It's Time To Reform US Ethanol Policy

• Virtually all of the assumptions underlying the Renewable Fuels Standard enacted in 2007 have changed, as the US emerges from energy scarcity into abundance.
• The linkage between the RFS and food prices is controversial, but a new quantitative model underscores concerns, especially for its impact on developing countries.

This April, two separate bills were introduced in the US House of Representatives to reform, or repeal, the federal Renewable Fuel Standard (RFS) that mandates how much ethanol and other biofuels must be blended into gasoline. A similar bill has just been introduced in the Senate. To understand why reform or repeal makes sense now, we should recall the factors that led Congress to enact this standard six years ago and consider how many of the basic assumptions underlying its design have changed since then.

That requires a review of US fuel consumption and import trends, commodity prices, and the impact of the RFS on food prices. After summarizing the other points I want to focus on the last one, based on an interview I conducted with Dr. Yaneer Bar-Yam, an expert on complex systems who has developed a model that explains the behavior of food prices since the introduction of the first, less ambitious RFS in 2005.
In the fall of 2007, when Congress was debating the Energy Independence and Security Act that included the current, enhanced RFS, the US energy situation looked dire. For four years oil prices had been rising more or less steadily from their historical level in the low-to-mid $20s per barrel (bbl) to around $90, on their way to an all-time nominal high of $145/bbl the following summer. US crude oil production was in its 22nd consecutive year of decline, while our crude oil imports had climbed to 10 million bbl/day, twice domestic production that year.

Even more relevant to the thinking behind the RFS, US gasoline consumption stood at a record 142 billion gallons per year and had been growing at an average of 1.6% per year for the previous 10 years–another 2 billion gallons added to demand each year. In its annual long-term forecast for 2007, the Energy Information Administration (EIA) of the US Department of Energy had projected that gasoline demand would grow to 152 billion gal/yr in 2013 and 168 billion gal/yr by 2020. Meanwhile, US net imports of finished gasoline and blending components had reached a million barrels per day in 2006, equivalent to 15 billion gal/yr–equal to the corn ethanol target set by the 2007 RFS for gasoline blending in 2015. And by the way, US corn prices for the 2006-7 market year averaged $3.04 per bushel (bu). In this environment, policy makers regarded ethanol as a crucial supplement to dwindling hydrocarbon supplies, from a feedstock that was cheap and readily expandable.

Without belaboring the events of the last five years, virtually every one of those trends has reversed course. That has occurred partly as a result of the recession and the lasting changes it produced in the US economy, and partly due to an energy revolution that was largely invisible in 2007 but had already begun.

US gasoline consumption peaked in 2007 and has since declined to 133 billion gal/yr last year. The EIA forecasts it to fall to 128 billion by 2020 and 113 billion by 2030. US crude oil output is the highest in 22 years and is set to exceed imports this year, while the US has become a net exporter of gasoline and other petroleum products. Since 2007 US ethanol production has grown from 6.5 billion gal/yr to 13.3 billion gal., and it seems more than coincidental that corn prices had doubled to an average of $6.22/bu by last year.

That brings us to the controversy that has been widely referred to as “food vs. fuel”. In the last several years I’ve read numerous papers attempting to determine by correlation or other empirical methods whether and to what extent the increase in US ethanol production from corn has affected food prices. To put this in context, since 2005 the quantity of corn used for US ethanol production has grown from 1.6 billion bu/yr to 5 billion bu/yr, or from 14% to 40% of the annual US corn crop.

Some studies, such as this 2009 analysis from the non-partisan Congressional Budget Office found a significant influence on food prices. Others, including an Iowa State study recently cited in a blog post from the Renewable Fuels Association, found a negligible influence. What differentiates the work of Dr. Bar-Yam is that he and his colleagues have developed a quantitative model based on two key factors — corn consumed for ethanol and commodity speculation — that closely fits the behavior of a global price index. Their model also accounts for the “distillers dried grain” byproduct from ethanol plants, which returns about 20% of the corn used in the form of protein-upgraded animal feed.

Before speaking with Dr. Bar-Yam, I was a bit skeptical of his results. Aside from skepticism being my default mode in such situations, I had spent a lot of time looking at claims of speculator influence on crude oil prices in the 2006-8 period and was never convinced that they were more than the “foam on the beer”, rather than a basic driver of prices. However, as I was reviewing his paper prior to our call, a light went on.

