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Study Challenges the Claim That Ethanol Makes Gas Cheaper

Posted on the 11 October 2013 by Dailyfusion @dailyfusion
A gas station somewhere in Wyoming, USA. (Credit: Flickr @ Yuya Sekiguchi A gas station somewhere in Wyoming, USA. (Credit: Flickr @ Yuya Sekiguchi

Does ethanol make gas cheaper? According to the “2013 Ethanol Industry Outlook” report by the Renewable Fuels Association, ethanol currently represents nearly 10 percent of the motor fuel supply in the U.S and the ethanol industry saves the average household more than $1200 in gasoline bills. Yet, a paper forthcoming in The Energy Journal, co-authored by an an MIT economist Christopher Knittel, states that the price of gasoline is not substantially affected by the volume of its ethanol content.

According to the above-cited “2013 Ethanol Industry Outlook”, ethanol enhances Americans’ economic security by reducing the prices they pay at the pump. Adding some 13 billion gallons to the nation’s motor fuel pool—and blending it with gasoline in E10—has a similar effect to the U.S. oil industry finding a way to extract 10 percent more gasoline from a barrel of oil. Since the supply of motor fuel is increased, there is a downward pressure on its price.

The report goes further saying that these factors “help to explain why U.S. ethanol reduced wholesale gasoline prices by an average of $1.09 per gallon in 2011, $0.89 per gallon in 2010, and an average of $0.29 per gallon since 2000.” These were the findings of a study by economists Dermot Hayes of Iowa State University and Xiaodong Du of the University of Wisconsin based on a methodology they previously published in a highly respected academic journal.

In Christopher Knittel’s view however, “whatever the benefits or drawbacks of ethanol, price issues are not among them right now.” According to an MIT article, the study seeks to rebut the claim, broadly aired over the past couple of years, that widespread use of ethanol has reduced the wholesale cost of gasoline by $0.89 to $1.09 per gallon.

“The point of our paper is not to say that ethanol doesn’t have a place in the marketplace, but it’s more that the facts should drive this discussion,” says Knittel, the William Barton Rogers Professor of Energy and a professor of applied economics at the MIT Sloan School of Management.

U.S. fuel ethanol production capacity was 13.9 billion gallons per year (903,000 barrels per day), as of January 1, 2013, as it is stated in a report released by EIA on May 20, 2013. Most of that quantity is produced from corn. Most gasoline sold in the United States contains 10% ethanol by volume. However, gasoline that is 15% ethanol, which the Environmental Protection Agency approved as E15 in 2011 for use in vehicles built since the 2001 model year, began selling last summer.

However, as the article explains it, the claim that the increase in ethanol content produces serious savings at the pump is problematic. It is derived from the previous studies on the issue, which involved something the economists call the “crack ratio,” which is effectively the price of gasoline divided by the price of oil.

The crack ratio is something energy analysts can use to understand the relative value of gasoline compared to oil: The higher the crack ratio, the more expensive gasoline is in relative terms. If ethanol were a notably cheap component of gasoline production, its increasing presence in the fuel mix might reveal itself in the form of a decreasing crack ratio.

So while gasoline is made primarily from oil, there are other elements that figure into the cost of refining gasoline. Thus if oil prices double, Knittel points out, gasoline prices do not necessarily double. But in general, when oil prices—as the denominator of this fraction—go up, the crack ratio itself falls.

The previous work evaluated time periods when oil prices rose, and the percentage of ethanol in gasoline also rose.

Knittel and Smith assert that the increased proportion of ethanol in gasoline merely correlated with the declining crack ratio, and did not contribute to it in any causal sense. Instead, they think that changing oil prices drove the change in the crack ratio, and that when those prices are accounted for, the apparent effect of ethanol “simply goes away,” as Knittel says.

To further illustrate that the previous study was touting a correlation, not a causal relationship, Knittel and Smith conducted what are known in economics literature as “antitests” of that study’s model. By inserting unconnected dependent variables into the model, they found that the model also produced a strong correlation between ethanol content in gasoline and, for instance, U.S. employment figures — although the latter are clearly unrelated to the composition of gasoline.

The previous work also claimed that if ethanol production came to an immediate halt, gasoline prices would rise by 41 to 92 percent. But Knittel does not think that estimate would bear out in such a scenario.

“In the very short run, if ethanol vanished tomorrow, we would be scrambling to find fuel to cover that for a week, or less than a month,” Knittel says. “But certainly within a month, increases in imports would relax or reduce that price impact.”

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