The EPA is not the Federal Reserve of oil markets

Energy market pricing behavior seems contrary to the relationship between supply and demand. The oddly behaving RIN market is an intermediate factor that influences gasoline prices for automobiles. RIN (Renewable Identification Numbers) should be decreasing. Instead, they are too high.

Bio-fuel pricing anomaly

RIN establish compliance with standards for non-fossil fuel usage, specifically, for corn-based ethanol as a blend in gasoline. In 2007, legislation was passed to encourage greater use of ethanol. The percentage requirement of ethanol is set by the EPA. It increases annually, and is calculated at an aggregate level, measured volumetrically, over all U.S. domestic consumption.

My favorite energy blog, Platt’s Oil Barrel, featured a guest post* by former Special Assistant to President Obama and Senior Director for Energy and Climate Change of the National Security Council Jason Bordoff, explaining anomalous RIN price behavior, and what the EPA is doing about it. He noted two reasons for the seemingly anomalous pricing.

Hitting the blend wall

Renewable Fuel Standards (RFS) were revised in 2007, based on the assumption that gasoline usage would increase over time. In fact, it has not done so, not consistently. Instead, it decreased during 2011-2013, yet the schedule of increasing amounts of ethanol has remained, as legislated. As a result, according to Bordoff, we are now hitting the “blend wall”, when blenders physically cannot put enough ethanol into the gas supply to comply with RFS law.

Bordoff identified a second reason:

broad-based skepticism in the market that EPA will use its waiver authority to avoid the blend wall—even though EPA just went to unusual lengths to signal precisely that it will.

Federal Reserve v. EPA: Powers and purpose

The bio-fuel situation bears an odd resemblance to the rational expectations based logic of monetary policy. It is difficult for the Federal Reserve to effectively signal to markets, e.g. the anticipated (and appropriate!) end of quantitative easing. The Federal Reserve System has taken measures to increase transparency. Fed Governors Bernanke and Yellen hold scheduled press conferences. Bernanke was the first Federal Reserve governor to do so. The Fed was audited by the GAO in 2012. Federal Open Markets Committee (FOMC) meeting notes are published and posted online.

wow.. just wow.. Citi talking of QE4 now with inflation expectations collapsing pic.twitter.com/ZzH2u7nrA8

— Chris (@lebullmarche) October 8, 2014

The Fed also has the necessary tools to carry out monetary policy e.g. quantitative easing known as QE.

@lebullmarche @LadyFOHF OMG | QEn s.t. n = 1 ~> ? It is unnatural. Fed wasn’t intended for this; is worse than a centrally planned economy

— Ellie Kesselman (@EllieAsksWhy) October 8, 2014

Despite all of the above, the “job creators” aren’t investing, and the Fed is now contemplating QE4.

Industrial Production and Capacity Utilization

The Philadelphia Branch of the Federal Reserve Bank released its September 2010 Industrial Production and Capacity Utilization report this morning. It is an interesting economic indicator, due to its frequency (monthly), timeliness (within a fortnight of the prior month-end), and long history of well-documented tracking, readily available from 1972 through the present.

The salient number, based on my review and recall from past days of buy-side proprietary trading of fixed-income securities, is the capacity utilization percentage. This is why:

• Rising industrial production levels, in absolute terms, were driven by technological progress in manufacturing methods, more than increased economic activity.
• The same can be said for capacity, although the Fed does provide helpful indexing as a percentage of the historical peak level in 2007.
• Utilization is the percentage of actual capacity used for production, which indicates to me the level of demand  required for actual goods (not services!) and thus the demand for U.S.-manufactured industrial products, as a percentage of the maximum possible supply that could be produced.

The preliminary annualized utilization for September 2010 is 74.7% of capacity. This is well below the yearly average of 80.6% from 1972 through 2009. However, utilization of capacity has increased from the 2008-2009 low of 68.2%, as well as the September 2009 value of 70.5%. While I feel some concern about the economic situation in the immediate months ahead, it is encouraging to note the breakdown by process stage:

• For crude production, the operating rate increased 0.7% points to 86.9%, almost half a point higher than the 1972 to 2009 average
• For primary and semi-finished stages, utilization declined 0.6% points, to 71.5%, about 10.1% points below the long-run average
• For the finished stage, utilization decreased 0.1% points to 73.8%, about 3.7% points below the long-run average

If crude production rates drive primary, semi-finished and finished stages, then the more historically comparable rates of crude manufacturing will perhaps carry through into the later stages of production in the next three manufacturing reports of the fourth quarter of 2010.

*Note that for the purposes of this Federal Reserve Statistical Release, the industrial sector is comprised of manufacturing, mining, electric and gas utilities, as well as the logging, newspaper, periodical, book, and directory publishing industries.