Algeria & Morocco: Natural Gas Cartels, Fertilizer Mercantilism, and Rising Tensions

This originally appeared last week at The Oil Drum. I may have a brief, original post this week if time permits.

____________________________

Algeria is one of the world’s most important oil and gas exporters. Morocco has no significant oil and gas production, but has about 2/3 of the world’s rock phosphate reserves, a critical component in global fertilizer supply that increased 300% in price in the past year (.pdf) and may peak alongside global oil production. The two nations have historically been at odds, especially over the phosphate-rich territory of Western Sahara. Now, more than ever, their exports are critical to the energy and food supplies of the world. Alongside increasing importance, tensions between the two are on the rise as the US and Russia provoke the situation with massive opposing arms deals and bi-lateral trade agreements. This article will look at the forces behind these rising tensions and consider issues of fertilizer mercantilism, infrastructure vulnerability, and the potential formation of a natural gas cartel.


Will Demand for Gas & Fertilizer Bring New Conflict to Morocco & Algeria?
Country Briefs:

Algeria: Algeria is an important exporter of both oil and natural gas (background .ppt on NG supplies to Europe). Algeria is Europe’s third largest supplier of natural gas, providing 30+ bcm via pipelines and 20+ bcm via LNG tanker in 2007. Major projects are currently underway to expand pipeline infrastructure to Italy (via Tunisia) and to Spain (both direct undersea and via Morocco), and to expand LNG export capability. Algeria hopes to expand total natural gas exports to 85 bcm/year by 2010, making their production roughly the equivalent of Norway (Europe’s 2nd largest provider). Significantly, the potential to expand natural gas supplies to Europe enhances Algeria’s importance as an alternative supplier in light of current dependence on uncertain Russian gas supplies. Algeria also faces an active Islamist insurgency, a separate threat from the rising al-Qa'ida in the Land of the Islamic Maghreb, and serious demographic challenges in the form of a 1.22% population growth rate (graph) and sharp ethnic divisions (map).


Figure 1: Algeria's Place Among African Natural Gas Reserves

Morocco: Morocco's importance to the global economy is due to its control of at least 2/3 of the world's reserves of rock phosphate. The USGS has stated that there are no substitutes (.pdf) for rock phosphate in agriculture. With biofuel demand increasing steadily, and world food shortages hitting the headlines, rock phosphate is arguably as important to the world situation as oil supply. Importantly, Patrick Dery has performed a Hubbert Lineraization on world phosphorus production and estimates that we have already passed peak phosphorus (see graph below). While the importance of rock phosphate has been discussed here before, its impact on the situation between Morocco and Algeria has not. Additionally, fertilizer supplies are a critical component of many biofuel projects, creating an interrelationship between phosphate and energy supplies. Like Algeria, Morocco faces an internal Islamist insurgency (though currently less troublesome than in Algeria) and has significant demographic challenges with a population growth rate of 1.6% (graph) and sharp ethnic divides (map).


Figure 2: Peak Phosphorus? A Hubbert Lineraization of Global Phosphate Production

Tensions: The Sand War, Western Sahara, and Islamist Insurgencies

There are several sources of tension between Morocco and Algeria. The two states fought the Sand War from 1963-64 over a mineral-rich border territory. In 1975, when Morocco took control of Western Sahara, Algeria began overtly backing the Polisario Front in an ongoing insurgency that continued unchecked until a 1991 cease fire. Both states also suffer from internal Islamist insurgencies, exacerbated by increasing demographic problems. The situation in Algeria is most severe: after independence from France, the revolutionary National Liberation Front ruled the country until Islamists won the first free elections in 1991, prompting the military to immediately seize control. More than 160,000 people were killed in the ensuing civil war between 1992 and 2002. While the country is relatively peaceful today, factions of the Islamist rebels have remained, operating out of rural regions inside the Malian border and elsewhere in the Sahara, and have recently merged with al-Qa'ida to form AQIM (al-Qa'ida in the Land of the Islamic Maghreb). The group has recently carried out several attacks in Algeria, including the April 11 2007 Algiers Bombing, the December 11 2007 Algiers bombing, the 2007 Batna bombing, and the 2007 Dellys bombing, as well as being possibly involved in the 2007 Casablanca bombing in Morocco. The pace of attacks has not slowed, with at least five bombings in the last two months alone.

Infrastructure Targeting?

While Algerian Islamists have generally mirrored target selection of Islamist groups elsewhere, one attack in December, 2006, specifically targeted Haliburton workers in Algeria. This tactic, of targeting critical infrastructure and energy industries, has been increasing around the world as non-state groups everywhere realize that they can maximize their return on investment with these targets. With rising internal threats and state sponsored proxy conflicts, and the potential for direct state military attacks no longer too remote to consider, it is concerning that both Algeria and Morocco present some extremely high ROI energy and resource infrastructure targets:

- Morocco: The Fosbucraa Conveyor, the world’s longest conveyor belt, transporting phosphates from the world's largest phosphate mine at Bou Kra 100km to the port of el Aioun. The conveyor was successfully attacked several times by the Polisario Front. Here's a satellite image.

- Algerian pipelines & LNG infrastructure: Algeria is chock full of high-vulnerability, high-consequence targets. Algeria recently signed a 100 million euro contract with French defense firm Thales to secure oil and gas pipelines. With 16,200 km of major pipelines to protect in Algeria alone (and scheduled to increase to 21,000 km by 2010), the task is daunting. Additionally, two potential future infrastructure projects may represent appealing targets. The proposed Trans-Saharan natural gas pipeline, that would deliver Nigerian natural gas to Europe via a 4,550 km pipeline, would represent a lengthy and vulnerable target to multiple groups if it is ever built (construction is “penciled in” to start in 2015). Additionally, speculative plans (such as the Trans-Mediterranean Renewable Energy Cooperative, or TREC) to leverage high solar insolation in the Sahara to generate electricity for Europe would require huge transmission infrastructure that would be both highly vulnerable and highly attractive. Neither the Trans-Saharan pipeline nor TREC is in any danger of being built in the immediate future.

Thoughts on the Future: Proxy Wars & Proxy Mercantilism

Recently, the fragile 1991 cease fire agreement with the Western Saharan Polisario Front has become increasingly unstable. Complicating the situation with Western Sahara, French President Sarkozy announced his support to Morocco's decision to postpone indefinitely the self-determination referendum promised in the 1991 accord, along with increased Algerian support to Polisario leadership. All this comes against a backdrop of rising military tensions between Morocco and Algeria. In 2008, the US doubled military aide to Morocco and announced arms deals worth billions of dollars. At the same time, various sources confirmed that Russian concluded a $7.5 billion deal to provide advanced arms to Algeria.

Is there any deeper meaning behind these moves? At least two possibilities must be considered. The first is proxy-mercantilism by the United States to secure control of phosphate supplies. In 2004, the US entered into a bi-lateral free trade agreement with Morocco. This can be explained as a natural extension of the long history of economic and military cooperation between the US and Morocco, but in light of proposed biofuel programs, skyrocketing rock phosphate prices, potentially peaking phosphate production, and mercantilist moves by other great powers, the more nefarious possibilities must be considered. The second possibility is that Russia hopes to leverage increased influence with Algeria to exert greater influence in global natural gas markets. Because Algeria is one of Western Europe's few true alternatives to Russian natural gas supplies, especially given the prospect of sharp increases in Algerian natural gas exports, Algeria represents either a threat to Russian natural gas leverage, or a great enhancement of that leverage by entering a defacto gas cartel. At a minimum, we know that Russia and Algeria are actively engaged in talks on this topic. Also, a recent offer by Gazprom to buy all of Libya's additional oil and gas production supports this suggestions that Russia hopes to control Europe's alternative sources of natural gas.

Both notions of phosphate mercantilism and a gas cartel are merely informed speculation at this point, but the stakes are so high that these possibilities must be considered. While there may be no deeper motive behind recent moves with Morocco and Algeria, at a minimum the stakes and tensions are increasing. Because both Algeria and Morocco are fragile Nation-States, with active Islamist separatist movements, significant internal terrorist threats, and complicated ethnic/territorial problems, the potential for interruption in critical exports of phosphate, oil, and gas is increasing.

Demand Bifurcation Point

The future of the global economy will, in my opinion, turn more on this question than any other:

Will demand destruction hit India and China, or will their oil consumption continue to rise?

