Jan 19 2012

Returning to Simplicity

January 19, 2012

Dear Readers: I’m currently writing a long-form post twice a month now for Chris Martenson’s excellent wesbsite. Accordingly, I’ll be publishing the first (and free) part of these essays here at Gregor.us. Enjoy. — Gregor

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photo: BP Oil Leak photo series via Boston Globe, Mark Ralston – AFP/Getty Images

Eventually the point is reached when all the energy and resources available to a society are required just to maintain its existing level of complexity.

- Joseph Tainter

The modern world depends on economic growth to function properly. And throughout the living memory of every human on earth today, technology has continually developed to extract more and more raw material from the environment to power that growth.

This has produced a faithful belief among the public that has helped to blur the lines between human innovation and limited natural resources. Technology does not create resources, though it does embody our ability to access resources. When the two are operating smoothly in tandem, society mistakes one for the other. This has created a new and very modern problem — a misplaced trust in technology to consistently fulfill our economic needs.

What happens once key resources become so dilute that technology, by itself, can no longer meet our growth needs? 

We may be about to find out.

Recent History

The twin disasters, Deepwater Horizon in the Gulf of Mexico and Fukushima in Japan, took place only nine months apart in 2010-2011, but together they have provided the world’s economy with a lesson in 21st Century un-priced risk. Our various energy systems, vastly arrayed across regions and hemispheres, have now reached a late phase of complexity. And societies, particularly in the West, have enjoyed technological progress for such a long, uninterrupted period of time that the delicate nature of this modern infrastructure has evolved to escape notice.

The BP disaster arose within the oil and gas sphere more than a century after the start of widespread oil extraction. The collective knowledge of the industry was, in one sense, a support to the operation that allowed the recovery of oil several miles below ocean and earth, using ultra deepwater drilling techniques. But a century of global oil production was also a constraint, as Deepwater Horizon illustrated the outer reaches to which a mature industry had been driven to obtain its next tranche of resources. The capital BP has set aside for cleanup stands at $40 billion. Additionally, government resources, from equipment to personnel, that were diverted to the Gulf and Gulf Coast that summer (see photo above) were reminiscent of a small military operation.

Deepwater Horizon also showed that modern energy extraction now occurs with the greatest-ever separation between human operators and their resource target(s). This physical distance is so great that, in the case of very deep offshore oil drilling, it’s no longer possible to reliably stop a blowout. Why? Because no equipment exists to easily take men and material to such depth to conduct repairs. Indeed, it was at least as much due to luck as skill that BP was able to halt the well flow several miles down. And the almost comical trial-and-error efforts (junk shots) proved what many have long asserted: In the past decade, the cost of the marginal barrel of oil has crossed a threshold to a completely new era. It now becomes possible to ask the question, Is it worth it? Is it even economic to obtain this new tranche of oil?

The Fukushima disaster, triggered by the an offshore earthquake, ripped the lid off Japan’s power grid and illustrated how the country has historically balanced its lack of domestic fossil fuel supply against its enormous manufacturing base. On a small level, the actual sequence of events at the Fukushima nuclear power plant revealed an amazing vulnerability. For it was not the passing of the tsunami that performed critical damage to the installation’s structure; rather, it was the auxiliary power that was knocked out, depriving the plant of its cooling functions. Hence the meltdown, and the subsequent issues with recriticality (resumption of fission).

Meanwhile, on a larger level, the world came to understand how dependent Japan had become on nuclear power, which provides 30% of the country’s electricity needs. Japan is also one of the largest importers of LNG (liquefied natural gas) and still has to import 80% of its overall energy mix, which includes oil and a very great quantity of coal. (Indeed, Japan is the fourth largest world consumer of coal, behind only China, the US, and India). Unsurprisingly, the country had to significantly boost imports of LNG and coal in the wake of the disaster.

What has been the cultural response to the Deepwater Horizon and Fukushima disasters? In the US, the oil spill in the Gulf, which exacted a great economic toll, echoes the aftermath of other post oil-spill environments: The moratorium on offshore drilling was quickly lifted, but in its place lies a new set of regulations and restrictions. Most of these have a single aim — that similar blowouts in deepwater be preventable or fixable. The evidence seems to suggest that deepwater drilling in the Gulf has peaked. The rig count has recovered but is still down below the highs, with many of the largest and most expensive operators having left for other parts of the world.

Meanwhile, the global response to the Japanese catastrophe rippled through several economies, especially those, such as Germany, that rely heavily on nuclear power. German chancellor Angela Merkel announced that her country had to accelerate its transition to renewables, becoming less reliant on nuclear. Other countries have increased their inspection procedures, and for the first time in many years, it seemed possible that many aging plants in the US would not see their licenses renewed. In Japan, there have been protests. And given the long lifespan of the nuclear event, which will ripple outwards for decades upon the affected portions of the northeast Japanese coast, it is not surprising:

TOKYO (AP) — Chanting “Sayonara nuclear power” and waving banners, tens of thousands of people marched in central Tokyo on Monday to call on Japan’s government to abandon atomic energy in the wake of the Fukushima nuclear accident. (Source)

Western Faith in Progress

Education in the West has, as a core feature of its curriculum, a narrative of progress. This is especially true of US history offerings and of any discipline that addresses the post-Industrial Revolution (roughly the two centuries after 1800). The examples of technological progress most available to Western cultures, as we moved from the Age of Wood to the Age of Coal and finally the Oil Age, are highly confirming of the view that humanity always finds a way. And in particular, it finds a way to grow, and even thrive.

It is particularly worth noting the symbiotic relationship between the machines that were developed to extract resources (like the steam engine that pumped water from coal mines) and the life cycle of those machines as utilizers of those resources. Coal mining triggered development of machines that would run on coal, just as oil would eventually power the latest machines that would be used to extract oil. It is this awesome ratchet effect that’s so persuasive to Western culture, and it is the story it repeatedly tells itself.

One can hardly fault the highly educated person, with an advanced position in business, communications, technology, or academia, for generally believing that innovation (and the power of prices) will obtain all of the resources we require. I believe this bias is what Daniel Kahneman would call an availability heuristic. The risk to this bias is that at some point in human development innovation and technology may very well carry forward and confirm society’s faith, but at the same time start to offer increasingly diminishing returns to progress. In my opinion, that is the lesson of Deepwater Horizon and Fukushima. And I expect it also to be the lesson of the Alberta Tar Sands.

