Back in May, I discussed a study conducted for the Renewable Fuel Association (RFA) by Iowa State University’s Center for Rural and Agricultural Development (CARD). The study claims that from January 2000 to December 2011, “the growth in ethanol production reduced wholesale gasoline prices by $0.29 per gallon on average across all regions,” and reduced average gasoline prices by a whopping $0.89 per gallon in 2010 and $1.09 per gallon in 2011. Ethanol boosters like the RFA and USDA Secretary Tom Vilsack tout this study as proof that federal biofuel policies benefit consumers and should be expanded.

The CARD researchers, Xiaodong Du and Dermot Hayes, attempt to determine the consumer benefit of ethanol by inferring what motor fuel prices would have been over the past decade had there been no increase in ethanol production. Ethanol now constitutes roughly 10% of the motor fuel used by U.S. passenger vehicles. Du and Hayes conclude that without ethanol, U.S. motor fuel supply would be significantly smaller and pain at the pump significantly greater.

This procedure, I argued, is ridiculous. First, it assumes that refiners are like deer caught in the headlights and do not respond to incentives. Even if motor fuel prices increase by up to $1.09/gal nationwide over a 10-year period, we’re supposed to believe refiners would not increase output and take advantage of this opportunity to sell more of their product at higher prices. But that’s exactly what refiners would do. In the process, supply would come back into balance with demand, pushing fuel prices down.

Second, the CARD study ignores the opportunity costs of ethanol policy. Capital is a finite resource. Dollars that refiners are mandated or bribed to invest in ethanol production are dollars they cannot invest in gasoline production. The CARD study implausibly assumes that all the refining capacity diverted by federal policy into ethanol production would have been left idle in a free market and not used to produce gasoline instead.

Admittedly, the CARD study is full of math I don’t understand. But two experts in the field – MIT energy economics professor Christopher Knittel and UC Davis agricultural economics professor Aaron Smith – have just produced a technical critique of the CARD study. Titled “Ethanol Production and Gasoline Prices: A Spurious Correlation,” the researchers make several telling points, some of which are funnier than the standard fare found in the ‘dismal science.’  

Knittel and Smith begin with a discussion of basic economics to “place loose bounds” on the potential effects of ethanol production on gasoline prices. They note that the largest component of the price of gasoline is the cost of crude oil.

A barrel of crude oil contains 42 gallons, so every dollar per barrel increase in oil prices raises wholesale gasoline prices by about 2.4 cents. Thus, when oil is $100 per barrel, roughly $2.40 of the price of gasoline will be the cost of crude.

Ethanol production can have only a “minimal impact” on crude oil prices. U.S. ethanol constitutes only 1% of world oil use. In addition, ethanol has one-third less energy content by volume than gasoline, so U.S. ethanol production replaces only 0.67% of world oil. Ethanol’s impact on the biggest factor affecting gasoline prices is likely very small.

Ethanol production could however affect gasoline prices by decreasing refiners’ profit margins. The CARD study concludes that the “crack spread” – the weighted average price of refined products minus the price of crude oil — would have been $0.89 higher if ethanol had been removed from the market in 2010 and $1.09 higher had it been removed in 2011. But, argue Knittel and Smith, crack spreads never stay that high for an entire year. Indeed, the “crack spread has not exeeded 60 cents for more than a few brief periods in the past 30 years.” The reason is that when “the crack spread is high, large profits encourage entry into the refining industry, which in turn puts downward pressure on the crack spread.” Or, as I put it above, refiners are not deer in the headlights; they respond to market signals (prices).

The CARD study implies that, but for ethanol production, the crack spread in May 2010 would have been $1.37 — “20 cents higher than the highest crack spread ever observed in the data.” Knittel and Smith comment: “For this to be a long-run effect — which is the implicit assumption in the RFA’s claims — we would have to expect that these historic high crack spreads would not increase capacity utilization,” even though refinery utilization averaged 86.4% in 2010, “lower than every year from 1992-2007.” In other words, we would have to assume that refiners don’t want to get rich.

For reasons of space, I won’t try to summarize Knittel and Smith’s detailed discussion of “issues related to model specification.” More newsworthy and certainly more entertaining is their discussion of “spurious correlation.” Using the CARD study’s models, they estimate the effects of ethanol production on natural gas prices and unemployment rates — “dependent variables” with no particular connection to ethanol. Here’s what they find.

