Entry of Alternative Fuels in a Volatile U.S. Gasoline Market

By Vedenov, Dmitry V.; Duffield, James A. et al. | Journal of Agricultural and Resource Economics, April 2006 | Go to article overview

Entry of Alternative Fuels in a Volatile U.S. Gasoline Market


Vedenov, Dmitry V., Duffield, James A., Wetzstein, Michael E., Journal of Agricultural and Resource Economics


Dramatic increases in levels and volatility of gasoline prices observed in recent years may create market incentives for adoption of alternative fuels characterized by lower price volatility. This hypothesis is investigated by applying the real-options pricing approach to develop optimal thresholds for switching from conventional gasoline to alternative fuels such as ethanol blends. The main result of the paper is that given the historical price patterns of conventional gasoline and ethanol, switching to ethanol blends is an economically sound decision provided this does not decrease efficiency of the vehicle. Analysis of data subsamples during the periods of higher volatility of gasoline prices (Gulf War and War on Terrorism) provides even stronger support for this result.

Key words: alternative fuels, decision making under uncertainty, ethanol, price volatility, real options

Introduction

Since the turn of the 21st century, the volatility in gasoline prices causing price "spikes" has become increasingly common (Ashton and Upton, 2004). Gasoline prices tend to exhibit asymmetry, with steep price spikes followed by gentle declines. U.S. Energy Information Administration data confirm this price asymmetry, where retail prices typically rise more rapidly than they fall (Cook, 1999). Such volatility harms the entire macroeconomy and is at least partially responsible for the U.S. economy falling into the 2001 recession. As reported by Ferderer (1996), oil price volatility, which directly impacts gasoline volatility, affects the entire U.S. economy through sectoral shocks and uncertainty. Irreversible investment decisions adversely affected by this volatility have placed a significant drag on the economy. This is consistent with the results of Kneller and Young (2001) who found that oil price volatility is robustly negatively correlated with economic growth. Not surprisingly, corporate stock prices also respond inversely to increased price volatility of petroleum products (Sadorsky, 1999).

Alternative hypotheses have emerged as explanations for the increased gasoline price volatility. Crude oil costs are certainly a contributing factor, but Speir (2004) concludes oil price volatility alone explains less than half of gasoline price movements. This result is supported by Ashton and Upton (2004) who cite changes in inventory carrying levels, increased concentration and vertical integration of the petroleum industry, and the advent of boutique fuels as major factors in increased price volatility.

With world demand for oil continuing to increase and U.S. refiners operating at full capacity, a tight market for gasoline currently exists (Speir, 2004). In such a market, price volatility is reinforced when a boutique of fuel types creates unique local markets with barriers that prevent the reallocation of fuels for meeting changes in short-run regional demands (Hutzler and Shore, 2002).

With upward-trending oil prices and heightened concerns over energy security stemming from the 9/11 terrorists attacks, expanding domestic renewable fuel production has become a major policy objective for the United States. Renewable fuels are generally more expensive than their petroleum counterparts and require government support in order to compete in the U.S. fuel market. For example, since the late 1980s, ethanol producers have enjoyed a motor fuel tax credit, currently standing at $0.51 per gallon.

Efforts to promote renewable fuel production have intensified in the past few years, as the U.S. Congress and many states have adopted numerous policies to increase the use of domestic ethanol and biodiesel in the U.S. transportation sector (Collins and Duffield, 2005; North Carolina Solar Center, 2005). In addition, environmental regulations, such as the Clean Air Act Amendments of 1990, have been passed to encourage the replacement of petroleum fuels with renewable fuels to address air quality concerns. …

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Entry of Alternative Fuels in a Volatile U.S. Gasoline Market
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