There is a lens through which we can view events like Deepwater Horizon and Fukushima. Charles Perrow, in his important work on Normal Accident Theory (NAT) examines these accidents by type and plots them according to their complexity. See, for example, where nuclear power is located on the following grid: (Source: Accidents, Normal — opens to PDF).

What has begun to take place in global energy extraction is that the current tranche of resources obtained by more complex methods — deepwater drilling, underground fracturing, in-situ mining, and other strip mining — have begun to move towards the quadrant of Perrow’s chart that is occupied by nuclear power and chemical plants. Here, systems are both technically advanced and tightly coupled, which is to say that failures anywhere in their operations can spread easily and cause systemic failure.

Additionally, the boundaries of those failures can also be rather broad. That nuclear contamination spreads over large geographical areas has been known for some time. But Deepwater Horizon warned that contemporary oil extraction has also crossed the threshold into very wide boundaries. Despite the current euphoria over North American shale natural gas and the continuing confidence that production can be lifted in the Alberta Tar Sands, there are already indications that groundwater supply is going to become a much, much bigger issue as we try to increase access to these resources.

As Joseph Tainter explains (see the quote in the header to this essay), resources in civilization are eventually marshaled not for further growth but simply to maintain current systems, usually in their most advanced iteration. This is the terminal phase of expansion that the large, OECD regions (Japan, Europe, US) have likely reached. This is a vexing and frustrating limit that just about everyone, no matter their political orientation or economic view, will struggle to digest. For example, in an analysis of Fukushima’s impact on future energy policy, I thought this reaction from the team at the BTI Institute, was somewhat correct but perhaps a bit hasty:

Yet lost in the hyperbolic claims of nuclear opponents, the defensive reactions of the nuclear industry, and the carefully calibrated repositioning of politicians and policymakers is the reality that Fukushima is unlikely to much change the basic political economy of nuclear power. Wealthy, developed economies, with relatively flat energy growth and mature energy infrastructure haven’t built a lot of nuclear in decades and were unlikely to build much more anytime soon, even before the Fukushima accident. The nuclear renaissance, such as it is, has been occurring in the developing world, where fast growing, modernizing economies need as much new energy generation as possible and where China and India alone have constructed dozens of new plants, with many more on the drawing board.

(Source)

While it’s true that the long-forecasted nuclear renaissance in the West never took place, with little prospect now that it ever will, it’s not exactly true that the developing world is choosing nuclear power in any meaningful way. Coal remains the dominant energy source in the developing world, for obvious reasons: it’s portable, it stores well, it remains cheap, and (most of all) it is not complex.

Given that the externalities of coal use are rather brutal, it also the case that human beings place steep discount rates on the future. Society is much more fearful of accidents which take place suddenly and with little warning, than of the long term negative effects of a different set of policies on their health. It may not be logical, but that is our preference.

Tilting Away from Complexity

An emerging theme out of Silicon Valley over the past few years has been the epiphany that venture capital experienced regarding the extraordinary difficulty of greentech. “No mas” has been the conclusion. Why build expensive prototype energy boxes or invest in large vats of algae, when little apps can populate quickly across Internet devices, with no heavy lifting or messy cleanup? The difference between the two worlds has been summed up like this: In Atoms vs. Bits, it’s undeniable that “atoms are simply too difficult.” Yes, and this, too, is the lesson of Deepwater Horizon and Fukushima. If investment in complex resource extraction has either tail risk that could overwhelm returns, or externalities that overwhelm the well being of society, why do it?

Recently I spotted an insightful remark that addresses the issue, from Alan Nogee on Twitter.

In Part II: Why We Must Embrace Simplicity Now, we explore how diminishing returns have now triggered in our various complex systems. Eventually it will become clear that the cost to repair damages from their destructiveness is simply too great. Technology is practically telling us (begging us?) to place less faith in its ability to solve all problems.

It’s obvious that our elected leadership has no concept of a growth limit that could render the economy’s obligations insoluble. The Fed transcripts are yet one more piece of evidence that unless we get a better handle on the enormous, complex systems we are already operating, we will continue to suffer more frequent and painful “unexpected” economic accidents. Given our track record in this regard, the alternate route would be to step back from these complex systems and regain our footing in simplicity. Or else maintain the status quo approach until market forces pressure us to.

Click here to access Part II of this report (free executive summary, enrollment required for full access).

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Author: Gregor Macdonald   Posted in: Alternative Energy  Systems   Tagged:                  
Jan 10 2012

For A Million BTU

January 10, 2012

The price differential for a million btu is blowing out once again, between Global oil and North American natural gas. The extraordinary discount has persisted for some years. But today, with West Texas Intermediate (WTIC) oil above $100 and Brent oil above $110, the spread has reached new highs. The energy content of natural gas is trading at an 83% discount to WTIC Oil, and at an 85% discount to Brent oil. An economist might be persuaded to say: “That is a gap that must eventually close. Or, at the very least, which gives North American energy markets a huge, competitive advantage to source cheap, domestic btu compared to the rest of the world.” I would not disagree. However, the infrastructure problems associated with energy transition do not make such switching from expensive oil to cheap natural gas an easy, or rapid, endeavor. I address these issues continually, but a post of mine from last year, Vexed By Natural Gas, might be worth a read for those who want to ponder the situation further.

As you study the chart below, consider for a moment a less well advertised price spread: the disparity between North American natural gas (which remains landlocked) and the price for landed LNG in the United Kingdom. As energy market observers already know, North American natural gas will—in the next couple of years—be released through LNG export terminals in British Columbia (Kitimat) and Louisiana (Sabine Pass). That will trigger a rather momentous price convergence globally, as world LNG prices adjust to the entry of North American volumes.