Based on the CARD models, had no ethanol been produced in the U.S. in 2010, “natural gas prices would have increased by 65 percent.” Similarly, “eliminating ethanol in 2010 would have decreased U.S. unemployment by 65 percent.” (So much for RFA’s claim that ethanol creates jobs!)

The authors comment:

These empirical relationships are a classic example of spurious correlation. Ethanol production during this time period is increasing. Therefore, other variables that have a predominant trend, either upward in the case of unemployment or downward in the case of natural gas prices, are likely to correlate well with ethanol production.

To nail down the point, the researchers provide a “whimsical” example. Using CARD’s models, they find that every additional million barrels of ethanol produced increases the age of daughter Caiden Knittel by 26 days and that of daughter Hayley Smith by two months. Policy implication: Eliminating all ethanol in 2010 would ”cause Caiden to be a newborn (12 days old) and would cause Hayley’s age to be negative.”

Knittel and Smith conclude:

The results of Du and Hayes are at odds with the historical levels of either the crack spread or the crack ratio [the price of gasoline divided by the price of crude oil] and are inconsistent with an equilibrium [a long-term balance between supply and demand] in the oil refining industry. While an instantaneous surprise elimination of all ethanol sold in the U.S. might raise gasoline prices for a short period, one cannot assume these instantaneous effects would persist for more than a few weeks. This is precisely what Du, Hayes, the RFA, and Secretary Vilsack have done.

In the wake of high gasoline prices, the ethanol industry is making the rounds in Washington, and they want you to believe that the Renewable Fuel Standard has lowered gasoline prices by up to $.89 per gallon. This would be remarkable, if it were true. The ethanol industry relies on a study produced by the Center for Agricultural and Rural Development at the University of Iowa. Here is the abstract:

This report updates the findings in Du and Hayes 2009 by extending the data to December 2010 and concludes that over the sample period from January 2000 to December 2010, the growth in ethanol production reduced wholesale gasoline prices by $0.25 per gallon on average. The Midwest region experienced the biggest impact, with a $0.39/gallon reduction, while the East Coast had the smallest impact at $0.16/gallon. Based on the data of 2010 only, the marginal impacts on gasoline prices are found to be substantially higher given the much higher ethanol production and crude oil prices. The average effect increases to $0.89/gallon and the regional impact ranges from $0.58/gallon in the East Coast to $1.37/gallon in the Midwest. In addition, we report on a related analysis that asks what would happen to US gasoline prices if ethanol production came to an immediate halt. Under a very wide range of parameters, the estimated gasoline price increase would be of historic proportions, ranging from 41% to 92%.

If we go to E85prices.com, we see that as of March 29, 2012 the average nationwide price-spread between E85 and E10 is 14.7%, with E85 costing an average of $3.31/gallon and E10 costing an average of $3.89/gallon. Ethanol has less energy content than gasoline, so a direct price comparison is not appropriate. The generally accepted metric is that E85 must be priced about 28% lower than E10 in order to break even, meaning that the cost per mile driven is equal between E85 and E10.

Ethanol is blended into gasoline at refineries throughout the United States, and most gasoline that is sold in the United States is composed of 10% ethanol, 90% gasoline. If ethanol was really responsible for massively lowering the real cost (adjusted for energy content) of gasoline, we would expect E85 (a rough estimate of the actual cost of delivering ethanol to market) to cost much less than gasoline, below the break even point at least. As you can see, it doesn’t, and after adjusting for energy content ethanol is still more expensive than gasoline.

What the study does is it looks at refinery capacity throughout the United States. Refineries in the United States often run at close to max capacity, meaning if there were suddenly a very large increase in the demand for gasoline (suppose that every car driving American decides they want to take a road trip across the country, beginning tomorrow), refineries would be unable to immediately ramp up production, and gasoline prices would skyrocket. The same would happen, as the author notes in the abstract above, if ethanol production were to suddenly disappear overnight, as their refining capacity would drop precipitously.

