BRAZILIAN ETHANOL AS A BACKSTOP ALTERNATIVE TO OIL

My comments on the piece below:

The following paragraphs are a small part of a brilliant article by economist David Cohen, and were taken from “The Oil Drum”, a site that discusses Peak Oil and its consequences.

Mr. Cohen notes that biofuels are one of the only alternatives to gasoline derived from light, sweet crude. The only other remotely-viable options are heavy oil shales and tar sands, both of which are big polluters and very costly to process.

To Mr. Cohen acknowledges that there is, indeed, a substantial difference between ethanol made from corn and ethanol made from sugarcane. He believes that “the current enthusiasm for ethanol from a corn feedstock (as opposed to Brazil's use of sugarcane) is a good case in point. The hyperbole (surrounding corn ethanol) leads to a false belief that the substitute under discussion is a perfect backstop for conventional oil.”

The section below comes at the end of a rather lengthy and informative article. I encourage you to read the rest by clicking here. H.O.

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The Tragic Consequences of the High Discounting of Oil Extraction

An economic theory of finite non-renewable resources refers to a perfect backstop. This is more widely known as a complete substitute for the resource under consideration, which is conventional oil in this case. If such backstop exists, then Hotelling theory predicts that the price should rise according to Figure 6, taken from Khanna.

Figure 6 – Impact of Backstop Resource. Pnr indicates the price of the non-renewable resource; Pb indicates the price of the backstop. Tnr indicates the depletion of the nonrenewable resource.

The fundamental insight is that the price rises and the remaining resource stock is all used up prior to the switch because the existence of a perfect substitute renders the resource worthless. In theory, when the price reaches the backstop price, all of the resource would have been consumed and substitution occurs. Therefore, the perception that perfect substitutes actually exist increases the extraction rate of the resource.

Do perfect substitutes for conventional oil exist? The answer is "No". There is no perfect backstop but there are a plethora of imperfect substitutes—that we might call wedges—that might replace some part of the role conventional oil plays. The very notion of a substitute for oil is fuzzy. Note that in the general case, almost any abundant source of hydrocarbons, regardless of considerations affecting their production, is perceived as a backstop for conventional oil. Here is a brief list of the main wedges.

1. Canadian tar (oil) sands
2. Orinoco heavy tar
3. Coal/Natural Gas/Biomass to liquids
4. Oil Shales
5. Electric transportation
6. Wind, Hydro, Solar and Nuclear to support #5

It is important to remember that when one hears hyperbole about any of these substitutes, it is not the case that any of these backstops is perfect because they don't scale or their net energy return is low (if not = 1) rendering them expensive —and in the worst case— uneconomic to produce. This is just a partial list. The current enthusiasm for ethanol from a corn feedstock (as opposed to Brazil's use of sugarcane) is a good case in point. The hyperbole leads to a false belief that the substitute under discussion is a perfect backstop for conventional oil. Kronenberg states that for both the resource owner O and the resouce consumer C, this can lead to what he calls strategic interactions that lead to serious market failures.

Strategic Interactions

Here is a description of the game that Kronenberg terms strategic interactions.

* The resource owner O knows the total stock of the resource. The resource consumer C does not.
* C has the option of developing a backstop technology at any time
* O can delay the development of the backstop by influencing C's decision by lying about the stock of remaining resources.

Here is the result as described by Kronenberg (page 25):

Thus, if there are information asymmetries between the owners and consumers of a resource, strategic interaction takes place, and credible announcements play a critical role. Specifically, resource owners will have an incentive to overestimate the resource stock, so as to delay the development of substitutes for the resource. To make this announcement credible, they have to follow an extraction path consistent with the overestimated resource stock, so extraction will be faster than socially optimal. Resource consumers will have an incentive to announce the development of a backstop technology, and resource owners will react to this threat by raising the extraction rate and lowering the resource price (if the demand curve is downward sloping). In both cases, resource extraction occurs faster than socially optimal.

This interaction may be viewed as a reason for the failure of the Hotelling model. In fact, the suspicious OPEC reserves increases that took place in the 1980's is cited as a possible example and Kronenberg notes that resource (both national and state-run) owners have clear incentives to systematically over-estimate their remaining reserves which, in turn, leads to serious market failures. In order to manage consumer perceptions, extraction must remain higher than is socially optimal for a finite non-renewable resource in all cases.

Follow what's happening in the Brazilian ethanol market on Ethablog, the only blog in English dedicated to Brazilian ethanol.