The answer here will determine much of how peak oil plays out. It isn't a "tipping point" where we'll suddenly enter a post-peak world, or an energy-scarcity world. We're already there. Rather, this is a "bifurcation point"--a potential radical divergence in the impact that peak oil has on the global system.

If the Indian and Chinese economies are fragile--as many think--and can't continue to grow with $150 oil, then they will cut back on demand, and oil prices may stabilize as global oil demand stays in line with gradually declining global net oil exports. This will allow for a more gradual response to energy scarcity, a re-tooling toward renewable sources, new settlement patterns, etc. If, however, the Indian and Chinese economies are much more resilient than many think--as I think is the case--then Indian and Chinese oil demand will continue to rise rapidly, more than making up for any demand destruction in the more mature western economies. The result will be continued rapid price oil price increases, additional economic stress in the West, and greater turmoil in general. I think the answer to the question will largely turn on the vibrancy of internal consumer demand from the growing middle class in both states. It's simply too early to predict with confidence, but here's an indicator that suggests Indian and Chinese oil demand will continue growing:

China June Auto Sales up 15% Year-on-Year

That's 836,000 new cars in China in June alone. And, significantly, in China the majority of these new cars are the first car for an individual consumer--so these aren't replacing existing cars that were already on the road, but rather are new cars that weren't on the road before. In India, May auto sales were up 14% year-on-year to 110,000 cars--that shows how much room to grow India has just to catch up to China's level of automobile penetration in the populace! GM expects global auto sales to increase 4% in 2008, meaning 2.8 million more vehicles will be sold this year than last. Especially considering that sales in mature western economies are expected to stagnate or decline, the majority of these new sales will come in developing nations where they are disproportionately more likely to represent a new, additional car on the road, not a replacement car.

The prospects for global demand destruction are not looking good. Oil is a globally fungible commodity--demand destruction in the US may be rising very slowly, but this is irrelevant in the face of rising global demand. Personal investments in cars increase the inelasticity of demand--when people have sunk cost in a car, it skews their calculation on the value vs. cost of consuming gasoline. Unless the trend in global car sales turns around, it's hard to envision a long-term retreat in oil prices...

Nigeria - Significance of the Bonga Attack

NOTE: An updated version of this post is now available at The Oil Drum.

Militant attacks have shut in as much as 345,000 barrels per day of Nigerian oil production in the past few days. One of the attacks was against a facility 120 km offshore, demonstrating a significant new militant naval capability. This may prove to be an extremely important development: 1.25 million barrels per day of new offshore production is scheduled to come online in Nigeria over the next 6 years, and all of it was previously believed to be beyond the reach of militants.

Shell’s $3.6 billion “Bonga” Floating Production, Storage, and Offloading vessel (FPSO), 120km from shore in 1000m deep water, was recently attacked by MEND militants.

Overnight on June 19th, militants from the Movement for the Emancipation of the Niger Delta (MEND) struck Shell’s offshore Bonga facility, resulting in Shell declaring force majeure for deliveries of 225,000 barrels per day in June and July. Bonga, the first and largest Nigerian offshore facility, is 120km offshore. Then, on June 20th, militants destroyed a key Chevron pipeline near Escravos, Nigeria, forcing Chevron to shut-in and declare force majeure on 120,000 barrels per day. This article will analyze the significance of the Bonga attack in light of Nigeria's efforts to grow its offshore oil production.

What is at Stake?

This recent attack is particularly troubling in Nigeria, where a February, 2006 Citigroup report noted that "clearly most of the (oil production) growth near-term looks to be in the Nigerian deepwater and as such should be less subject to current disruptions." While offshore production currently only accounts for 16% of Nigeria’s oil production, it is expected to account for 90% of future growth. MEND has already demonstrated its capability to shut in significant portions of Nigeria’s onshore oil production, and now it is threatening to re-attack offshore facilities, urging expatriate workers to abandon them immediately. Significantly, Nigeria’s onshore production is already mature, and government hopes of raising total production to 4 million barrels per day are entirely dependent on the success of the offshore sector. If MEND can continue to interrupt offshore production, the prospects for any increase in production from Nigeria look dim. The situation in Nigeria is particularly important as Nigeria is one of the few states with the potential to significantly increase both production and exports. The megaproject list on WikiPedia shows 345,000 bpd of offshore production set to come online in 2008 (Agbami field, Oso field); 220,000 bpd of offshore production in 2009 (Akpo field, Oyo field); 220,000 bpd of offshore production in 2010 (Bonga North, Bonga Ullage fields); 285,000 bpd of offshore production in 2011 (Bosi, Ukot, Usan fields); 250,000 pbd of offshore production in 2012 (Bonga SW, Nsiko fields); and 150,000 bpd of offshore production in 2013 (Egina field).

That’s 1.25 million barrels per day of new offshore production planned in the next 6 years. None of it was previously considered vulnerable to attack. Now it all appears to be within the demonstrated reach of MEND.

MEND: Potential for Innovation & Improved Capabilities

This most recent offshore attack also highlights significant development in MEND’s capabilities. Comments as early as 2006 noted that MEND’s offshore capabilities are continuously improving, and that facilities as far as 50-60 km offshore may be at risk. Bonga is twice that far offshore, at 120km.

I predicted a year ago that MEND would increasingly focus on Nigeria’s offshore facilities for two reasons: to differentiate their ideologically-grounded struggle from the privateers and criminal bunkering that is also interrupting Nigerian production; and as a result of the innovation that naturally results from their decentralized structure. While this most recent attack demonstrates MEND’s ability to operate in the deepwater environment, it also shows significant room for improvement. MEND’s press release stated that their goal was to gain access to and destroy the facility's main control room, but that they were unable to do so. Their failure, however, most likely provided MEND with the specifics of what capabilities, training, and equipment they will need to succeed in the future, suggesting that the improvements in capability demonstrated in this attack are part of a larger cycle of capability improvements (an OODA Loop).

The recent attack demonstrates three significant and separate advances by MEND: targeting, naval equipment, and training. By targeting far-offshore infrastructure that was previously considered to be beyond their reach, and by targeting projects that are key to the Nigerian government’s revenue plans, MEND has accurately identified a very high return on investment target. This demonstrates an advancement in their ability to pursue “effects-based targeting”—that is, the ability to carefully select targets for their ability to produce the desired effect. For MEND, the desired effect is to force the Nigerian government to better meet the needs of the Delta peoples. Previous tactics of kidnapping and attacking pipelines were poor choices for several reasons: they spawned criminal activity within the Delta, they increased pollution in the already polluted Delta region, and they did not effectively compel the desired action on the part of the Nigerian government. While it is yet to be seen if the current targeting choices will be more successful, in my opinion they are an advancement in targeting skill on the part of MEND.

The Bonga attack also demonstrates a significant advance in MEND’s ability to operate far offshore. While MEND has always been noted for their riverine naval capability, their demonstration of offshore capability suggests an improvement in naval equipment. No information is available on what types of watercraft were used by MEND in the recent Bonga attack, but at a minimum they have demonstrated that their boats have 120km range.

Additionally, MEND demonstrated a fairly advanced set of navigation skills. Standing in a rigid inflatable boat, at 1.7 meters above the water, the visible horizon is only 5km away. Even if Shell’s Bonga facility flares at 100m above the surface, the flare is still below the horizon at 40km. Reports that the attack commenced at 1 a.m. suggest that MEND has developed fairly advanced offshore and nighttime navigation skills, that Nigeria’s naval presence in the region is not currently capable of protecting offshore facilities, and that all major Nigerian offshore facilities are within MEND’s reach.

Conclusion: Geopolitical Feedback Loops in Action

The recent attacks in Nigeria should be viewed as a product of geopolitical feedback loops. I’ve written previously about these feedback loops in operation in Nigeria, and will begin to reassess and update them in upcoming posts. These geopolitical feedback loops are significantly undermining Nigeria’s ability to deliver on their potential to increase oil production and exports. While it may be tempting to view these geopolitical feedback loops as separate from the geological phenomenon of Peak Oil, it is more accurate to view the geopolitical factors as a direct result of geological peaking—-but for geological factors, disruptions in Nigeria would simply cause oil exploration and production to move to other, equally fertile grounds. Instead, the geological reality that there are very few “geologically fertile grounds for increasing oil supply” forces companies to accept the high costs of doing business in Nigeria.

**Note: for those hoping for a rhizome post this week, I apologize... world events are conspiring against my efforts to write on a non-oil topic. Next week! Maybe...

Eliminating Subsidies Won't Solve the Oil Demand Problem

This week's post is an article that I wrote for The Oil Drum. Also, several new links on the side column this week. Starting next week, I hope to move away from discussing oil for a few weeks and turn to discussion of rhizome as an open source platform for developing personal and community self-sufficiency, something of a "rhizome toolkit."
____________________________

Cheap gas and diesel due to government fuel subsidies has become one of the favored whipping boys of late—a convenient way to blame high oil prices on the actions of some other government or faraway people (See 1 2 3 4 5 6 7 8). But how much can subsidies really be blamed for present oil demand? Would cutting a 30% gasoline subsidy reduce demand by 30%? Why not? I’ll stake out and defend a somewhat extreme position: reducing, or even eliminating fuel subsidies will not cause a significant, long-term reduction in demand and may even cause demand to increase more quickly than with subsidies in place. More importantly, we must not fall prey to claims that cutting fuel subsidies is an easy solution to our energy problems.

A Hummer dealership in Caracas, Venezuela, where consumers pay only pennies for a gallon of gasoline as reported by the New York Times


Fuel subsidies are currently in place for nearly half the world’s population. Fuel subsidies around the world have previously been covered at The Oil Drum in Fun With Subsidies and Taxes, as well as numerous articles in the media on the topic in the past few weeks (links above). Additionally, most OECD states indirectly subsidize fuel consumption in a variety of ways. I won’t rehash this existing coverage, though I do need to point out that every article* I’ve been able to locate has argued that cutting subsidies will have a significant effect on demand, and will help to lower oil prices (*only one analyst, Benoit de Vitry of Barclay Capital, seem to agree with me). To me, this wave of media coverage of subsidies is just like the waves of media coverage past on speculators, big oil conspiracies, and the promise of oil shale: a source of false hope that a magical solution exists to our energy problems. For that reason, my intent here is to argue that the long-term effect of cutting fuel subsidies is, contrary to the reports in the media, not of much significance.

Demand Elasticity is a Marginal Matter

The first reason that cutting subsidies won't have a dramatic impact on demand is that the fuel demand elasticity of a country is the aggregate of the marginal demand elasticity of each of its consumers. For that reason, the elimination of a 30% subsidy for fuel will not result in a proportional drop in demand of 30%. For some users, price increase will completely price them out of the market, and their marginal demand will be completely eliminated. For others, either because of wealth or the value of liquid fuels to their economic activity, the elimination of the subsidy will result in no decline in consumption. The vast majority of consumers will lie somewhere in between. Therefore, right at the outset, we can say that the elimination of a 30% subsidy will not result in a 30% drop in demand. I’d love to be more precise on this point, but neither the data nor methodology currently exists to project with any confidence exactly how much demand reduction would result from the elimination of subsidies—all we can say with any certainty is that it will be smaller than the size of the subsidy eliminated.

Evaluating the Energy Intensity of the Opportunity Cost to Subsidy Expenditures

The next question—and perhaps the most important—is to evaluate the opportunity cost of a government’s expenditures on fuel subsidies. If a government does’t spend $X billion on fuel subsidies, what will it spend the money on? What is the energy intensity of that expenditure compared to the amount of demand reduced through cutting the subsidy?

Take India, for example. In India, the total cost of fuel subsidies could be as high as 2-3% of GDP. What happens to that spending if it doesn’t subsidize fuel use? There are two theories here, both of which create at least some fuel consumption that didn’t exist before. One theory is that it will be spent in a way that results in lower fuel consumption—but almost certainly not in a way that results in NO fuel consumption. The argument in favor of this position is that, because fuel subsidies distort economic calculations in favor of consuming fuel, a neutral use of the same amount of funds should result in less fuel consumption. However, there is an opposing position: because subsidies are, according to market theory, a sub-optimal allocation of resources when compared to free-market allocation, the elimination of subsidies will result in stronger economic growth (or less economic decline) than with the subsidies. This is especially true if the money saved from subsidies isn’t spent at all, but rather reduces the tax burden or lowers the rate of inflation. It remains potentially true to a lesser degree even if the money is merely spent elsewhere, since neutral spending is likely to have a less distorting effect on economic activity. Therefore, according to this theory, elimination of a fuel subsidy may actually result in greater fuel demand over the long term—and that demand may be even more inelastic because it stems from a more efficient allocation of resources. This is the argument of Benoit de Vitry of Barclay’s Capital. In the end, it may come down to this question: What’s worse (from the admittedly very skewed perspective of demand management): 100 million Indian middle class paying 40% under market for diesel with a GDP growth rate of 5%, or 200 million Indian middle class paying market for diesel with a GDP growth rate of 7%?

Cutting Subsidies Won’t Slow the “Export-Land” Effect

Finally, cutting fuel subsidies in exporting nations won’t significantly slow the grinding effect of the Export Land Model, whereby rising revenues of fuel exporting countries lead to increasing domestic consumption and declining net exports. What happens if subsidies are suddenly cut, and citizens of Venezuela or Saudi Arabia have to pay the market rate for oil? The extra money they spend on oil goes to their own government, rather than to some other nation. And that money can then be spent on other projects or programs—the opportunity cost issue noted above. However, to make the cuts in subsidies viable, they are likely to be offset by progressive spending plans that disproportionately benefit the poor. This is exactly what is currently happening in Malaysia. The result may actually increase demand: the rich, who are not the beneficiaries of these offsetting handouts, are also the least likely to reduce their demand due to price rises. The poor, who may otherwise reduce their demand, are the most directly benefited by the handouts. And, because it may be possible to prevent any demand destruction by simply handing out 1/2 or 2/3 of the money previously spent on subsidies to the poorest consumers, there is likely to be money left over to be spent elsewhere (or not taxed in the first place), which brings us right back to the previous discussion on the energy intensity of that alternative spending.

To conclude, I’m certainly not advocating the maintenance or increase of existing fuel subsidies. They are an inefficient allocation of resources, resulting in less economic activity for every barrel of oil consumed. Rather, my intent here is only to dispel the notion—increasingly popular of late—that eliminating fuel subsidies is some kind of magic bullet to derail the demand train. At best, I think the elimination of fuel subsidies will result in a minor and short-term decrease in the rate of demand growth in developing nations. It will not significantly alter the energy crisis facing humanity. Either way, the elimination of subsidies may not be politically practicable—where they have been cut there have been riots (1 2), and there are numerous movements attempting to actually increase fuel subsidies (1 2 3 4 5).

Recession or Reallocation?

I've been fairly outspoken on my opinion that the US is not in, and likely will not enter, a recession this year or next. I'll argue for that point again today, in light of oil at $137/barrel, but first I want to address an important issue in psychology. Other people (not me!) are susceptible to getting so invested in a belief that they begin to view new information that tends to either confirm or disprove that belief with what psychologists call "confirmation bias"--that is, they discount information that goes against their belief as either insignificant or biased, and see information supporting their belief as credible and weighty. Since, to the best of my ability to investigate, I seem to also be similarly wired as a human who evolved the ability to think rationally on top of (primate/human brain, mostly prefrontal cortex), not in substitute for, my ability to think reflexively (reptilian/fish brain), it seems that I may be susceptible to the same hard-wired tendency to engage in faulty reasoning! Fortunately, thanks to my awareness of my own limitations, I'm trying to review my opinions here with extra care to identify exactly that kind of bias. Take it for what you will--I think I'm presenting this information as objectively as I am capable, which may or may not be very objectively objective. Fortunately, I seem to have been modestly but consistently right with regards to my predictions to date (2006 2007 2008), but, again, I need to remind myself that correlation between my predictions and reality does not necessarily prove that I am anything more than a highly biased and highly lucky person :)

So, given my attempt to look at the situation without confirmation bias, how can I still think that we're not in for a near-term recession when so many economists are worried about the impact of high energy prices, when so many pundits think that the economy simply can't survive on $5 gas (or $6 gas or $10 gas)? First, I think that our current media/pundit complex is very, very biased--much more so than me (confirmation bias?). Second, I can remember strikingly similar calls that the economy would collapse at $3 gas, at $4 gas, at $60 oil, and at $80 oil (and even that $40 oil would have serious negative effects). The key to discounting these renewed calls is in following the money. What happens when we pay $5/gallon for gas? Where does the money go?

