Assessing the Impact of US Ethanol on Fossil Fuel Markets: A Structural VAR Approach

Abstract:     
Despite the growing importance of biofuels, the effect of biofuels on fossilfuel markets is not fully understood. We develop a joint structural Vector Auto Regression (VAR) model of the global crude oil, US gasoline, and USethanol markets to examine whether the USethanol market has had any impact on global oil markets. The structuralVARapproach provides a unique method for decomposing price and quantity data into demand and supply shocks, allowing us to estimate the distinct dynamic effects of ethanol demand and supply shocks on the real prices of crude oil and US gasoline. Ethanol demand in the US is driven mainly by government support in the form of tax credits and blending mandates. Shocks to ethanol demand therefore reflect changes in policy more than any other factor. In contrast, ethanol supply shocks are driven by changes in feedstock prices. A principle finding is that a policy-driven ethanol demand expansion causes a statistically significant decline in real crude oil prices, while an ethanol supply expansion does not have a statistically significant impact on real oil prices. This suggests that even though USethanol market is small, the influence of US biofuels policy on the crude oil market is pervasive. We also show that ethanol demand shocks are more important than ethanol supply shocks in explaining the fluctuation of real prices of crude oil and US gasoline.

Keywords: Crude oil, gasoline, and ethanol; Demand or supply shocks; Structural Vector Auto Regression (VAR)

JEL Classification: Q1, Q2, Q4, C1

Accepted Paper Series