* High initial costs per gallon make fuels controversial
* Baucus says "freedom fuels" help get U.S. off foreign oil
* "Green energy" may challenge military readiness -Inhofe
By David Alexander
WASHINGTON, Nov 28 (Reuters) - The U.S. Senate voted on Wednesday to strike restrictions in its annual defense policy bill that would have severely limited the military's effort to develop biofuels for jets and warplanes.
The Senate voted 62-37 to remove language in the National Defense Authorization Act that would have barred the military from buying the controversial alternative fuels if they cost more than petroleum.
The Senate is expected to vote on the NDAA in coming days. After that, it must be reconciled with the version passed by the House of Representatives, which contains limits on biofuels, before going to President Barack Obama for his signature.
Supporters of alternative energy development welcomed the vote.
"This would have been a terrible signal to private investors if there had been a pullback from this program because what we all want is for these advanced biofuels to become commercialized and therefore cost competitive," said Phyllis Cuttino, director of Clean Energy Program at the Pew Charitable Trusts.
"You're certainly not going to get there if private investors think there is a kind of on-again, off-again policy."
Spending on biofuels by the different military services has been controversial among lawmakers and the public because production of initial test batches of the new fuels costs many times more than petroleum.
The Air Force has been testing small batches of alternative fuels in its aircraft to prove they can be reliably used once prices become competitive with petroleum. It paid $59 per gallon for 11,000 gallons for one test batch this year.
The Navy has a broader mandate to develop alternative fuels. It spent $12 million for biofuels - more than $26 a gallon - to power warships and aircraft as part of its "Great Green Fleet" demonstration this summer.
Navy Secretary Ray Mabus has set a goal of using biofuels to supply about half the Navy's non-nuclear fuel needs by 2020, about 8 million barrels a year.
He notes that biofuels could help insulate the Navy from oil market price shocks. A one dollar increase in the price of a barrel of oil boosts the Defense Department's fuel bill by $130 million annually.
The military's focus on alternative energy sources provoked a backlash in Congress this year among lawmakers concerned the spending was misplaced at a time when tight budgets are forcing reductions in military personnel and programs.
"What we're doing is trying to experiment in green energy at the expense of our ability to defend America and our (military) readiness," Republican Senator Jim Inhofe said in debate on the amendment.
Inhofe, who inserted the restrictions on biofuels into the original bill, noted that the military has been ordered to cut $487 billion in projected spending over the next decade and faces the possibility of another $500 billion in cuts over that period beginning in January.
"If that were not enough, the Obama administration continues to force the military to spend greater proportions of its already depleted funds on an expensive green energy agenda," Inhofe said.
But supporters of the military program noted that biofuel development supported the farm economy, created jobs and helped to insulate the military from price shocks in international oil markets.
"I call these freedom fuels," said Democratic Senator Max Baucus, whose home state of Montana is the source of some biofuel feedstocks. "Why? Because they help get us off of foreign oil and help bring good paying jobs to Montana."
Senator Jeanne Shaheen said the U.S. Defense Department, as the largest single fuel consumer in the world, had a special role to play in trying to develop alternative sources of fuel.
She said its participation in the market was helping drive down the price of alternative energy sources.
"Advance biofuels are not yet in full production and so they can't compete with oil, since the oil market is 100 years old," she said. "But DoD investment has caused the price to drop dramatically over the last two years."