The study holds refinery capacity constant over the past years, and models the effect that an absence of ethanol would have on gasoline prices. This is not a realistic assumption as there is no reason to believe that in the absence of ethanol, more refining capacity would have been built in the United States over the past decade.

I wrote about this same study in June of last year, and will quote the conclusion of analysis written by the Institute for Energy Research then:

The recent Iowa State study claiming that ethanol production has suppressed the growth in gasoline prices is very misleading. It takes for granted the current refinery capacity and other infrastructure that industry uses to deliver gasoline to motorists, without realizing that federal policies over the years have distorted the development of these markets. Ethanol only survives in the market place at its current levels because it is propped up by artificial mandates and preferential tax treatment.

The regression analysis of the Iowa study doesn’t accurately capture the timeline that would have occurred had the free market been allowed to operate. Of course a sudden disappearance of all ethanol would cause a bigger price spike in the Midwest than in the East Coast. That’s because the artificial federal support has displaced the development of oil-based gasoline delivery in the Midwest more than in other regions. The fact still remains that ethanol (at its current market share) is very inefficient. Taxpayers and consumers would be richer if the government dropped its support programs for it.

The final sentence is key. Despite generous subsidies for decades and a federal mandate, the real cost of ethanol is still higher than gasoline. Even the environmentalists are on our side on this issue, having realized that the environmental benefits of ethanol production are non-existent and the net effect (once you consider how much land globally has been converted to grow corn) is possibly worse than regular petroleum production.

According to F. Scott Fitzgerald, the finest writer in American history, “The test of a first-rate intelligence is the ability to hold two opposed ideas in the mind at the same time, and still retain the ability to function.” By this criterion, Rep. Ed Markey (D-MA) is a real genius, because he manages to function in the Congress, despite the fact that he thinks the price of gasoline should go up and down, simultaneously.

As one of the Congress’s foremost global warming alarmists, Rep. Markey believes that hydrocarbon energy is the cause of the supposed “problem” that is global warming. Due to this belief, he is a staunch supporter of energy policies designed to make hydrocarbon energy more expensive, so that Americans use less of it, and thereby fight global warming. For example, he co-authored the American Clean Energy and Security Act, a cap-and-trade energy rationing scheme passed by the House of Representatives in June 2009. (Thankfully, the bill died in the Senate.) Because the entire point of this policy was to “put a price” on carbon, it would have increased the price of gasoline, by design.

OK….So Rep. Markey supports higher gas prices to fight climate change. However, Rep. Markey is also a politician, in addition to being a global warming alarmist. And, like all American politicians, he gets the vapors when gas prices rise. The reason is simple: Americans get angry when they have to pay $4 a gallon, and nothing terrifies incumbent politicians like angry voters. This is why Rep. Markey last week told the press,

“Now, next week I will have legislation out on the floor that ensures that we do have a strategy to deploy the Strategic Petroleum Reserve. When President Bush 1 used it during the first Persian Gulf War, the price of oil went down 33 percent. When Bill Clinton used it in September and October of 2000, the price [of gas] went down 18 percent. When George Bush 2 used it after Katrina, it went down 9 percent.”

That is, he intends to introduce a policy to lower the price of gas.

The cynic in me thinks that Rep. Markey is trying to have it both ways, depending on the direction of prevailing political winds, which suggests his “green” principles are rooted in the thin soil of expediency. But perhaps he’s only trying to be a “first-rate intelligence.”

In case you haven’t checked recently, gas prices are high again. Fear not, because the DoJ is on the case: “High gasoline prices prompt Justice department to eye energy industry.” From the article:

Attorney General Eric Holder made no secret the move is a direct response to public angst, not to current evidence of any illegal conduct.

…

While promising official vigilance, the attorney general acknowledged regional differences in gasoline prices, and said, “It is also clear that there are lawful reasons for increases in gas prices, given supply and demand.”

At least give them credit for admitting that they’re wasting taxpayer dollars on a bunch of nonsense. If public conern is the only metric for a DoJ bureaucratic task-force, there are a number of other issues American’s are inappropriately worried about. I’d be shocked if the Department of Justice was interested in wasting its time on those issues.

There was a good piece in Forbes explaining the (lack of) evidence that speculators have been driving the price of oil by Jerry Taylor and Peter Van Doren.