Embedding High-Priced Energy

As the revised Senate version of the energy bill passed by the House of Representatives heads to another vote today, moving closer to a possible Presidential veto, it's ironic that arguably its worst element remains the least controversial, with both Houses of Congress and the White House aligned behind it. Despite my grumbling about the bill's lack of attention to conventional energy supplies, I believe the expanded Renewable Fuels Standard constitutes a serious error of judgment. Not only would this enlarge a policy with consequences for global food supplies that The Economist calls "reckless," but it embeds expensive energy in the US economy in ways that will be hard to unravel in the future.

I've devoted a lot of space in the last couple of years to the problem of ethanol's energy return on energy invested. This may seem like an abstract concept with few practical consequences, and it is certainly one that ethanol advocates usually dismiss out of hand, either because they don't understand its implications, or because they understand them all too well. Simply put, the fact that corn ethanol returns only 130 BTUs of energy for every 100 invested in its production means that it can never deliver a fuel that is much cheaper before subsidies than the petroleum products it is intended to replace.

Ethanol's biggest benefit is that relatively little of the energy it consumes comes from oil--mainly the fuel used in cultivation, harvesting and transportation to and from the distillery. The biggest contribution comes from the natural gas used for process heat and to make the fertilizer needed to grow the corn. For all the margin problems that ethanol producers have experienced this year, as corn prices rose and output expanded faster than the market could absorb, they have caught a significant break on natural gas prices. We shouldn't assume that gas will continue to trade at a 46% discount to its BTU value against oil, as it has in 2007, based on a comparison of the relevant futures prices on the New York Mercantile Exchange. Since January 2000, gas has sold at an average of 73% of oil's BTU value, and there have been years like 2003, when it approached BTU parity with oil. In the long run, with imports making up a growing share of North American gas supplies, and as gas's lower CO2 emissions begin to be reflected in its price, it could even command a slight premium over oil.

What does all this mean? Well, at the BTU price implicit in $85/barrel oil, the cost of energy in a quantity of ethanol sufficient to displace a gallon of gasoline would be approximately $1.45/gallon. Add the contribution of corn at $4 per bushel, and you're at $3.50/gasoline-equivalent gallon, before taxes/subsidies and transportation by rail to the blending terminal. That compares to an equivalent wholesale gasoline price of about $2.35/gallon at the tank-truck rack. This comparison doesn't look any better at higher or lower oil prices, either.

The Energy Bill would double the existing mandated target for corn ethanol from 7.5 billion gallons per year by 2012 to 15 billion by around 2017, while adding an additional mandate for 21 billion gallons of non-corn ethanol and other biofuel by 2022. But from the analysis above, whatever this would do to enhance the energy security of this country by reducing our oil imports, corn ethanol cannot reduce the cost of energy to the US economy, even though subsidies and the lower energy content of a gallon of E-85 may superficially mask that effect for consumers. Now, reducing the cost of fuel may not be the top priority of US energy policy, at a time when we are concerned about climate change and our growing reliance on oil imported from unstable suppliers, but it's certainly relevant to businesses and consumers, and it ought to be of some interest to voters. Sooner or later, someone is going to have a lot of explaining to do, once the public figures out that ethanol is not the panacea we have been led to believe.