Timing: The Credit Crunch & Peak Oil

Those with a more apocalyptic bent seem to see the onset of a world peak in oil production and the current economic “credit crunch” as a sure sign that the end is nigh. I disagree—I think we’re in the midst of a “slow crash” that will unfold over the next several decades. That doesn’t, however, mean that I think the timing of the credit crunch won’t have a serious effect on peak oil…

I think that our economy is fundamentally strong, both in America and world wide. Yes, I predicted there would be no recession in the US in 2008, and I still think that there isn’t a “real” recession in those parts of the economy grounded in reality. There certainly isn’t a recession where I live, judging by the job market, by the lines at drive-through Starbucks, etc. I'm sure that can all change very quickly, but the booming energy economy in the Denver area seems to be compensating for the weakness in housing. I think the “recession” in America is just the evaporation of the foam of the fantasy-financial instrument economy from the top of the beer. Despite all the problems of the (quasi?) free-market capitalist system for the environment, for human rights, for fulfilling human ontogeny, it is remarkably resilient. Right now we’re going through a bit of a correction, but we’ve been through them in the past (some, admittedly, more serious than others), and we’ll “get through” this one just fine. Housing values were overstated due to easy credit, and the broader market for credit derivatives (derived from everything from home mortgages to corporate debt) led to a bit of a bubble across the board. This bubble is deflating, but it won’t bring down the world with it (sorry). What it will do is restore a more reality-based relationship between assets and their values, and this will, in the end, make the expanding global economy even more robust and resilient. Nothing in the "credit-crunch" changes the most fundamental building blocks of the modern economy: when two people specialize in each producing one item, rather than both producing both items, if the transactions costs for exchange of the two items are less than the savings by specializing, wealth is created. The credit crunch is only temporary friction in that system of exchange, not the fundamental shift to a world where transaction costs exceed benefits of specialization. At some scarcity of energy, on the other hand, transaction costs do begin to exceed the benefit of exchange.

This increase in transaction costs of our specialization-driven economy is the real problem, and it is driven by peak oil—actually peak primary energy. Right now, our global economy is fundamentally based on the easy energy surpluses available to us, primarily from crude oil, high-quality coal reserves, and natural gas. Evidence suggests that global production of crude oil has peaked, and that natural gas and then coal are not particularly far behind. But, while the peak may be here now (or very soon), significant decline in production has not yet arrived. This is highly significant for two reasons: 1) significant decline isn’t far off, and 2) these energy sources (oil, coal, natural gas) represent our society’s primary energy sources. By primary energy source I’m not pointing to the fact that they represent the largest share, but rather that they produce energy with such a high Energy Return on Energy Invested (EROEI) that they can fuel the economic energy of our society. This high EROEI keeps the benefit from exchange, especially the very complex and long-distance specialization and exchange in a modern industrial economy, providing benefits in excess of transaction costs. No “alternative” energy source can make this claim—not photovoltaics, not wind, not biofuels, and probably not nuclear (which, at least with current technology, is also subject to a peak in uranium production). I think that solar thermal power has the best chance of proving me wrong here, but no one has yet performed sufficiently inclusive analysis of an operational solar thermal plant to convince me that it can be our salvation. Some alternative energy advocates make outlandish claims about the EROEI of new sources, but when the totality of energy inputs is accounted for these claims fall flat, as I’ve argued many times. Here's one recent example of how the cost for wind generation--one of the "EROEI darlings" of the renewable power world--is (surprise) experiencing dramatic cost increases as an associated phenomena raises its ugly head, what I've called "boot-strap EROEI." That is, while renewables may produce an apparent 5:1 EROEI when they can leverage inputs and infrastructure that was build on 100:1 EROEI "easy oil," the EROEI of these renewables begins to drop precipitously when new or replacement supporting infrastructure, ores, transport, etc. must now be provided with 20:1 or even 10:1 EROEI oil. This drives home the criticality of primary energy to the functioning of our society.

It’s important to point out that we don’t know that these alternatives won’t, at some point in the future, become truly viable primary energy sources to fuel society (though this only raises the Problem of Growth, which I’ve covered previously). And I could certainly be wrong in my EROEI calculations—we could currently have technology sitting in some R&D lab that can power the world. But there is a fundamental difference between developing a new, sustainable primary energy source in a laboratory that *could* power society and actually building out the full panoply of energy generation facilities and accompanying infrastructure necessary to actually continue society as we know it. This is where the timing of the credit crunch and the onset of significant declines in global oil production due to peak oil becomes vitally important: the current economic slowdown due to the credit crunch is masking the price signals that will warn of the significant declines to come, and is postponing the political viability of any kind of crash-program to adapt our present society to one that is based on a sustainable energy source.

