Warren Ward Associates

A-Maize-ing Grace?

No one enjoys having to pay more for something than is absolutely necessary but knowing what’s necessary can sometimes be a challenge. Courtesy of the laws of supply and demand, most markets tend to remain pretty much in balance. Grocery stores don’t stock extra milk during the summer in case of a snow storm. Yet, we would be surprised if stores did not do so during the winter – especially if bad weather is forecast. The supply and demand equation is more complicated with power generation than with milk. All of us want enough electricity available so that our air conditioning can run during the hottest part of the summer but no one wants to have to pay to keep an extra power plant standing by year round, just in case.

The same balance holds true for the oil-based fuels we count on to run our vehicles, heat our homes and, sometimes, provide our electricity. The past few years have exposed us to another round of high gasoline prices. These have been brought on by a combination of reduction in supply and hedge fund speculation in the markets. These price spikes have raised questions about replacing some of our [mostly] imported oil with some [possibly] home-grown ethanol. In fact, in his 2007 State of the Union address, President Bush proposed a ten-fold increase in ethanol usage from around 3.5 to 35 billion gallons per year by 2017.

If my initial contention re supply and demand holds true, the current supply of corn should be fairly close to the demand for it. What might be the result of a significant increase in demand for corn? We found out last year when the rise in oil prices led to increased demand for ethanol which, in turn, sent corn prices up. In Mexico, where corn is used to make the staple food tortillas, those rising corn costs drove tortilla prices up 70% between Sept 2006 and January 2007. President Felipe Calderón had to cap the price of tortillas in response to protesters in the streets. Is it possible that producing ethanol isn’t the most important use of corn?

Developing a biofuel strategy may be a politically popular answer to controlling gasoline prices but there are significant issues beyond rising corn prices which must also be dealt with. Since ethanol and gasoline cannot be transported through the same pipelines, either a huge increase in tanker truck capacity or numerous "hometown" processing plants will be required. According to the US Department of Agriculture, ethanol currently costs more to produce than gasoline and would not be at all cost-competitive without the 51¢ per gallon tax subsidy that the federal government provides.

Several other biofuel concepts are being tested around the world including utilizing trees to replace corn as the basic feedstock. When I read about that in "The Economist" recently, I found myself wondering about the potential for conflict when one green concept like reducing fossil fuel use must compete with another, i.e. preserving our forests.

Whether our dependence on oil, imported or not, can be resolved through replacing some of it with ethanol is a complicated question. In my mind, it goes beyond sound bites delivered on the evening news. If our country does proceed down this road, it will not be without substantial costs. As things stand, corn crops are subsidized by the government, ethanol plants receive tax relief and ethanol fuel offers consumers fewer miles per gallon. The question which must be considered is this: How much will each of us be willing to pay, not for energy independence, but simply for reduced reliance on imported fuels?

All That and a Tank of Gas

As US residents, we are part of the world’s most vibrant economy. That can make it easy to forget that there is a very big world beyond our borders and not every country’s economy operates like ours. Neither, of course, do their political systems. Over the years, I have learned that politics and economics are usually intertwined and recent increases in gasoline prices have brought the politics of gas pricing back to mind. While our government taxes gasoline, other governments tax it more highly while still others choose to subsidize it instead.

It is obvious that gasoline prices fluctuate, although perhaps less obvious why. I continue to believe that the primary factor driving price changes is supply and demand but the fact that crude oil is valued in a currency which has been weakening for years (the US dollar) has certainly had an impact. I have heard it said that recent price increases have been caused by additional speculators in the markets but since those individuals deal only in paper contracts, never actually taking delivery of oil, it doesn’t seem likely that additional trading activity would be the underlying issue.

Regardless of the world price for crude oil, citizens of different countries pay different prices at the pump. Here is a chart reprinted from the May 29th 2008 issue of the British magazine The Economist(click to enlarge).It shows gasoline prices per liter in US dollars, adjusted for relative currency value. As you can see, the price we pay falls about halfway between the highly taxed German drivers and the heavily subsidized Venezuelan drivers. You can also see that Mexico falls below us, at around 60¢ per liter, compared to $1.04 per liter in the United States.

It’s always foolish to discount the ingenuity of our fellow citizens, especially when it comes to locating a good deal. While MSN compiles daily gasoline price information for the entire country, some Texas and California residents have another option available – driving across the border and getting a fill-up in Mexico. For political reasons, the Mexican government has chosen to keep gas prices low in the poorer farming areas in the northern part of the country. Since US citizens can travel back and forth without any special paperwork, filling-up south of the border has become popular. This has led to a boom in the business of installing of supplemental fuel tanks in trucks, which in-turn increases the number of gallons bought by US citizens. Mexico’s subsidies cost over $20 billion per year and I suspect various government ministries are reviewing their options very carefully right now.

As you look around, you probably see that Americans have begun to take conservation more seriously, driving more fuel efficient cars and even canceling vacation trips. Yet Chinese consumers, members of the world’s fastest growing economy, have a smaller incentive to do the same in their headlong rush to join the First World. According to The Economist, they pay less for fuel than we do.

Every component of the oil-to-gasoline "pipeline" is expensive. Increasing capacity for drilling it, transporting it over land and across the sea and refining it into useable form all require significant outlays in both time and money. In deference to the potential risk to our environment, no oil can be drilled in various portions of Alaska and the Gulf of Mexico. If Congress were to change its mind and allow drilling, for example in the ANWR, it has been estimated that it would be ten years before new fields were producing and a new pipeline available to transport that oil to refineries. In May, Congress passed legislation which halted the systematic purchases of oil for our Strategic Petroleum Reserve. Unfortunately, such politically motivated changes have little effect on the market. After having been endlessly debated and widely publicized, the impact of the halt in purchases has long been factored into the price of crude oil. Unlikely as its implementation might be, the appointment of an "oil czar", empowered to make day-by-day decisions about governmental purchases, would probably have been a more useful strategy in helping control oil prices.

An energy shortage serves no one, not even energy producers. Only a couple of countries are in a position to quickly increase the flow of oil. If they should do so, or if the Chinese build-up of fuel stocks ahead of the Olympics should abate and reduce demand, prices will probably fall again. The issue before the citizens of our vibrant economy will then be to decide if we have the political will to address our long-term energy needs systematically, rather than ignoring the issue until it once again looms large.