Dollar devaluation and energy

Environmental Capital and Green Sheet pick up on what is in my opinion the least interesting part of Geoff Styles' recent piece on "Deficits, Dollars, and the Price of Energy." Obviously if the dollar falls, the price of all globally traded goods get more expensive from a U.S. perspective, not just oil.

I left a comment on what I feel is a much more interesting line of discussion:

I agree that “higher oil prices don't automatically make alternative energy more competitive,” but I’m not sure that’s the lesson we should draw from 2006-2008. Obviously a weaker dollar makes all global commodities more expensive from a U.S. perspective, not just oil, but the 2006-2008 commodities bubble was driven by more than just a weakening dollar. (Growing demand, higher-cost marginal supply, maybe speculation, take your pick, but major commodities went up far more than the dollar fell.)

If we take the example of biofuels, at $140/bbl crude the value of ethanol as fuel was well above the cash cost of corn, so corn ethanol made economic sense (although most of the value was captured by the growers as corn started pricing off its value-in-use as fuel). Similarly, higher natgas prices meant higher power prices and better economics for wind and solar. Overall higher crude prices did make alternative energy more competitive in 2006-2008, which is why we saw a lot of investment inflow and subsequent collapse (although the credit crisis didn’t help).

I whole-heartedly agree that a sincere call for fiscal discipline – from either side of the aisle – would be a most welcome step in Washington.

Amen to fiscal discipline. Rather than just link to this two posts in a row, I'll post the graph here this time:


Update: Discussion with Geoff in the comments, starting with his response:

Amen.

I'm not sure that a large influx of investment into a sector is a good indicator that it's economically competitive. Take ethanol. By the end of June '08, just before oil prices peaked at $145/bbl, the "crush spread" gross margin on turning corn into ethanol had fallen below $0.50/gal, half its value of a year earlier, despite wholesale gasoline prices having risen more than a buck in the meantime. Higher energy prices drove up the cost of corn's inputs, just as competition for corn to put into ethanol plants pushed up its price, destroying the margin available. If you look at what's happened to the ethanol industry since then, in retrospect it appears to have been in as much of a bubble as real estate.

Me:

I disagree on ethanol - the "end-to-end" economics of corn ethanol were good in June '08, the value was just captured by the corn growers rather than the ethanol refiners/blenders due to supply-demand dynamics.

Energy prices drove up fertilizer and fuel input costs, but total corn production costs were well below market price in June '08 (since some input costs - e.g. seed, agrochemicals, labor - are not strongly energy-linked). The supply/demand dynamics were in favor of the feedstock suppliers, so corn growers captured great margins, while as you said the margins for ethanol refiners/blenders weren't great.

Things have crashed since then, but if high oil prices return and capital is available, I think the integrated economics of biofuels will start to look pretty attractive once again (although that's no guarantee that any particular step in the value chain will make big money).

Geoff:

R,
That may well be, but it's small consolation for all the ethanol firms that went bust. Investors tend to remember things like that.

At the same time it strikes me that the end-to-end economics only matter if the industry has many fully-integrated firms. Oil does; biofuels doesn't. If there's no way for the ethanol distiller to capture any of the upstream margin, he can't pay out his investment in plant and equipment. That argues for a structure more like tolling agreements, in which the grain farmers bear more of the downstream risk, but why would they wish to do that?

Me:

I tend to think that if the end-to-end economics are good, the market will figure out how to take advantage at some point, barring any unusual barriers. Not sure whether it will be refiners integrating upstream, the ADM's of the world integrating downstream, the pricing mechanism shifting to reward distillers more, or second-gen breakthroughs that allow the use of cheaper feedstocks, or something else I haven't even thought of... but I don't see the barriers that would stop this from happening if the price of oil were sustained well above the cost of biofuel feedstock and production.