–Gregor

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Author: Gregor Macdonald   Posted in: Americas   Tagged:            
Jan 05 2012

A Punch to the Mouth – Food Price Volatility Hits the World

January 5, 2012

Dear Readers: I’m currently writing a long-form post twice a month now for Chris Martenson’s excellent wesbsite. Accordingly, I’ll be publishing the first (and free) part of these essays here at Gregor.us. Enjoy. — Gregor

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Perfect Storms

2011 was an abysmal year for the global insurance industry, which had to cover yet another enormous increase in damages from natural disasters. Unknown to most casual observers is the fact that during the past few decades the frequency of weather-related disasters (floods, fires, storms) has been growing at a much faster pace than geological disasters (such as earthquakes). This spread between the two types of insurable losses has moved so strongly that it prompted Munich Re to note in a late 2010 letter that weather-related disasters due to wind have doubled and flooding events have tripled in frequency since 1980. The world now has to contend with a much higher degree of risk from weather and climate volatility, and this has broad-reaching implications.

And critically, it has a particular impact on food.

Many factors seen over the past decade have produced higher food prices: population growth, urbanization, the decline of arable land per person, and the upgrading of diets for example. But more damaging than food inflation has been the pushing of global food prices out of their long, quiet envelope of stability. From the recently released UN Report on the World Food Situation:

The FAO Index (Food and Agriculture Organization of the U.N) shows that, while prices are once again down from a peak, a troublesome volatility started to affect food prices this decade. These are the very prices that caused social instability in countries like Mexico in 2007-2008 (pressure on corn prices, owing in part to US corn ethanol mandates) and more recently in northern Africa (Arab Spring).

Commodity observers will note the rough correspondence with oil prices, and of course that’s no mistake. Inputs to food production are heavily composed of fossil fuels. In the same way that both high (and highly volatile) oil prices play havoc with economies, food prices and marginal speculation in food have done the same.

2011 also saw the highest average oil prices since 2008, at $94.81 per barrel. That is not far below the average high of 2008, at $99.67. In between was a crash in oil prices — and most commodities — which unfolded at a rate almost as rapid as the original run-ups from 2006-2008. What happens next?

The USDA has just released its Food CPI readings for 2011, along with their forecast for 2012.

With 11 months of data recorded, the outlook for the 2011 Consumer Price Index (CPI) and food price inflation has become clear. The CPI for all food is projected to increase 3.25 to 3.75 percent. Food-at-home (grocery store) prices are forecast to rise 4.25 to 4.75 percent, while food-away-from-home (restaurant) prices are forecast to increase 2 to 2.5 percent. Although food price inflation was relatively weak for most of 2009 and 2010, cost pressures on wholesale and retail food prices due to higher food commodity and energy prices, along with strengthening global food demand, have pushed inflation projections upward for 2011.

For 2012, food price inflation is expected to abate from 2011 levels but is projected to be slightly above the historical average for the past two decades. The all-food CPI is projected to increase 2.5 to 3.5 percent over 2011 levels, with food-at-home prices increasing 3 to 4 percent…

With non-existent wage growth and a dearth of investment opportunities, these price advances in food costs have much more impact than it appears. What asset classes are keeping pace with the year-over-year increases in food? Certainly not stocks, as the S&P 500 has gone nowhere in a decade. Moreover, a 3.5% increase in Food CPI this year, with more to come next year, falls on top of a deeply under-utilized US economy in which tens of millions derive income from government transfer payments, most of which are not sufficiently ratcheting higher from “inflation-adjustments.” Food Stamp recipients, for example, are not seeing food inflation adjustments in their benefit checks that would compensate for the price increases. Not even close.

As you may have heard, milk was the top commodity performer in 2011, up 40% on the year in the futures market. A question: do you think milk is a central staple in American family diets? There’s more. On a year-over-year basis through November, according to USDA, beef prices are up 9.8%, egg prices are up 10.25%, and potato prices are up 12%. (This partly explains why junk-type grocery foods make up an ever-larger portion of food-stamp purchasers’ shopping carts. Sadly, people are buying caloric content, not nutrition).

Now, compare these price increases to the average individual Food Stamp benefit, which is basically flat year-over-year, moving from $133.79 in 2010 to $133.84 in 2011. And to the extent that households use Food Stamp benefits to plug overall cash flow problems, the very central and related pressure from higher gasoline prices also deflates the impact of the Food Stamp benefit.

Food Stamp Nation

The march higher in Food Stamp participation following the 2008 crisis has been relentless. The trend has paid no attention whatsoever to assertions of economic recovery or jobs growth in the US.

Yes, in the aggregate there has been moderate growth in private sector payrolls since the lows. There has also been a very big turnaround in exports, as this part of the economy has seen a veritable resurrection, growing to 15% of GDP. However, the upsurge in national Food Stamp participation (SNAP) has been stronger than them all. In December of 2007, just after the declared start of the “recession,” national participation in SNAP (Supplemental Nutritional Assistance Program) stood at 27.385 million. As of the latest data, this has ballooned to 46.268 million.

Because the national figures are so enormous and harder to comprehend, for several years I have kept track of Food Stamp (SNAP) users in Los Angeles County — alongside oil prices. Southern California illustrates well the dilemma for most of the nation: Through the force of US demand, we have lost the control we once enjoyed over oil prices, while at the same time we remain locked in to automobile-based transport. Previous recessions in the US would have knocked gasoline prices down for longer. Not so anymore. Earlier this year, it became clear to me that before year end, the number of L.A. County participants on Food Stamps would eventually cross the one million mark. That grim marker has now been achieved:

The above chart of L.A. County SNAP users echoes the FAO chart from the United Nations. Upward-moving volatility in energy is concurrent with wild swings in food prices and waves of people in need of public assistance. Wages in the US have remained flat while millions of workers remain either unemployed or underemployed. Meanwhile, urbanization in the developing world has continued apace, forcing food prices and energy prices up at the margin. The results are not complicated. When demand begins to hit a resource whose supply cannot be easily increased, then price moves to ration demand and price becomes more volatile.

That process, so obvious to many, can unfortunately digress into a series of time-wasting arguments about speculators and whether the world is running out of…(insert your preferred natural resource here). On the contrary, natural resources rarely, if ever, run out in the marketplace. The US is not running out of oil, or corn, and the world is not running out of coal, or copper. What we have seen however in the past decade is that a number of structural changes to human development, primarily industrialization in the Non-OECD, have combined to put an unexpectedly large burden of demand on world resources – at a rapid rate. Meanwhile, many natural resources, such as copper and oil in particular, had already reached a more difficult place in the arc of their own extraction history when this started to unfold.

