no way out?

The barriers to developing an alternative fuels industry are not technical, but social.

by Galen J. Suppes and Truman S. Storvick

During last year's political season, the topic of outsourcing became a hot-button issue. America's manufacturing base, we were told, was being shut down and reestablished in places such as southern India and eastern China. Some people fretted that it was close to impossible to find backers for investment in new plants or industrial projects in the United States.

If that were true, it would be a certified disaster. Infrastructure investment is debatably the most important step a democratic and free society can take to assure prosperity and security. The absence of domestic infrastructure investment already has led to the near extinction of the U.S. steel and textile industries. And due to lower wages and less stringent environmental regulations abroad, the consensus is that garnering investment into major energy or chemical process infrastructure on U.S. soil is all but futile.

Essentially giving up on the prospects of attracting new manufacturing industries, many states are working to attract early-stage, high-tech companies. Michigan has created a $150 million high-tech venture capital fund, and California recently passed a multibillion dollar stem cell research initiative.

Fortunately, the obituary for the U.S. manufacturing industry need not be written—at least not yet. There is more to this story, and it resides in the driving forces for investment and, specifically, the profitability analysis estimates on which corporations base investment decisions. Investment in industries such as transportation and synthetic fuels production can make business sense even in a First World setting, but only if we are honest about the true barriers to infrastructure investment.

To find out where the true barriers lie, we conducted a case study on the investment in a hypothetical project that used the Fischer-Tropsch process for converting Wyoming coal into a synthetic oil alternative to imported petroleum. The impact of technology cost was compared to the following four non-technical barriers: petroleum reserves, intangible costs, tax structures, and the expected return on investment.

Unlike imported petroleum, which is brought to American refineries with relatively little labor, synthetic fuels are made through a manufacturing process. That means that labor costs—salaries, benefits, payroll taxes, insurance, and the like—make up a major component of the price needed to support synthetic fuel production. Does that put manufactured fuel at a disadvantage when trying to compete with fossil fuels?

The measuring stick we used to determine profitability was the investment rate of return because it will provide the "threshold" price of the synthetic oil product. Petroleum prices above this threshold price would justify investment. In our calculation, the "threshold" price for the synthetic oil is adjusted until the net present value of the process is $0 at the end of the process life (15 years for the base case). That means any price above the threshold will yield a profit above the demanded return on investment.

After preparing a base case investment rate of return, the sensitivity of the threshold synthetic fuel price to the four non-technical barriers was determined by repeating the calculation for the upper or lower limits of each of the non-technical barriers.

The base case yielded a threshold price of $41 per barrel of synthetic oil. However, this base case assumed no intangible costs and zero years of oil reserves for the corporation making the investment. But neither of those assumptions is realistic. Today's reality is that vested interests in oil reserves and intangible costs rapidly increase threshold petroleum prices to more than $150 per barrel. Indeed, we found that the ownership of oil reserves was the biggest barrier to a corporation's investment in synthetic fuels. Oil corporations will invest in a U.S. alternative fuel industry only when their petroleum reserves are depleted to about the time it takes to build the alternative fuel infrastructure, or about two years of reserves.

Reserves will not fall to this level any time soon. Even if investing in such a project were seen by society as necessary, the United States cannot rely on oil corporations to make the investment. Corporations make investments based on corporate profitability, not the greater good.

As an alternative, society (through the government) could select energy options that do not rely on the refineries or distribution networks of major oil corporations. Increasing the fuel economy of vehicles is such an approach, but it has limited potential. A new technology referred to as plug-in hybrid-electric vehicle technology has the potential to substantially displace oil with domestic electricity and may be a technology that displaces petroleum. Hydrogen gas would be used on fuel cell versions of plug-in HEVs, but no hydrogen distribution infrastructure will be required. (Hydrogen could be produced via an onboard electrolysis system.)

Intangible costs are the second greatest barrier to investment in a domestic alternative fuel industry. Anti-trust laws tend not to cross international boundaries. Needed investments in a U.S. domestic fuel industry are not made (in part) because OPEC could flood the world oil market with low-price petroleum and drive domestic synthetic production out of business. Factoring in such a potential oil glut raises the threshold price for synthetic crude to between $67 and $97 a barrel.

International treaties or price-dependent tariffs that effectively extend anti-trust laws across international boundaries are one potential fix to this problem. But such treaties or policies must be in place at the time investment decisions are made, which means they need to be established now, not tomorrow.

Corporate demands for high return on investment had the third greatest impact on the threshold price. To lower this barrier, states could encourage corporations to invest by providing tax credits or land for plant sites. For example, Alabama has used incentives to attract automotive industries.

State-negotiated incentives work. a more direct approach, however, would be for local and state governments to provide capital with government bonds. If such a direct investment approach were used, communities would be able to match their capabilities and needs with the industry that the community is trying to attract. The underlying message here is that communities realize value from local industry beyond the return on investment realized by the corporation, and it is often good policy to provide incentives to attract industry. In this approach there must be assistance to communities to help them make smart incentive decisions.

Remove economic barriers and coal could be profitably turned into oil.

Domestic taxes have a greater impact on investment decisions than the cost of the technology. Under present conditions, about half the price of a barrel of synthetic petroleum produced from Wyoming coal would be taxes (corporate income, personal income, property, FICA, and so on) while imported oil is scarcely taxed at all. About 10 cents per barrel is charged to imported petroleum, basically to cover docking or harbor fees.

