after
the date of this letter. At that time, we will send copies to interested
Members of Congress. This letter will also be available on GAO's home page
at http://www.gao.gov.

If you have any questions about this letter or need additional information,
please call
me at (202) 512-3841. Major contributors to this letter included Godwin
Agbara, John
Furutani, Mike Hartnett, John Karikari, Mehrzad Nadji, Barbara El Osta, Amy
Stewart,
and Lynn Wasielewski.

Sincerely yours,

Jim Wells
Director, Natural Resources

and Environment

Enclosure

                U.S. Ethanol Market: MTBE Ban in California

         Briefing for Senator Feinstein's Office February 22, 2002

Objectives, Scope, and Methodology

* Objectives

(1) To what extent would ethanol supplies be available to satisfy
consumption if California bans MTBE after 2002, and what factors could
potentially contribute to

ethanol price spikes in California?

(2) What is the current structure of the U.S. ethanol market and what
conditions could conceptually affect competition in the ethanol market?

* Scope

* Review focuses on ethanol market and does not analyze impact on gasoline
or corn markets, both of which could ultimately be affected by the MTBE ban
and replacement with ethanol as an oxygenate.

* Methodology

(1) Interviewed officials, reviewed relevant documents, and analyzed data
from the ethanol industry and trade organizations, consulting firm,
petroleum industry, fuel-transportation

industry, DOE/EIA, USDA, DOT, CRS, the California Energy Commission (CEC).
We also estimated future U.S. and California ethanol consumption because we
did not find

projections reflecting the MTBE ban in California for this period.

(2) Reviewed relevant economic literature and interviewed officials from the
ethanol and petroleum industries as well as academia.

* We verified portions of the statistical information with relevant federal
agencies.

Background

* The 1990 amendments to the Clean Air Act (CAA) requires that an additive
(oxygenate) be added to the gasoline used in areas with excessive carbon
monoxide or ozone pollution to help mitigate these conditions.

* The CAA specifically requires those areas with "severe" ozone pollution to
use reformulated gasoline, which contains at least 2 percent oxygen by
weight.

* In addition, several areas have voluntarily chosen to use reformulated
gasoline to help achieve their clean air goals.

Figure 1: Reformulated Gasoline Program Areas

               Source: U.S. Environmental Protection Agency.

Background

* Under the CAA, about 80 percent of the gasoline used in California would
require oxygenate by 2003.1

* In California, like most other affected areas of the country, oil refining
companies predominantly use the oxygenate methyl tertiary butyl ether (MBTE)
to meet the CAA requirement.2

* Because MTBE has been detected in ground water, the governor of California
issued an executive order in March 1999 to ban MTBE in the state's gasoline
by the end of 2002.

1California already uses a special gasoline formulation, called California
Air Resources Board gasoline (CARB), that is more stringent than the
federally mandated specifications.

2MTBE is a chemical compound that is manufactured by the chemical reaction
of methanol and isobutylene. MTBE is produced in very large quantities (over
200,000 barrels per day in the U.S. in 1999) and is almost exclusively used
as a fuel additive in motor gasoline.

.

Background

* According to oil industry officials, ethanol, which is primarily produced
and used in the Midwest, is expected to become the predominant oxygenate
used if the ban goes into effect.

* Other areas of the country where MTBE is currently used may subsequently
eliminate MTBE, as recommended by a blue-ribbon panel commissioned by the
U.S. EPA.

* In addition to its use as a gasoline oxygenate, other fuel-related uses of
ethanol in the U.S. include use as: a gasohol blend, an octane booster, and,
to a smaller extent, a straight fuel for ethanol-fueled vehicles.3

3Gasohol is a motor fuel that is blended with up to 10 percent ethanol and
90 percent gasoline. Octane in gasoline helps to improve the combustion
properties of the fuel.

Ethanol Consumption, Supply, and Price

* U.S. ethanol supply, historically mostly from domestic production, has
been generally sufficient to satisfy consumption.