Well, as a net-importer of oil, much of that money goes overseas. Where it is spent. Generating economic activity. The portion of that money that goes to domestic oil producers stays in the US, where it is spent. Generating economic activity. This is the key: high energy prices alone do not lead to recession, but rather to reallocation. While the two may feel the same if you're one of the people who's money is being reallocated out of your pocket and into the hands of Exxon or ARAMCO, they're very different animals. Recession is an aggregate decrease in economic activity. It means less opportunity overall. Reallocation, on the other hand, is not an aggregate decrease, but rather a shifting of who gets the benefit and who gets burned. It means the same--or even greater--opportunity, but in different places and in different manner than in the past.

Therefore, this is my working theory: the US, along with the global economy, is not facing a recession, but rather a reallocation. I don't think that actual economic activity will decline until actual energy availability declines (something that might not be too far off). Until that begins to happen--when we're just facing increasing prices, but not yet declining availability--we will instead see reallocation. Take a look at this graph from the latest edition of BusinessWeek:



Overall, the US economy grew at an annual rate of 0.9% in the first quarter of 2008 (yes, you can legitimately dispute those numbers due to inflation, etc.--I certainly do--but I'm looking at the official numbers so that I can compare apples to apples). Excluding autos and housing--two areas on the losing side of economic reallocation--the economy grew at nearly 4%, which is higher than the optimist's expected long-term growth rate for the US.

What to do in the face of reallocation? Reallocation hurts the most those who are not expecting it. Expect it to continue, and to intensify. Don't follow the moronic investment advice offered over at CNN Money, but rather try to tease out where the money will be reallocated to, and put yourself in position to take advantage of those new opportunities ("get yourself to the non-discretionary side of the economy," get linked to the energy economy, the local food economy, etc.). Reduce your exposure to having costs reallocated to you (e.g. by reducing commute times or transport modes, by establishing partial food self-sufficiency, by generating your own electricity/growing your own woodlot, etc.). Reallocation is change, but it is not necessarily "bad." If you're assuming that you can keep driving your F250 to work 20 miles away at the Ford plant, reallocation will feel--quite convincingly--like a recession. But that won't make the pundits who proclaim that we're already in a recession correct. It will just mean that they, like you, have fallen prey to confirmation bias and are mistaking reallocation for recession. Well, at least that's my opinion, subject to all the standard disclaimers of human thought processes.

Crash Course

This week I'll be reviewing the book "Crash Course: Preparing for Peak Oil" by Zachary Nowak. The book has a concise introduction to the concept of Peak Oil, followed by what I see as the strength of the book: an interesting discussion on scenario planning, rounded out by an extensive guide to the skills and knowledge that will be necessary to make the best of a less-than-ideal future.

Scenario planning is something that I think is vitally important for everyone to perform on an ongoing basis. I wrote about the concept last week, but in reality it's something that we should all be doing continuously for all manner of life decisions. In "Crash Course," Nowak outlines four separate future scenarios for planning purposes (setting aside "Status Quo" and "Total Armageddon" as either too remote or pointless to plan for): The New Green Revolution (most optimistic), Powerdown USA, the Great Energy Depression, and The Crash (most pessimistic).

He then discusses the merits of planning for the future via a "refuge" or through fostering "community." He discusses the merits of these various approaches, and suggests that alternatives such as the rhizome model for communities that I've suggested may offer a viable compromise between the two. I increasingly think that the our future plans must be seen as a continuum--resilient community is the goal but cannot be just set up like a lego set; personal refuges are immediately implementable for many because they are under individual control but are not desirable long term solutions; the answer seems to lie in planting seeds of personal refuges that, from the outset, are intended to anchor the networks of sustainable community, knowledge sharing, and local solution development that will one day grow into resilient local communities. While certainly an imperfect historical parallel, I think that the monasteries of Dark Age Europe serve as a valuable example of how "refuges" can survive tough times, carry knowledge forward from past civilizations, develop newly appropriate skills and techniques, and later serve as the physical and intellectual framework for the construction of a new society. Nowak points out exactly this--that refuge and community are not mutually exclusive paths--but I would like to see this point developed in more depth. That might be asking too much, however--it's something I'd like to do, as well, but have not been able to put together satisfactory principles and rules for how it can be best accomplished. Perhaps this is because the transition plan between refuge and community is necessarily one customized to a cultural set, to a geographic area, and to an unknown future.

Nowak then discusses "the house." He goes through a variety of alternative techniques and discusses several books on the topic. Some, such as "Shelter" by Lloyd Khan are outstanding, and I second the recommendation. Others, such as Earthships, are not among my favorites (I think the Earthship design places too much emphasis on aesthetic homogeneity, and does a poor job balancing insulation and thermal mass for all but a few climactic zones--a proper mix of insulation (e.g straw bale) and thermal mass inside the insulating barrier (e.g. adobe, cob, etc.) seems like a better rule of thumb). Nowak also covers rainwater harvesting and greywater (I like his recommendations) and discusses passive annual heat storage concepts that I think are critical (though I prefer Don Steven's take to the recommendation Nowak provides, and I'm currently working to adapt these same principles to create a passive annual solar COOLING system...). I've also heard of the rocket stoves that Nowak discusses for home heating, but his recommendation made me finally purchase Ianto Evans' book on the topic. I also appreciate that Nowak points out that the "back to the land" movement of the '60s and '70s did not fail, per se, but rather helped to perpetuate knowledge of old sustainability techniques and develop new ones so they will be available when the current generation actually NEEDS them (I'd say one cause for the failure of the prior movement was it wasn't immediately necessary, in the minds of many, and lost out to the allure of moving back to the suburbs and living during the last decades of the economic "good life" in America).

Next, Nowak discusses food production and storage. Nowak points out--rightly I think--that 1) it isn't that easy to garden, and 2) that even if you're a great gardener and have a large garden, it's not always possible to count on only your own garden to meet all your food requirements due to drought, pestilence, etc. One solution to this is to diversify beyond mere raised bed gardening into perennials vegetables and forest gardens (I heartily concur with his recommendation to read Eric Toensmeir's "Perennial Vegetables" as well as David Jacke and Toensmeier's "Edible Forest Gardens."). I've discussed this very topic in "Creating Resiliency in Horticulture." I like that Nowak discusses the need to augment the yields of a garden with wild harvest from surrounding fields, woods, etc. I think this is a critical component of any resilient scheme--both skills and the access to suitable environments to ensure that when garden yields fail, natural yields pick up the slack. This is an integral part of my own planning--the need to acquire land not only sufficient to grow an intensive garden and less intensive forest garden, but sufficient to create a natural buffer (lightly "guided" with planing, rainwater harvesting earthworks, etc.) that will serve as a back up. In fact, my choice of location is largely driven by the ready availability of forageable foods--especially those that are consistent in times of drought and not readily recognized as food by most people (for me, mesquite trees). Nowak also deals with the essential skill of preserving foods--no matter how well planned and successful one's garden harvest, it's unlikely that the right food will always be available for the picking!

If I could point to one weakness in Nowak's book, it is that the book consists largely of a series of book reviews. That is also one of its greatest strengths. Any book that proclaims to provide all the knowledge that you'll need to deal effectively with Peak Oil should be dismissed as bunk at the outset. Instead, what most people (myself included) really need is a pathway to gain the knowledge necessary to succeed in a variety of future scenarios--both topical knowledge AND the analytical framework for future scenario planning to apply that knowledge. In that respect, "Crash Course: Preparing for Peak Oil" excels. "Crash Course" is like a knowledge map, outlining a concise path through the myriad of useless, incorrect, or irrelevant books, and taking you directly to those books that really should be on your shelf. I highly recommend the book for those interested in learning how to better prepare self and family for whatever future scenario you envision.

Is the Falling Dollar behind Oil Price Rises?

It's difficult to turn on CNBC, read any newspaper article on oil prices, or listen to other discussions of the topic of oil prices without hearing this theory: really, it's the decline in the dollar that's responsible for the rise in oil prices. "They" advance two reasons for this: first, dollar-denominated oil traded on the NYMEX must go up equal to the amount that the dollar goes down, or it's actually losing value. Second, the belief that the dollar is losing its footing as the world's reserve currency is causing a flight from dollars to commodities and other hedges against a falling dollar. Lots of words, but very little data is usually provided to back this up. I decided to put together a little graph that cuts right to the heart of the matter:



Figure 1: US Dollar Index (Bottom) and NYMEX Crude Oil (Top) contracts concurrent price charts

So, let's look at two periods: before about March 10, 2008, and after about March 10, 2008.

