Gasoline Column - July 24, 2007

ALTERNATIVE FUELS: NO MAGIC BULLET

Current Gasoline and Diesel Market Conditions

The average United States retail price of regular gasoline, as reported on July 23 in the weekly Energy Information Administration survey, fell by 9 cents per gallon (“cpg”) to $2.96, the lowest level since mid-April. All regions experienced declines. This came as a welcome change after a two-week price rise that saw gasoline passing $3.00 for the first time since early June. Diesel prices remained unchanged at $2.89 per gallon.

Crude oil prices rose during the last few weeks, closing at an 11-month high of $75.92 per barrel on the New York Mercantile Exchange (“NYMEX”) on July 19 – the highest level since August 2006. The NYMEX crude price decreased a little over the next two trading days, to settle at $74.89 on July 23 – still 15 percent higher than in early June. News accounts attributed the increase to continuing production problems in the North Sea and Africa and government reports of lower domestic crude oil inventories, as well as strong speculative interest from trading funds. Higher crude oil prices nearly always lead to increased gasoline prices, because crude oil costs account for more than half of the price of gasoline at the pump.

On a positive note, the International Energy Agency (“IEA”), in the updated Medium Term Oil Market Report that it issued July 12, predicted that increased crude oil production and expanded world refining capacity may lead to a somewhat more favorable supply-demand balance in 2008. The IEA, however, also forecasts that increases in global oil demand will again surpass production growth by 2012, portending continued long-term tightness in oil markets. This suggests that longer-term alternative transportation fuels will become more important to motorists.

Can Ethanol Replace Gasoline as the Primary Fuel for U.S. Automobiles?

For many years the marriage of the internal combustion engine and relatively cheap gasoline has resulted in an automotive propulsion system far superior in terms of cost and performance to alternatives once seen on American roads, such as steam and electric vehicles. But 100 years of a gasoline-powered transportation system have eaten into the pool of cheap petroleum, and an increasing concern that the use of fossil fuels contributes significantly to global pollution and global warming has focused attention on the development of alternative power systems, especially those that are renewable and cause less pollution. Biofuels extracted from plants are a primary type of alternative fuel, and the largest current source of biofuels is ethanol.

Ethanol – a form of alcohol – is derived from the sugar or starch that exists in all plants. In the United States, ethanol is manufactured mainly from corn, by first converting the starch in corn kernels to sugar and then to ethanol. In Brazil, the second-largest producer of ethanol, the ethanol is produced more simply and inexpensively, by converting the sugar in sugar cane directly to ethanol. Most automobiles in the United States cannot run directly on ethanol, but rather run on a blend that is often 90 percent gasoline and 10 percent ethanol. In conventional vehicles, ethanol-blended gasoline gives slightly lower mileage than straight gasoline. Specially designed flexible fuel vehicles (“FFVs”) can run on a blend containing 85 percent ethanol (known as “E85"), although currently there are only approximately 6 million FFVs out of a total of 230 million vehicles in the United States.

Ethanol can lead to lower emissions of some pollutants and of the exhaust products classified as greenhouse gases and associated with global warming. Some, however, have raised concerns that ethanol could cause increases in other kinds of air pollutants, and the total environmental effect of a complete switchover to ethanol cannot yet be determined. Nevertheless, the environmental benefits associated with fuels such as ethanol led to the inclusion of mandates for (or encouragement of) cleaner or alternative fuels in the Clean Air Act Amendments of 1990 and the Energy Policy Act of 1992. More recently, the Energy Policy Act of 2005 and President Bush’s Advanced Energy Initiative have increased the use of biofuels. In his 2007 State of the Union address, the President called for the use of 35 billion gallons of renewable and alternative motor fuels by 2017.

Other nations have also concluded that biofuels are important to their – and the world’s – energy future. Although the United States is the largest producer of ethanol – with a current capacity of 5.6 billion gallons per year and additional capacity of 6.1 billion gallons under construction – Brazil has become self-sufficient in petroleum over the last 30 years by replacing 40 percent of its consumption of gasoline with ethanol. Europe, which has long favored diesel-powered cars, has mandated that biofuels account for 10 percent of fuel usage on that continent by 2020. Earlier this year, Brazil and the United States joined India, China, South Africa, and the European Union – all of which have a significant commitment to biofuels – to create the International Forum on Biofuels. The International Forum’s eventual goal is to make possible a world market in ethanol and biodiesel that would function in the same way that the international market in oil does today.

Although this news signals an increased use of biofuels, it is also crucial to take a hard look at the costs and consequences of switching to alternatives for gasoline-powered automobiles. In the first place, gasoline is still cheaper to produce and distribute than ethanol. Only through large government subsidies – paid for by all taxpayers – is ethanol cost-competitive with gasoline. Even if only the current set of tax credits, grants, and loan guarantees for biofuels were extended for the next 15 years, the cost would approach $140 billion. The largest part of that cost would be a $131 billion extension of the 51 cpg ethanol tax credit, now scheduled to expire in 2010. Moreover, gasoline blended with ethanol is more costly to distribute than straight gasoline: the ethanol attracts the small amount of water present in pipelines, corrupting the fuel. For this reason, currently ethanol must be shipped by truck or barge, then blended with gasoline as the latter is loaded into tank trucks for delivery to the service station. Congress is considering proposals to provide a subsidy for a dedicated ethanol pipeline (or perhaps ethanol pipelines from the Midwest to both the East and West Coasts). During summer months in many regions of the country, gasoline blended with ethanol must be refined to more demanding (and hence more costly) specifications to stay within ground-level pollution targets. Add in the fact that gasoline provides better fuel economy than ethanol, as well as the additional design and manufacturing costs that automobile companies would incur to produce flex-fuel or ethanol-only engines, and the total cost of switching to ethanol climbs.

In addition – and perhaps the most important issue to consider – using corn to produce ethanol increases the demand for corn. The traditional buyers of corn for use in consumer food products, beverage manufacturing, and animal feed now have to compete with fuel ethanol producers for their primary input. Not surprisingly, this has caused the price of corn to increase, quite significantly in some markets – price increases that ultimately are passed on to consumers. One University of Iowa study estimates that consumers are paying an extra $14 billion per year in food costs because of increases in the price of corn. (Of course, this issue of displacing some food-based production would apply to ethanol made from any other agricultural source, such as soybeans, sugar cane, or beets.)

Another issue to consider with respect to corn-based ethanol is that more corn is grown in the United States as the demand for the crop increases. Because corn is heavily fertilized, the runoff of fertilizer chemicals into lakes, streams, and estuaries may increase concerns about water quality.

Corn is not the only source of ethanol. Earlier this year, the Department of Energy awarded $385 million in grants to support the construction of six biorefineries that are expected to produce 130 million gallons per year of cellulosic ethanol when fully operational. Cellulosic ethanol uses non-food sources such as switchgrass and wood chips. Proponents argue that cellulosic ethanol is superior to corn-based ethanol in terms of both environmental benefits and net energy – the amount of energy produced by the ethanol, minus the energy required to produce it. (In that regard, a 2006 University of Minnesota study published by the National Academy of Sciences reported that corn-derived ethanol provided a net energy gain only if the energy value of byproduct animal feeds is factored into the calculations.) Nevertheless, cellulosic ethanol is still ethanol, and its use poses the same challenges in terms of distribution logistics and fuel economy as any other source of ethanol.

Thus, although increased ethanol use can decrease our dependence on gasoline, it also comes with its own costs. Those costs may be worth paying in order to get the environmental and security benefits that come with increased reliance on renewable, domestically-grown fuels. But consumers and policy makers should be aware of those costs and should know that their decisions, no matter how well-informed, will be choices among imperfect alternatives. Ethanol is not a magic bullet that can easily solve this nation’s transportation problems with no additional costs. High gasoline prices will provide incentives to supply alternative products, but no single product is likely to replace gasoline in the foreseeable future.