* While consumption increased from about 1,040 million gallons per year
(mg/y) in 1994 to about 1,480 mg/y in 2000, domestic production increased
from about 1,280 mg/y to about 1,630 mg/y. On average, domestic production
exceeded consumption in 5 of the 7 years.

* Moreover, data on production capacity-the combined quantity of ethanol
that all existing U.S. plants would be capable of producing-show producers
could have produced more during that period, if needed. Production capacity
exceeded both consumption and production for each of the 7 years from 1994
to 2000.

Figure 2: U.S. Ethanol Consumption, Production, and Production Capacity
(1994-2000)

Note: Production capacity numbers are not necessarily as of the end of the
year.

Sources: U.S. Department of Transportation, U.S. Department of Agriculture,
and BBI International.

Ethanol Consumption, Supply, and Price

California Consumption

* Banning MTBE in California and switching to ethanol by the end of 2002
would result in significant increases of ethanol consumption in California.

* We estimate, based on its projected gasoline consumption, that California
would consume an average of about 880 mg/y of ethanol from 2003 through
2005, as compared with only about 60mg/y in 2000.4

Figure 3: California Ethanol Consumption (2000, 2003-2005)

Sources: U.S. Department of Transportation and GAO estimates.

4 California's ethanol consumption projections are based on historical and
an annual growth of 1.1 percent for gasoline (using data from 1990 to 2000)
and 5.7 percent volume of ethanol requirement.

Ethanol Consumption, Supply, and Price

U.S. Market

* We estimate aggregate U.S. consumption of ethanol would increase under the
ban from about 1,480 mg/y in 2000 to about 2,780 mg/y in 2005.5

* Although a 2001 survey by the California Energy Commission (CEC) showed
that domestic ethanol producers could build up significant capacity that far
exceeds the projected consumption between 2003 and 2005, there are some
major caveats.6

Figure 4: U.S. Ethanol Consumption and Production Capacity (2000, 2003-2005)

Sources: U.S. Department of Transportation, California Energy Commission,
BBI International, and GAO estimates.

5 U.S. ethanol consumption projections are based on historical and an annual
growth rate of 5.1 percent of ethanol for the rest of the U.S., excluding
California (using data from 1993 to 2000), plus the projections for
California's ethanol consumption.

6According to the CEC, the results of this survey, including the production
capacity projections, represent the most complete inventory of current and
likely near-term U.S. ethanol producers available as of August 2001.

Ethanol Consumption, Supply, and Price

Caveats

* Consumption projections assume that only California would ban MTBE and
switch to ethanol during 2003 through 2005. If other states also ban MTBE
and switch to ethanol, U.S. ethanol consumption could be significantly
higher.

Figure 5. Oxygenate Use in Reformulated Gasoline Areas (2000)

               Source: U.S. Environmental Protection Agency.

Ethanol Consumption, Supply, and Price

Caveats (cont.)

* Projected production capacity includes existing plants, those under
construction or new plants planned. Projected capacity may be lower if some
existing plants cease production, plants under construction do not come on
line in time, or some new plants planned do not materialize.

Figure 6: Ethanol Consumption and Existing and Future Production Capacity
(2003-2005)

Sources: U.S. Department of Transportation, California Energy Commission,
and GAO estimates.

Ethanol Consumption, Supply, and Price

Caveats (cont.)

* The future role of imports is unclear.

* Currently, ethanol imports  do not play a significant role in U.S. ethanol
supplies.

* Brazil is the world's largest producer of ethanol, but about 85 percent of
its production capacity cannot be exported.

* The U.S. generally has a 54 cents/gallon tariff, which discourages ethanol
imports.

Figure 7: World Ethanol Production (1998)

                   Source: California Energy Commission.

Ethanol Consumption, Supply, and Price

* Based on average monthly data from January 1993 through May 1998 (the last
year we found data on U.S. ethanol price), the U.S. ethanol price has been
generally stable, staying approximately within the range of $1.00 to $1.20
per gallon, except during a period in 1996 when it exceeded this range.7

Figure 8: U.S. Ethanol Prices (January 1993 through May 1998)

Source: California Energy Commission.