The curve his model predicted, which closely matched food price behavior, looked very much like the behavior of a process control loop responding to a ramped change in the set point–forget the jargon and think about how the temperature of your home responds to a steady increase in your thermostat setting: overshooting, then undershooting, before converging. We discussed this and he confirmed that it was effectively an "under-damped oscillator", which can be characterized the same way whether you're talking about an electrical circuit or a market. In effect, the steadily increasing corn demand from the ratcheting up of the RFS started corn prices rising, and the presence of lots of speculators, including “index fund” investors, caused the price to successively overshoot and undershoot the equilibrium price track one would expect.

Dr. Bar-Yam explained that he had arrived at these two factors by eliminating factors that other groups had investigated, but that turned out to have no predictive value. These included shifting exchange rates, drought in Australia, a dietary shift in Asia from grains to meat, and linkages between oil and food prices. In his view the focus on ethanol and speculation is validated by the shift in dialog on this issue away from other, extraneous causes.

He also emphasized that his main concern is not the price of processed foods in developed countries such as the US, for which commodity grain costs are only one input, but rather the price paid for simple foods by poor people in the developing world. From that standpoint he doesn’t just want to see the RFS reformed. ”It is important not just to repeal, but to roll back the amount of ethanol used in the US.” He would prefer not 10% ethanol in gasoline, let alone 15%, but about 5%. “The narrative has to shift,” he said, “to recognize that people are going hungry.” Those are powerful words, and I’m still thinking about them.

At current production levels ethanol from corn contributes the energy equivalent of 6% of US gasoline consumption and about 2.5% of total US liquid fuel demand. That’s not trivial, and there’s a whole domestic industry of investors, employees and suppliers who made that happen at our collective request. However, If Dr. Bar-Yam has accurately captured the relationship between ethanol and global food prices, then we urgently need to reassess what we’re doing with this fuel.

We are also in a far better position now to consider scaling back our use of ethanol produced from grain than we were when the RFS was established. With increasing production of shale gas, tight oil and various renewables, the energy scarcity that has defined our policies for the last four decades is far less relevant to our policy choices going forward. I’ll tackle the practical aspects of RFS reform, in terms of the so-called “blend wall” and its impact on gasoline prices, in a future post.

A slightly different version of this posting was previously published on Energy Trends Insider.

"All of the Above" Must Be Weighted by Common Sense

• "All of the Above" is just a cliché if not tempered by an appreciation of the strengths and weaknesses of different energy sources, and a standard basis of comparison.
• Renewable energy is gaining market share, but fossil fuels--especially oil and gas--will play crucial roles in the energy mix for decades.

Last month, Real Clear Politics and API hosted an energy summit in Washington, DC entitled, “Fueling America’s Future”. It was intended to provide a quick overview of most of the key technologies and issues associated with an all-of-the-above energy strategy for the United States. Going through the highlights of the webcast gives me an opportunity to summarize my point of view for new readers of this blog. I’d sum that up as “All of the Above”, with asterisks for the proportions and situations that make sense.

This slogan, at least in the manner in which it has been espoused by politicians in both parties, has attracted fair criticism for being overly bland and safe. I suspect that critique reflects a general sense that our energy mix has always been composed of all of the above, or at least all of the technologies that were sufficiently proven and economic to contribute at scale at any point in time. However, as both our technology options and choice criteria expand, our understanding of the evolving energy mix is hampered by metrics and assumptions that are overdue to be revisited.

The summit’s first panel examined the technologies of the mix, in a “lightning-round” format of five minutes apiece. The panel covered oil, natural gas, coal, nuclear and renewables, led by wind power.

The interim CEO of the main US wind energy trade association, AWEA, cited his industry’s progress in reducing the technology’s cost, increasing the domestic content in its US value chain from 25% to 67%, and expanding its market penetration. Mr. Gramlich was also surprisingly forthright about wind power’s continued dependence on federal subsidies, a point to which I’ll return in future posts.

He began with a statistic indicating that wind power was #1 in new US electric generation capacity last year. This is more than just a talking point, but it calls for some refinement if we’re to see an accurate picture of the changing US electricity mix. When most generating facilities operated within a narrow band of expected utilization, say 60%-80% of the time, comparing their nameplate capacities like this was satisfactory. Exceptions such as “peaking” gas turbines that only operate a few dozen or hundred hours a year were never the recipients of targeted government incentives.

Now, however, our energy mix includes technologies with effective utilization rates, or “capacity factors”, ranging from as low as 10% for solar photovoltaic (PV) installations in cloudy northern locations, to roughly 90% for nuclear power. Wind comes in around 20-35%, depending on site and turbine size. In terms of their likely annual power generation, new natural gas facilities actually led new wind farms by roughly 2:1 last year.

