Does blending ethanol in transportation fuels lower costs?

While widespread drought has driven corn prices up in the U.S., pinching ethanol producers, debate has emerged about the economic impacts of blending corn-based ethanol into gasoline and diesel used as transportation fuel.

As local gas pumps may tell you, U.S. transportation fuels may contain ethanol.

Under the EPA's U.S. Renewable Fuel Standard program, transportation fuel sold in the United States must contain a certain amount of renewable fuel.  Corn is the feedstock for the vast bulk of the ethanol biofuel used to meet the renewable fuel standard.  Despite near-record levels of corn planting, drought across much of the country has led to crop reductions and high prices for corn.  At the same time, the demand for gasoline and diesel has not grown as it had been projected to do.  This slackening of demand comes from both increases in vehicle energy efficiency and decreases in fuel demand due to the economic slowdown.  Between higher feedstock costs and reduced product demand, many biofuel ethanol producers are struggling or failing to turn a profit.

Some policy questions surrounding the blending of corn ethanol into transportation fuel remain controversial.  One argument used to support the practice points to evidence that blending ethanol into gasoline and diesel reduces the cost of fuel.  A widely-cited study by Xiaodong Du and Dermot Hayes titled "The Impact of Ethanol Production on U.S. and Regional Gasoline Markets" found that over the period of January 2000 to December 2011, growth in ethanol production for fuel reduced wholesale gasoline prices by an average of $0.29 per gallon.  Looking at 2009 alone, they reported that the average effect across all regions increased to $1.09/gallon, with regional price suppression  impacts ranging from $0.73/gallon in the Gulf Coast to $1.69/gallon in the Midwest. 

Not so, according to a study released earlier this month by Christopher Knittel and Aaron Smith.  Their July 12, 2012 paper, Ethanol Production and Gasoline Prices: A Spurious Correlation, disputes many of the findings of Du and Hayes's research.  In Knittel and Smith's view, the previous researchers' results were "driven by implausible economic assumptions and spurious statistical correlations".  Like Du and Hayes, Knittel and Smith provide a detailed analysis of the "crack spread" and "crack ratio", measures of the margin associated with refining.  They challenge the accuracy of the previous study's results, arguing that "the empirical results are extremely sensitive to the empirical specification; however, empirical models that are most consistent with economic theory suggest effects that are near zero and statistically insignificant."

Which view is more accurate is a question that remains to be seen.  The answer may have implications for the future course of U.S. policy on blending corn-based ethanol into gasoline and diesel fuels used for transportation.