7According to an agricultural economist at USDA whom we interviewed, ethanol
prices spiked during this period because of production declines caused
mostly by unusually sharp increases in the price of corn, which is a major
input into ethanol production.

Factors That Could Potentially Contribute to Ethanol Price Spikes in
California

* While difficult to predict with certainty, ethanol price spikes may occur
in California or elsewhere in the U.S. if a disruption at any point in the
supply system causes a temporary supply shortfall relative to demand.8

* Oil company officials based in California who plan to use ethanol for
oxygenate raised concerns about:

* Availability of excess capacity *Inventory

* Transportation

8There is no standard definition of price spikes. However, in a previous
report-U.S. General Accounting Office, Motor Fuels: California Gasoline
Price Behavior GAO/RCED-00-12 (Washington, DC: April 28, 2000)-we defined
gasoline price spike as a price increase of at least 6 cents a gallon in a
relatively short period of time-from 4 to 21 weeks.

Factors That Could Potentially Contribute to Ethanol Price Spikes in
California

Availability of Excess Capacity

* In general, if sufficient excess production capacity is not available,
ethanol producers may not be able to increase production to make up for
disrupted supplies, a situation that could exacerbate potential price
spikes.

* While officials from one oil company stated the ethanol industry has
estimated that there is currently an estimated 15-20 percent excess
capacity, future projected excess capacity is, in part, dependent on plans
for new plants that may or may not materialize.

Factors That Could Potentially Contribute to Ethanol Price Spikes in
California

Inventory

* If ethanol inventory is not sufficient to provide an immediate source of
supply, it could exacerbate price spikes during supply disruptions.

* Some officials of oil companies in California told us they plan to keep a
10-day inventory in storage but expressed concern about potential storage
infrastructure constraints in California, such as scarcity of land to build
storage.

Factors  That  Could  Potentially  Contribute to  Ethanol  Price  Spikes  in
California

Inventory (cont.)

* About  62 percent of U.S. ethanol inventory  available as of December 2001
was located in the Midwest.

*  Storage in  California  would be  more effective  in helping  to mitigate
potential  price spikes in  the state  than out-of-state storage  because of
potential delay in transit.

Figure 9:  Ethanol Stocks by Petroleum  Administration for Defense Districts
(PADD) in Millions of Gallons (December 2001)

   Source: U.S. Department of Energy, Energy Information Administration.

Factors That Could Potentially Contribute to Ethanol Price Spikes in
California

Transportation

* Ethanol imports from other regions are vital. However, any potential price
spike could be exacerbated if it takes too long for supplies from
out-of-state (primarily the Midwest, where virtually all the production
capacity is located) to make their way to California.9

Sources: Renewable Fuels Association and California Energy Commission.

9U.S. ethanol is produced largely in the Midwest corn belt because it is
generally less expensive to produce ethanol close to the feedstock supply.
About 90 percent of ethanol is produced from corn.

10According to EIA, PADD is the geographic aggregation of the 50 states and
the District of Columbia into five districts originally defined during World
War II for purposes of administering oil allocation.

Factors That Could Potentially Contribute to Ethanol Price Spikes in
California

Transportation (cont.)

* Inability to move ethanol quickly from areas where supplies are readily
available to where it is needed would exacerbate price spikes during supply
disruptions

* According to oil and ethanol industry officials whom we talked to,
transportation of ethanol from the supply areas of the Midwest to California
would be mostly by rail and barges, which can take about 1 to 3 weeks in
transit.11

* While rail and barge industry officials believe that they have sufficient
transportation capacity to move ethanol from the Midwest to California, some
oil industry officials have raised the concern that because of Jones Act
restrictions, there may not be sufficient vessels to move as much ethanol to
California as may be needed during supply disruptions.12

11A pipeline would be the fastest and most economical mode of transporting
ethanol, but shipping ethanol by pipeline is not feasible because of
insufficient volume and technical problems associated with such shipments.
Moreover, there is currently no pipeline connecting the Midwest to
California.

