Monday, November 12, 2012

Price Controls Have Consequences

Two recent events have brought the topic of energy price controls to my mind. The first is in Brazil, where government pressure on Petrobras, the state-owned energy producer, has caused it to continue to hold down prices on gasoline in Brazil for the foreseeable future.  Thanks to governmental pressure, Petrobras has subsidized its gasoline, selling below fair market value, since 2005.  Brazil's government has a strong interest in cooling down inflation and part of that is attempts to hold down the value of the currency, which is already overvalued.  But trying to push against a gas price rise has led to some unintended consequences (gated, unfortunately).

Essentially, cane sugar mills that might otherwise be producing high-value ethanol to sell into the fuels market are now facing a situation where rising fundamental input prices are pushing them out of the market. The price levels of their fundamentals - labor, raw material inputs, and the like - are continuing to rise with inflation, because there is no universe in which government price controls can change the underlying market forces.

In order to remain competitive, ethanol must be sold at a significant discount by volume to gasoline, which has a higher energy content.  Price controls on gasoline have historically cut the profitability of ethanol, and it is now reaching the point where cane ethanol producers cannot sell into their own domestic market because of the artificially low price of the competing product, gasoline.  Perversely, this has caused the Brazilian ethanol market to preferentially export ethanol to the US once again (aided and abetted by the US's renewable fuels standard, and reversing the trend of the last few years) and to overproduce sugar, the price of which isn't being held down by the Brazilian government.

The second bit of news was brought to my attention by the always-informative Geoffrey Styles at his blog Energy Outlook.  Mr. Styles' discussion is more detailed than my own, so I would definitely recommend reading his post.

After the recent election Senator Ron Wyden (D-OR) is now likely to chair the Senate Committee on Energy and Natural Resources.  His views on shale gas exports show a dangerous tendency to protectionism.  Essentially, Senator Wyden is worried that raising the natural gas price in the US by selling LNG onto the world market will harm America more than it will help it.

Senator Wyden's protectionist reasoning is dependent on two assumptions: first, that shale gas production in the US will continue to provide energy at the same cheap price levels we see today, and second, that a low gas price is unambiguously good for America now and in the future.

The first assumption is unambiguously wrong. The shale gas price level is so low that drilling activity has drastically decreased and continuing production is depending on co-production of natural gas liquids - so-called "wet" gas wells.  "Dry" gas fields with little-to-no natural gas liquids have largely remained unexploited this year.  Additionally, Mr. Styles points out one reason that the pricing mechanisms that govern gas production might currently be difficult to discern: that much of the continuing production is due to contractual obligations that require the exploitation of reserves at a set pace independent of market signals.

However, this lack of a price incentive to drill is keenly felt in industry. There is a virtual consensus that price levels must go up to encourage more drilling.  If exports are blocked and contribute significantly to the price remaining low (there is some controversy as to whether exports will play a big part of this), then Senator Wyden will see his policies causing the shale gas revolution to peter out.

Senator Wyden is also wrong to think that low gas pricing is unambiguously good for America in both the short and long term.  In the short term, it is worth remembering that high energy prices are good for the (US-based) producers as well as for consumers. At minimum, keeping the shale gas price artificially low by minimizing exports will amount to a redistribution from resource extraction companies to consumers of those resources, with the results unclear.

In the long term, Senator Wyden may also find that keeping the gas price low hurts some of the very sectors he may be inclined to support.  Renewable energy hopefuls for both electricity and vehicular fuel must now compete against a very cheap, high quality and clean burning substitute that was literally not in contention three years ago.  Senator Wyden will undoubtedly find that holding down the price of natural gas will sound the death knell for a whole host of renewable electricity and renewable fuels projects - maybe even including some in his home state.  We may venture that holding down gas prices now might well lead to a very uphill battle when the gas begins to run out and we have no renewable infrastructure to fall back on.

Price controls create perverse unintended consequences, in the energy world and out.

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