EclectEcon

US Biofuel Policy: "We need to set realistic targets...instead of just throwing taxpayer money out the window."

Smittie, a frequent commenter here at EclectEcon, came across this item last week and sent it on to me, noting that it says things pretty similar to what I have been arguing for several years on this blog. I note that its authors are primarily civil engineers, not economists, but it looks as if their economic intuitions are pretty decent. Some excerpts:

The United States needs to fundamentally rethink its policy of promoting ethanol to diversify its energy sources and increase energy security...

The paper, "Fundamentals of a Sustainable U.S. Biofuels Policy," questions the economic, environmental and logistical basis for the billions of dollars in federal subsidies and protectionist tariffs that go to domestic ethanol producers every year. "We need to set realistic targets for ethanol in the United States instead of just throwing taxpayer money out the window," said Amy Myers Jaffe, one of the report's authors.

...[T]he report notes that in 2008 "the U.S. government spent $4 billion in biofuels subsidies to replace roughly 2 percent of the U.S. gasoline supply. The average cost to the taxpayer of those 'substituted' barrels of gasoline was roughly $82 a barrel, or $1.95 per gallon on top of the retail gasoline price (i.e., what consumers pay at the pump)." The report questions whether mandated volumes for biofuels can be met and whether biofuels are improving the environment or energy security.

The full study is here, and it includes considerable use of fundamental economics. The monograph is lengthy and seems to consider nearly every issue that has ever been raised on the topic. It should be a go-to study for anyone interested in the details of biofuel production and effects.

But as regular readers of EclectEcon know, I see no reason for gubmnts to set targets for biofuel production. I truly doubt that bureaucrats or even very smart scholars, not risking their own money, can make better decisions in this area than can private investors.

If the gubmnt wants to dissuade people from using petroleum-based fuels for various reasons, my argument has long been that legislators should raise the taxes on those fuels. The result will be that individuals and firms will make efficient decisions, on their own, as to when and whether it is reasonable to switch to hybrid fuels or biofuels. Otherwise, as this study points out so well, the externality arguments simply are not strong enough to carry the day.

$20 Oil by December??

Former US gubmnt advisor Philip Verleger says that falling demand and near capacity storage will force oil prices down, possibly as low as $20/bbl by December. It's hard to believe that forecast when oil prices are hovering around $70/bbl as I write this. Here is his argument:

A crude surplus of 100 million barrels will accumulate by the end of the year, straining global storage capacity and sending prices to a seven-year low, said Verleger, who correctly predicted in 2007 that prices were set to exceed $100. Supply is outpacing demand by about 1 million barrels a day, he said.

“The economic situation is not getting better,” Verleger.... “Global refinery runs are going to be much lower in the fall. If the recession continues and it’s a warm winter, it’s going to be devastating."

Of course not everyone agrees with Verleger. From the same source:

Oil will average $63.91 in the fourth quarter, according to the median of analyst forecasts compiled by Bloomberg. Crude for December delivery traded at $65.61 today [July 16th] in New York. Prices have rebounded on expectations of a demand recovery, led by China and other developing economies, and concern expansionary monetary policy would stoke inflation and weaken the dollar.

At the other end of the spectrum from Verleger, Goldman Sachs Group Inc. predicted in a report yesterday oil will rally to $85 a barrel by the end of the year, and recommended that clients buy futures contracts for delivery in December 2011.

Natural Gas Prices:Supply, Demand, and Cobwebs

Natural Gas prices have been all over the place for the past couple of years, ranging from just over $2 per million British Thermal Units (MMBtus) to over $13/MMBtu. Peter Hall effectively uses supply and demand to explain the wild swings:

So far, a classic case of elementary economics: tight supplies boost prices, high prices boost investment, increased production brings prices back to equilibrium. But are today’s sagging prices actually in equilibrium? Not exactly. Unfortunately for the industry, increased supply coincided with the largest economic contraction in six decades. As such, demand for gas has swooned by 5% to date this year, on a 13% drop in industrial demand. For the moment, prices are abnormally low.

Prices are expected to remain subdued while the world economy works through the current period of weakness. In response to soaring inventories, gas producers have scaled back activity, but are expected to ramp up again as the recovery takes hold. As we march through 2010, prices are expected to climb back to the US $5-6/MMBtu level, enough to kick-start production again.

