Paying $300 for Oil

Predicting the future price of oil has always been something of a sucker bet. Although the fundamentals of the moment are relatively transparent, they are subject to interpretation, and future fundamentals--and thus prices--are affected by diverse and daunting uncertainties. I've seen oil-price forecasts ranging from $20 to $200 per barrel, while the market consensus reflected in the forward pricing curve of the futures market hovers around $70 past 2010. But there's at least one market that values oil much higher, with practically no uncertainty. I'm referring to the oil price implicit in US government incentives for some hybrid cars and alternative fuels. While these programs doubtless offer benefits beyond simply displacing imported energy, including stimulating new jobs and reducing emissions, the effective price paid for the avoided energy or emissions is still relevant, because it contributes to the federal deficit and determines how much of these benefits we can afford to buy.

In a well-known mystery story Sherlock Holmes points out "the curious incident of the dog in the night-time", referring to a dog that didn't bark when it would have been expected to. In the context of energy, the dog that didn't bark is the energy we didn't consume, but might have. In particular, if we avoided consuming a gallon of gas or kilowatt-hour of electricity as a result of investing in more efficient technology, then the cost of that investment puts an implicit price on the energy we saved. When it's lower than the going rate, we get an economic return on our investment. When we pay more than a market price, the premium paid comes at the expense of other things we could have bought with the extra money. That's true at either at the personal or national level.

Consider a typical hybrid car tax credit from the IRS's list of those available in 2009, noting that the tax credits for all of Toyota's popular hybrids have expired. The Ford Escape small SUV qualifies for a $3,000 credit on the front-wheel-drive version. Based on its EPA fuel economy estimate of 32 mpg, the Escape hybrid would save 1,223 gallons of gasoline over a 100,000-mile life, compared to the 23 mpg non-hybrid 4-cylinder Escape. On an undiscounted basis that equates to $2.45/gal. for the avoided fuel. That's a little higher than current pump prices but seems reasonable enough. Still, after you factor in the $0.184/gal. federal excise tax not collected and convert to barrels, Uncle Sam is paying the purchaser of that Escape Hybrid the equivalent of $110/bbl for the fuel it won't use. Some of the other hybrids on the list look a bit better on this metric. For example, the Dodge Durango Hybrid qualifies for a $2,200 tax credit. At 21 mpg, compared to 16 mpg for the non-hybrid Durango, the same calculation yields an effective price of $70/bbl of fuel avoided.

Of course the key to this comparison is the tricky assessment of what a consumer would have bought if the tax credit weren't available. Perhaps instead of comparing the Escape Hybrid to its non-hybrid version, we should assume that the combination of $3k and the allure of a "green" hybrid might divert someone from buying a larger SUV, such as the 17 mpg Explorer. In that case, the effective price of avoided petroleum consumption would be closer to $50/bbl and a smart buy for the government and consumers alike. Unfortunately, this logic can cut both ways. A new federal tax credit offers buyers up to $7,500 toward the purchase of plug-in hybrid electric vehicles (PHEVs). Even if a future buyer of the widely-publicized 100 mpg Chevrolet Volt were lured away from buying an 18 mpg gas guzzler, the cost of avoided fuel would equate to around $75/bbl, while on the much likelier comparison to a Toyota Prius it would rise to a whopping $322/bbl, due to the diminishing returns of higher fuel economy. And that completely ignores the energy that goes into the grid electricity inputs needed to reach the notional 100 mpg estimates for a typical PHEV.

Similar comparisons are possible for other federal energy incentives, such as the $0.45/gal federal blending credit for ethanol. On the surface, this looks pretty good, at least in oil displacement terms. After adjusting for ethanol's lower energy content relative to oil, the direct cost works out to $0.68/gal. of avoided gasoline, or less than $30/bbl. However, that's before accounting for the significant inputs of oil and natural gas required to produce the corn-based ethanol that dominates the US market. With an average net energy input of 77 BTUs of fossil energy--mainly in the form of natural gas and gas-derived fertilizer--required for every 100 BTUs of corn ethanol produced, a more realistic assessment of the effective cost of the net oil-equivalent energy ethanol contributes would be around $120/bbl.

These figures are all ballpark estimates and they ignore the value of the emissions reductions that accompany the energy savings or gains involved. Nevertheless, they highlight an important, under-appreciated aspect of US energy policy that has been accepted with little dissent. I can only imagine the outcry if the Congress granted US oil producers a guaranteed price ranging from $100-300 per barrel. Yet although hybrid cars and alternative fuels have acquired an enviable "motherhood and apple pie" aura, we should be equally cautious about subsidizing them to such an extent that they embed high implicit energy costs into our economy. Just as paying over $100 per barrel for imported oil last year was rightly viewed as an unsustainable drain on our financial resources, paying over $100 per barrel to avoid those imports might prove equally unsustainable, if these subsidies are continued beyond their present expiration dates or phase-out limits.