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In the search for alternative fuels and technologies to oil-based engines, basic cost-benefit analysis is often over-looked, and yet the dissemination of a new technology works is most successful when the market actually wants it. In making an initial assessment of the potential of a new technology, venture capitalists often apply a set of relatively simple tests to determine whether the business potential is there at all. These tools may be applied in the case of any sort of new fuel and vehicle; perhaps no fuel has no greater potential than compressed natural gas (CNG), an alternative heavily promoted by the likes of T. Boone Pickens and Aubrey McClendon, CEO of shale gas powerhouse Chesapeake Energy. How does CNG stack up?

The first test applied is that of cost or benefit differential, also known as comparative advantage. In general, venture capitalists look for a new product to be at least 25% less expensive or better than the incumbent product. There is nothing special about the 25% threshold, but a number around this range is commonly used in the industry. In our case, the appeal of the consumer is made on the basis of cost. A consumer should buy a CNG vehicle because it’s cheaper than gasoline. Does this assertion hold up?

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We looked at retail regular gasoline and CNG prices in three states: California, Texas and New York. In each of these states, CNG at the pump cost $0.80 – $1.10 less than unleaded gasoline on a gallon of gasoline equivalent (GGE) basis. In each case, CNG was 28-43% less expensive, comfortably passing the 25% threshold test.

But would anyone care? Do consumers actually want a lower-priced fuel? Lower price does not always equal market demand. Indeed, early stage technology companies often mistake a cost advantage for a value proposition. They are not the same. To induce switching to a new product, the difference not only has to be of sufficient size for people to take notice, it also has to be material to the customer in terms that matter, that is, compared to their incomes or budgets. Sometimes it doesn’t. Take, for example, retail financial products like checking accounts or credit cards. Although a competitor may introduce a product with lower fees or better benefits, most people will not switch—not because the offer isn’t better, but because switching is a hassle and the savings aren’t that important in the greater scheme of things.

In general, we use a 1% threshold for this test. That is, if new the product/service saves 1% of a person’s ongoing income or budget, then they will tend to switch to the new product/service. We can apply this test to CNG.

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If we assume the average vehicle uses 500 gallons of fuel per year, then the savings from switching to CNG would range from $400 to $500 per year per vehicle for the states we examined. If we look at the value of such savings, we can see that, for our sample states, about 40% of households should be interested.

Importantly, these are the lower 40% of households by income. The market opportunity for alternative fuels is therefore primarily at the bottom of the market, not at the top. Peak oil, therefore, is not a primarily an affliction of the rich, or more precisely, the above-average. It hits lower income households disproportionately hard. They will be the market segment looking for an alternative, because the savings that CNG offers are meaningful to them.

This should not come as a surprise. And yet, many of the alternative-fuels solutions proposed are really targeted at wealthy individuals. Consider the battery-powered Chevrolet Volt. Its list price has been reported in the $40,000 – $43,000 range. Thus, it competes head-to-head with, say, the BMW 328i. Is the consumer going to consider the Chevy Volt superior to a BMW? And if it is, will it surpass the US sales of the BMW 3-series, pegged at around 200,000 units per year? Probably not. Thus, the value proposition for a high-priced battery-powered vehicle will be quite different from that of a CNG vehicle. The market for CNG vehicles is predicated on price, and estimated on the basis above, represents an addressable market of up to 5 million new passenger vehicles per year in the United States. The Chevy Volt can hope to take a slice of a market of less than 1 million units, and within that, must struggle for product superiority, rather than competing on cost. Taken as a whole therefore, the market potential for a battery-powered vehicle, based on the economics of the Chevy Volt, is perhaps one-tenth that of a CNG vehicle. This explains why several studies, including those by the Boston Consulting Group and Nissan, conclude that sales of battery-powered vehicles will only range from 6-10% of the total market in 2020. Of course, should the economics of battery-powered vehicles change, its market potential will change in tandem. But for now, CNG vehicles have a potential to alter consumer behavior in a way electric cars do not.

Thus the second test, which tests for ‘market opportunity’, tells us that there is a significant market opportunity for CNG vehicles that is an order of magnitude greater than that of battery-powered cars.

For completeness, let’s address the last two tests: profit potential and barriers to entry. ‘Profit potential’ refers to the ability of a company with a new product to be able to make a profit. For example, newspapers nowadays can have many readers but are finding it hard to turn a profit. For this test, the numerical thresholds are those standards used in the respective industry and can be measured as gross or net profit margins, internal rates of return or net present value.

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We look at the gross margin for CNG in California. Although CNG retails for about $1 less than gasoline, it costs even less on a wholesale basis, about $0.80 / GGE. As a result, it would appear to provide a gross margin four times that of gasoline. We have not looked at operating costs yet, but an initial analysis would suggest that CNG could be a quite profitable business for filling stations, provided they could sell the fuel in large quantity. More work needs to be done in this area, as well as in the area of vehicle manufacturer’s cost, and we are conducting a workshop to examine the matter in greater detail in conjunction with the Center for Energy, Marine Transportation and Public Policy (the Energy Center) at Columbia University in New York. Notwithstanding, our initial analysis suggests that CNG has the potential to be a profitable product—indeed, in the era of peak oil, the profitable product—for filling stations in the next 10-15 years.

Finally, the issue of barriers to entry: Whenever a company introduces a new product, it has to defend the uniqueness of the product to maintain its profitability. In the case of vehicle fuels, the barriers to entry are high. If the average consumer could choose between CNG and gasoline today, they would, in most cases, choose CNG because it is much less expensive. However, they can’t, because the fleet on the road today cannot use CNG without modification and, even if it could, there are few places to buy compressed natural gas. The barriers to entry are high indeed, and today they work against CNG, rather than in its favor. This is again an issue—in reality, a series of issues—which requires further examination and comprises some of our efforts with Columbia University’s Energy Center.

CNG and battery-powered vehicles are often presented as competing alternatives for the future of transportation, and in some sense, that’s true. However, based on today’s economics, they have far different potentials and address quite different market needs and niches. For those who believe in peak oil, at least in the sense of a limit on the volume of affordable oil, CNG represents potential as a critical alternative fuel which can permit the global economy to grow again.

On the other hand, CNG is unlikely to reduce carbon dioxide emissions. Peak oil theory dictates that all the oil that can be produced at reasonable prices, will be. By extension, oil demand is therefore assumed to be greater than supply over time, with oil a shortage commodity characterized by rising prices. Struggling with an inadequate supply of fuel, the market will be hungry for an additional source of energy, and natural gas may fit the bill. As a result, natural gas will tend to augment, rather than displace, oil-based fuels. Consequently, under most scenarios (but not all), natural gas as a transportation fuel will tend to increase CO2 emissions, even if natural gas is clearer burning than oil. Battery-powered vehicles, by contrast, have greater potential to be green.

CNG and electric vehicles, therefore, should be understood to target different market segments and solve different social problems. Both are potentially important alternatives for society in the coming years.

Mr. Kopits manages the New York office of Douglas-Westwood, energy business consultants. Douglas-Westwood assists energy companies with market research, strategy development and transactions support.

(Note: Commentaries do not necessarily represent ASPO-USA’s positions; they are personal statements and observations by informed commentators.)