The Decline of Arable Land

The result is that energy resources, and thus the ease of using energy resources in food production, began to converge with a long decline in the availability of arable land.

It is not for nothing that farming acreage in the US Midwest is up over several hundred percent since the lows twenty years ago. (As a personal aside, I remember those lows very well; I lived on a struggling soybean farm in Iowa during graduate school in the late 1980s). The world is in the midst of a New Great Game. But this time, the hunt is not on only for energy resources, but for agricultural resources — mostly cropland.

On my own blog, I recently did a short post on a study of urbanization in China’s Pearl River Delta and its aggregate effect on climate and precipitation. In short? Paving over the earth decreases rainfall. I also found these two photos from NASA, comparing satellite views of the Pearl River Delta over a 24-year period from 1979 to 2003.

The loss of arable farmland per capita in China has placed enormous pressure on the global food system and all of its inputs, especially fertilizer. The miracle of the food revolution, much trumpeted over the past 30 years as the latest achievement of technology and innovation, is not to be dismissed. But there are limits. We can only convert so much farmland to urbanscape while making up the difference with N, P, and K (Nitrogen, Phosphorus, and Potassium) before we lose resiliency — and redundancy — in the global food system. It did not used to be the case that a bad wheat crop in Australia or the Ukraine would hit global wheat prices so hard. Moreover, because food is a renewable resource, a level of overconfidence about our ability to respond to demand crept into policy-making and forecasting.

In Part II: Preparing for Higher Food Prices, using the most recent data, I show what’s happened to arable land around the world and talk about how we have created ever more tightly-coupled fragility in our systems of food production. I also chart the relative performance or return on various investments, compared to food, and show that despite the avoidance of the matter, stagflation has now entered the US economy. (How does one cope with flat wages and rising food prices?) Finally, I have just finished reading Julian Cribb’s The Coming Famine: The Global Food Crisis and What We Can Do to Avoid It, 2010, and found his discussion of virtual water very much on point, and relevant to our next set of challenges:

In theory, countries that lack water can import virtual water as food commodities with those with plenty. So too, countries that lack the energy to grow all their food can import surplus food from countries with highly productive oil based farming systems–provided they are rich enough to afford it. The fact, however, that a billion people starve while another billion wallow in surpluses of food so huge that they throw away half undermines this idea.

– from The Coming Famine by Julian Cribb, page 122.

As I discuss in Part II, the United States is also becoming swept up in the globalization of food production, as it remains a titan of commodities exports, on an absolute basis. But the hunger for US food exports has implications for our own population, which struggles with falling (real) wages and depressed purchasing power. Will Americans be able to afford to pay what the world can afford to pay for food?

Click here to access Part II of this report (free executive summary, enrollment required for full access).

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Author: Gregor Macdonald   Posted in: Food  forecast   Tagged:                              
Jan 02 2012

Tail Risk and Embalming Fluid, in 2012

January 2, 2012

I feel motivated today to write about global markets, and especially the lingering fear that’s sure to carry over from 2011 to 2012. The last 18 months have supplied historians with every reason to believe that a replay of the 2008 financial crisis was about to unfold. The difference being that the private sector debt crisis which triggered 2008′s terrible domino event has now been transposed, into a similar risk in sovereign debt. Especially the sovereign debt of peripheral Europe. As a student of macroeconomics, and as one who observes the procession of market psychology—when markets slowly move from the comfort of sleep to the Ker-Pow! of recognition—I am strangely in the position of thinking the following, mildly heretical thought: tail risk in global markets is now much, much lower than most anticipate. If that’s true, certain asset classes are going to make very large, very surprising moves in 2012.

My reputation as hugely negative editorialist on developed world economies is fortunately not in jeopardy. For the past three years at this blog, I have articulated the intractable dilemma of debt and resource scarcity that will plague the EU, US, and Japan for the balance of the decade. In short, oil prices are never going to come down again—not for any length of time. And US house prices and US wages are not likely to ever go up again—not for any length of time. The dream of higher wages and lower oil prices is just that. And the utopia of 1999, when purchasing power was flipped (compared to now) and the US Dollar stood like a giant against food and energy, will eventually be accepted as a lost era. Never to be regained.

While enormous advantages can be lost in absolute terms, however, in relative terms the developed world still has some advantages. The US, while not often thought of in this regard, is a veritable titan of natural resources. Not in oil, so much, but along with North America more generally the US sits on a tremendous cache of timber, natural gas, coal, and arable land. Meanwhile, Europe and Japan remain epicenters of the highly technical manufacturing bases the world will need as it transitions away from liquid fossil fuels to the powergrid, and transport globally becomes increasingly electrified. I have written endlessly about failure of Western economists to sufficiently account for the influence over natural resources now held by the 5 billion people in the developing world. However, the pressure that their gargantuan demand places on oil, coal, copper, and food is still offset by the crucial advantages still offered by the West, from our engineering traditions. This makes for ironic portraits. For example, the United States with its political dysfunction is unable to do the correct thing and choose rail over automobile transport, which itself is now a low to negative ROI economic proposition. Meanwhile, China correctly embraces rail tranport but there is a problem: many of the large engineering projects in Asia and in China—and I’m sorry to say this—are not constructed very well. The economic might of Germany, therefore, is not a fluke: that country continues to make along with other parts of Europe the finest infrastructure equipment the world can buy. If you think this tradition can be replicated easily, you are wrong.

This does not change the fact, however, that the West—particularly Washington and London—has fucked up big time in allowing private and public sector debt levels to reach a terrifying escape velocity that now extends way, way beyond any reasonable growth prospects (in industrial terms) that we could achieve in our future. If you want to be calmed about debt and find yourself turning to the whispers of the Keynesians and MMT-ers for comfort, at least recognize that included in every scolding article from Paul Krugman about debt fear-mongering is an admission that growth, yes, economic growth, will still be necessary to escape our current debt levels. Unfortunately, I must remind that the entire economic policy and business complex is still operating with the assumption that economic growth is inevitable and will resume. There remains alot of market risk, embedded in that belief.

But there is another market risk as we move into the new year that fascinates me more. And that is the strong possibity that no discontinuity, no Lehman Event, no cataclysm is forthcoming. You see, while the private sector is especially good at producing such meltdowns the public sector has a few tools to handle such events, converting them from something quite acute, to something rather chronic.