The bottom line? Surging supply and stifled demand have pummelled natural gas prices. Consumers will enjoy the brief hiatus, but producers can look forward to more normal pricing in 2010.

In the above explanation, Peter Hall is assuming that decision-makers have somewhat myopic expectations (or what are typically referred to as adaptive expectations). In the first paragraph, he assumes that investors expect prices to remain high and hence overinvest; there is no anticipation on the part of the investors that other people will be expanding capacity as well and that prices will fall. I.e., there is a systematic error in the expectations. Rational expectations are out the window.

And then, again, when the price is low, investor-producers do not invest on the basis that they expect the price to rise to $5-$6/MMbtu. Instead, they wait to see if the price actually does rise that far.

These cycles remind me of the old myopic-theory of agricultural prices for the corn-hog cycle and that was (and perhaps still is) taught as the cobweb theory. [note: this Wikipaedia explanation is very good]

I tend to like adaptive expectations models, given my own inability to formulate rational expectations in many instances. And this is probably a fairly good example of that application.

Addendum: James Hamilton has an equation here that captures this adaptive expectations model with a simple lag structure. For those who are interested, note the alternating signs on the lagged variables, which seem consistent with a cobweb model.

Update: it is really clear that these clowns do not understand the cobweb (adaptive expectations) model. Contrary to their assertion, it involves continued overshooting.

Serious Questions about Wind Turbines

A recent C.D.Howe Institute release, authored by Michael Trebilcock, raises serious questions about the efficacy and efficiency of wind turbines. His five major objections are:

1. Industrial Wind Turbines Have Minimal Impact on Carbon Emissions
2. Industrial Wind Turbines Are Uneconomic
3. Industrial Wind Turbines Cause Insufficiently Researched Health Effects
4. Industrial Wind Turbines Have Adverse Effects on Adjacent Property Values
5. The Decision-making Process is Undemocratic and Will Undermine Efficient Regulation

Trebilcock raises important questrions in his explanations, but I especially like his conclusion, in which he emphasizes how bad politicians are at picking winners:

Good Politics, Bad Policy
In debates over climate change, and in particular subsidies to renewable energy, there are two kinds of green. First there are some environmental greens who view the problem as so urgent that all measures that may have some impact on greenhouse gas emissions should be undertaken immediately, whatever their cost or their impact on the economy and employment.16 Then there are the fiscal greens, who being cool to carbon taxes and cap-and-trade systems that make polluters pay, favour massive public subsidies to themselves for renewable energy projects, whatever their relative impact on greenhouse gas emissions. These two groups are motivated by different kinds of green. The only point of convergence between them is their support for massive subsidies to renewable energy (such as wind turbines). This unholy alliance of these two kinds of greens (doomsdayers and rent seekers) – a classic Baptist-Bootlegger coalition, harking back to the Prohibition era – makes for very effective, if opportunistic, politics (as reflected in the Ontario government’s Green Energy Act), just as it makes for lousy public policy: politicians attempt to pick winners at our expense in a rapidly-moving technological landscape, instead of creating a socially efficient set of incentives to which we can all respond. (emphasis added)

Incentives and Adjustments:Subsidies and Black Liquor

The US, in its misguided attempt to encourage more use of bio-mass for fuel, has provided a (probably unintended) subsidy for the pulp and paper mills that use their "black liquor" (what is left after the pulp is extracted) for fuel. Here is just one article on the subject (h/t to Emirates Economist).

The issue  centres on black liquor, a biofuel byproduct of the papermaking process. At kraft pulp mills, wood is boiled in caustic chemicals, causing the pulp to separate from the various combustible chemicals in the wood. What is left after the pulp is removed is black liquor, which is refined and burned as a biofuel energy source in most kraft pulp mills.

While pulp mills have been burning black liquor for decades, American paper companies have begun receiving large tax rebates from the U.S. government, which Canadian papermakers complain puts them at a distinct disadvantage.

Here are some of the bizarre and not-so-bizarre effects of the policy:

• In order to qualify for the subsidy, firms in the US must burn a blend of petroleum-based fuels and bio-mass based fuels. So while the pulp mills had been merrily using purely bio-mass based fuel for decades, they now blend it with diesel fuel to qualify for the subsidy, thus increasing the demand for diesel fuel.
• The subsidy amounts to a cost reduction of nearly 25% of average costs for US firms. Understandably, this subsidy has Canadian pulp mills hurting and upset.