Given the enormous and largely unanticipated natural gas renaissance in the US, that shouldn’t surprise anyone. In my first blog post over nine years ago I posed a series of questions, including whether we were on the verge of an energy technology breakthrough. I had in mind something involving renewable or nuclear energy, energy storage, or vehicle technology. The shale gas revolution was already starting to emerge from obscurity, but I, along with most other energy experts at the time, remained oblivious to it.

The new head of the American Natural Gas Alliance described gas as clean, abundant and affordable. At least the last two points should be uncontroversial by now, backed up by market prices and resource assessments. We tend to think of gas as a bridge fuel to a lower emission future, but I think we’ll increasingly hear it called a “foundation fuel,” as Mr. Durbin did.

The spokesman from the Solar Energy Industries Association accurately referred to solar as our fastest growing energy source, though he didn’t explain how it would grow from 0.1% of US generation last year to more than 1% by next year. He alluded to a plausible inflection point based on policy and innovation, but his enthusiasm that solar was expanding rapidly outside California and the Southwest ought to worry us.

Until PV prices fall much lower than they have, a surge of installations in places like Vermont and Wisconsin means that taxpayers and ratepayers are paying more than they should to make that happen. And the global competition and “survival of the fittest” he touted has mainly resulted, not from capitalism, but from dueling government incentives for solar, especially in Europe and Asia. I’m much more positive about solar than the above might suggest, but like other renewables, it will cost less and achieve more for us in locations with high-quality resources.

The discussion on oil was more globally focused, based on BP’s forecasts and annual Statistical Review. Contrary to the widespread view of oil’s continued dominance, it has been losing market share over the last 40 years — including the last 13 years in a row — and stands at its lowest market share in the US since at least World War II.  The representative from BP linked this performance to oil’s concentration in transportation fuel, where it has been squeezed out by efficiency, low economic growth (and to some extent biofuels, which got short shrift in the session). At the same time, the growth of North American production, another dividend of the shale revolution, puts increasing pressure on OPEC. I’ll come back to this dynamic in future posts.

Wind and solar aren’t the only, or even the biggest, renewables, despite the attention they receive. I was glad to see hydropower–often the forgotten renewable–represented on the panel, though I was disappointed by the absence of geothermal power. Both are more geographically constrained, yet have features that wind and solar could only wish for.  Hydro generated nearly 7% of US electricity last year from just 3% of US dams, with significant potential for growth through retrofitting unpowered dams. The Executive Director of the National Hydropower Association quoted Senator Ron Wyden (D-OR), the new chairman of the Senate Energy and Natural Resources Committee, as saying, “Hydro is back.” That could prompt some interesting discussions.

I’m glad I wasn’t there representing coal, which must surely be the least loved energy source today. It continues to grow globally, with US coal exports playing a role, but the domestic US story is a “decline narrative” as the VP of the National Mining Association described it. He managed to find a note of optimism in the more efficient coal power fleet that will remain after 68,000 MW of old capacity retires by 2020, under pressure from various regulations and competition from natural gas. Unfortunately, efficiency alone isn’t sufficient. From my perspective, carbon capture and sequestration (CCS) is the key to reconciling coal’s convenience and low energy cost with its high emissions. CCS wasn’t mentioned by name, but was only alluded to as “technology that does not exist.” That dismisses it too lightly, as I’ll explain when time permits.

The head of government affairs for the Nuclear Energy Institute spoke last in the lightning round on technology. (The subsequent panel on energy issues is worth your time, too.) He emphasized nuclear’s anchor role in the US electricity mix, with 12% of US generating capacity contributing around 20% of the electricity supply at a cost of 2¢ per kilowatt-hour (kWh). Yet despite five new reactors under construction and a wave of license extensions, post-Fukushima the center of the nuclear industry is shifting to places like China and India. 66 reactors are under construction outside the US, mainly in the developing world, because that’s where demand is growing.

I’ve worked in various aspects of energy for more than 30 years, and for much of that time our energy mix and the forces that drive it have been in a state of flux. With that in mind, my recipe for “all of the above”  starts with what we have now, recognizes the inertia of existing fleets and infrastructure, and evolves as costs shift and our emphasis on environmental consequences grows.