Normally, at this point in the post, I would run a chart of the balance sheet expansion of the European Central Bank, showing that despite their failure to but up billboards with the letters “QE” on every European motorway, that a grand panic-neutralization operation has been underway for some weeks now. I could also show that the Eurostoxx 50 Index actually bottomed 4 months ago, or display a chart of the slumping Volatility Index. And how about the ratio of Gold to the SP500— showing that the face of lion, a Blakean fearful symmetry, actually peaked out in late August? Instead, I am going chartless today. And linkless, too. You market addicts can see these images in your mind already. I want to make my case with words, because, what’s happened is that the three main central banks of the OECD are methodically placing tranche after tranche of our unpayable debt into cold storage. With the solemn and purposeful laboring of an undertaker, their embalming fluid is released each day through the veins of the system, dampening the urge for radical simplification (collapse).

For 2012, therefore, I am planning not on rupture (or rapture) but on decay. The market will go through the year with a persistent desire for drama. But at this point, after psychologically anticipating a rupture in our tightly coupled financial system, the exit of a country from the Eurozone would more likely be greeted with relief. The Euro is not going away, neither is the Dollar, nor the Yen. Instead, like the system itself, they will simply continue their chronic declines against food prices, energy prices, and yes, gold. What’s frankly the most terrible outcome for young people in the West is that the placing of our unpayable debt into cold storage prevents the explosive reset of the system, which, although terrible, would trigger the blossoming of wildflowers. Let young people be not confused: the policies which crush your opportunities are designed to save the retirement of the aging class.

Our current moment in the markets, therefore, aside from the chronic structural problems I’ve described, reminds me most of the twin crises phase of 1997-1998. There is much that doesn’t work in this analogy, but in terms of price action alone it might be worthwhile to pay attention to that sequence. Asia crumbled in 1997, and the rest of the emerging markets crumbled in 1998. The problem, once again, was debt. And the Federal Reserve’s bailout of LTCM and a double rate cut in the Autumn of 1998, allowed global asset prices to recover. But remember, global markets today are not focused so much on industrial growth but nominal prices. In the same way it would be a mistake to think an SP500 at 1250 is the same level as SP500 at 1250 ten years ago, it would also be a huge mistake to think SP500 1500 is impossible simply because OECD countries are hopeless. We are now in the domain of asset switching, and capital oscillation. And that is all. The SP500 at 1250 today buys less of just about everything, than its same level 10 years ago. So despite however much you agree with the dissertations of Russel Napier, Albert Edwards, and Kyle Bass (and I do), “higher” price levels are not hard to achieve. After all, they don’t mean much. (By the way, which asset class today—outside of stocks—would you choose as the analog to the Nasdaq 100 of 1998, which after a 30% correction, rose 14 straight weeks to double by early 1999?)

If markets come to understand, therefore, that tail risk is much lower than the current short position the EUR indicates, or that current yields on US Treasuries indicate, then there is a fairly large move ahead in stocks and bonds before markets turn their attention back to fundamentals. This is the risk that was underpriced coming out of the spider hole in March 2009. Zooming to a larger view, if you read the scholarly work on collapse from Joseph Tainter and Jared Diamond, and also study the myriad ways in which resource scarcity halts the growth of large systems, you will come to understand better that fast collapse is the anomaly and decline is the norm. Moreover, I would also point out that systems in ascent experience short, sharp pullbacks. But systems in decline will experience speed bumps of a different kind: sharp advances.

Happy New Year, to all.

–Gregor

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Author: Gregor Macdonald   Posted in: forecast   Tagged:          
Dec 28 2011

Obama Memo: Redeem Yourself With Rail

December 28, 2011

Has the Obama Administration, in its first three years, helped the United States ween itself from fossil fuels? Or more urgently, from oil? The 2005-2008 period sent another stern warning that a discretionary, oil-based lifestyle was unlikely to be sustainable in America. The data now proves this out. From the highs of 2005, US oil consumption has fallen 10-12% as a growing tranche of the country can no longer afford petrol. The tragedy of course is that the Obama Administration could have easily used the financial crisis to start rebuilding our rail system: securing for itself a win-win in both job creation, and, a lessening of the economy’s energy intensity. Instead, token investments in select city transport projects and a symbolic interest in high-speed rail have masked the reality that both parties in Washington remain fully committed to the Automobile-Highway complex.

Good news springs forth from the bad news, however. The footprint of America’s passenger rail system may lie beneath overgrown lilacs, but the majority of the rights-of-way have been maintained. To give some idea of the great contraction that took place with our rail system as the folly of our national highway program went into overshoot, these two maps from a half century ago tell the tale. (source: National Association of Railroad Passengers). The first is from 1962, when the intercity passenger rail network still covered 88,710 route miles.

Just 10 year later however, with intrusive highways bisecting American cities and ruining the integrity of their downtowns, the number of passenger route miles had collapsed by over 75%, to 19,366 miles.

Was the Obama Administration correct in thinking that oil prices would moderate, thus making our continued, outsized investment in Automobile Infrastructure the correct policy choice? There’s no longer any need to argue, about the answer. In the same way that normalcy bias disabled the Administration from understanding that the “recession” was not a typical, post-war affair, the same obsolete thinking guided Washington to believe a return to normalized oil prices was in our future. Now for the data: 2011 oil prices are at the highest annual average since 2008, at $94.81 per barrel. Gasoline prices at the pump were at the highest ever during the just concluded Christmas period. And total energy expenditures as a percentage of GDP are back above 9.00%.

This blog advised the Obama Administration to run hard, very hard, towards rail back in 2009—prior to entering office. Now that oil consumption is in decline in the US, its the responsibility of Washington to give Americans the alternative which most cities are already choosing: streetcars, light rail, commuter rail. On a national level, we need an even larger investment to finally separate intercity rail lines for passengers away from existing freight lines. And, the two main corridors on West and East coasts beg for a decade long series of mega-projects, with world-class high-speed service. As it’s a fairly good bet Obama will win reelection, I suggest the Administration redeem itself with rail in its second term.