We tend to teach our students that if another country wants to subsidize production of something, then we should let them, gladly. It's as if they're giving us stuff cheaper than we can produce it ourselves AND they allow us to free up our scarce resources to produce something else.

It's a nice theory, assuming that capital, resources, and labour are all completely fungible and freely mobile. Then, sure, the capital and labour being used in Canadian pulp mills can just find alternative uses in Canada, and we'll all be better off in Canada if the US wants to subsidize pulp production, right?

How likely is it that the capital of a pulp mill will find an alternative use? How long will it take labour, located where the pulp mills are, to find new jobs? And what kind of jobs will these be?

We cannot teach trade theory and policy using two-by-two-by-two models (two inputs, two outputs, two countries) and expect them to make sense to real people in the real world who understand that adjustment is painful and has costs.

These adjustment costs are dealt with, to some minor extent, in Canada with various transitional adjustment programmes as well as our higher social safety net than exists in the US. But at the same time, this type of subsidy in the US (which I suspect policy makers did not anticipate) must be fought via NAFTA and the WTO. I don't know that much progress can be made in these fights, but at the same time, it makes little sense for Canada to offer countervailing subsidies.

Man, this bio-mass energy kick sure created some weird and awful distortions.

Gasoline Prices are NOT Proportional to Oil Prices

Several weeks ago, a friend asked me why, when oil prices had fallen to a third of what they were a year ago, gasoline prices had fallen by less than half of what they were then. And the other day, I heard some talking-head mediot* ask,

"So tell me this: if oil has fallen from $140/barrel to $50, why have gasoline prices only fallen from $1.29/litre to $.79/litre? Huh?"

Here is a graph of a few of the observed data points to which they were referring:

[Update: several people were confused by the original graph, so here is a better-labeled one. It is a scatter plot of the price of gasoline versus the price of oil at three different points in time:]

Applying the famous "Palmer Eyeball Algorithm" to these data and completely ignoring the lack of degrees of freedom, it appears that gasoline in Ontario is roughly priced at about $.55  x [1+  (price of oil)/100]. In other words, about 55 cents of the price of a litre of gasoline is due to other costs that do not vary with the price of oil. These costs include, of course, taxes, but they also include the bulk of labour and capital costs as well. These costs cannot be altered much as the price of oil changes, and hence their influence on the price gasoline cannot change much when oil prices change.

It is nearly a linear relationship, but because of the comparatively fixed costs, the relationship is not proportional.

Finally, did you ever notice that the people who complain when gasoline prices don't fall in proportion to a fall in oil prices do not express gratitude when prices rise less than proportionally with oil prices?

*mediot: a contraction of the words "media" and "idiot".

Calling All Truckers!

Remember how truckers and trucking firms wept and wailed about how the gasoline tax had to be cut to help them survive back when gasoline was over $1.30 per litre in Canada and about $4/gallon in the US?

Maybe now that gasoline prices are the lowest they have been for the past four or five years, these same firms will support an increase in the gasoline tax?

Oh? It's not symmetrical?

Didn't think so...

Note: Both Becker and Posner think it would not be a good idea to raise the gasoline taxes right now, given that the US economy is in a recession. Becker, however, prefers a gas tax increase to a tightening of gasoline efficiency standards:

"Although neither higher gas taxes nor tougher fuel-efficiency standards are desirable at this time, higher taxes would be preferable to tougher standards."

And Posner supports a petroleum tax once it is clear we are emerging from the current depression.

Me? I prefer driving our minivan to driving our smaller car on my commutes, and gasoline is so cheap nowadays that I am seriously thinking of doing so on a regular basis.

"People respond to incentives..."

Conspicuous Consumption/Advertising

Back in the early 1990s, as Lithuania was emerging from socialist dominance by Russia, two colleagues and I visited there to present a series  of seminars on tax policy and on bankruptcy law.

While we were there it became apparent to me that the high-end restaurants were brightly lit -- lights on everywhere. Meanwhile, the offbeat dens and lower-scale establishments were often quite dark, with a few dim lights and possibly several candles to provide the lighting. It all seemed backwards from what we were used to in North America, where the fancy-schmancy places have dimmed lights, and the mom-and-pop eateries have bright lights.