Before March 10, 2008, there was a general (though not very convincing) correlation between dollar movement and oil price movement. We need to remember that correlation does not necessarily equal causation here, even if there are rational explanations for a potential causal mechanism. This correlation extends back into 2007 (not shown--chart begins about Jan. 1st, 2008).

After March 10, 2008, there is not a correlation between dollar movement and oil price movement. The dollar has remained relatively steady and constrained within a relatively narrow trading channel. During this same time period the price of oil experienced one of the most dramatic increases in history.

Problem: How can we infer causation from the rough correlation from 2007 to March 10th, 2008 between dollar decline and oil increase if the two data sets become uncorrelated between March 10th and the present? There are possible answers to this question--possibly because there's a lag time between dollar decline and the move to oil and other commodities, possibly because there was some new countermanding force propping up the dollar since March 10th, or something else entirely. The point isn't that there's no explanation for this--the point is that the break in correlation itself defeats any rational use of correlation as the sole basis for asserting causality. At a minimum, we'd need to perform a three-factor analysis here and see if, then, we can derive a continuing correlation--say between an identifiable fed action data set, the dollar index, and crude oil. To my knowledge, no one in the media who has been bandying about the dollar-oil theory has done that. That seriously undercuts the argument that oil price rises are due to dollar decline, in whole or in part. As with any scientific experiment to determine causality, the non-correlation between March 10th and the present must be explained or the entire dollar-oil theory falls apart. I realize that it might be beyond the attention span/sound-bite requirement for most media to discuss this, but it certainly could be addressed in a newspaper or magazine article. I have seen neither. I'll keep thinking about it, but if there are any theories that people would like put to the test, please comment!

Future Scenarios

Two points for discussion tonight: David Holmgren's new Future Scenarios site and the recent Economist coverage of Peak Oil.

First, Adam Grubb of energybulletin.net tipped me off to the launch of David Holmgren's new site, futurescenarios.org. Holmgren, co-founder of the permaculture concept and still a critical proponent working to advance that field, has done an excellent job of placing the permaculture analytical framework and toolkit into the world of peak oil scenario planning. The site is still in its infancy, but is well laid out and does an excellent job of framing both peak oil and climate change in a "how can permaculture affect these problems" sense.

I think that the notion of scenario planning is a truly critical area of inquiry. This stems from the fundamental proposition that we don't know what the future will hold. I think that, with careful inquiry and investigation, we can gain a good feeling for future probabilities, but anyone who tells you that "the future WILL contain X" is most likely acting largely on faith, not reason. The closest that we can come to a "truth" is that we don't know what the future holds, but that we may be able to discern probabilities for different scenarios. In light of this probability, we must plan our course of action in light of 1) our goals and 2) the solution space of possible future scenarios.

I don't want to get bogged down in a discussion of goals, beyond the notion that it seems that we tend to get stuck on derivative goals (like increasing GDP or decreasing poverty) when these are in fact just means to achieving our actual goals--call them happiness, stability, fulfillment, etc. It's my opinion that we'd be best served by building our goals around our genetically determined requirements--in other words, to reach for fulfilled ontogeny. Once we've carefully identified our actual goals--not mere intermediary means to achieve those goals--then we can begin to approach how to achieve these goals in an unknown but probably probabilistically determinable future environment.

So what is that future solution space? Let's frame it, for the purpose of this analysis, along only one axis--future energy availability. Let's call one end of the axis "catastrophic energy cliff due to peak oil and other primary energy sources with no substantial mitigation" and the other end of the axis "unrestrained and continuing growth in energy consumption due to new reserve discoveries or the development of adequate substitutes." Or, if those labels are too lengthy, "doomer" and "cornucopian." I contend that anyone who says we "know" which way the future will go is taking an irrational, faith-based approach. Therefore, I argue that the only rational approach is to say that both scenarios (and all points in between) are possible. We can still, of course, argue about the probabilities of the various scenarios coming to pass. I think that both extreme scenarios are sufficiently possible that we must seriously plan for them, but I think that something in the general direction of the "doomer" scenario is significantly more likely over the medium to long term. This is an area that fundamentally demands individual determination, but assuming that you accept my evaluation, what is to be done about it? This is where scenario planning comes in, and it's a topic that I've discussed in the past in future planning: hedging the solution space. The basic notion--especially where it differs from conventional wisdom on planning for the future--is to evaluate options based on their composite ability to succeed in any possible future. That is, don't just pick what you think the most likely future scenario is and plan for that alone, but rather plan a solution that addresses all possible future scenarios simultaneously, prioritizing in order of probability. In particular, I think that today's conventional wisdom focuses entirely too much on how to hedge within what conventional wisdom considers to be very probable future scenarios (though I dispute their assumptions) without placing any concern on the ability of these plans to deal with outlying scenarios (such as Peak Oil, which I actually see as "probable," but which hasn't yet been fully accepted by the mainstream--more on this below).

I think that scenario planning, such as the more limited solution space proposed by Holmgren in futurescenarios.org, is a very important start in this direction. One point that Holmgren does an excellent job of addressing is the need to address this solution space on different levels. IF we could count on our national and global means of governance addressing our problems, then that could potentially be the best way to deal with the problems facing humanity. However, because human organization at that level seems unlikely to actually address our problems in any serious way due to temporary political demands and our inability to deal effectively with inherent uncertainty, it is important that Holmgren points out how it is also possible for communities and individuals to address our path into the future solution space. I take this even further--it is my opinion that we must begin to address the future solution space at the individual level, and that only once we have established a foundation of individual, resilient self-sufficiency in light of future uncertainty can we begin to build a community and then a global solution to our problems. This is because any attempt to solve problems without first addressing security at the individual level seems to leave humanity open to the lure of populist but illusory programs. Much more about this notion in The Problem of Growth.

----------------------------

I'd also like to briefly address the coverage of Peak Oil in the latest edition of The Economist. The Economist asks whether current high oil prices are caused by speculators or peak oil, and concludes that the answer is "neither." Addressing speculators, The Economist concludes rightly that the theory is "plain wrong." They provide an excellent and concise explanation of why, as I've explained here previously (essentially, that oil is a deliverable commodity and prices must ultimately be set by the consumer's willingness to pay a given amount). Next, they claim that "[t]here is little evidence to support the doctrine of "peak oil" in its extreme form." This, in itself, is an important qualification from previous statements by The Economist (and most others in the mainstream) that "peak oil" is flatly wrong. Instead, they only discount the "extreme form" of the theory (conveniently, without ever defining what differentiates "extreme" peak oil from "conventional" peak oil). Of course, they then proceed to offer up two completely unfounded arguments in support of their already unclear position. First, they claim that supply should rise in the near future due to current high prices (which is much different than showing significant extant increases), and second, they discount the "above ground" factors of increasing cost of production and resource nationalism as somehow divorced from peak oil, something that I've repeatedly (and I think convincingly) linked as a direct result of peak oil. I would like to see a more rigorous analysis from The Economist, but I guess this is what I should expect from a paper with such an ideological ax to grind. That said, I still enjoy reading The Economist because at least their ideological spin is so transparent that it is always easy to adjust for.

Oil Price "Head Fake"?

Late post today as I've just returned from vacation--I try to get new posts out early Monday mornings, but at least it's still Monday...

Oil prices have certainly been in the news lately, and I've written here and elsewhere that the concept of Peak Oil has "tipped" in the mainstream media and in the markets. Many people still think that oil prices are just a bubble. Others think that the recent run-up in oil prices are just due to the declining dollar (apparently they haven't viewed a chart of oil price superimposed over the Dollar:Euro price chart lately, as that clearly can't explain the last few weeks' dramatic run-up). Others think it's all evil speculators--I won't repeat what I've said before about why that opinion does little but demonstrate a fundamental misunderstanding of the oil markets. But increasingly people are waking up to the reality that this is simply an issue of geologically and geopolitically constrained supply and rising demand. Over the long-run, we'll either develop a new substitute for oil and/or we'll reduce our demand for oil. Unless some new miracle technology (or miracle cohesive political will) moves us consciously away from oil, or unless the global economy collapses for reasons other than energy, then over the long-run these substitutes or this demand reduction will be a result of prices rising to significantly higher than they are now. The questions, to me, is whether this price rise will be relatively smooth or whether it will come in waves with serious retracements.

In other words, will oil prices make a "head fake," and decline significantly for a few years as current high prices cause a global recession, only to prevent us from mitigating the near-term onset of production declines causing truly dramatic price increases 5-10 years down the road? Charles Hugh Smith seems to think so.