–Gregor

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Author: Gregor Macdonald   Posted in: Policy  rail   Tagged:                  
Dec 25 2011

Under the Surface of Non-OPEC Supply

December 25, 2011

In 2002 Non-OPEC oil production contributed 60.75% of the world’s total oil supply. But technology, competition, and access to capital through listings on stock exchanges have not been able to overcome limits of geology. Global giants such as Royal Dutch Shell and Exxon Mobil have essentially abandoned the effort to meaningfully expand their oil reserves. Instead, they are now shifting course in favor of a strong, natural gas emphasis. The result is that Russia in the past decade has accounted for nearly all of the supply growth in crude oil, among Non-OPEC producers. Indeed, without Russia, Non-OPEC supply would be in steep decline. Instead, it’s merely flat.

So far in 2011, Non-OPEC oil production now accounts for 57.12% of global supply, with nearly 1/4 of that now coming from Russia. Let’s puncture two myths at once here. Do you think the West is going to become oil independent on the backs of Canada, Brazil, North Sea, and United States? No, no, no, and no. Furthermore, from a geo-political standpoint, what does it imply for the West that a decade ago Non-OPEC ex Russia accounted for nearly 50% of world oil supply—but now only accounts for under 44%? Under the surface of Non-OPEC supply, therefore, is not a swing in power towards the West but rather a more pronounced swing back towards the Middle East, and Russia. The implications are obvious: the West, especially the United States, needs to stop investing in liquid-fuel based transport. The march towards electrification, and the resurrection of rail should be our top priority.

–Gregor

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Author: Gregor Macdonald   Posted in: Policy  Russia   Tagged:          
Dec 23 2011

Studies in Causality: Precipitation Deficit in The Pearl River Delta

December 23, 2011

When analyzing complex systems the issue of causality becomes its own problem. I’ve grappled for years with the issue, at the intersection of oil prices and the economy. This got me to thinking, remembering rather, a very good talk by Robert Kaufmann of Boston University, at the ASPO conference in the Autumn of 2006. Kaufmann, at The Center for Energy and Environmental Studies, made an impression with his discussion of causality—in particular, Granger Causality. And, I noticed that the Granger appears again in a recent paper of Kaufmann et. al, Climate Response to Rapid Urban Growth: Evidence of a Human-Induced Precipitation Deficit. The paper asserts that construction in the Pearl River Delta has caused a change in that region’s climate, reducing its rainfall during the dry season. Below is a map of the delta, which marks the meteorological observation sites used in the study.

In a world where attempts are made to prove or disprove “big stuff” I have a soft spot for studies such as this, which occur within a boundary. Granger Causality, which actually attempts to establish predictability, grants that proof is difficult to achieve when the focus of systemic analysis is very broad in scope. Indeed, my view is that the demand for precision should not be allowed to roadblock reasonable conclusions. As I discussed in a post earlier this week, the issue of causality has significant policy implications because many of the advisory institutions and professions which congregate in Washington, D.C., for example, remain sanguine about a number of our largest systems to, essentially, repair themselves. Whether the environment, energy supply, or the economy, a certain obsolete expertise (H/T Paul Kedrosky) presently guides our political class. The result has been a series of wrongly crafted regulation, which has usually favored the view that dumping liabilities into the commons is mostly cost-free.

It is not. In the same way that paving over large swaths of the Pearl River Delta has reduced life quality for all in China, so has the socialization of risk in the United States reduced the viability of our financial system, and economy, for all. The Kaufmann study cited here neatly shows that large scale alterations of our environment do in fact change the climate. In the tension between precision and scope, therefore, beware those who would continually and exclusively demand the former for its likely they wish to avoid the more accurate conclusions which emanate from the latter. We humans are now running a number of gigantic and tightly coupled systems on the planet, from global finance to aggressive extraction of (and dependence on) natural resources. Ignorance of the Anthropocene—the view that humankind’s impact on the planet has now crossed a threshold—is not disproof of its existence.

–Gregor

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Author: Gregor Macdonald   Posted in: China  Systems   Tagged:        
Dec 22 2011

Why Oil Prices Are Killing the Economy

December 22, 2011

Dear Readers: I’m currently writing a long-form post twice a month now for Chris Martenson’s excellent wesbsite. Accordingly, I’ll be publishing the first (and free) part of these essays here at Gregor.us. Enjoy. — Gregor

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“Oh, that was easy,” says Man, and for an encore goes on to prove that black is white and gets himself killed on the next zebra crossing.” ― Douglas Adams, The Hitchhiker’s Guide to the Galaxy

Have rising oil prices just put the final coffin nail in the entire 2009-2011 economic recovery?

Given the slowdown in China, the new recession in Europe, and the rocky bottom in the US economy, it certainly seems that way.

Oil’s Relentless March Higher

Oil prices emerged from their spider hole over two and half years ago. Having fallen from the towering heights of $148 a barrel in the summer of 2008, the early months of 2009 saw a return to prices in the $30s. Interestingly, during that great oil crash, the price of West Texas Intermediate Crude Oil (WTIC) spent only 20 trading sessions below $40. That is the exact price that most analysts only three years prior believed oil could never sustain as the world would pump “like crazy” should prices ever reach such “impossibly high levels.”

Given the enormous debt troubles the West is currently facing and the fact that oil has averaged over $100 during several months this year, it does seem reasonable to suggest that, once again, the economy has been pushed off a ledge by oil. Let’s take a look at oil prices over the past several years.

Although they won’t admit to it, many economists and older energy analysts have been simply blown away by the persistence of oil prices, especially in the weak economic environment post the 2008 crisis and financial market crash. How did oil prices manage to recover to $80 (let alone to $40 or $60), and make their way back all the way to $100? (And this is just a chart of WTIC oil. Brent oil has been even stronger the past year). Why, for example, has a 12% reduction in US demand and weak economies elsewhere in the OECD not translated to much cheaper oil prices? Why did oil not simply flatten out in price, post 2008? After all, many claimed oil was nothing but another in a series of ‘Made in America’ financial bubbles. With “no shortage of global supply” (as many said), and with a market “awash in oil” (as others said), why didn’t oil prices simply go to sleep at, say, $50 per barrel?

Do Higher Oil Prices Really Cause Recessions? (Answer: Yes)

Before we unpack some of the factors behind oil’s strength, I want to address the subject of oil prices and recessions. I think readers should be aware that some analysts reject any reflexive, easy causality between high oil prices and sharp contractions in the economy. There are a range of views on this topic, from those who embrace the idea of substitution to those who assert that oil prices and oil supply rise concurrently with movements in the economy.

