In theory, the US Environmental Protection Agency's move last week to slash the amount of ethanol to be blended into gasoline next year should have reduced the value of volatile compliance credits to near zero.
With a lower ethanol blending target next year, there is little incentive for refiners to stock up on so-called Renewable Identification Numbers (RINs), credits used to show they have met their quota for using biofuel. With the 2014 target easily within reach, there should be a surplus of RINs available next year to fulfil the EPA's mandate.
Instead, after a brief dip, ethanol RINs are now trading at around 21 cents each, less than a nickel below where they were before the EPA's announcement. The surprisingly small decrease illustrates the premium that traders are placing on the uncertainty hanging over the agency's controversial decision to put the brakes on eight years of biofuel growth.
"If sometime next year a judge overrules the EPA and says part of their legal arguments for waiving a part of the mandate is not valid, then you have a scenario where you go back to 2013 prices," said Scott Irwin, an agricultural economist at the University of Illinois Urbana-Champaign.
"The market has to average the price of those two outcomes and that's where you see the price now," Irwin said. At current prices, Irwin assigns about a 20 percent chance that the EPA's proposal gets overturned in a legal challenge.
The resulting uncertainty premium means the ethanol credits may continue to add a few pennies to gasoline prices for months to come. Prices for ethanol RINs surged from about 5 cents at the end of December to nearly $1.45 each in mid-July, driving up gasoline costs and giving refiners a powerful argument in their fight against ethanol. Prices began to tumble after the EPA said in August it would use "flexibilities" in the law to lower the mandate for 2014, signalling plans to ease the mandates.
In last Friday's announcement, the EPA said it will seek to cut the corn ethanol mandate to about 13 billion gallons for 2014, versus 14.4 billion required by law. Ethanol proponents such as the Renewable Fuels Association have already hinted they may seek legal action to prevent the cut from going into effect.
No lawsuit could be filed until the agency finalises its rules, which are expected in June. Even then, the absolute fastest a court could decide the case would be about 90 days, meaning the ethanol credits could maintain some material value for about another year.
For refiners like Valero Energy Corp, which estimates as much as $600 million in additional costs for the credits in 2013, any sense of relief is offset by the realisation that deep uncertainty will prevail well into 2014.
"We just need to see how it's going to shake out," said Valero spokesman Steve Lee.
To guard against legal challenges, the EPA spent a full eight pages out of its 204-page proposal lauding the ambiguity of a 2007 law requiring the rising ethanol mandates.
To get the corn ethanol volumes down to about 13 billion gallons, the agency plans to use an escape hatch in the law known as a general waiver authority. The provision allows EPA to cut the mandate if it believes there is "inadequate domestic supply" - but does not specify inadequate domestic supply of what.
"Congress spoke in general terms and did not address the scope of activities or persons or places that are the focus in determining the adequacy of supply," EPA wrote in its proposal. The "broad and ambiguous wording provides EPA the discretion to reasonably interpret" the waiver as it sees fit, the agency argued.
EPA settled on an interpretation that means not only the availability of renewable fuels such as ethanol, but also the ability to deliver them to consumers - a point that is expected to be the crux of any legal challenge.
Refiners argued that the ambitious 2007 law ran afoul of fuel-supply realities, because they cannot sell gasoline with more than 10 percent ethanol due to concerns over engine damage in most car models on the road today.
Left unchanged, the 14.4 billion gallon mandate for 2014 would have put the industry over this 10 percent threshold, nicknamed the "blend wall" - a finding with which the EPA explicitly agreed. It was the risk of hitting that supply wall that caused the spike in RINs this summer, which refiners say forced them to pass the costs on to consumers by charging more for gasoline.
The high price of RINs provided the "winning argument" that convinced the White House to reverse course on its pro-ethanol policies, said Bruce Babcock, an energy economist at Iowa State University. "I think that's what swung the politics around," Babcock said. "Right now, Congress won't step in because EPA did the work for them."
The EPA will probably face two legal challenges before its rule takes effect, at which point the ethanol credits could deflate completely.
"The 800 pound gorilla in this discussion is what the courts are going to do," said David McCullough, an attorney at law firm Sutherland Asbill & Brennan LLP who specialises in energy issues.
The first challenge is a set of lawsuits filed in October by the oil industry's two top lobby groups and joined by refiners PBF Energy and Monroe Energy, a unit of Delta Air Lines.
They argue that the EPA's tardiness in finalising its 2013 mandates - issued in August this year, more than eight months past their due date - makes it difficult for refiners to comply with the rules. If the refiners win, potential relief might include a partial waiver of the 2013 mandates, which were applied retroactively.
A decision could come as early as April, potentially putting the EPA in a difficult spot when it issues its 2014 rules, expected in June, seven months after the Nov. 30 deadline established by Congress.
The second challenge will likely come from ethanol and other renewable fuel groups if the EPA stands by its decision to cut the mandate using its "inadequate domestic supply" justification.
"I think the EPA know they're going to get sued on this by one or more stakeholder groups," said Susan Lafferty, energy lawyer at Sutherland.