Economics has only four basic principles: marginality, elasticity, substitution and time preference. And as anyone who ever completed a basic course can attest, prices are set at the margin. It is the price offered for the last unit produced and the cost of producing the last unit that really matter. These principles from the so-called dismal science paradoxically give us reason to be optimistic about the world's energy picture. As I never tire of pointing out, usually to the consternation of the hot-commodities crowd, long-term constant-dollar prices for commodities must decline for reasons of substitution and the price elasticity of demand. As price rises, additional substitutes become economic and demand for the marginal unit declines. Of course, we are dealing with a set of two-edged swords here. The very same roster of energy alternatives bandied about today were bandied about in the 1970s: solar, wind, oil sands, oil shale, heavy oil, coal gasification and/or liquefaction, liquefied natural gas, coal seam gas, Devonian shale, tight sands gas, tidal and so on. Why are these sources still called alternative? The marginal unit of conventional fossil fuels remained cheaper and more abundant than any of them and therefore the alternatives remained uneconomic. Billions of dollars were wasted on those alternative energy projects by both private firms and governments until the 1985-86 oil-price collapse brought the farce to an end. As I emphasized
last March, everyone running an energy business today is a survivor of that collapse, and as Mark Twain observed, a cat that sits on a hot stove will not sit on a hot stove again. Or a cold one.
But biofuels have come to mean two things: a diesel fuel substitute derived from vegetable oils such as soybean oil, and ethanol derived from sources such as corn and sugar. These two biofuels were the subject of an excellent presentation at a conference in London last week, the gist of which I will summarize below. First, those hoping for free-market economics are advised to look elsewhere. Mandates abound, from the European Union's "soft" mandate for 5.75% biodiesel use by 2010, up from 2% today, and its tax credit of $450 a metric ton, to the U.S. exemption of ethanol from the federal gasoline tax, to Brazil's mandated targets for ethanol use in motor fuels. The combination of agribusiness interests, farm-state votes, green lobbies, petroleum displacement and industrial policy is irresistible to politicians. Second, high-petroleum product prices make production attractive. This is true for both European and American biodiesel derived from soybean oil and for American ethanol derived from corn. However, the recent jump in sugar prices, discussed here in February, has pushed Brazilian ethanol derived from sugar right to its break-even zone. This is a clear warning, one that we will return to below.
Let's stipulate right now that we are not going to divert 100% of the world's corn, sugar and vegetable oil crops to fuel production. As much as drivers everywhere want cheap fuel, most want to eat on occasion, too. While commodity optimists such as myself point out that few endeavors are more suited to technological -- read "genetic" -- efficiency gains than the conversion of existing organic matter into either food or fuel, we are facing a situation in which the energy business is exerting an increasing claim on certain of the world's foodstuffs. Even this year, U.S. ethanol production could grow to a point at which it claims nearly all of our corn exports. I might point out as an aside some major transatlantic attitudinal differences. The Europeans at this particular conference, including a very well-versed representative of the International Energy Agency, kept returning to carbon dioxide and the global-warming issue; the Americans generally shrugged. The Europeans have different attitudes on the genetic modification key to increased corn and sugar production as well: They fear it palpably while the Americans accept it. In sum, Europeans want all of the "green" benefits of biofuels and are not willing to accept at least one cost, genetic modification. In reality, we no doubt need to both increase the use of genetic modification and reduce carbon emissions.