Substitutionists tend to also be positive, or constructive, transitionists I might add. Many of these come from technical and engineering backgrounds, and often have very good exposure to economic theory. In their view, higher oil prices drive human innovation and spur entrepreneurs to create new technology. High oil prices for them are actually a positive. Understandably, they also want all subsidies and other externalities, which we pay as a society to the fossil fuel industry, to be phased out. And frankly, I sympathize with that view.

Meanwhile, analysts who see the relationship between energy supply and the economy as more equalized, more symbiotic if you will, tend to hold the view that if the economy demands more oil — and is willing to pay the price — then the earth will reliably “give it up” to the resource extractors over time. You can see this view very much at play currently, in the excitement over natural gas and also oil extracted from shale. Indeed, the learning curve, in which the hydraulic fracturing technique moved from experimentation to perfection, conforms very much to theory.

If one expands on these two schools of thought — human innovation that conquers limitations, and a symbiotic view of the economy and energy supply — it becomes rather easy to imagine that high oil prices present a real but rather small problem for the economy.

Of course, I take a different view.

Writing with my friend and colleague Chris Nelder at the HBR Blog earlier this fall, we warned of not one but two risks associated with stubbornly high oil prices. First, we referred generally to the history of oil spikes and recessions, noting that in the post-war US economy, one generally followed another. For an economy that has been geared towards oil for many decades, this should come as no surprise, especially when energy expenditures rise over certain thresholds, as they did in the 1970s, and again more recently. But we also warned that an over-confidence had developed over the decades, especially in America, and that any pressure from energy prices was ultimately solvable. And we encouraged corporate management to be more skeptical of the idea that the global oil and gas industry would be able to continue bringing to market resources that most could afford.

One of the more thoughtful reactions to our essay came from Michael Levi at the Council on Foreign Relations. Levi called into question whether any reliable threshold existed, regarding energy expenditures to GDP, that would trigger recession once crossed. In a general sense, that strikes me as reasonable. And to clarify, the notion of proving a magical threshold — say, when energy expenditures to GDP rise above 5% — was not exactly our central point. Indeed, I would agree with Levi more specifically that the rate of change might be at least as damaging, if not more so, than any threshold. In Does Expensive Oil Inevitably Cause Recession?, Levi also makes an additional point worthy of attention:

There is, however, a possible back door explanation for why high petroleum expenditures relative to GDP seem to correlate with recessions even if they don’t do a good job explaining them: it is easier for petroleum expenditures to undergo big changes in short periods of time if they are starting from a high level. If, say, the price of oil rises 50% from a starting point where petroleum expenditures are 2% of GDP, the change in spending is 1% of GDP; in contrast, if the price of oil rises the same 50% from a starting point where petroleum expenditures are 6% of GDP, the change in spending is 3% of GDP. Whatever your transmission mechanism – supply side contraction, demand destruction, shifts in consumer preferences for durable goods – the 3% jump is going to be far more economically damaging than the 1% one. Indeed the years where oil spending was high but recession was absent generally come from a period where prices were fairly stable.

(Source)

As we look at the historical table from EIA Washington, showing expenditures to GDP from 1949-2010 (opens to PDF), illustrative to Levi’s point are the levels from which we rose, starting in 2004. Because in 2003, the level was already sitting at 6.8%. But in 2005, it rose to 7.3%, and then reached the very high level of 9.8% in 2008. Today I am mainly concerned with the outlook to 2012, given that the global economy was granted only the most brief reprieve from high energy prices in 2009, before resuming in 2010 and this year, 2011. To provide the most to up-to-date data, let’s also look at the chart, also from EIA Washington:

Understanding Causality

It is difficult to satisfy a demand for precision — when asserting that high energy prices, or fast rates of change in energy prices, or energy-prices-to-GDP thresholds — has caused a recession. The most significant hurdle lies in the organic complexity of the economy itself. With all of its political and cultural variances, and the mercurial nature of social moods and trends, how does one make certain claims about such a large system?

Some have suggested therefore that high or rising oil prices cause changes in GDP — and hence, recession. To try to put this in layman’s terms, Clive Granger attempts to assert causality within a more uncertain matrix, saying essentially that certain events follow others reliably, but in a sequence where causality is difficult to quantify. As has been pointed out by some, Granger is unfortunately paired with the word causality, when in fact it is really a test or a method by which to determine predictability. (For some of the best work on energy prices and recessions, and Granger Causality, I point readers to the work of James Hamilton, who also runs the popular macroeconomics blog, Econbrowser.)

A broader discussion of the economic impact of energy prices would also include the problem of energy transition. Or, if you like, the broader subject of adaptation. For example, perhaps oil-induced recessions historically were exacerbated or ultimately made possible by policy mistakes. It once was the habit of central banks to raise interest rates in the face of higher oil prices. But what if the economy had simply been left to handle higher prices on its own? More recently, Ben Bernanke has allowed that the central bank cannot control oil.

“There’s not much the Fed can do about gas prices per se. After all, the Fed can’t create more oil. We don’t control emerging markets.” ~ Ben Bernanke, 2011

This suggests an evolution in thinking over his predecessors. Could the economy adapt better to resource price pressures if policy mistakes were not a feature of the economy?

I’m not so convinced of that, either. After all, the volatility in free markets can have its own deleterious effect on new investment. One of the most vexing features of any reliance on high fossil fuel prices alone, as a trigger for investment in alternative energy, is the volatility of prices. If those with capital are to be encouraged to invest in new energy technologies, many of which capture more diffuse energy — or which create energy, but at a higher cost — then there must be some confidence that cheap fossil fuels will not re-enter the scene, making new investment uneconomic. Encouragingly, that particular issue now looks more resolved than ever because the price of the master commodity — oil — which is still the primary energy source of the world, is now structurally higher and is almost certain to stay that way.