Here's Smith's graphic depicting a potential "head fake" in oil prices.

Let's consider the potential for such a "head fake" more closely:

Taken in isolation, I don't see how increased oil prices cause destruction in demand sufficient to cause prices to decline, but rather only enough to prevent or slow additional price increases. The exception to this is the time-delay inherent in demand destruction. If oil prices now make everyone choose a more fuel-efficient car when they buy their next car, then current prices will cause a reduction in demand that continues over several years as we roll-over our auto fleet. Similarly, it may take oil prices staying at current levels before people are adequately convinced that they'll remain high, and therefore incorporate these prices into their decision making. That's a reasonable enough argument, but absent this time delay, I don't see how oil prices alone can cause a massive collapse in demand that isn't already present at current price levels. I do see how we could reach a wall where it would be difficult for prices to rise further because any increase is met immediately with a demand response, but that doesn't seem like a possible cause for a significant price decline--a "head fake." Why would $5 gas suddenly cause people to radically cut consumption any more than $4 gas did? I think there's a generalized perception that at some point there will be a demand response to high prices, but I think the common fallacy is assuming that this response will be digital, that at some magic number everyone will sit up and take action. Rather, demand response to high prices is extremely graduated, with a little bit happening at every rise in demand. Sure, some psychological barriers (e.g. $5 gas) may have a bit of an extra kick, but in general price increases won't cause a decrease in demand sufficient to significantly lower price. It just isn't logical--why would $4 gas cause prices to drop to $3, when people were apparently willing to consume enough gas at $3.50/gallon to sustain that price level? It's difficult to account for the time-lag issue, but I don't think that there's such a large time-lag waiting to unfold to actually decrease prices significantly.

The "head fake" scenario proposed by Smith IS, however, possible if increased oil prices merely act as a catalyst to set off a larger economic chain reaction that, in turn, destroys far more demand than the catalyst alone can account for. This is similar to what happened with the recent credit crunch--mispricing of risk in one area cause an entire risk-pricing industry to suddenly clam up, over-correct, and over-price risk for a brief period. This same thing could happen if gas prices caused a general recession that led to people postponing capital investments and other economic activity until the recession had ended--a sort of chicken and egg problem. While I do think that gas prices alone can cause economic hardship, any recession caused by high gasoline prices seems to be only a problem of the global economy evolving to a new reality, not to an inability to maintain current levels of economic growth. If $500 Billion a year is going to the Middle East, and they are in turn spending it on luxury products, then the global economy must re-tool and re-orient to produce luxury goods for Middle Eastern sheiks rather than Fords for Ohio factory workers. That might be a painful transition, but it doesn't necessarily reflect either a decrease in economic activity OR a decrease in energy consumption, just a shift in where and how it takes place. It is important to differentiate a recession caused by the market's inability to quickly re-tool for a new economic environment due to high oil prices and the very different even of a recession due to an actual decrease in economic production due to a decline in oil production (and, possibly, also total energy available to the economy). This latter event--something that I think is still a few years away--could cause a very serious recession. The former--just high prices due to tight supply/demand issues--should only cause a re-focusing, which might be painful for some, and painful in general in the short-run, but may actually be beneficial in the long-run because it could allocate energy to higher value-added tasks than in the present. I'm not sure that the more minor recession caused by mere high oil prices would be enough to cause a "head fake" in prices, but I think it is a distinct possibility due to issues of market psychology.

One think does seem certain--if we accept the assumption that oil prices will rise over the long-term, then a steady rate of increase with minimal volatility will best facilitate adaptation to a lower-energy, costlier-energy world. The "head fake" that Smith writes about is potentially very dangerous because it could cast new doubts over the very notion of Peak Oil at exactly the time when the world must address the problem with great urgency. A "head fake" would breathe new life into the abiotic oil crowd, the "markets will always provide" crowd, the Super-Hummer crowd, etc. Because I think that there is a significant possibility of a "head fake" due to market psychology (or, possibly, due to a short-term increase in supplies if the megaproject and geopolitics stars all align over the next 24 months or so), I think that our outlook and investing in the energy sector needs to incorporate a fairly long-term time horizon. I don't think that $200 oil is a sure thing this year or next (though I think it's a strong possibility). But oil under $200/barrel in 2016 seems highly, highly unlikely absent a general economic collapse (and, in that even, we have equally big problems to deal with).

Hat tip to FutureJacked.

Peak Oil Tips (Out of Backwardation)?

Has Peak Oil, as a meme, "tipped"?

One indicator of a "tipping point" for acceptance of Peak Oil may be the state of backwardation in oil futures. I first raised this idea over 2 years ago, but recent market movements, coinciding with attention in the press, may be validating it: when the markets accept Peak Oil, we will see the end of backwardation in crude oil markets, and possibly even Contango. Here's what has happened over the past 6 weeks:



UPDATE: Chart updated with 10:00 AM EST, May 19th data to reflect move into contango.

A few quick definitions: Backwardation is when prices in the future are lower than in the present. Contago is the reverse, where future prices are higher than in the present.

Normally, oil markets are in backwardation. It is conventional wisdom that oil markets will always return to backwardation for several reasons:

- The Hotelling Rule, e.g. the expectation that improved technology will lead to ever lower extraction costs (which, of course, Peak Oil theory rejects, and in fact argues for the opposite)
- The vicious cycle theory: when backwardation reaches zero, there is no incentive to hold inventory of oil, which then causes inventory to decrease, which then causes spot prices to rise, resulting in increased backwardation
- There is no incentive to fix current prices at today's price, because the time-value-of-money would actually result in you paying more than today's price for oil (which only makes sense if you accept that Peak Oil will likely lead to dramatically higher prices in the future)
- Arbitrage (discussed below)

Is contango even possible in oil markets? The conventional wisdom is no, at least not over a sustained period of time. The theory behind this is that if oil is selling for more two years in the future than it is today, then producers will use arbitrage. They'll buy a front-month oil future, sell a distant-month oil future, pocket the difference, take delivery of the front month oil and store it for delivery at the later date. This prevents oil in the future for selling for any more than the cost of storage of oil until that date, and when time-value-of-money is accounted for, that usually requires that future oil sell for less than spot oil.

Contango could exist if a few circumstances were met: present rate of oil production would need to be effectively fixed, there would need to be a consensus that future rate of production will be lower and that demand will remain highly inelastic, and there must be some impediment to storing today's oil to sell in the future. If all three of these came to pass, then the oil markets could be in significant contango and arbitrage would not be able to remedy the situation. Of course, it seems unlikely that these things (specifically the inability to store oil) will come to pass unless through some kind of political or regulatory move, but it is possible.

Because backwardation is the norm, and contango seems unlikely, I think it is highly significant that oil has gone from very large backwardation to nearly zero backwardation over just the last 6 weeks. It seems consistent to me with an emergence of Peak Oil awareness in the markets that led the market to the rejection of every reason for "normal backwardation" listed above except arbitrage (which can only maintain backwardation equal to the difference between storage cost and time-value-of-money).

It's easy to explain away the spot price of oil in isolation without resorting to some form of Peak Oil theory. It is much more difficult to explain away the dramatic decrease in backwardation.

CDSs vs. CDOs: Why the party isn't over quite yet

The Economist has an interesting article on the Credit Default Swap marketplace ("Swap Shop"). I've written about this market before, but it is one that is even more important today than it was just a 18 months ago. Credit Default Swaps are essentially bets that anyone (well, any financial institution) can place on another credit instrument (e.g. a corporate bond). You can buy or issue a CDS without being a party to the underlying credit instrument, though often the participants in the CDS market use these vehicles to hedge their risks as parties to credit issuance. CDSs are different from the current black sheep of the finance family, the Collateralized Debt Obligation (CDOs: basically a pool of mortgages or other debt that is bundled, chopped up ("securitized"), and then re-sold). While the current "Credit Crunch" is largely a result of a meltdown in the CDO market due to mispricing of risk and other negligent/reckless lending practices in home loans, the CDS market is prospering. It grew from $34.4 Trillion in 2006 to $62.2 Trillion in 2007 and continues to grow rapidly (yes, you read those numbers correctly--the CDS market is many times larger than the entire US economy, even if most people have never heard of it). Here's the rub: this vibrant CDS marketplace will actually rescue us from the "Credit Crunch," unless of course it manages to cause the entire global economy to implode in the meantime. Fortunately, that unless isn't very likely. Yet. The CDS marketplace is like a safety net. As it grows more dense, more complex, more perfectly optimized as a risk-management tool, it also becomes more rigid--losing the very flexibility that it needs to perform its function. Currently, firms use the CDS marketplace as a network of insurance policies. When something goes wrong, as long as those firms that are obligated to pay under the CDS system have the spare change to do so, the safety net functions admirably. Of course, as a largely unregulated world shrouded in the fog of murky and non-transparent accounting practices (or worse, overly rigid ones like the new Basel-II standards), it isn't really possible to tell when a firm has over-committed themselves in this CDS shadow-world. Because CDS providers make money by issuing these swaps, and because at the right price there is a virtually unlimited market to purchase said swaps, the ratio of committed reserves to actual reserves of the financial industry in aggregate is rapidly accelerating. This makes the CDS marketplace increasingly "rigid"--where rather than absorb a shock, it spreads through the network without dissipating.

