Monday, October 27, 2008

Why does fungibility matter (and where did it go)?

Why fungibility matters. Take any of a number of hypotheticals: revolution in Saudi Arabia cuts 8 million barrels per day of global oil supply; congress passes strict prohibition on burning coal; revolution in Algeria cuts natural gas supplies to Europe; dispute with the Ukraine cuts natural gas supplies to Europe; peak oil creates oil production supply drops much sharper than expected. What do they all have in common? Answer: our ability to cope, adapt, and overcome these problems is largely a function of substituting with alternatives. And our ability to substitute with alternative sources of energy is a factor of how fungible energy really is--how easily we can bring alternative B to replace lost supply of energy A.

Truly fungible? Traditionally, the term fungibility is used to describe the notion that a given energy commodity such as crude oil is of roughly equal value if it is delivered to China or the US. This is critical because it means that a drop in consumption in the US is negated by an equivalent rise in consumption in China. Likewise, it means that it's pointless to "remove our reliance on Middle Eastern oil" if that just means we buy the same amount of oil from elsewhere--the fungibility of oil simply tells us that when we stop buying from A and buy from B instead, the previous customer of B will now buy from A and little will change. But, of course, it isn't that simple. If you're protesting over the simplicity (naivete?) of my little A-B/B-A example a sentence ago, that's because there's no such thing as a truly fungible commodity. The point of this article is to discuss how the real world tends to intrude on fungibility of our various sources of energy and what this matters...

How do we define fungibility? Several ways. First, we can look at the characteristics of an energy source. Solar and wind supplies are seasonally, regionally, and temporally variable. In other words, sometimes the sun shines, sometimes the wind blows, and sometimes it doesnt--in very different patterns in different places. Fossil fuels are geologically constrained. Hydro has its own unique set of availability characteristics that are largely a result of decisions and compromises in dam construction. All of our energy sources are geographically constrained to some extent--you can't just "move" an oil field to China because that's where the demand is. In this sense, very few energy sources are "geographically fungible." Small nuclear reactors (as on naval vessels) and solar photovoltaics are eamples of energy sources that are geographically fungible, though one can argue that these are really conversion mechanisms, not sources. We can also define degree of fungibility by the characteristics of the energy produced. How easily can coal substitute for a shortfall in oil? How easily can uranium substitute for natural gas? Most importantly, we can define fungibility of an energy source by its characteristics transportability. Oil can be transported quite easily by tanker truck or tanker ship. Enriched uranium can be transported, as can liquified natural gas, coal, and electricity. It's important to point out, however, that the different problems encountered by the different means of transporting various types of energy introduce differing degrees of fixedness to our energy system.

Demand fixedness. How fixed is our demand for specific characteristics of energy? How important is is that we have the "instant on" of a natural gas stove versus a slower electric induction cooktop. How much have we already invested in liquid fuel-driven transportation that is keeping us from quickly and easily conveting to electrically-powerd transport. How long woudl it take and how much would it cost to make the switch? What about electric light vs. oil lamps? And what about electricity for communications and computers? It seems quite difficult to substitute any other form of energy to that end.

Storage/time fixedness. Likewise, how does the timing of our demand for a type of energy relate to our ability to store that type of energy? If we want hot water for a 6:00 a.m. shower, it makes it more difficult to rely on a solar hot water heater. If we want reliable electricity supply from solar or wind then we either need lots of batteries or a very expansive transmission grid with localized capacity to generate surplus electricity. This is one of the key characteristics that makes liquid fuels so fungible--they store easily in a readily accessible form and are relatively easily transportable.

Transport/geological fixedness. Pipelines introduce a very significant element of fixedness into our oil and gas supplies, just as transmission lines do for electricity.

Other generators of fixedness that I'll explore in future posts: Generation/conversion infrastructure fixedness; Project timeline fixedness; Fixedness due to sunk cost; Fixedness due to financing constraints; Geopolitical fixedness.

Is there a trend toward fixedness? While I've rambled a bit about these various sources, the real question that must be answered is whether our energy system is becoming less fungible, more fixed--and by imlication less adaptable to crisis, less resilient, more brittle.

Monday, October 20, 2008

Geopolitical Risk: Derivatives Markets without the Upside

There has been a lot of discussion about derivatives over the past few months, and for good reason. Derivatives--a broad class of complex financial instruments--include collateralized debt obligations (securitized-mortgages) and credit default swaps, which are right at the core of our current financial crisis. It's easy to get down on derivatives because when things go wrong, they can go terribly wrong (potentially much worse than we're currently seeing). But there's also an up-side to derivatives: they spread risk, allow parties to risk to effectively insure themselves, enable projects and ventures that would otherwise be untenable, etc. In this post, I want to compare and contrast the kinds of financial risk addressed by derivatives with geopolitical risk.

Defining geopolitical risk. Geopolitical consists of the following: the risk that the political or legal environment will change (e.g. nationalization, money transfer restrictions, etc.); the risk that the security environment will change (military coup, civil war, insurgency, etc.); the risk that the probability of either of these increase, thereby creating a positive-feedback loop that destabilizes the environment. That's all a fancy way of saying "all risk that isn't financial risk."

