Energy and Financial Instability

In 2002, in The Listener, a popular NZ magazine, a letter to the editor was published that said as plainly as it could: "Oil is going to decline soon." It bade readers to take heed. Those that followed the directions to www.dieoff.org were in for a short sharp shock. Skeptics may have brushed it all off and put their faith in human ingenuity, but events over the intervening years have decisively brought the topic of peak oil to the fore.

At about that time a book was being written by Richard Duncan, formerly a consultant to the IMF and employee of the World Bank. Duncan, an economics and literature graduate with years of professional experience behind him, including a close study of the Asian crisis of the late nineties, provocatively titled his book "Dollar Crisis". Again, many would have given his analysis scant regard. But time has been kind to his conclusions as well.

Day by day these two subjects are more and more entwined. Energy and financial instability are joined at the hip, marching into a tumultuous future.

Since 2003, when Dollar Crisis was published, it has become more and more evident that Duncan's central thesis was correct. He held that the expansion of credit throughout the nineties had created imbalances in the global economy that could only be rectified by a correction in the value of the US dollar, much like he had observed first hand while working for the IMF in Thailand. It was also clear at the time that he was writing that the efforts of the Federal Reserve to inject credit into the flagging equity market after the 2001 bust would only increase the hazard.

This has become almost received wisdom. In fact being a US dolar bear has become rather au fait. The Economist magazine ran a cover touting the endangered status of the greenback, Steven Roach from Morgan Stanley has preached from his Wall Street pulpit on the imbalances and the threat of financial cataclysm, and countless goldbugs, peakniks and assorted analysts have watched on with interest. If you are unconvinced by this choir of dissenters, try the General Manager of the Bank of International Settlements.

But Duncan was very clear as to when he thought correection would come:

"When the US property bubble pops. In 2002 the global economy is being supported by an American shopping spree that is being financed by a bubble in the U.S. property market." (Duncan, Dollar Crisis, pp.189)

It has of late become very difficult to avoid the words 'housing bubble'. From being labeled just unfounded pessimism as little as a year ago, it is now widley accepted that property price rises have become unsustainable.

So it was not surprising to see this graph that came out of US housing data recently:



THere is no saying whether this is the beginning of a real bust for house prices, but it does look pretty nasty at first glance. Volumes are still up, but it is the price that will obviously determine how easily people will be able to refinance and continue spending.

Over to the energy sector. The long term effect of Hurricaine Katrina on energy markets is still unclear. What is clear is that two very important things have happened. A sizable amount of oil and particularly natural gas production are going to be off line for months. Also a significant percentage of refinery capacity will be out for a similar time. Having refinieries out, and with the US and EU governments opening their petroleum reserves, crude prices have fallen. But this is not going to help refined products. Gasoline and heating oil are going to be problematically expensive for some time, as is natural gas.

So as winter begins we will likely find consumers being pinched by energy costs and by a deteriorating property market. That will not be a pleasent outlook for retailers in the run up to Christmas, which will not please manufacturers, transport firms and so on. This article is an interesting look at how this sort of thing begins in your home town and ends up affecting the whole country, and then of course the rest of the world...

Where does that leave us? Another autumn bust in the markets? Perhaps this article might be instructive. It concerns the work of an MIT finance professor and hedge fund manager, Andrew W Lo, who has been studying the economics of the hedge fund market. He has concluded that hedge funds that are invested in illiquid assets such as real estate and interest rate swaps (are there any that aren't!?) are prone to very sudden and catastrophic losses. Ominously he found that these corrections are often preceded by a period of mediocre performance, exactly as hedge funds are experiencing right now. Lo states that the hedge fund industry (for lack of a better word) is more illiquid than it has been for 20 years. Yikes!

So with a big bite taken out of the US energy sector and finacial imbalances abounding, are we heading for a crisis? It's far from certain when a shakeout of the economic system might occur, but it is getting too late in the day to say the night won't come.