At any given point--such as now--it is much more likely that the system absorbs whatever shock it receives. But, as every moment passes, the CDS system becomes more optimized, and therefore less flexible and more brittle (there are historical precedents for this). Over time it will become increasingly likely that the any given shock shatters an increasing inflexible CDS system, but, in my opinion, we're not there yet. There is still lots of room for optimization in the system--for example, this CDS-style risk-management notion really hasn't spread to the retail level. When that happens--when I can buy a CDS on my neighbors mortgage to protect myself from the decline their bankruptcy and resultant foreclosure will cause in my home value, then I'll think we've crossed the Rubicon. Coincidentally, that's a really good business idea... (note: only partial sarcasm... I've long thought that there is a huge and untapped market for retail hedging of risk exposure far beyond life, car, and home insurance: why don't more individuals hedge exposure to volatile energy costs, food costs, housing values, job markets, etc.??)

So am I just saying that, most likely, we'll recover from our current economic mess? Not quite. What I am saying is that the current economic problems are caused by a very curable problem--poor credit practices. They are, admittedly, being exacerbated by the onset of the next source of economic problems, Peak Oil, but that is not yet the underlying cause of what's happening. I must admit, the media does seem fixated on telling us how there really is a depression, right now, in America--in my opinion because they have to talk about something, and because you don't get ratings for saying "nothing particularly striking to report today, Bob." Parts of the broader media complex--blogs and websites mainly--do nothing but cherrypick news that supports their view that we're one wake-up away from a "Mad Max" apocalyptic future. All this motivates me, at times, to defend my prediction that we aren't in a recession, and that we won't see a real recession this year at all. Of course, this conflicts starkly with my other prediction that we are currently experiencing a "slow crash." Am I schizophrenic? I don't think so (who does?)--rather, I suggest that these two views are compatible provided that the differing time periods are kept in mind.

I maintain my prediction that we won't enter a recession this year. Of course, I take that narrow-minded position that a recession should actually have to conform to the definition of recession before it counts--if people are allowed to go about willy-nilly and define what a recession is and then tell me that I'm wrong when I say the current data doesn't meet the definition, more power to them. Just for completeness, US Q1 2008 GDP growth = 0.6%, and a recession is officially defined as two consecutive quarters of zero or negative GDP growth. Contrast this with the incessant ranting of the media that "7 out of 10 Americans think we're already in recession" (and the unspoken data point: 9.9 out of 10 Americans can't actually define the threshold for recession, but the media still reports their opinion... kind of like "7 out of 10 Americans think the Surge in Iraq is working" while "9.9+ out of 10 Americans don't have the data to reach an informed opinion on the topic"), the current economic figures suggest that we are NOT in a recession.

So there's nothing but smooth sailing on the horizon and I'm transitioning my oil call options into suburban homebuilders? No. There are some grey swans that could create a true recession or depression: actual and sharp decline in oil production is one of them. I don't care how high oil prices go ($300/barrel, $500/barrel), as long as it's just a bidding war for plateauing, but not yet declining supplies, this won't cause a true recession in my opinion. Our very ability to bid prices to such heights will be reflective our our economic strength. But once actual energy supplies begin to decline substantially (say, 5% from peak), then this will cause economic damage.

Net oil exports are one key data point to watch--and they may already be showing substantial declines (in the 5% range). However, to the extent that oil exporting countries are increasing domestic demand by stepping up purchases of consumables and durables from the West, this may temporarily postpone the impact of net oil export declines. No telling, yet, whether net oil export declines or actual net production declines will be the first to start to impact the global economy, but I think we'll have time for one more bout of partying before either one puts the permanent kaybash on the festivities...

Giving Up the Car

I just finished reading Noel Perrin's "Giving Up the Gun: Japan's Reversion to the Sword, 1543-1879" for the second time. The first time I read it was for a dinner party/discussion group with noted military history professor Dennis Showalter in 1998 while attending the US Air Force Academy. This book is very important for a number of reasons...

First, let's not pull any punches: Perrin's historiographical method is poor. Perrin didn't speak Japanese, and largely fails to discuss one key to Japan's successful "giving up the gun" was that Tokugawa had unified the country and eliminated the impetus for warfare that existed prior to the Shogunate.

That said, the book is really an in-depth exploration of the ability of society to effectively "turn back the clock," to set aside an available and known technology due to a cultural preference. In the end, Japanese society consciously chose to set aside the gun in favor of a less "efficient" form of military killing that better suited their desire to maintain the class and cultural status quo. Specifically, samurai found that their heroic stature on the battlefield, their cultural significance, and their place in Japan's feudal hierarchy were endangered by a weapon such as the gun that effectively leveled the playing field and allowed plebeian marksmen to mow them down at will. Because of their leverage within the Shogunate, and because of the prevailing desire to maintain cultural "harmony" by the elites, the gun was effectively marginalized.

Even when I first discussed this book in 1998, it was in the context of the ability of human society to set aside a technological possibility for the long term benefit to humanity of not pursuing the short-term gain promised by that technology. Then, the specific focus was nuclear armaments. I re-read the book for the same reason, but today my interest was in the ability of human society to set aside our energy-intensive culture for our own long-term benefit--whether that comes in the form of climate change, preparation for peaking of fossil fuel production, or simply maintaining a level of information processing and hierarchy that is compatible with the human genome. I still think that Perrin's book has valuable insight to offer on this question--a question that I think is increasingly critical for the future of humanity.

Unfortunately, after re-reading Perrin, I am more pessimistic about the ability of modern society to set aside our current reliance on cheap and polluting energy in favor of some more sustainable economic basis for society. Perrin's analysis of Tokugawa Japan highlights (in part due to his historiographical failings) one key feature that facilitated Japan's "giving up the gun" but that is not present in modern society: economic, political, and military power all unified within a shared cultural framework. In Japan, the feudal economic and military system was composed of individual who were also the key to the contemporary military order, who shared a common cultural ethos, and who uniformly benefited themselves by supporting the Shogun's efforts to maintain that system by marginalizing guns. Modern society does not enjoy this kind of "unified command" of political, military, and social elements. Rather, and especially in comparison to modern industrial society, Japan in the Shogunate was hegemonic and could effectively move in unity in a single direction provided that the class of power-brokers uniformly benefited. Today, if the US were to effectively transition to a sustainable economic footing, India and China would most likely just pick up any slack in the system, and would likely even leverage the short-term benefit they would enjoy in both economic AND military advantage. Similarly, if one corporation or one individual were to make such a transition to sustainability, others would likely exploit their short-term inefficiency (or failure to maximally exploit the environment) to their own advantage. It is a new twist on a classic "tragedy of the commons" scenario: the global commons in energy consumption and environmental degradation requires that all players maximize their near-term consumption and pollution or lose out in power to those who do, without actually preserving energy or the environment through their own sacrifice.

It's a poor analogue, but "giving up the car" may be the close to the modern equivalent of giving up the gun. Absent a modern Shogunate to impose upon the masses what may (ultimately) be in our own best interest--preserving our environment, embarking on some form of oil depletion protocol, minimizing impact on climate--we likely won't choose to do so on our own. And even if we could muster the political will to do so in America, or in Europe, someone else will recognize this for what it is--an opportunity--and their resultant increase in consumption/pollution will eliminate any positive effect of our sacrifice. Which leads me to Vail's 10th Law (I'm still working on the first 9): any "solution" that requires people or government to behave better than they have in the past is doomed at the outset to failure. Or at least doomed to working as well as that strategy has worked in the past...