Wind and especially solar will grow, but will add the most value when used with, rather than against the grain of their limitations. Nor will energy storage turn them into reliable, baseload energy sources like nuclear and coal, at least until it is much cheaper. The US natural gas opportunity looks transformative in a way that renewables don’t, yet, with value well beyond power generation. Coal will linger, but without effective CCS will remain vulnerable from many angles. Meanwhile, oil remains the indispensable fuel for transportation, which is the cornerstone of our global economy. Yet its indispensability will erode in increments each year, as EVs eventually grow from novelty to significance and new biofuels start to emulate oil’s trump cards of convenience and energy density. It’s a great time to be talking about energy, as it has been for the last nine years.

A slightly different version of this posting was previously published on Energy Trends Insider.

Could US Oil Trends Alter How Oil Prices Are Set?

• Oil prices weren't always set by a transparent global market. Current pricing mechanisms emerged from much less transparent precursors.
• Resurgent US production, combined with restrictions on US oil exports, could disconnect the US from the global oil market, with unexpected results.

If you follow energy closely, you've likely lost count of the number of times you've heard an economist, executive or government official explain that oil prices are set by the global market, and not by oil companies or the US government.  Although somewhat over-simplified, this statement has been valid for roughly 30 years.  However, it hasn't always been the case. Current trends in US production, together with existing regulations, make me wonder if it will remain accurate in the future, as the US inches closer to what is commonly referred to as energy independence. 

The market-based system of oil prices, with its transparency and easy trading among regions, didn't appear overnight.  Until the early 1970s, Texas played a role similar to Saudi Arabia's current swing producer role within OPEC.  By limiting the output of the state's oil wells, the Texas Railroad Commission effectively determined the global price of oil--to the extent there was one--until Texas had no spare capacity left.  That set the stage for OPEC, a succession of oil crises, and the US oil price controls that were imposed in the 1970s in an attempt to help manage inflation. There was also no single, representative oil price.  Instead, prices were set by producers' contract terms and the discounts large refiners could negotiate, or by federal regulations.  The current system emerged from a series of developments in the 1980s.

When US oil price controls ended in 1981, oil futures trading was just getting underway on the New York Mercantile Exchange.  The heating oil contract was launched in 1980, followed by the West Texas Intermediate (WTI) crude oil contract in 1983. This combined large-scale oil trading with an unprecedented level of transparency.   It was also significant that the US, the world's biggest oil consumer, had become a major oil importer after domestic production peaked in 1970.  Because refineries on the coasts competed for oil supplies with refiners on other continents, the price of WTI couldn't get too far out of line with imported crudes without creating arbitrage opportunities for traders.  And any part of the US connected by pipeline to the Gulf Coast was effectively linked to oil prices in Europe, the Middle East and Asia.

After OPEC miscalculated the response to the very high prices its members were demanding in that period--reaching $100 per barrel in today's dollars--global oil demand shrank by nearly 10% from 1979 to 1983, while non-OPEC production grew by more than 12%.  Prices soon collapsed, and OPEC's dominance of oil markets faded for most of the next two decades, during which the futures exchanges and trading relationships of the modern oil market took hold. 

What could shake the current system of oil prices?  It has already withstood recessions, wars in the Middle East, the collapse of the Soviet Union, and the explosive growth of Asia, with China alone adding oil demand comparable to that of the EU's five largest economies.  However, since the current system is based on the free flow of oil between regions, anything that impedes that flow could undermine the way oil is currently priced.

Setting aside conflict scenarios, consider the potential impact of sustained growth in US production, combined with flat or declining demand and no change in the current prohibition on most US crude oil exports.  The gyrating differential between WTI and UK Brent crude, reflecting rising production in the mid-continent and serious logistical bottlenecks, provides a glimpse of what this could be like.  With much of the new US production coming in the form of oils lighter than those for which most Gulf Coast refineries have been optimized, keeping rising US crude output bottled up here could result in US crude prices diverging even farther  from global prices, while forcing US refineries to operate less efficiently and import and export more refined products.  With oil imports drastically reduced and oil exports still banned, US oil prices might be influenced more by the global market for refined products, with its different dynamics and players, than by the global crude oil market .

In some respects, that sounds a lot like what many politicians and "energy hawks" have been seeking for years: a US no longer subject to foreign oil producers' price demands.  Yet this same scenario could yield all sorts of unintended consequences, including a less competitive US refining industry and higher or at least more volatile prices for gasoline, diesel and jet fuel.  And just as we've seen with cheap natural gas, cheaper oil could undermine the economics of the unconventional oil and gas production that makes it possible in the first place. 