Can you insure against geopolitical risk? Yes. But there's a fundamental difference between insuring against financial risk and insuring against geopolitial risk. When we insure against financial risk, we make the whole system more stable (to a point, admittedly, and one we've been testing of late). Therefore, the more that people insure against financial risk--default, bankruptcy, etc.--the more stable the system becomes. This means that more insurance activity (more volume on the derivatives market) makes that insurance less expensive. Not so with geopolitical risk. You can essentially place a bet with one of a variety of geopolitical risk insurance providers that, say, your oil lease in Nigeria won't be reposessed, or that your employees in the Ogaden won't be kidnapped. But that activity of insurance doesn't make these events less likely to happen. Arguably, it actually makes them more probable (in the case of leasing, it commits more desirable and seizable infrastucture and resources to countries that might nationalize, for kidnapping it provides an alternative to investing in security services and ensures there's money via K&R insurance to pay ransoms).

In the end, this is because financial risk is spread through dillution, whereas geopolitical risk spreads through contagion. When we use derivatives to spread financial risk, we create both positive and negative effects. On the negative side, more parties are exposed to the risk, creating a higher degree of interdependency. A potential shock is no longer contained, but rather spreads to all involved parties. However, on the positive side, the speading of financial risk also dilutes that risk (you can argue this is undone by simultaneously facilitating yet more leverage, but up to a point this is still a good thing). That isnt' true of geopolitical risk. With geopolitical risk, hedging against geopolitical risk doesn't dilute the risk at all--it just shifts it from the insured to the insurer. And, because the shield of insurance facilitates increased involvement in geopolitically risky regions, the net effect is actually to increase interconnectedness. Geopolitical risk can't be diluted (only redistributed), and hedging against it actually makes the shock waves travel further.

Why these differences are important, especially to energy supply. It is critically important to understand this difference between financial risk (and associated markets) and geopolitical risk (and associated markets), especially when it comes to understanding our energy future. Right now, high energy prices create an incentive to explore and produce energy resources everywhere--including the most geopolitically riskly locales. Normally, the geopolitical risk would make many such areas financially inaccessible. However, with inaccurately priced means to hedge geopolitical risk (both through pure geopolitical risk derivatives and through various other vehicles such as long-term futures contracts, tax deductions, etc.), all comers are wading waist-deep into the fast running waters of Nigeria, Angola, Sudan, Ethiopia, Khazakstan, Bolivia, and elsewhere. As a result, we're maintaining global energy production and facilitating our ongoing profligate consumption of these resources while dramatically increasing our exposure to geopolitical risk. In part because of the positive feedback-loop nature of this risk (see my brief on the topic), this creates a self-fulfilling prophecy of geopolitical supply shock. And here, just like with the credit markets, the longer it takes for this shock to materialize, the more severe it will be.

At the end of the day, while financial derivatives markets are a key component of our current financial mess, they are a truly powerful tool that can be used for great long-term good if regulated (with an understanding of long-term systemic risk issues) to ensure they are not abused for short term profit. Derivatives markets that address geopolitical risk, on the other hand, only delay an inevitable accounting for the underlying causes of the risk--rather than diluting risk they merely facilitate increased exposure to that risk. When this incrased exposure is combined with the geopolitical positive feedback loops that I've discussed previously, it is a recipe for disaster. In particular, because the "force of nature" character of geopolitical positive feedback loops is not well understood, geopolitical derivatives tend to be priced incredibly inaccurately, ensuring that the future geopolitical situation comes as a severe shock.

Monday, October 13, 2008

The Timing of the Financial Crisis & Peak Oil

Here is the big topic that needs to be developed over the next several weeks and months: the interrelationship between peak oil/peak energy and the financial crisis/global economy.

In my opinion, it's necessary to take a deeper look at the impact of the financial crisis on our economy--because it is not clear at this point that "financial crisis" is the same as "general economic crisis." The financial crisis is like a falling soufle--you pump enough air into something by way of what I've called "financial wizardry," and eventually it will pop and deflate. But it isn't like a balloon--when the derivative-driven froth is blown off the pint of beer, there's still beer underneath. It's a question of how much...

I'll stop with the metaphors (for now). It's undeniable that the implosion of global credit and derivatives markets has very real effects--both on the global demand for oil and for general economic activity.  However, the recent tumble in oil prices is, in my opinion, more due to the aggressive pricing into the market of a long global recession than it is of an actual change in the supply and demand situation.  It's worth noting that the IEA just revised their projection for the next year's oil demand growth from 0.8% to 0.5%.  Note that is still growth, a very real 350,000 barrels per day or so.   What is also undeniable is that, even if global credit locks down permanently, there are very real prospects for economic activity and growth. At one extreme, if the credit markets lock down, you can't buy a $800,000 house with nothing down, no credit, and no verification of income. That hurts the housing price bubble. On the other hand, even with no credit market at all, the Adam Smith-style economic opportunities still exist: you can still grow vegetables and sell them, you can still assemble raw materials into a value-added product you can still provide services for money or barter, you can still build furniture, buy houses, etc. Every "real" economic activity that can be done with credit can be done without. There is, of course, a huge catch here: you can't do it the same WAY.

