Iowa State University Study: Ethanol Lowers Gas Prices

Cnet’s Green Tech Blog has a post I missed a few days back about a Iowa State University study claiming that Ethanol has had a big impact on lowering gas prices for consumers. Is ethanol lowering prices at the pump for consumers? It cites a study done by Iowa State University (pdf link) that shows that ethanol has lowered pump prices between $0.29 and $0.40 per gallon. The post also then states:

I find their $0.29 to $0.40 per gallon results a surprisingly large number, indicating that ethanol production, while providing on average well less than 5% of our gasoline supplies over their study period, could have affected prices at the pump downward to the tune of greater than 2 to 3 times that percentage level. That result is a huge win for ethanol proponents, as it suggests that adding ethanol to the US fleet has significantly benefited consumers (as one would expect), and also suggests that the ethanol subsidy program (at about $0.40 per gallon for 5% of the US gasoline production works out to around a 1 to 2 cent effective tax on gasoline at current levels) may well have paid for itself up to 20x over or more.

Taking aside the contentious issue of net petroleum usage in the production of corn ethanol, the above statement about the beauty of corn ethanol and the value of our subsidy of that industry is flat out ridiculous as it ignores the true economic costs to get that $0.40 drop. First off, assuming that the researchers are correct – what this “efficiency” tells us is that the fuel supply in our country is – and there’s no big surprise here – tighter than a snare drum. If a less than 5% increase in supply due to ethanol results in a 2x percentage drop in price – it’s telling us is that we are right at the point where marginal increase in supply or decrease in demand will have profound effect on consumer pricing. Obviously, it is to the advantage of oil producers (and ethanol producers) to keep us teetering right on that edge to prop up prices – but not so high that it causes a shortage that politicians might be forced to change policy to fix. If the true taxpayer costs associated with oil policy – particularly the strategic petroleum reserve which has been actually stockpiling reserves at these historically high prices and during this historically tight market – were included in The Green Tech Blog’s calculation of ethanol’s value to the gas market – its doubtful that ethanol would look so attractive.

While the return on our 1-2 cent “tax” to save $0.40 seems like a great deal – even a return on investment (eyes rolling) as implied by the phrase “paid for itself” – it really points out the failure of political policy on this topic and the realities of externalities in the alternative energy and renewables market.

While our politicians talk about economically brain dead ideas like a tax holiday for gas, a much more sound economic policy would be to release some of the oil in the strategic petroleum reserve. Matching that marginal 5% of ethanol with reserves from the SPR would require less than 1/3rd of its daily release capacity, would generate over $80MM a day in profit for the U.S. government given its current inventory cost of $28 a barrel, and running a program over the 100 day summer driving season at those levels would result in using less than 20% of the overall reserves. It also would have profound impact on the home heating oil market and other petroleum reliant industries such as anything made with plastics, etc., because about 1/2 of every barrel of crude turns into gasoline – the rest into other products. This would have a nifty side benefit helping keep real inflation in check by lowering commodities prices – which isn’t a bad idea given we still have a way out of the woods on the sub-prime mess and could use the looser monetary policy at the lowest possible inflation. But that would be too smart for our politicians.

So which do you think is better – lowering gas prices by 40 cents by spending 2 cents of tax payer money per gallon of gas sold – BTW that “$0.02 tax” that looks so nice, well that’s a pretty big number folks – about $200 million taxpayer dollars a month. Or… lowering gas prices by 40 cents while putting 40 cents of profit into the U.S. treasury for every gallon of gas put into the market – or $7.2 Billion over 100 days or roughly $2.4B per month. Personally, I like the second idea better.

But as they say on late night TV, “But wait… there’s more.” We don’t even need to sell out of the SPR at the rate I cite above to get the most important part of the benefit (more supply balance). We merely need to stop buying for the SPR to get about 1/3rd of that benefit for nothing – well we get to save money too by not stockpiling oil at historical peak prices. Yes, that’s right folks, we are stockpiling oil when, according to Iowa State University, the market is so tight that we are getting a 2 to 1 leverage on price per gallon added or subtracted at the marginal gallon in the market (e.g., a 1% increase in supply results in a 2% decrease in price). Instead, the SPR is actually currently adding oil to the reserve at a rate approaching 3% of US daily oil consumption – that’s at cost of about $1.20 per gallon of gas sold given today’s oil prices (and I am only assuming 50% of the cost per barrel since each gallon of oil could be refined into 0.5 gallongs of gasoline and therefore only half of that spend would be attributed to gasoline – the rest I am attributing to the other byproducts – which is conservative in my mind – I could argue all $2.40 should be assigned to the cost of gasoline because the byproducts are just that – byproducts of fixing our fuel mess).

So what that means is that our SPR policy is propping up the marginal gallon of fuel (ethanol in this case) to the tune of approximately $1.30 – $2.50 per gallon in externalities (10 cents of marginal pressure (1/4th of that 5% of fuel market) plus $1.20- $2.40 in expense in maintaining that marginal pressure through SPR buying). This is an expense that could easily be avoided were we merely to stop constricting our own supply and loosen the SPR for 100 days. If you toss in the opportunity cost of profit from not selling that stored oil in a strong market – we are at over $1.70-$2.90 per gallon in costs to you (assuming you are a U.S. citizen), me and every American to get that $0.40 ethanol “miracle.”

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