EU Energy Policy Blog

Producing ethanol or more oil domestically will not significantly increase our energy independence unlike conservation which protects consumers from oil shocks.

The world oil market controls the price you pay for gas at your neighborhood gas station. Taxes, gas station profits, and oil-refinery profits also take their toll, but when you see the price of gas go up twenty cents in one week, that’s the world oil market in action. There’s no escaping it. Even if your gas station sells gasoline made from 100 percent American oil, the price goes up exactly the same amount. Even if you buy American corn ethanol, the world oil market hits you just as hard.

This spells bad news for the most popular path to energy independence: alternative fuels. But [...] the world oil market treats conservation more kindly.

[...] “Liquid fuel” includes alternative fuels, not just oil, because the oil market extends to all liquid fuels that can substitute for each other in the transportation system. They don’t have to be perfect substitutes; it just has to be fairly cheap to use one in place of the other.

For example, it’s easy to use more ethanol and less gasoline, or vice versa. Anytime two fuels are good substitutes for each other, their prices are closely tied together, so we can think of them simply as part of the world liquid-fuel market.

[...] We can produce more liquid fuel by converting corn to ethanol, converting soybeans to diesel, drilling for oil in Alaska’s Arctic National Wildlife Refuge, or converting coal to gasoline. The future will bring even more options—some better, some worse. The alternatives have different costs and different pros and cons. To the oil companies, alternative fuels means liquid coal, shale oil, and oil from federally restricted areas. To environmentalists, alternative fuels are renewable biofuels. From an energy-security perspective, alternative fuels are all the same, even though they differ sharply in their effects on global warming.

President George W. Bush promised that we will be making 35 billion gallons of alternative fuels by 2017. So you might think we are well on our way to energy independence and are at least partly protected from the next OPEC oil shock. Unfortunately, even with that much ethanol, an oil shock would hit U.S. drivers just as hard as it would without the extra fuel. But there would be one big difference: The alternative-fuel producers would make a killing. They would sell each of those 35 billion gallons of ethanol for exactly the same price as OPEC-based gasoline and pocket the price increase as profits. That’s how the world market works.

This is not just a theory. We produce almost half our gasoline domestically, and the cost of producing that gasoline doesn’t change at all when OPEC raises the price of oil. But when the world oil price increases, so does the retail price of all gasoline, whether it is made from domestic oil or foreign oil. You don’t find low-price gas stations selling domestic gasoline. You won’t find low-price domestic ethanol stations or low-price domestic liquid-coal stations either. As we’ve seen, all liquid-fuel prices move together.

So is the produce-more strategy just a hoax? Not quite. It helps in two ways. First, producing more (or consuming less) helps reduce the world price of oil. Producing 35 billion gallons of ethanol could reduce the world price of oil by 2 or 3 percent. Second, it means some of our gasoline dollars that would otherwise flow to OPEC or Canada will instead flow to the American or semi-American companies that make the extra liquid fuel. I say semi-American because Archer Daniels Midland, the biggest ethanol producer, as well as the big oil companies are all multinationals.

So if terrorists blow up a Saudi oil field, alternative fuels will provide no protection for American consumers. If we are using lots of American-made alternative fuel, alternative-fuel companies will make a killing off the oil price shock by charging American consumers the world price of oil.

[...] Rather than producing more domestic oil or biofuels the path to independence is to consume less. The math on this approach is simple. If your car uses half as much gasoline, you are hit half as hard by an oil price shock. If your car uses the same amount of fuel but a different kind, you are hit just as hard. All liquid fuels change price together. Conservation provides protection that alternative fuels fail to provide.
Replacing a gallon of gasoline with corn ethanol and conserving a gallon of gasoline both reduce oil use by about the same amount. Conserving that gallon saves slightly more oil because alternative fuels, such as ethanol, use a little gasoline in the making. So conservation reduces imports slightly more than the use of alternative fuel and lowers the world oil price slightly more.

[...] In previous posts, I discussed two reasons why conservation is the best strategy: It is available more quickly than increased supply, and it saves more than increased supply can replace. Here I add a third reason why conservation dominates: It protects consumers from oil price shocks, something an increased supply does not do.

Steve Stoft

These are excerpts from chapter 9 of my forthcoming book Carbonomics.

This entry was posted on Sunday, December 24th, 2006 at 10:51 pm and is filed under Carbonomics. You can follow any responses to this entry through the RSS 2.0 feed. You can leave a response, or trackback from your own site.