The 20% Dream

Imagine a world where the United States reduced its gasoline usage by 20%. World oil demand would slip by roughly 4 million barrels per day. Spare capacity would expand to 7 million barrels per day. The influence of countries like Iran would be dramatically diminished. Prices would plummet, and the average American family would save hundreds if not thousands of dollars on fuel every year.

At the same time, America would increase domestic production. This additional production would be augmented by a dramatic increase in biofuels, including ethanol from agricultural waste, wood chips, and switchgrass. The combination of reduced consumption, increased domestic oil production, and increased alternative fuel production would put us very near the political ideal of energy independence.

The dream
President Bush made several proposals in the State of the Union address intending to lead us toward the world just described. I picked out several specific proposals that we can examine:

1. Continue research on batteries for hybrid vehicles and ethanol from biomass.

2. Increase fuel-efficiency standards for cars to save 8.5 billion gallons of gasoline in 2017.

3. Set a mandatory fuels standard to require alternative fuels totaling 35 billion gallons in 2017.

4. Increase domestic oil production.

5. Double the capacity of the strategic petroleum reserve, or SPR.

Hybrid vehicles and biomass ethanol
When I was a young engineering student, I had a chemistry professor who talked endlessly about polymer chains that had a great deal of promise in battery technology. He talked about how if these chains could be modified, batteries could store enough energy to make an electric car, and it would change the world. That was in 1987. Battery technology has progressed, and hybrid cars and plug-in hybrids really show a lot of promise to fundamentally change the transportation industry. However, it's unlikely that a breakthrough is right around the corner; rather, technology will likely evolve over the next 10 years via continuous improvement. For now, the battery behemoths are Sanyo and Matsushita (NYSE: MC  ) .

Likewise, the government has been funding research on biomass ethanol (ethanol from wood chips, corn stalks, switchgrass, and so on) for more than 25 years. There are a few pilot plants out there, but large, commercial-scale production will not affect the nation's fuel supply for many years. Time will tell if there will be a winner in this area, but if you know of anyone turning a profit here (without government handouts), let me know.

Increasing fuel efficiency standards
For now, we will assume the 8.5 billion gallons is an annual number to be achieved by 2017. The U.S. is the world's largest consumer of gasoline, consuming 384.7 million gallons per day. That 8.5 billion gallons in a year translates into 23 million gallons per day -- a 6% reduction in consumption. Assuming gasoline demand actually falls over the next 10 years, the big losers would be refining companies like Valero (NYSE: VLO  ) and Tesoro (NYSE: TSO  ) . Only last year, the president was talking up the need for additional refining capacity, and companies like Marathon have responded by spending billions to increase domestic refining capacity.

Mandatory fuels standard
Increasing alternative fuels to 35 billion gallons in 2017 is a big goal. If achieved, total alternative fuel production would be 2.3 million barrels per day -- enough to replace nearly 15% of domestic refining capacity. I'm assuming most of this production would be in the form of ethanol, which means more farming, and more farming machinery sold by Deere & Co. (NYSE: DE  ) . Even with big government subsidies, which already exist, it's tough for small ethanol players to make money, so I'd put my money on the scale of Archer Daniels Midland (NYSE: ADM  ) .

Increasing domestic oil production
Few people realize that only Saudi Arabia and Russia produce more oil than the U.S. Even though we've been producing oil since 1869, there are plenty of promising drilling prospects in the Lower 48 and the Gulf of Mexico. If domestic production is to get a big boost, it's tough to know which company will get the drilling rights to any given property, so I'd take a look at the service companies, especially those focused entirely in the U.S. Motley Fool Hidden Gems recommendation Dawson Geophysical (Nasdaq: DWSN  ) is the best example I know of, with its services entirely focused on the domestic market.

Double the SPR
Doubling (and subsequently filling) the strategic petroleum reserve would add substantial artificial demand to world oil markets. The SPR has a capacity of 727 million barrels of oil, with just under 700 million barrels currently in storage. Assuming the additional 700 million barrels are added over the next 10 years, this represents nearly 200,000 barrels per day of artificial demand, accounting for about 0.2% of annual demand growth over that period. In a world of tight supply and demand characteristics, an additional 0.2% of demand growth could be substantial, causing prices to remain higher than if the demand did not exist. The winners would be the oil-exporting countries of the world.

Waking from the dream
There has always been a conflict at the heart of our energy independence dilemma: The energy from other countries is cheaper than the stuff we produce domestically. Ethanol is only competitive with gasoline with the help of government subsidies. The downside of the aforementioned domestic drilling prospects is that they require much higher oil prices to be profitable. Saudi Arabia makes a profit when oil is selling for less than $10 a barrel. Oklahoma makes a profit somewhere closer to $25 a barrel. So, for the United States to be energy independent, we all have to agree to pay higher prices.

One way to achieve a 20% reduction in demand would be to provide big subsidies for both ethanol and domestic oil production. Ethanol producers already need the subsidies, and domestic oil companies would need subsidies to increase production in the face of falling world oil prices. A logical place to get the funding would be high fuel taxes, because if we cut demand, prices would fall. If prices fall, it's likely consumers would not be so interested in energy independence. Expensive fuel would let consumers know they need to conserve.

Of course, the above proposal would be political suicide. The politician sponsoring it might as well put on a cardigan sweater and start talking about public transportation. It will never happen.

Final thoughts
It seems at least once a week I receive an email hyping some penny stock, claiming it will be the next big winner due to a change in government regulations. I like my companies to make their money in the real world of supply and demand. For the time being, I'm sticking with the oil boom.

I do know one proposal is a sure winner. Whatever the merits of ethanol, I've never seen a politician vote against it. I expect big increases in ethanol production, and I'll be adding Deere & Co. to my Motley Fool CAPS portfolio in the near future.

For related Foolishness:

Interested in outstanding small-cap stocks flying under the market's radar? Join Tom Gardner and other investors like you on the Motley Fool Hidden Gems discussion boards -- available for 30 days with a free trial.

Fool contributor Robert Aronen owns shares of Dawson Geophysical and thinks the oil patch will be just fine for the next decade. Feel free to share your comments with him. The Fool has a disclosure policy.

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