US oil export policy merits a thorough reevaluation, and soon, because the regional impacts of a continued no-export stance could become pronounced, even if the US never reached overall oil self-sufficiency. Such a review should include related regulations, such as the Jones Act restrictions on shipping. With crude oil exports to Canada -- virtually the only allowed export destination for our newly abundant crude types--already rising rapidly, some Canadian refineries may be positioned to supply US east coast fuel markets more cheaply than refineries in New Jersey.  That certainly qualifies as an unintended consequence.

A slightly different version of this posting was previously published on the website of Pacific Energy Development Corporation.

...and Two Steps Back for Cleantech

• The Better Place bankruptcy ends an interesting effort to circumvent some big impediments to the wider adoption of electric vehicles.
• DESERTEC's original concept would have matched European solar investment with superior North African solar resources, but was no match for European politics.

Within the last week two of the previous decade's Big Ideas for accelerating the shift from fossil fuels to renewable energy--or at least to electricity generated from a variety of cleaner sources--have come up short.  On May 26th electric-vehicle-battery-swapping firm Better Place filed for bankruptcy liquidation in Israel, and just a few days later the DESERTEC Foundation reportedly "abandoned its strategy to export solar power generated from the Sahara to Europe".  Both of these concepts originally looked promising, and I take no satisfaction in their apparent failure.  However, these events must be telling us something.

Better Place was aimed squarely at two of the largest perceived barriers to wider acceptance of electric vehicles (EVs): the limited range of today's EV batteries and the relatively long times required to recharge them, compared to a typical three-minute fill-up at the gas pump.  Better Place's big idea involved the standardization of EV battery packs on a design that could be quickly removed from the vehicle and robotically replaced with a fully charged battery. This required large up-front investments in facilities and hardware, but the firm didn't fail for lack of capitalization. 

Despite having raised around $800 million since its founding in 2008, and convincing French carmaker Renault to produce vehicles designed to work with their technology, Better Place failed to standardize the emerging EV battery market.  Tesla used a different battery configuration from the start and has focused on its own fast-charging technology, while even Renault's global alliance partner Nissan didn't make compatibility with Better Place a standard feature of its Leaf EV in markets like the US or Australia. That led Better Place to invest in building more-conventional EV recharging networks to accommodate other EVs, diluting both its capital and its concept. 

I see two lessons here. First, EVs and related services are still a niche market, and in spite of its aspirations Better Place became a niche within this niche, largely dependent on the success of EV manufacturers at growing their potential market.  That's a poor place from which to launch a business that ultimately depends on achieving high volumes.  The other lesson is that when you can't make sense of a company's revenue and working-capital model, there's probably a good reason.  At this stage in their development, EV battery packs are apparently still too expensive to sit idle in large numbers, waiting for a swap, when the hardware to exchange them requires the same retail footprint as a car-repair bay--all this to support a service arguably only worth a few hundred dollars per year to an EV owner, compared to the normal cost of recharging.

DESERTEC's big idea was even simpler than Better Place's.  A well-sited solar array in North Africa would inherently generate at least twice as much electricity per year as the same array in Germany, the Netherlands, or Belgium.  All else being equal, it would make more sense to invest in solar where the sun shines brightly for more than 6 hours a day, on average, and to send it by wire to the cloudy, northern countries that want more green power.  Of course physics can't always trump politics, and I suspect that this has more to do with DESERTEC's withdrawal from its basic concept than the cited concerns about transmission capacity and grid congestion across Spain and France. 

Politics enter the story in two main ways.  Renewable energy in the EU is deeply entangled with industrial policy and green jobs. From that standpoint, it's even better if a PV panel in Germany produces half the output as one in Morocco, because you can sell twice as many, all installed by local firms and workers. Then there's the interaction between the EU's generous solar subsidies and the solar manufacturing incentives in Asia and elsewhere, resulting in enormous overcapacity, relative to demand, and a now-global wave of solar bankruptcies and defaults.  This has pushed PV module prices down to a level at which the other costs of solar energy, including installation and transmission, begin to outweigh the module costs. That erodes North Africa's solar advantage relative to its northern neighbors. Throw in the lingering effects of the financial crisis, and a once-big idea looks like an unworkable dead end, at least for now.

Neither the failure of Better Place, which might yet find a bargain-hunting savior, nor the retreat of DESERTEC looks like a mortal blow to the long energy transition now underway.  However, they do suggest that the timeline is a little less likely to be shortened by the kinds of big leaps they offered.  EVs will have to gain market share the hard way, with better, cheaper batteries and ample recharging infrastructure--plus continued taxpayer subsidies--while inefficient solar subsidies continue to divert investment away from some of the world's best renewable energy resources, keeping the technology's global contribution smaller for longer.