If I had to boil down my thinking into a meta-theory, it is that the trajectory of human society is a result of the structure of that society, and not of the individual wills at work within it. Change requires changing that structure, not producing some "great man" to lead the pliant masses. Right now our structure doesn't allow us to "give up the gun," or to give up the car either. At least not voluntarily. We may be able to, as individuals, see that it would be the wisest long-term course of action, but that is a very different thing than taking that path, collectively, as human society...

Thoughts on Demand Destruction

Oil is currently well over $100/barrel. Demand is effectively holding steady in the US despite this recent run-up in price. There are some measures that suggest a decrease in demand, and the press has seized upon these to “prove” that high oil prices are causing people to drive less. I think this is cherry-picking of statistics: one commonly watched demand indicator, the one-week domestic gasoline demand figure as published by the Energy Information Agency in This Week in Petroleum actually shows a 91,000 barrel per day increase in gasoline demand for the week ending April 11, 2008 over the week ending April 13, 2007 (9.338 mbpd in ’08 vs. 9.247 mbpd in ’07). That’s a 0.98% increase year on year—so where’s the demand destruction??

This flies flat in the face of repeated statements recently in the press and blogosphere that gasoline demand is going down, so let’s look at it a bit more carefully. Here are the EIA’s full historical tables for gasoline demand, both week ending and 4-week average. Using the smoother 4-week average, the 2008 demand has been consistently lower than in 2007, but not by much. However, using the finer-resolution one week data, 2008 demand was higher than 2007 for the weeks ending 4/11/08, 3/28/08, but lower the weeks ending 4/4/08 and 3/21/08. For two of the last four weeks, demand for gasoline has been higher in 2008 than in 2007. This is hardly conclusive evidence of demand destruction, and completely ignores that the most recent demand figure shows a year-on-year increase.

Will we see significant demand destruction in the future? There is no clear answer to that at this time, but I think one thing is clear: it’s time to take a deeper look at the mechanics behind how demand destruction will work, if and when we see it (or, if we already are).

Does a lack of demand destruction when oil is well over $100/barrel mean that prices must go even higher to destroy demand? How much higher? Or is it enough that prices hold at this level for long enough to cause people to gradually make long-term purchases with this price in mind, and thereby destroy demand? How long? Finally, how much of current US demand destruction (to whatever degree it exists—even if only as a decrease in growth of demand) is due to current economic conditions, and how much can be attributed to price alone?

Figure 1: No significant demand destruction based on EIA’s gasoline demand chart… the most that can be stated definitively is that the past year has not shown appreciable US gasoline demand GROWTH over 2007.

Time-Lag in Demand Destruction: Major Purchases Drive Energy Consumption

One way that demand destruction occurs is that, when making major energy-consuming purchases such as a car or a house, people make more energy efficient choices based on the price of energy. These choices happen over time—everyone won’t (and couldn’t) rush out tomorrow to buy a more fuel efficient car, even if gas suddenly hit $10/gallon. How long is the time lag in these choices? Moody’s says that the average time between car purchases is 4.33 years. Even if we could figure out a magic number at which every consumer will pick a new car based on improved fuel efficiency, it would take at least 4 years to affect this transition. In reality, however, no one knows what percent of people would change to a more efficient car, and how much more efficient that new car would be, based on a given price of gas.

What about houses? Americans move houses on average every 5 years. Well, at least they did when they were upwardly mobile in a growing economy and sub-prime credit was easy to come by. It is yet to be seen how the current economic situation will change this figure, but it seems likely that our rate of moving will slow. In theory, when we move homes, we could choose more energy-efficient homes (better insulated, better solar design), or, possibly more importantly, homes that require less driving to commute to work. However, the massive sunk-cost in suburbia must be taken into account. While these homes may go down in value because of the commuting difference, they will likely remain largely occupied because, while the cost of commuting may skyrocket, the cost of ownership in the suburbs may decline to even this out. After all, the average American home is about 30 years old, and despite the promise of “New Urbanism” or downtown condo living to reduce gas consumption via commuting, the turnover of America’s housing infrastructure will take time.

Return on Investment Driving Demand Destruction

Demand destruction happens in other ways than buying a more efficient car or moving to a house closer to work. It is also possible to reduce demand by choosing a less convenient, less pleasurable, or slower option over another that consumer more gasoline. Take carpooling, for example. The passenger-miles-per-gallon of any car immediately doubles when a single commuter adds another commuter as a passenger. Four adults in a Honda Civic hybrid would average about 200 passenger-miles-per-gallon. Even four adults in a Hummer would get respectable mileage per passenger! If this is so simple, then why don’t we all do this? Because carpooling costs time, both in the time required daily to pick-up and drop off the additional passenger, time required to set-up the carpool system, and time in the form of inconvenience of people unexpectedly needing to work late, not being ready for pick-up on time, etc. How do we value this? There are no statistics that I’m aware of that track % of people who commute with one or more commuting passenger, or that track something similar, nor do I have any statistics for average “inconvenience time” per additional carpool passenger. At some gasoline price level, it makes sense for any given person to arrange to carpool. At $4/gallon, however, my impression is that most Americans will still value the time saved more than cutting their gasoline bill in half. The calculations for riding the bus, light rail, walking, riding a bike, etc. are essentially the same—how do you balance the money saved on gas with value of added inconvenience and additional time? For some people the decision clearly makes sense—but those are the people most likely to already carpool, ride the bus, etc. New demand destruction doesn’t occur until the price of gasoline changes the calculus, where it didn’t make sense at $3/gallon, but does makes sense at $X/gallon. How high would gas prices have to be for it to “make sense” for 50% of suburban commuters to carpool or ride the bus?

Economic Cycles and Demand Destruction

Ultimately, the kind of calculus suggested above is inextricably linked to the health of the broader economy. Rich consumers with large and growing disposable incomes are likely to value their time and potential inconveniences at a much higher rate than those struggling to buy groceries (notably, those with high disposable income are also the most able to pay now to upgrade to more efficient homes or cars, but least incentivised to do so). Another point to consider in evaluating demand destruction is the cause of economic problems. If economic problems are caused by high energy prices, then it seems accurate to consider demand destruction attributable to these economic problems as demand destruction caused by high energy prices. However, to the extent that economic problems are the result of an economic cycle, and not due to high energy prices, then the energy demand destruction that results does not seem accurately attributable to high energy prices. Our current economic troubles seem to be a function of both issues, but in my opinion more a short-term cyclical issue (inaccurate pricing of risk and the resultant correction, as I argued a few weeks ago (LINK)). At least some of the decrease in US oil demand can be attributed to economic cycles, and not to high oil prices, but we probably cannot separate these causes and isolate the portion of demand destruction caused by economic cycles. Can we even say whether or not demand would actually continue increasing at $113/barrel IF the US was in an economic boom? Does a statistic like GDP/barrel of oil consumed allow us to see through this fog? It might if we had a very accurate measure of inflation, but the CPI certainly doesn’t qualify. For that reason, comparing the 2006 GDP/barrel consumed vs. the 2007 GDP/barrel consumed is also problematic. Furthermore, it does not necessarily follow that, in a cycle-driven recession, GDP will shift to more energy efficient paths.

Conclusion

With gasoline well over $3/gallon, and oil well over $100/barrel, there does not seem to be any significant demand destruction in the US. Reasonable people can argue that demand is up about 1% or down about 1% since this time last year, but I am defining this entire range as “minimally significant.” What is the boundary of “significant” demand destruction? By significant, I mean significant impact on the supply-demand equilibrium for oil. If a low-end estimate of the decline rate for oil production post-peak is something between 2% and 5% per year, then I think that is the boundary for “significant” demand destruction. Demand destruction of 1% per year on an ongoing basis, compared with oil production decline of 5% per year, won’t have a significant impact on the supply-demand equilibrium. Conversely, a year-on-year demand destruction of 5% compared with an oil production decline of 5% has a very significant impact on the supply-demand equilibrium because it negates the impact of the production decline rate—this is a form of what Heinberg suggests in his Oil Depletion Protocol.

If this analysis tells us anything, it is that there is no easy way to calculate exactly what price point will cause demand destruction of X%. I remember when many proclaimed that $3/gallon gasoline would cause huge demand destruction. Now many of these same people proclaim that demand destruction will explode at $4/gallon or $5/gallon gasoline. Europeans, though admittedly in a very different situation, don’t seem to be driving significantly less at $8/gallon. In the end, we simply cannot know how demand destruction will unfold, and I think that is highly significant for calculatin