Imagine the rewards for finding a viable substitute to oil. I can’t think of another situation where the positive incentives are better aligned to encourage the entrepreneurial discovery process.

Governor Schweitzer is dealing with this today at his Montana Symposium. He believes that Montana can lead by producing synthetic fuels from our coal. In addition to promoting energy independence, the Governor touts synfuel’s environmental benefits (e.g., the production process removes toxins like sulfur, mercury, and arsenic).

Turning coal into synfuel has great appeal. First, Montana has about 25 percent of U.S. coal reserves; about 120 billion tons. Second, turning coal into liquid fuel is an old, well-tested process. It was developed by German researchers Franz Fischer and Hans Tropsch in the 1920s. During World War II, General Patton’s Third Army rolled into Germany using synthetic fuel from captured German vehicles.

I wish the Governor well, but would caution him (and all Montanans) to place hopes and expectations in separate baskets. Here’s why.

The Governor recognizes that “[t]he hurdle in making synfuel has always been the [high] cost of production, about $35 a barrel.... But as we all know, times have changed.” Indeed they have. But change is rarely unidirectional. Recall that in both 1986 and 1999 oil was $9 a barrel. From 1869 to 2004 the average inflation-adjusted world price for a barrel of oil was $19.41.

Some analysts believe that we’re finally looking at “the end of oil.” They estimate that hydrocarbon reserves will become scarce somewhere around the middle of the century. As they do, prices will move toward $100 a barrel. Perhaps. But about 30 billion barrels of oil a year are pumped from proved reserves; and about the same amount is replaced by new discoveries. And remember, 90 percent of the world’s ocean floor is unexplored. Deep-water drilling used to be impossible; now it’s just expensive. But with experience, costs decline. Montana’s synfuels must compete in this global energy market.

Lack of capital investment, just a few billion dollars, holds this project back. Governor Schweitzer recently said, “There are a great number of believers, potential partners, who will put their money down.” Great! If this is such a sure bet, let’s make sure Montana taxpayers aren’t forced to underwrite the deal.

The governor admits that “there will be significant start-up costs for private companies, but risk can be alleviated with long-term buyers like the military and with new federal loan guarantees.” Sen. Baucus has already invested your money in this project by writing tax incentives for it into this year’s energy and highway bills. Thanks, Max!

Venture capitalists have access to ever more and better information. They are the most optimistic investors in the world, earning their living evaluating risks and rewards. If a Montana synfuels project has economic merit, it will attract their funds. If not… only subsidies will make this pig fly.

Here’s the problem with tax incentives: someone will game the system. For example, New York State’s $44.5 billion Medicaid program is a magnet for fraud. Politics involves the pursuit of power, privilege, and opportunities. Businesses and special interests will seek favors from government to win advantages they can’t get through capital improvements, better management, or increased productivity.

Taxpayers have been supporting synfuels since the 1970s. Sections 29 and 45 of the IRS Code provide tax incentives for synthetic coal. For example, the Electric Fuels Corp. of St. Petersburg, Florida, uses a “proprietary” manufacturing process; it takes normal coal and sprays it with pine-tar. Instead of running a legitimate operation, what they are really doing is mining the tax code -- to the tune of $390 million a year.

The IRS reviewed this scam and issued new rules designed to put an end to these abuses. However, the tax credits will continue to flow until December 31, 2007.

Governor, here’s a modest suggestion: Let the market process guide our energy future. Markets work through trial and error, experimentation and feedback. Their constant search for efficiencies subjects ideas (both new and old) to ruthless, systematic testing. This is a far more efficient and equitable process than relying on decisions made by politicians and their business cronies.