Ethanol Hasn’t Made Gasoline Cheaper

The Renewable Fuels Association (RFA) is touting a new study claiming that ethanol reduced gasoline prices by more than a dollar per gallon in 2011. As with similar studies in the past, the methodology used here to calculate this number rests on a basic fallacy in how they frame the question, which we’ll explain below. Beyond framing the question incorrectly, there is the obvious point that ethanol has lower energy content than conventional gasoline. If ethanol really were efficient, it wouldn’t take government favors to prop up the industry.

The Alleged Benefits of Ethanol

Here’s an excerpt from the RFA’s media blitz:

America’s growing use of domestically-produced ethanol reduced wholesale gasoline prices by an average of $1.09 per gallon in 2011, according to updated research conducted by economics professors [Dermot Hayes and Xiaodong Du] at the University of Wisconsin and Iowa State University…

“Growth in US ethanol production has added significantly to the volume of fuel available in the US,” said Professor Hayes. “It is as if the US oil refining industry had found a way to extract 10% more gasoline from a barrel of oil. This additional fuel supply has alleviated periodic gasoline shortages that had been caused by limited refinery capacity…” [Bold added.]

The part we’ve put in bold gives away the game; it shows how Professor Hayes and Du got the ethanol rabbit in the hat. Although their study relies on apparently impressive regression analysis, what they are doing in a nutshell is looking at the U.S. refinery infrastructure in 2011 and asking, “What would happen to gas prices if all ethanol production suddenly disappeared overnight?” Based on their careful statistical tests, they conclude that gasoline prices at the pump would jump more than a dollar per gallon.

Yet that is a totally different claim from saying that if the U.S. government had never subsidized and mandated the increased use of ethanol, that gasoline prices would now be higher.

The basic mistake underlying the paper is that it assumes the conventional refining capacity of the petroleum sector would have developed in the same way, under a free market in fuels. But on the contrary, had the government not artificially carved out market share for ethanol, then conventional refining capacity would have grown more quickly than it did in reality. In that alternate timeline, the lack of ethanol in 2011 wouldn’t have made gasoline more expensive; in fact, because ethanol needs to be propped up by the government to maintain its current market share, gasoline would have been cheaper in 2011 if the U.S. had had a free market in fuels for the last decade.

The authors actually admit all of the above criticism when they wrote in their original 2008 paper:

These [theoretical] reductions in retail gasoline prices [reported in the paper] are surprisingly large….The availability of ethanol essentially increased the “capacity” of the U.S. refinery industry and in so doing prevented some of the dramatic price increases often associated with an industry operating at close to capacity. Because these results are based on capacity, it would be wrong to extrapolate the results to today’s markets. Had we not had ethanol, it seems likely that the crude oil refining industry would be slightly larger today than it actually is… [p. 13, bold added]

Unfortunately, the authors don’t seem to realize the full significance of this admission, and they don’t appear to have carried forward these caveats into their latest update of results.

Pro-Ethanol Results Make No Sense

Perhaps the best way to show that there is something fundamentally wrong with the Hayes and Du paper, is to look at their Table 3 where they provide their disaggregated, regional results. The two extreme ends of the spectrum show that they think ethanol in 2011 made gasoline 73 cents cheaper per gallon in the Gulf coast, while ethanol in 2011 made gasoline a whopping $1.69 cheaper in the Midwest.

Stop and ask yourself: Does that make any sense at all? Can it possibly be that in the absence of ethanol, gas prices would have jumped only 73 cents in the Gulf coast, while prices would have risen more than twice as much—$1.69—in the Midwest?

Of course not; that wouldn’t have happened. Market forces and competition would have spread out the price rise uniformly; there couldn’t be such a huge discrepancy laid on top of the small differences already present.

So what then is generating the strange result in the Hayes and Du paper, showing that ethanol apparently is much stronger at slowing gas price hikes in the Midwest than it is in other parts of the country?

The answer relates to the development of refining capacity. Given the government’s support and mandates for ethanol, it makes sense that the Midwest (where corn is grown) would see the biggest deviation from how the market would have normally developed. So then if we ask—as the study does—which region of the country would be shocked the most if ethanol suddenly disappeared, it would naturally be the one that was most distorted by the ethanol programs in the first place. Yet this hardly shows that Midwest gasoline prices were held down more than in other areas of the country; instead it shows that the whole premise of the study is flawed.

Common Sense

Besides all of the high-brow statistics, we can tell there is something fishy about the RFA’s claims by considering the obvious fact that ethanol contains less energy by volume than conventional gasoline. Indeed, AAA has estimated that even at today’s relatively high prices, once we adjust for BTUs (i.e. energy contain), E85 (i.e. fuel with 85% ethanol content) is more expensive than conventional gasoline mixtures. The government isn’t helping motorists by using tax dollars and mandates to force refiners to incorporate a fuel that gets less mileage for the money.

Conclusion

Ethanol may have a niche in the fuel market, even without government intervention. But in order to tell just how it fits in, we need a level playing field. Government subsidies and mandates for ethanol do not help consumers and they don’t make gasoline cheaper.