By Cezary Podkul
NEW YORK (Reuters) - With two words, the U.S. environment regulator may be handing oil refiners the biggest win of a long battle to beat back the seemingly inexorable rise of ethanol fuel.
In a leaked proposal that would significantly scale back biofuel blending requirements next year, the U.S. Environmental Protection Agency (EPA) says the blend wall - the 10 percent threshold of ethanol-mixed gasoline that is at the crux of the lobbying war - is an "important reality".
The agency's rationale for a cut in the volume of ethanol that must be blended echoes an argument the oil industry has been making for months: the U.S. fuel chain cannot absorb more ethanol.
Few retailers are able to sell ethanol blends beyond the 10 percent maximum, or willing to take the legal risk that comes with it, they argue.
The words will cut deep for proponents of biofuels. They have argued for years that the blend wall is largely a fiction constructed by an oil industry that doesn't want to cede any more share of a shrinking U.S. gasoline market.
If approved, the proposed cut in the biofuel mandate in 2014 to 15.21 billion gallons from 18.15 billion would mark an historic retreat from the ambitious 2007 Renewable Fuel Standard (RFS) law that charted a path toward ever-greater use of clean, home-grown fuel, which the biofuel industry counts on to underpin bank loans and new factories.
Even though the EPA proposal has not been publicly released or approved by the White House, both sides are gearing up to shift the fight over the future of the country's fuel supply to a new venue: the courts.
This week two U.S. oil industry groups sued the EPA over its 2013 biofuel targets. On Thursday, their opponents appeared to signal a likely challenge to the 2014 rule.
"Let me be clear: any plan to roll back the targets ... under the guise of addressing the blend wall would be patently unlawful," said Bob Dinneen, president of the Renewable Fuels Association, an industry group.
The EPA's proposal puts ethanol proponents in a tough spot.
The Renewable Fuels Association has previously argued that Congress need not amend the 2007 law because the EPA has enough flexibility under the law to make changes to reflect market realities. The agency is now exercising some of that discretion - but certainly not as proponents would like.
The law has run up against an unexpected reversal in U.S. gasoline use, an emboldened oil industry saddled with soaring ethanol credit costs, and differences over what kind of fuel can be safely used in today's cars.
The EPA has ruled that gasoline blended with as much as 15 percent ethanol (E15) is safe for use in cars made after the 2001 model year.
But most car warranties only cover use of up to 10 percent ethanol, or E10. And most service stations don't sell anything more than E10 due to a lack of infrastructure to distribute higher blends or concerns over liability if motorists use the wrong pump.
'INADEQUATE DOMESTIC SUPPLY'
The mechanism for the EPA's proposed rollback is an escape hatch called a "general waiver" that Congress built into the 2007 law. This can be used to reduce the volumes in two cases: if enforcing the law were to cause economic hardship; or if it were simply not feasible due to "inadequate domestic supply".
The EPA has set a high bar for the economic hardship scenario. Last year, the worst drought in 50 years prompted a waiver petition from several state governors and food producers concerned about the soaring price of corn, the main ingredient for domestic ethanol production. The EPA denied the request.
This year, with the blend wall concerns forcing a jump of almost 2,800 percent in the cost of credits used to enforce the ethanol mandate, the agency itself is proposing for the first time to use a waiver, citing a lack of usable fuel.
Ethanol supply is certainly not the problem. Bouncing back from last year's drought, the corn industry is looking at a record crop this year. And production of other biofuels, such as biodiesel - a kind of diesel that can be made from recycled cooking oil - is continuing at a healthy pace, EPA data shows.
Instead, the agency appears to be viewing the blend wall as a factor: "We interpret the term 'inadequate domestic supply' as it is used under the general waiver authority to include consideration of factors that affect consumption of renewable fuel," the agency wrote in the proposed rules.
"It's a very loose interpretation of the criteria," said Dave Juday, a commodity market analyst in Washington D.C. "I would not be surprised if it was challenged."
Regardless, according to an August 26 draft proposal seen by Reuters, the waiver has enabled the EPA to cut the amount of corn-based ethanol that would be required in 2014 to 13 billion gallons.
That is about 6 percent less than this year and well short of the 14.4 billion gallons required under the 2007 law, but it is in line with a waiver request from two oil groups to cap the ethanol volume at 9.7 percent, about 12.88 billion gallons.
An EPA spokeswoman was not able to comment on the proposal or confirm the authenticity of the document.
The White House Office of Management and Budget (OMB) must sign off on the EPA's rules before they are released for public comment. It is expected to do so only after the end of the partial government shutdown.
LAWMAKERS COMING ALONG
The EPA also said its proposal set out a "durable methodology that could be used in 2015 and beyond to reduce market uncertainty", by using industry estimates and Monte Carlo options analysis to estimate usable supply.
That may be an acknowledgement that the original law, as written, could cause more problems.
The RFS was based on an assumption that gasoline demand would continue to rise, allowing the volume of biofuel to grow even if the overall share did not.
Instead, the severe recession and rising vehicle fuel efficiency led to a sharp drop in gasoline demand: 133 billion gallons are now projected to be consumed in 2014, according to the Energy Information Administration (EIA), down from an estimate in 2007 of 154 billion.
The fall in demand means that the larger volumes of ethanol embedded in the 2007 law are being crammed into a shrinking gasoline pool, rapidly expanding its share.
Lawmakers are attempting to craft amendments to the law. The House Energy and Commerce Committee is weighing a proposal to cap the ethanol requirement at below 10 percent for two or three years, according to a person close to the committee.
The proposal, which is not yet finalized, would give the industry time to study the use of higher ethanol blends during that time and then raise the target above 10 percent, according to this source.
"Things are moving, and they're not moving in the direction that 'big corn' would like them to be moving," said Stephen Brown, vice president of federal government affairs for refiner Tesoro Corp. in Washington D.C.
"So it's really starting to become a question of 'when' the thing gets changed, not 'if'," Brown said.
(Reporting By Cezary Podkul; Editing by Jonathan Leff and Alan Raybould)