Asking the Right Question

And so, to answer the question, Do high energy prices cause recessions? I would say with full respect to uncertainty and causality, yes. Eventually, however, the energy transition away from fossil fuels will gather enough momentum that we will interpret high-energy prices differently: We will say they (helpfully) forced a necessary transition. But as we are so early in any global transition to alternatives, it would be better for economists, policy makers, and business to consider the Douglas Adams quote that’s in the header of this essay. Trying to prove that black is white may be a noble effort, in the fullness of epistemology and causality, but in the short term it could get you run over in a crosswalk.

We face a more immediate question: Is the global economy headed back into recession in 2012? Almost certainly, I think.

The Coming 2012 Global Recession

In Part II: Why It’s Now Easier to Predict the Outcomes of the Coming Recession, I explain why oil prices currently are so stubbornly high, paying particular attention to how tight the oil market has become (again) since the 2008 crisis. So as not to be simplistic, however, I will not reject the fact that debt saturation and crises of confidence will play a role in 2012. Indeed, Granger causality can be employed in both directions, not merely whether energy prices affect GDP, but whether GDP affects oil prices. This is useful because the combination of a very tight oil market, along with Western economies that have reached the terminus of credit-based consumption, makes for a very tricky price landscape in 2012, for oil. This is no doubt why bets on volatility, a very wide band oscillation in oil prices, are popular for next year.

Finally, how much can the global economy adapt, should oil prices reach even higher levels? Can we make the right policy choices, should another oil spike unfold? Remember, policymaking ,which is always imperfect at best, can be even more dysfunctional in a crisis.

Click here to access Part II of this report (free executive summary, enrollment required for full access).

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Author: Gregor Macdonald   Posted in: Uncategorized   Tagged:                      
Dec 13 2011

Old Oil Depletes, And the New Oil is Slow

December 13, 2011

Exxon Mobil has released its 2012 Outlook for Energy: A view to 2040 report. I actually find these industry forecasts helpful, especially for their nuanced contrast with comparable long-range reports from EIA Washington and IEA Paris. For example, I find Exxon’s view that oil will retain its role as the primary energy source—not to be eclipsed by either natural gas or coal—unrealistic. But this is the same view held by IEA and EIA. Where Exxon is more on track however, is in their call that growth in global coal consumption rises very strongly through the end of this decade. This is the call I would have expected IEA and EIA to make as well. Given current trends, I explained as much in Coal’s Terrible Forecast: Because it is coal, not oil, that is steadily growing in supply. And you can’t increase consumption of a resource whose supply has been flat, for the past six years.

Interestingly, Exxon alludes to the structural reasons behind oil’s stalled supply growth, in the following graphic. | see: Global Oil Production by Discovery Date ( 2012 Outlook for Energy: A View to 2040, page 43—click to expand).

The reason oil cannot possibly avoid losing its grip as the world’s primary energy source, to either coal or natural gas, is that the rate of discoveries has slowed down dramatically since 1980. Moreover, “discoveries” since 1980 have primarily uncovered what I call Slow Oil. Slow Oil, unlike the large deposits of conventional crude—found onshore and brought online quickly—is extracted from complex reservoirs, at great depth, in harsh environments, or comes from unconventional deposits like tar sands. Exxon Mobil writes:

Much attention is paid to new energy technologies, with good reason. But it also is important to know that most of today’s liquid fuels come from fields that have been producing for decades. More than 95 percent of the crude oil produced today was discovered before the year 2000. About 75 percent was discovered before 1980.

The common mistake made in journalistic coverage of recent oil discoveries is that these consist of a wholly different tranche of oil, than pre-1980 oil or even pre-2000 oil. This is absolutely the reason why global oil production has been held below a ceiling since 2005. As I have noted before, forecasters who’ve been predicting for years that global oil production would start to increase again have finally gone quiet, and for good reason.

–Gregor

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Author: Gregor Macdonald   Posted in: EIA  forecast  fossil fuels  IEA  Oil   Tagged:          
Dec 11 2011

Transition to Renewables and The Forward Speed of Economies

December 11, 2011

From CarbonTracker.org comes this very useful accounting of global fossil fuel reserves, by market listing on stock exchanges. The risk identified in their report, Unburnable Carbon – Are the World’s Financial Markets Carrying a Carbon Bubble?, is that markets have accorded value to energy resources which may never be extracted. The reason? A rather hopeful one. According to the group: “the threat of fossil fuel assets becoming stranded, as the shift to a low-carbon economy accelerates.” The report pays particular attention to the value of London listings, a country which itself has dwindling fossil fuel resources.

While I think Carbon Tracker has performed a useful exercise here, the prospect that fossil fuel resources are left in the ground may come about more from resource nationalism, extraction costs, or simply the end of industrial growth. It’s certainly true that present growth rates for renewable energy are amazing. But the monster known as coal continues its drive towards dominance. In a previous post of mine showing the world’s mix of energy resources, I highlighted the very encouraging fact that growth in power generation from wind and solar alone was running at 36% in non-OECD countries. Unfortunately, however, 20 years of coal-fired power generation in developing Asia has created a fearsome path-dependency.  As the most recent IEA World Energy Outlook highlighted, “coal-fired capacity accounted for one-third of all the generating capacity additions worldwide over the period 1990 to 2010. Nearly 70% of these coal-fired capacity additions were in China.” Worse, coal is now the preferred energy source of the entire developing world as persistently high oil prices have dampened growth rates of autos and highways, and as rural populations move first towards electrification. In short, coal dwarfs renewables and even stands to dislodge oil.

That said, the map of reserves listed on exchanges is not without implications. As mentioned, London’s competitive edge as an otherwise resource-poor nation has been to offer global capitalism safe harbor and given the limited prospects for growth in the OECD generally, the regulatory framework offered by The Square Mile will likely be retained. Indeed, this past week’s machinations between Britain and the EU were undoubtedly guided by Britain’s motivations, in this regard.

Meanwhile, I’m not convinced stock market capitalisation of global resource companies reflects full extraction value of their resources. Multiples on global giants like Royal Dutch Shell and Rio Tinto remain low. If anything, markets are not pricing in a rapid energy transition away from fossil fuels but rather a slow-growth future as a result of scarcity. If so, this presents an increasingly familiar paradox: global industrial growth is restrained by geological limits on resource extraction—but—this will only serve to slow the forward speed economies really need to make the discretionary transition to renewables.

-Gregor

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Author: Gregor Macdonald   Posted in: Alternative Energy  Policy  Scale   Tagged: