Flex-Fuel Competition for OPEC?

An op-ed in this morning's Wall St. Journal by former CIA Director James Woolsey makes an interesting and seemingly pragmatic suggestion for improving America's energy security. Instead of pushing new energy sources or new fuels, he seeks to break OPEC's cartel power by ensuring that US motorists have more choice at the pump, facilitated by flexible fuel vehicles (FFVs) that can operate on a variety of energy sources. The analogy to the electricity grid, in which no single source of generation can hold the entire market hostage, is clear. The question is whether this is really as useful as it sounds, to the point of justifying legislation that would force carmakers to make fuel flexibility the default, rather than an option on new cars.

Competition can be a powerful force, and Mr. Woolsey is correct that gasoline and other petroleum-based transportation fuels have had little competition at the point of sale to consumers. Even with ethanol making up 10% of most of the gasoline in the US, 94% of the energy we use for transportation still comes from oil. The idea of "multiple choice energy", which was the name of one of the corporate energy scenarios that I helped develop at Texaco more than a decade ago, is alluring. It's not hard to envision consumers being able to choose among gasoline, diesel, ethanol, other biofuels, natural gas (compressed or liquefied), electricity, hydrogen, and even exotic hydrogen-storing compounds such as ammonia borane, which recently appeared on my radar screen. As it has been for decades, however, the central problem is creating a market for these alternatives. That requires both cars and infrastructure.

Mr. Woolsey and his co-author are focused on the car side of the equation, suggesting that a $100 fix could enable most cars to run "a variety of liquid fuels in addition to gasoline." To make this happen, they espouse the Open Fuel Standard Act, a piece of legislation that has been floating around since at least late 2008 and that would mandate this hardware for all new cars. Then they extend this argument into natural gas vehicles and plug-in hybrid cars, both options costing a great deal more than $100 per car. While plug-in hybrids certainly provide very effective energy competition for oil, their cost and complexity ensure that their market penetration will be a long, slow process, pushing any real competitive benefits perhaps a couple of decades into the future. Nor do the natural gas cars I'm aware of--also much more expensive than simple FFVs--provide such a point-of-sale fuel arbitrage capability, because once converted to run on CNG or LNG, there's no going back to gasoline. (This feat isn't technically impossible, just impractical.) So for the near-to-medium term the main competition available would be from fuels like E85 and methanol.

I've written extensively about E85, a blend of 85% ethanol and 15% gasoline. The gist of it is that E85 has failed to take off so far, not because there aren't enough FFVs that can run on it--there are already millions on the road--but because its availability is limited and, more importantly, because its current pricing represents a poor value proposition for consumers. A gallon of E85 contains 27% fewer BTUs of energy than a gallon of gasoline with its typical 10% ethanol content. In cars not specially tuned to make the most of E85's high octane, that translates directly into a corresponding fuel economy penalty. So for E85 to be attractive to consumers, it should sell for at least 25% less than unleaded regular gasoline. As reflected on an industry website tracking E85 prices, that's only the case in a few locations, with the national discount currently averaging 16%. So on a miles per dollar basis, E85 is currently about 15% more expensive than gasoline. That doesn't sound like something that is likely to cause OPEC ministers to lose sleep.

Why is E85 so expensive? It's not mainly due to its limited availability, although its smaller scale relative to gasoline distribution probably costs it a few extra cents per gallon. Fundamentally, it's because ethanol prices reflect high input costs, including corn. Even at the current futures price on the Chicago exchange this morning of $2.72/gal., which does not include transportation and blending costs that can easily add another dime or more, wholesale ethanol costs 85% as much as wholesale gasoline, equating to 87% on an E85 basis. It's hard to see how you could start there and end up with pricing on the forecourt that offers a big enough discount to compensate consumers for the fuel economy penalty and the more frequent refueling that results from it. And in fact, EPA analysis of refueling data for 2008 found that it "equates to an estimated 4% E85 refueling frequency for those FFVs that have reasonable access to the fuel." So without a fundamental change in the pricing relationship, it's not clear that either more FFVs or even more E85 pumps will result in consumers purchasing large volumes of E85.

Mr. Woolsey's arguments about fuel competition make intuitive sense, although it does not necessarily follow that legislation requiring carmakers to produce more FFVs would achieve the results he suggests, particularly when GM, Ford and Chrysler have already agreed that half the cars they produce will be flex-fuel capable by 2012. $100 per car isn't an astronomical sum for this kind of experiment, but is there really a compelling reason to make it compulsory, rather than a matter of consumer choice?