As we talked about it, we realized that the high-end places were advertising their affluence and quality by using a lot of very expensive electricity to light their restaurants. The lower-end eateries simply could not afford to pay for the electricity to keep their places well-lit.

- - - - -

A couple of years ago, I ran across a similar phenomenon while visiting Chester, England, with our friend "The Chauffeur". We were there on an extremely hot day. As we looked for a place to sit, rest, and have a cool drink, I said,

"Let's make sure we go to a place with the doors closed -- it will be air-conditioned. They keep the doors closed to preserve the air-conditioning."

I was wrong. The first place we entered with closed doors had no air conditioning; they were trying to preserve what little cool air they had left from overnight, but it was still stiflingly hot. So we left and continued our search.

 As we walked past Piccolino, their windows were opened. I said,

"We don't want to go in here. They have the windows open, trying to cool the place off."

 Again, I was wrong: cool air was rushing out onto the sidewalk. It was great advertising, even though it was extremely expensive: we felt the cool air, knew they were air-conditioned, and stopped to go in.

It was a fascinating day in Chester (Piccolino is on the right in the above photo) -- lots of history and interesting sites, including some ongoing archeological digs (see photo below). And the food and service at Piccolino were excellent.

And we didn't even visit the outlet mall described in Le Deal.

Good News or Just Wishful Thinking?The Effect of Falling Oil Prices in Venezuela

The recent precipitous decline in oil prices (relative to their highs in July) will surely require Hugo Chavez to scale back his spending in (and out of!) Venezuela. But how serious will the effect be? From the WaPo,

The price of a barrel of oil has fallen from $147 in July to less than $70, and analysts say the drop is a blow to Chávez's free-spending administration, which depends on oil for 50 percent of government revenue and 95 percent of its export earnings. ...

Venezuela could be particularly exposed if the worldwide financial meltdown continues. That would slow economic growth, reduce the need for petroleum products and further drive down oil prices.

Venezuela exports about 1.4 million barrels daily to the United States, about 10 percent of U.S. oil imports. The dire predictions come as the inflation rate in Venezuela has surpassed 36 percent and the black market rate for dollars has shot well beyond the fixed government rate. ...

PFC Energy said in a report that oil must be at least $94 a barrel to ensure Venezuela's macroeconomic stability this year and generate enough money to pay for imports. ....

Nigeria needs the barrel to be at least $68 to cover its imports, while two Persian Gulf states -- Saudi Arabia and Iran -- need the price to remain above $55. ...

"Venezuelan fiscal profligacy and its huge off-budget populist programs has left it very little room for error," the PFC report said.

My prediction: if the price of oil stays under $75/barrel for long, look for even more price controls and other gubmnt restrictions in Venezuela. Further, the price controls, etc., will be enforced more strenuously (perhaps even more ferociously). And anticipating popular unrest, Chavez will tighten his reins on the police and military. Things will not be nice for the Venezuelan version of Joe, the plumber.

Maybe it will be good for most of us in the rest of the world if Chavez is eventually deposed, but the process will not be pretty, I fear.

More: The Emirates Economist has much more on the effect of declining oil prices on oil-producing economies.

Crude Oil Prices and Economic Policy

Now that crude oil prices are roughly half of what they were six months ago, I want everyone who favoured a windfall profits tax back then to pony up for a subsidy to the oil companies now.

Oh? It isn't symmetrical? Why not?

Oil Prices Down, Gasoline Prices Up

The Emirates Economist explains how hurricanes could cause both price movements. As refining capacity was either damaged or shut down, the supply of gasoline shrank, thus driving up the price of gasoline. At the same time, the reduction in refining capacity also led to a reduced demand for oil. He also offers other explanations.

Gasoline Prices Skyrocket along Texas Coast;and this is a good thing

From the Houston Chronicle,

Wholesale gasoline prices hitting $5 on Gulf Coast

Fuel prices are "going absolutely ballistic" today as Hurricane Ike heads toward the "largest refinery cluster on the planet," says Tom Kloza, publisher and chief oil analyst at the Oil Price Information Service.

Prices of spot or wholesale gasoline _ which is what refiners charge retailers _ ranges anywhere from $4.25 to $5 a gallon along the Gulf Coast. Some other markets also are up sharply, Kloza says.

