Tuesday, June 10, 2008

The Price of Alternative Fuels

A heat wave is hardly the ideal time for one's home/office air conditioning to break down--an unspoken risk of telecommuting, I suppose--but it's given me an opportunity to catch up on a raft of articles, as I camp out in libraries, coffee shops, and other refuges. A recent article in Business Week included a potentially serious misunderstanding about the economics of alternative fuels. Either the authors or the company on which they were reporting seemed to believe that the price of a substitute for petroleum-based fuel would reflect its lower cost of production, rather than the market price of the commodity with which it would compete. This notion is widely enough held, including among policy makers, that it deserves some comment here.

The article addressed the impact of high oil prices on US airlines, and its tone was appropriately sober. It mentioned the possibility of some relief on fuel prices from alternatives to oil-based jet fuel, citing the recent example of Virgin's "biojet" experiments and an initiative by Airbus to pursue alternative fuels derived from algae and other plants. The authors correctly cited the technical challenges involved in producing biofuels with the necessary combination of energy density and resistance to low temperatures, but then suggested that the cost of such biofuels might be "cheap enough for airlines to turn a profit." We've heard similarly attractive claims about a variety of alternative fuels, including cellulosic ethanol and liquid fuels from coal, and unfortunately they're all mistaken, or at least highly premature, based on the way the marketplace is likely to respond.

Imagine that you are running an airline with a sufficiently strong balance sheet to enter the alternative fuels business and make enough jet fuel substitute to supply your entire fleet, based on a process that is ready for full-scale production. Let's assume that this synthetic fuel matches all the specifications of ordinary Jet A, and it costs $2.00/gal. to produce, including all fixed and variable costs and a return on the investment meeting the firm's cost of capital. But should the facility transfer the biofuel to the airline operations division at cost, or at a market-based price? After all, if it meets all of the normal specs, you could sell it to one of your competitors at the jet fuel price, perhaps with a small discount because it is a new, less-tested product. There is more than just cost accounting at stake here, because this decision involves a real opportunity cost, and if operations received the fuel at cost, they might not focus as hard on efficiency as the airline's competitors.

We might convince ourselves that the airline's management would come up with a transfer price that gave their flight operations an advantage over their competitors, but not so low that this benefit would be squandered through inefficiency. But what happens in the likelier case that the airline can't afford to get into the fuel business, and must rely on someone else to build, own and operate the facility making the biofuel, selling it to them on an arms-length basis? Why would a third party sell to Airline X at $2, when Airline Y would pay more, perhaps even twice as much? The company producing the biofuels would naturally want to make as much profit for its investors or shareholders as possible, and in fact would have a fiduciary responsibility to seek the highest price for their output. The same would be true for alternative fuel manufacturers serving other market segments, such as motor vehicle fuel. While the cost of making alternative fuels will affect the survival and profitability of the producer, it won't determine the product's price in a market as competitive as the global transportation fuels market.

Of course that doesn't mean that the price of petroleum products would remain unaffected by the expanding output of biofuels and other alternatives. Even though ethanol still accounts for less than 6% of US gasoline sales, the price of gasoline is lower by an unknown amount than it would have been without this extra increment of supply. Bulk ethanol currently sells for less per gallon than gasoline, comparing the Chicago ethanol futures and New York gasoline futures prices. But that comparison changes when ethanol competes directly with gasoline at the service station. In May E85 at the pump averaged about 12% higher than unleaded regular, on an energy-equivalent basis. With the exception of those locations where it is priced at least 25% below gasoline, the price relief that ethanol is providing consumers occurs mainly as a result of swelling the overall gasoline pool by roughly 8 billion gallons per year.

Last year the US consumed just under 25 billion gallons of jet fuel, in a global market roughly three times that size, and essentially all of it came from crude oil. It's anyone's guess how much synthetic jet fuel from all sources would be required to drive down the price for that entire market by enough to make a difference in the economics of operating passenger jets, but it would certainly take more than a few facilities on the scale of current ethanol and biodiesel plants to do the trick. The minimum would probably be at least several billion gallons per year, on a par with the current US biodiesel capacity, or the entire output of one medium-sized oil refinery. As high a priority as it might be for airlines to find cost-effective alternatives to jet fuel produced from crude oil, I have to wonder how many of the current incumbents will survive long enough to see flightworthy biofuel arriving in sufficient quantities to help them.

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