Lower Gas Prices By Paying More at the Pump?

Thanks to all of you at Red Lion Reports for giving me the opportunity to post a few thoughts. As a new professor, I am a frequent blog reader, but have done little on the content side. Much of my research focuses on energy law and policy, so I thought I'd start there -- I welcome your comments!

The Energy Independence and Security Act of 2007 was signed into law on December 19, 2007. It contained a renewable fuel standard (RFS) as a major part of the bill. The RFS requires that that certain "obligated parties – refiners, importers, and blenders (other than oxygen blenders) –" account for a minimum of 9 billion gallons of renewable fuel in 2008, rising to 36 billion gallons per year by 2022.

In light of a spot price hovering around $100 per barrel for oil, the RFS could be a promising step toward reduction of domestic US consumption of foreign oil. The question is: at what cost? Renewable fuels on the level mandated in the RFS require expensive new processing facilities and distribution channels, and rely heavily on multiple-use commodities, most notably corn. To help facilitate the process, the Act includes significant subsidies for industrial fuel producers to facilitate the production of ethanol and other advanced biofuels.

These subsidies hide the real costs of this energy policy. To ensure the pipeline for these renewable fuels in the long term, many market contingencies must be managed. Earlier this year, in North Dakota and Minnesota, a number of ethanol plants either shut down operations or delayed opening because the high price of market inputs (read: corn) made operations too expensive. The current high oil prices could motivate the plants to restart operations. But, a significant drought, even with the RFS, might push renewable fuel production costs out of the profitable range.

If shifts in agricultural input prices can shut down renewable fuel plants, renewable fuel producers are also sensitive to the actions of the largest players in the market for oil – especially OPEC. Although some claim that OPEC cannot impact oil prices (an assertion about which I am highly skeptical), changes in demand for oil in global markets unquestionably can. The real test for the efficacy of the RFS will come down the road. If the RFS is effective in reducing oil demand for a period of time, and our resulting demand for oil does in fact reduce oil prices, what happens in five years if world corn prices triple and oil supplies are high because of reduced demand?

We will have two choices. We could rollback the RFS. But that would waste the major infrastructure and human capital (e.g., people moving to communities for renewable fuel-related jobs) investments needed to satisfy the RFS in the first place. Quite simply, sunk costs will be high. Second, we could enact law to provide additional subsidies to producers of renewable fuels to ensure production. Either way, consumers would end up, directly or indirectly, paying higher prices for fuel as a result of the RFS.

While high prices are not appealing, that is how markets work. High demand and low supply = higher prices. Econ. 101. But markets are not efficient when the primary consumers don’t know the real prices they are paying. And, because of RFS legislation and the government subsidies to support it, the real price of renewable fuels will not be reflected at the pump.

I, for one, am willing to pay higher fuel costs to help reduce our dependence on fuels coming from the many less-than-friendly nations providing much of our oil supply. As such, I support the concept of the RFS. However, market participants need better information. An RFS can help reduce our dependence on foreign oil, and that is a good thing for national security. Additional fuel production using U.S. materials and labor are also a good thing. But consumers need to know what they are getting into, and without better information, the market can’t work efficiently.

The solution: reduce taxes elsewhere, and fund all subsidies in the bill through a direct, per gallon tax. That way, we all pay for the true price of our consumption at the pump. Five dollar gas is expensive, but the better the information, the better decisions we can make, and the better the market will work. Is a little transparency too much to ask?