That's up from about $3.30 a gallon yesterday, before forecasts had Ike making landfall near Freeport and threatening Southeast Texas _ with all its refineries _ with hurricane force winds.

When the demand increases suddenly and the short-term price elasticity of supply is very low, one expects precisely this result: rapidly rising prices

The good thing about this is that entrepreneurs in other regions, outside the Texas Gulf coast, will now have a big incentive to rush tankers to the area during the next twelve hours or so (well before Ike hits) to capture some of the potential gains: high prices serve as a signal for more scarce resources to move into an area. Without those higher prices, the transportation costs and added risks would not be covered, and less gasoline would be shipped into the areas.

Furthermore, the high prices will deter many folks from topping up "just in case" and limit the gasoline purchases to those who value the gasoline more (in the sense of being willing to give up more to acquire it). Here's hoping they don't put in price-gouging laws to thwart these efficiency effects of the rising prices.

Are Wind Turbines Just "Subsidy Farms"?

When I see wind turbines, knowing next-to-nothing about the economics of their operation, I quite inexplicably think, "Oh, that's a neat idea." I am certainly not distressed when I see them cluttering the horizon in some places.

But if the only thing that makes wind turbines economically viable is subsidies, I'm concerned. Why do gubmnt planners think they know better than markets what will happen with alternative energy prices? Why do private entrepreneurs need subsidies to install wind turbines if, indeed, they will be economically viable as oil and natural gas prices rise?

From EUReferendum,

Last night.... in front of 400 local residents, in a packed hall set out for 250, North Shropshire Planning and Development Committee, decided to go with local sentiment and refused the application [for wind turbine installation rights] by a clear majority of 13-3.

However, the developers, Dutch-owned Nuon ..., are planning to appeal and, from past experience, it is likely that the government appointed planning inspector will approve the scheme, citing the essential need to increase the amount of renewable energy. ...

But, with £43 million of subsidy at stake, it is easy to see why Nuon are so enthusiastic about wind. This is easy, secure money, gained from ripping off customers through the so-called Renewables Obligation Certificate (ROC) levy, without which wind power would be economically unviable.

And that, at the heart of it, is what windmills are all about – money. Government policy, with the backing of the EU, has turned these useless eyesores into giant money-making machines and the corporates are now digging deep into the trough to grab their shares of the booty.

Still there are enough stupid people out there – and an awful lot of politicians – who are naïve enough to believe otherwise. But, for once, democracy and common sense have prevailed. But, such is this land of ours that it will very soon be cast aside. The windmills must prevail – for no other reason than money talks.

Sound Criticisms of Ethanol Policies

Doug Auld, an economist at The University of Guelph and former colleague (both recently and many years ago), published a scathing attack on Ethanol policies with the C.D. Howe Institute.

Federal and provincial policies that promote the production and use of ethanol fuel to reduce greenhouse gas (GHG) emissions are misguided, according to a Commentary released today by the C.D. Howe Institute. The strategy should be recon-sidered, says the study, since the net environmental benefits of ethanol fuel are uncertain, and the costs to consumers and governments are high.

In The Ethanol Trap: Why Policies to Promote Ethanol as Fuel Need Rethinking, economist Douglas Auld of the University of Guelph notes that Canada has become a major booster of increased ethanol production. In addition to federal efforts, a number of provinces encourage ethanol production through similar capital and production subsidies.

Auld finds that:

• • There is no conclusive scientific evidence that ethanol reduces GHGs or energy use once the entire production cycle is taken into account.
• • Even assuming that the use of ethanol has a net positive impact on CO2 emissions, public funds contribute approximately $368 for each tonne of CO2 reduced, roughly seven times greater than the cost of alternative policy measures. Auld finds that cellulose-based ethanol blends and solid biofuels provide a more promising approach to reducing GHGs.
• • To the extent that ethanol policy is meant to act as a rural development tool, ethanol mandates and production subsidies provide benefits to some farmers while hurting others, with perhaps more being hurt financially than helped.
• • Increased domestic production of ethanol contributes to increases in food prices, both direct and indirectly, for Canadian and foreign consumers. Domestically, increased food prices cost consumers an estimated $400 million each year.