12The Jones Act, 46 U.S.C., appendix 883, requires the use of American
vessels to transport merchandise between points in the United States.

U.S Ethanol Market Structure and Conditions That Could Conceptually Affect
Competition

* As of January 2002, the U.S. ethanol market consisted of:

* 44 producers, using 58 plants in19 states, with total existing production
capacity of more than 2,311 million gallons per year, and

* 16 new producers with new plants under construction, with a total capacity
of 427 million gallons per year, which will slightly lower future market
shares of large incumbent firms.

U.S Ethanol  Market Structure and Conditions  That Could Conceptually Affect
Competition

*  Market share  of  the largest  eight  ethanol producers  is currently  71
percent and is projected  to decline to 60 percent as new producers complete
new plants under construction.

Note:  Percentages are  rounded  to the  nearest whole  number.  Source: GAO
analysis of Renewable Fuels Association data.

U.S. Ethanol Market Structure  and Conditions That Could Conceptually Affect
Competition

Table 1:  Factors That May Enhance or Limit  Competition in the U.S. Ethanol
Marketa

13The conceptual market structure and firms' behavior factors are based on
economic theory. See for example, "Economics of Strategy", by David Besanko,
David Dranove, and Mark Shanley (New York: John Wiley & Sons, Inc. 1996),
p.376.

14The existing market structure and firms' behavior are based on analysis of
data for ethanol producers, discussions and interviews with oil companies,
relevant trade associations, other federal government agencies, and relevant
economic literature.

U.S. Ethanol Market Structure  and Conditions That Could Conceptually Affect
Competition

U.S. Ethanol Market Structure  and Conditions That Could Conceptually Affect
Competition

U.S. Ethanol Market Structure  and Conditions That Could Conceptually Affect
Competition

U.S. Ethanol Market Structure  and Conditions That Could Conceptually Affect
Competition

aThis table is intended to discuss several market structure and behavioral
factors as applied to the ethanol market. However, the overall competitive
conditions or price implications for the U.S. ethanol market will depend on
the interplay of all these factors and cannot be determined by any one
factor alone.

bEach factor is discussed assuming all other factors as well as state and
federal regulations affecting ethanol production remain the same.

cThe Herfindahl-Hirschman index is a measure of firm concentration that
describes the size-distribution or the relative importance of both small and
large firms in an industry. It is defined as the sum of the squares of the
market shares of the firms in an industry.

dMarket shares are based on GAO's analysis of Renewable Fuels Association
data.

eAlthough about 95% of oxygenates in gasoline consist of MTBE and ethanol,
there are also other oxygenates approved for blending. These include TAME
(tertiary amyl methyl ether), ETBE (ethyl tertiary butyl ether), DIPE
(di-iso propyl ether), and TBA (tertiary butyl alcohol). Since the first
three also contain ethers, they also, like MTBE, raise environmental
concerns.

fEconomies of scale refers to the reduction in production costs per unit as
the firm size increases. Economies of scope exist when it is less costly for
one firm to produce two separate products than two firms to produce them
separately.

gThere are two main production processes in the ethanol industry: wet
milling and dry milling. Plants using wet milling have greater production
capacities, are more capital intensive, and produce a greater variety of
products than dry milling plants. The dry milling process traditionally
generates only two products-ethanol and DDG, an animal feed product.

U.S Ethanol Market Structure and Conditions That Could Conceptually Affect
Competition

* Other Factors That May Enhance or Limit Competition in the U. S. Ethanol
Market:

* High market power of customers relative to suppliers tends to lower the
purchase price.

* Frequent orders by customers enable rival suppliers to react faster to
each others' price.

* Volatile demand or costs make it difficult for suppliers to detect other
suppliers that are offering low prices.

* Vertical relationships by suppliers across the different production and
distribution levels (e.g., between corn and ethanol productions, ethanol
producers and transportation modes, etc.) could make it difficult for
smaller firms to compete in the ethanol production market. On the other
hand, the vertical relationships could lower costs to buyers.

* Import competition from other international ethanol producers is limited.
*** End of document. ***