You can buy a house with a frozen credit market--you just have to save up the cash purchase price first. Novel approach, I realize, but there you have it. Believe it or not, people used to do this fairly frequently.

You can still manufacture complex products. But, rather than getting a loan to buy the capital equipement, materials, and pay the labor, then give it to the customer, get them to pay you, and repay the loan, now you need to 1) get the customer to pay you, or 2) maintain enough cash reserves to carry this cost until payment. This means that either the customer or the producer  needs to save up the money for the end product first, rather than pay later. This also has a dramatic impact on business models--the 'get big first, then figure out how to profit' model advanced by and others simply doesn't work. All these changes really shake up the rate of throughput while System B reverts back to System A.

Of course, it's also worth pointing out that our credit markets are nowhere near frozen. They just aren't quite as artificially lubricated as they recently were. As with most things in life, when it comes to credit today you can get anything you want, but most likely not everything you want.

So back to the froth on the beer. Most of that froth is going away. The question is how much beer is left underneath. When the economic fantasy land of recent credit-driven excess falls back down to earth, there will still be a very vibrant agricultural sector, a vibrant market for cheap, energy efficient transport, a vibrant market for clothes, homes, etc. just as there always has been. It might be more potatoes and less Cabernet. It might be more renting and less owning a 4,000 square foot home on a $50k/year salary. It might be more buses and light rail and fewer Escalades. And make no mistake--there will still be plenty of excess, plenty of luxury, plenty of waste. But, to the degree that things change, this is opportunity for economic activity and profit. The economies of specialization and centralization haven't gone away (though the energy cost of distribution from a centralized facility must be considered).  But the traditional economies of scale and place will be in increasing competition with what I've termed the "anti-economies."  Whether you're a farmer, an accountant, a furniture maker, or a nurse, you still perform an important economic function.

And that's the point: When the froth is gone, there is still a very vibrant economy hiding underneath. In fact, and this is where I start to get concerned, to the degree that we refocus our efforts away from keeping the froth full of air, we'll start to focus more of our effort to revving up the fundamental economic engine that sits beneath it. And so will the rest of the world, which brings me to the other half of the equation: Peak Oil.

It seems likely that it takes a few years to fully sort out the frothy mess we're currently in. But when this is sorted out, we'll still have 5 billion people in the developing world who want home heating and air conditioning, want to drive a car, want to eat more meat, want hot water on demand, etc. And there's no fundamental problem with our underlying economics that will prevent them from demanding these things. Except Peak Oil. The next two or three years of focus, budget, and effort fixing the financial crisis are two or three years where we aren't using oru rapidly dwindling supply of high net-energy surplus oil and gas to invest in a renewble energy infrastructure or to restructure our economy away from the demand for continual growth. In fact, the short-term drop (or at least fear thereof) in commodity consumption is likely to depress prices enough that there's no financial incentive to even invest in keeping production steady.

We're setting ourselves up for the perfect storm. Resurgent global demand for energy will hit just about the time that our energy supplies (especially our net energy supplies) begin to rapidly decline. As I've said in jest many times on this blog, the Mayan prophecies about 2012 may not be that far off the mark--at least as far as timing is concerned. This topic--the interrelationship (and political disconnect) between finance and energy, and what we can do about it--will be a frequent topic going forward...

See a few older posts on this topic:

Monday, October 06, 2008

Open Source Ecology--Help Needed

If you've been following my writing on rhizome, the problem of growth, and the hamlet economy, or if you've been reading John Robb's posts on the "Resilient Community," then you'll also be interested in the work being done on an open-source toolkit for the sustainable village of the future at Open Source Ecology.

There, Marcin Jakubowski, a person I met through the excellent P2P Foundation, is blazing ahead with a very real, implementable "Global Construction Set" of open-source tools, platforms, and knowledge sets to empower a future of sustainable, vernacular, and decentralized food production, energy generation, architecture, and social structures. Here's an visual overview:

One of my favorite parts of their plan is their work on an open source compressed earth block machine. This is something that is truly decentralized and vernacular-tech, but that can have a revolutionary effect on the architecture and energy demands of both the rural poor in the third world and the adventurous rich in American and elsewhere. Importantly, Open Source Ecology is not just a theory shop--they already have put much of this into practice in the real world, such as building a compressed earth block press, a hexayurt, and they're working on an open source solar turbine.

Right now what they need are both online and real-world volunteers and financial support. If you have money to contribute, this seems like a very worthy project (here's their donation page). If not, as long as you're interested in the topic you'll notice that their entire site is a wiki--contribute information, start new projects, etc. If, like me, you'd rather help design a annualized solar heating system than an open source tractor, Open Source Ecology has built an amazing platform to do just that...