Auld concludes that the headlong thrust into corn ethanol as a GHG reduction policy cannot be justified once the significant price effects, economic costs, and consequences for income distribution in Canada and, indeed, globally are considered.

Most of the points made in his study have been made before, but they need to be made again (and again) even more forcefully. And one of his points that has received less attention is that current ethanol policies, by driving up the prices of grains, have hurt many cattle operations.

Oil Production and Racism

Given that the world's largest oil producing countries are in the Middle East, is it racist to depict oil producers as Arabs in a commercial? Some of the Gulf State leaders think so. [h/t to BenS]

Gulf states may boycott the Nissan Motor Company as a result of an Israeli TV commercial that depicts Saudis angered by a fuel-efficient car, a Saudi official has said.

The new campaign by Renault-Nissan caused an uproar in the Gulf when it showed a group of Saudi oil barons screaming and attacking the Renault-Nissan vehicle.

The Saudis are shown leaving a hotel and encountering the new, fuel-efficient vehicle. One man pounds his fists on the car and is then held back by his companions as he shouts at it, "Hawks should peck at you day and night."

At the end of the commercial, the voice-over says, "It's clear the oil companies won't like you."

What On Earth Happened to Obama`s Economic Advisors?

Obama's solution [h/t Cafe Hayek]for dealing with high gasoline prices sounds just as dumb as, maybe dumber than, the one proposed by Hilary Clinton. Recall that she wanted to lower the federal gasoline tax, and Obama rightly criticized her plan pointing out that lowering the federal gas tax would increase the demand such that the pump price would not change much, if at all, and that in the end oil company profits would rise.

Well, we can't have oil company profits rise, now, can we! So Obama's solution is to give people $1000, regardless of whether they drive or even own a car, and to fund this lump-sum transfer by taxing the "excess" or "windfall" profits of the oil companies [What did I tell you!]

Does he have no advisors who are willing to point out how dumb this is? A tax on oil company profits might not reduce the supply of gasoline much in the short run, but it will surely lead to a reduction in supply in the longer run as financial capital flees to other, more lucrative investments.

And the Obama plan would surely increase the demand for gasoline, which would lead to higher, not lower, gasoline prices. And as gasoline prices began rise, the likely next step for elitist interventionists like Obama and his supporters would be price ceilings, followed by shortages with all the attendant problems we faced in 1979. Can rationing and political control of who gets the gasoline be far behind?

It is disconcerting that this form of demogoguery might work. We'd all like an extra thousand dollars, and we're happy to have it come from the coffers of the oil companies. So we might vote for this type of plan if we don't think about the implications. I'm willing to believe that over half the people who have had introductory economics would vote for this plan, and if that's so, we as economists are not doing a very good job.

Oh, Oh! Watch For More Calls for a Windfall Profits Tax

According to numerous news reports yesterday, the profits of major oil companies rose substantially. Both Shell and Exxon-Mobil had their profits increase by 11%.

Too many people will now argue that those profits are unfair and possibly even the cause of high oil and gasoline prices. They will then conclude that there should be a windfall profits tax levied on the oil companies (but why not on farmers who have been cleaning up lately???).

These arguments will be nothing more than thinly disguised envy: the oil companies got it, I want it, and I don't wanna pay for it.

1. Oil and gas prices are, for the most part, the result of competition in the global economy. Phenomenally increased demand is what has driven up oil and gasoline prices. After all, if the oil companies could boost their profits by jacking up oil and gasoline prices, why didn't they do so 20 years ago?
2. We all had a chance to get in on this action. We could have bought stock in major oil companies last year if we had wanted to. We have no cause for complaint if we chose not to take the risk.

I think the gubmnt should compensate me for not having bought winning lottery tickets all these years, too.

Update: What'd I say!

Don't Blame US Consumption for the Oil Price Spike

Ironman, at Political Calculations, presents a graph showing,

In simpler words, we confirm that individual Americans are not consuming an ever-increasing amount of oil. We can therefore eliminate increased U.S. consumption of petroleum-based products as a significant contributor to the recent spike in the world price of oil.... As we see in the chart ..., the amount of finished petroleum products consumed by U.S. residents started at 2.572 gallons per day in February 2007 and peaked at 2.661 gallons per day in August 2007 before plunging to 2.443 gallons per day in March 2008.

To see his chart and his analysis, click here.