Technorati: peak oil housing bubble energy decline economics

Signposts on the Back Slope

Well, things really are speeding up on our trip down the back slope. I hesitate to use such worn out phrases as 'tipping point' and 'paradigm shift', but it is hard to avoid the sense of a discontinuity having occurred

Katrina has already been the catalyst for a sobering dose of the absolutely indispensable nature of oil in our lives. From the rocketing prices at the pump for gasoline to the mushrooming gas lines in the US, it is clear that the immediate effect of Katrina is going to be significant. But the reality of our changed situation will only emerge with time. Here are a few of the signposts on the slope:

1. Along with oil and gasoline, there has been a bitterly steep rise in the price of natural gas in the US, and along with it the price of electricity. Remember, of course, that there is no equivalent of the SPR for natural gas, and the lost production from the Gulf will take a long time to restore. Moreover, there is little or no chance of making up for lost production by importing gas from foriegners. This brings to mind Richard Duncan's Olduvai Theory with his insistence that the real difficulty comes when the lights go out, which is becoming a distinct possiblity for the US.

2. The sheer monetary cost of the disaster and the effect this is likely to have on some of the large insurers and re-insurers is at the moment still very unclear, but when one hears numbers like 100 billion dollars being bandied about, it certainly gives pause for thought.

3. The last few days have seen a steep drop in the US dollar index. Some of this could be chalked up to rumours that the fed will put their rate hikes on hold, thereby dissuading buyers at the margin. However, this comes not long after a report about the inherent instability of the forex market and the possibility of a run on the dollar. To add fuel to the fire there is this report about the possibilty that Saudi Arabia would look to switch out of their peg to the US dollar.

4. While petrol is the big concern at the moment, and I think we can safely say that significant price rises will spread a lot further than the shores of the US, there is still the pressing issue of will the supply of crude hold up. Disturbingly, there were reports yesterday that explosions in Iran and Iraq have closed production facilities in both countries. It is hardly worth mentioning that this would be very opportune time for terrorists to strike at the West's achilles heel by bombing oil facilities.

5. An e-mail is circulating around the world at the moment, in many different national guises, urging people not to buy oil on the 5th of September, in order to "Stick it to the oil companies". While the whole thing is patently very poorly conceived and will not only acheive nothing, it is focussing on the wrong thing. People should be avoiding buying petrol, but they should be doing this by cutting down on the amount they use their cars, not simply waiting a day before filling up. This sort of thing is probably going to develop into more strident protests about the profiteering of the oil companies and the gouging of consumers as the shockwaves from Katrina bounce through the market. The anger is totally understandable and it certainly does raise the question, should we not be considering some kind of windfall-profit tax? But it is also delusional about the ultimate cause of high prices. After all, if we were all neatly constructed economic rational actors we would respond to high prices by reducing our demand, right?

6. The words "peak oil" were uttered at 7.30pm Sunday on the most popular free-to-air channel here in New Zealand. They were carefully linked to the word "doomsayers" to ensure the viewing public could be clear what they should think of such notions as the inevitable decline of oil production, but nonetheless they made it onto the airwaves. The piece was a reasonably informative one, talking about what measures the government might take in the event of an oil crisis (carless days, etc) and wasn't too inflammatory.

7. Bush admitted (to all intents) that they went to Iraq for the oil! The scales have fallen from my eyes. All is clear now. Sheesh!

It's going to be a hell of a bumpy ride. Keep watching the skies.

Tchnorati: peak oil energy decline gas prices

None so blind as those that won't see

As the price of oil increases more and more attention is paid to the reasons for this rise. This has meant that the words ‘peak oil’ have started to appear ever more frequently in print and other media. With this new found recognition has come the inevitable refutations and disputations.

An article by Peter Maas has drawn fire from Stephen Levitt, author of the best selling Freakonomics. James Howard Kunstler’s book The Long Emergency has had several hostile reviews. Matt Savinar, over at life after the oil crash, has been the target of a serial denunciator writing in a peak oil forum.