It makes no sense to burden domestic industry with taxes while foreign producers are allowed to enter the U.S. market without paying a similar tax to do business. While it is true that imported petroleum can have similar taxes paid to a foreign country, the key qualifier is can. If imported oil is produced in a country where taxes are primarily a value-added tax paid on domestic sales, a foreign producer could export to the United States with little or no tax burden.

The American tax system is a hodge-podge that has been implemented piecemeal over the past century. In almost every case, the taxes once seemed like a good idea. However, today's tax structure is not a good idea in a global market. Tax reform is needed. A solution could start with replacing all corporate taxes with a value-added tax applied to imported and domestic items alike. To eventually create a truly level playing field, many of the personal income, property, and FICA taxes could also be converted to value-added tax.

Taxing domestic and foreign products alike is fairer than selectively taxing either domestic or foreign producers. By contrast, the Chinese government levies a 17 percent value-added tax on all sales of semiconductors and integrated circuits, but as much as a third of this tax is rebated for those chips made in China. The U.S. policy of continuing to apply century-old tax policies is undermining the country's entire industrial base by increasing the incentive to invest abroad.

U.S. leaders and economists generally have overlooked the huge impact of allowing "tariff-free trade" in view of the U.S. tax structure. In his seminal work, The Wealth of Nations, the philosophical father of free trade, Adam Smith, considered two legitimate exceptions to free trade: When industry was necessary to the defense of the country and when tax was imposed on domestic production. Taxing domestic synthetic fuel production while importing crude oil duty-free fits Adam Smith's exception.

And the solution does not lie in subsidies. Selectively providing 55-cent-per-gallon incentives for domestic ethanol production (or $1 per gallon for domestic biodiesel production) to correct a poor tax structure displaces capitalism with political prejudice. Two wrongs do not make a right.

Often, experts assure us that the technology just isn't advanced enough for synthetic fuel to be a viable alternative to fossil oil. But this isn't the case, or at least not the whole story. On a level playing field, a barrel of synthetic oil made with off-the-shelf technology could be sold for as little as $13 and still make a profit. Even further technological advances can't overcome the headwinds of the non-technical barriers to commercialization we have identified.

There are yet more roadblocks: Even if a non-petroleum company were able to produce an inexpensive synthetic fuel, the producer would have to sell to existing oil corporations or face tens of billions of dollars of additional investment. In view of possible agreements with foreign producers, it is not certain that the major U.S. petroleum corporations would displace contracted petroleum with a synthetic oil alternative.

To see one way of successfully commercializing synthetic fuels, one should look north to the Canadian oil sand (formerly referred
to as tar sand) industry. At $9 to $15 per barrel, oil sand production costs are more than Fischer-Tropsch production costs. But even at these higher costs, large-scale mining of oil sands in Canada began in 1967 when oil prices were less than $10 per barrel. It took the better part of a decade to make a profit from the oil sands.

Commercialization was made possible by the Canadian National Oil Policy that, when introduced in 1961, established a protected market for Canadian oil west of the Ottawa Valley and freed the industry from foreign competition. This policy protected companies from the greater intangible costs and provided an environment for smaller companies (other than the major petroleum companies) to develop the technology. In addition, in 1974 the Canadian and provincial governments invested in Syncrude Canada Ltd.'s oil sand project and provided assurances about financial terms. New refineries were built—for one, the Shell Canada Limited Complex at Fort Saskatchewan, Alberta.

Today, with oil prices in excess of $40 per barrel, the Canadian oil sand industry is profitable beyond most investors' expectations. It provides energy, security, and quality jobs.

The conventional wisdom is wrong. It is neither cheaper foreign labor nor less stringent foreign environmental regulations that ultimately prevent new industrial infrastructure from being built in the United States.

Those trying to write the obituary for American manufacturing would be better to claim that U.S. industry died because society's leaders did not properly adapt policies for the global economy. National tax reform and antitrust laws that do not end at the border could save many industries and promote new U.S. infrastructure investment. Those policies would not overcome barriers related to vested interests of petroleum corporations in fuel reserves and distribution, but alternatives such as plug-in HEV technology could be implemented independently of fuel distribution systems.

Plug-in hybrid-electric vehicles are similar to the many models of HEVs on the market today. They allow extended battery packs (about 20 miles of range) to charge from grid electricity during the night, providing the first 15 minutes or so out of the garage each day without engine operation. Gasoline is fully displaced with grid electricity for most of each day's transit. Per-mile operating costs for grid electricity are about one-third the cost of gasoline. Rather than going to petroleum producers, the majority of the fuel operating revenues would go to local communities.

If a value-added tax were applied to imported fuels representative of taxes on domestic synthetic fuel production, the annualized operating costs of plug-in HEV technology should be less than a conventional gasoline-powered vehicle. Less oil would be imported, domestic jobs would be created, and the new demand for off-peak electricity would allow restructuring of the electrical power grid to include base load generation with increased efficiency for electrical power production and reduced greenhouse gas emissions.

The market alone cannot provide this positive result. But the market is not the only factor at work: The thumb of tax policy, regulations, and international agreements weighs heavily on the scale. But if we think a domestic energy infrastructure—indeed, a national manufacturing base—is a worthy goal, then it is possible to make this happen, if only we level the playing field.

Galen J. Suppes is associate professor and Truman S. Storvick emeritus professor of the department of chemical engineering at the University of Missouri in Columbia. Their book, Energy Disclosed: Abundant Resources and Unused Technology, was published in 2004.

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© 2005 by The American Society of Mechanical Engineers