As Matt points out in his rebuttal, as oil prices rose it was entirely predictable that there would be a raft of people who would appear to try to refute peak oil. What is surprising is that the people that do this are often very intelligent, some of them leaders in their fields. But no matter their credentials, a blindness to the fundamental nature of energy resources is a common feature of people from all walks of life.

This is almost uncomfortably illustrated by Steven Pinker in his 2002 book ‘The Blank Slate’. Pinker, who’s books have done more to popularise evolutionary psychology and the modern science of the human mind than anyone I can think of, is an exceptionally lucid writer with a penetrating intelligence. His ‘How the Mind Works’ is a peerless exposition of the current state of knowledge in a wide range of fields. He spares no holy cows in explaining the origin of our passions, prejudices and pastimes.

But in ‘The Blank Slate’, in a chapter appropriately titled ‘Out of Our Depths’ he offers the folowing:

“The immediate problem with Malthusian prophecies is that they underestimate the effects of technological change in increasing the resources that support a comfortable life…[In the twentieth century] reserves of oil and minerals increased, rather than decreased, because engineers could find more of them and figure out new ways to get at them… Many people are reluctant to grant technology this seemingly miraculous role… But recently the economist Paul Romer has invoked the combinatorial nature of cognitive information processing to show how the circle might be squared after all. He begins by pointing out that human material existence is limited by ideas, not by stuff. People don’t need coal or copper wire or paper per se; They need ways to heat their homes, communicate with other people, and store information. Those needs don’t need to be satisfied by increasing the availability of physical resources. They can be satisfied by using new ideas - recipes, designs, or techniques – to rearrange existing resources to yield more of what we want. For example, petroleum used to be just a contaminant of water wells; then it became a source of fuel, replacing the declining supply of whale oil.” (The Blank Slate, Pinker, pp 237-8)

Does Pinker really believe that human existence is limited only by ideas!? Does he suppose that if I think that I can run my car on sand it will happen. To suggest that we don’t need resources per se, just better ways to use them, is tantamount to saying that we can use any resource to do any job, or any amount of any resource to do a specific job. This is so patently untrue as to be laughable.

What Pinker is missing is that technological change invariably engenders an increase in the use of resources, particularly energy resources. His last point, that oil has gone from a contaminant to a fuel, actually demonstrates this fact. But it seems that he is saying is; when we have used up oil, just as we did with whales, something else that was once undesirable will step into the breach. If he has an inside running on what this is maybe he should tell someone.

The industrial era, with its ever-expanding energy budget has lulled people like Pinker into treating resources as largely irrelevant. In an age of plenty it certainly does seem like if you think it, then it will come to pass. But this is a temporary delusion. As we transition from using what is undoubtedly the best energy resource the planet was ever endowed with, to other more diffuse sources, all of the resources we have taken for granted will be more difficult to acquire.

Technology doesn’t increase the resources that are available for us to use. It changes the rate at which we can extract them, and it changes which resources are accessible at any point in time. But, like it or not, the amount of any fossil fuel or mineral resource is a fixed quantity. It is irresponsible to continue the myth that technology will only increase the amount of ‘stuff' available to us. In fact, technology hastens the day when we will have used all of the stuff up.

Pinker goes on to invoke the unlimited power of discrete combinatorial systems to come up with new ideas. The human mind is a remarkable organ and not to be taken lightly, but we shouldn’t confuse our ability to think up new ideas with an ability to defy the physical laws of the universe.

The arguments that are put forward so uncritically in this passage are, unsurprisingly, those of an economist. We see exactly the same arguments from Levitt in his commentary on Peter Maas' article for the NY Times. Would it be too much to expect that economists might actually shift their gaze from the market to the physical realities of resource use? Do they not actually talk to people that work in the fields they so happily prognosticate on?

Maybe the final judgment should go to Pinker himself:

"Self Deception is among the deepest roots of human strife and folly. It implies that the faculties that ought to allow us to settle our differences - seeking the truth and discussing it rationally - are miscalibrated so that all parties see themselves as wiser, abler and nobler than they really are." (The Blank Slate, Pinker, pp.265)

Technorati: peak oil energy decline economics