If the recovery from the credit crunch lingers on through 2008 and resolves in the middle of 2009, as I think seems likely, then America’s growth engine (and, to a lesser degree, the world’s) will get its feet under it again just about the time that global oil production will likely begin to experience significant declines, either from simple geologically driven declines, or from the addition of a more geopolitically-driven phenomena such as the Export-Land Model (LINK). Either way, the current “undulating plateau” of global oil production represents a vital, and probably fairly short-lived opportunity to seriously transition our economy to a sustainable energy source. It’s my opinion that, with the benefit of historical hindsight, it will be understood that the greatest significance of the credit crunch is that it caused us to squander 2+ years of our oil production plateau that could have been used to fuel an adaptation program. Just look at the political platforms of ALL the US presidential candidates—the near-term recovery of the economy is put first, and there is no mention of sacrifice now to save the future. You can only sell sacrifice when things are going very well, and even then it is very, very difficult to sell anything more than the appearance of sacrifice. From a practicality standpoint, it is probably only realistic to sell "sacrifice" in a reduction in the future *increase* in standard of living.

By the time it becomes obvious that we must transition to a sustainable energy source, the huge “down payment” of primary energy required to affect that transition seems unlikely to be available. And there won’t be any “sub-prime lender” of primary energy willing to give us 125% of equity on our economy! Judging by both US political time-frames and election cycles and by projections for the onset of serious oil production declines, the awareness of this energy shortfall seems likely to hit about 2012. By then I think it will be too late to make the switch, even assuming we do develop the necessary sustainable primary energy source in the mean time.

It's Still the Demand Inelasticity

Oil hits $103.95. Yawn. It seems rather obvious to me that the recent run up in oil prices has come primarily from a declining dollar and fears that inflation will errode the value of conventional (read: fictional) financial instruments. But when CNN runs an article suggesting that, but for all this insane "speculation" in oil, it would be trading at $60/barrel, I need to pull out my broken record player.

It's still the demand inelasticity.

I get the impression that most financial pundits cluttering the news these days have only recently even thought about commodities, and have spent most of their careers thinking about equities. Why is this relevant? Because, with equities, speculation can dramatically over-inflate the price beyond any immediate underlying value. There is no check whereby, within a relatively short time, the owner of that equity must demonstrate that the underlying assets actually have some real value now by selling them (and not merely selling the equity to another speculator). Not so with oil (and other commodities). At the end of the day (or, here, at the expiration of the contract), either a grass-roots consumer is actually willing to shell out cash for an oil-derived product, or not. Speculators cannot drive the price of exchange-traded oil higher than consumers are willing and able to pay at the pump. There is, admittedly, a bit of a lag here (most contract volume is at least a month out, and there is a delay between contract settlement and that price working through the refinery and distribution chain to the end consumer). But oil prices have been above $60 for some time--much longer than is necessary for these higher prices to reach the end consumer. Bottom line: unlike equities, there is a fundamental reality check imposed on commodity speculation. There simply isn't enough volume in long-dated contracts, nor enough spare storage capacity for arbitrageurs, to get around this.

I don't know what school of economics these pundits attended (OK, actually I do, but that's not the point), but where I come from, something is worth precisely what you can get someone else to pay you for it. This applies directly to consumables, and in light of the housing bubbles in parts of the US, a more inclusive definition may be "something is worth precisely what you can get the end-consumer to pay for it." Here, the end consumer seems willing and able to pay $100/barrel for oil. If that changes, for whatever reason, then the price of oil will change, regardless of "speculation."

Do exchange traded futures matter when there are also swaps and forwards?

In a word: yes. I wanted to post a follow up to a comment to my recent post “2015 Futures.” That comment argued, contrary to my own position, that the availability of crude oil futures out to 2015 didn’t substantially improve the ability of oil producers to ensure profitability of “expensive” oil ventures. Here it is:

Producers could fix their revenues out 5 yrs well before this listing. 1st, most large hedgers are likely to use calendar averaging swaps, not futures (which impose onerous variance margins, ie ongoing cashflow swings .) Swaps are cash settled against an index (typically NYMEX but often Platts) and are secured by an ISDA agreement and the balance sheets of the contarcting parties. Margin isn't assessed day to day so often it amounts to a long term loan.

The interbank market has quoted long dated swaps in these tenors for some time. Morgan Stanley and J. Aron are two of the larger market makers, but any highly rated investment bank would likely quote something out that far.

It is certainly true that swaps exist, and so do bilateral forward contracts for delivery which are arguably more important in this regard. The reason that exchange traded futures—negotiable instruments—are critical is that they alone most accurately fix the market price that is the basis of swaps and forwards. Any two parties can enter into a contract for delivery of oil at any point and for any point in the future. You can enter a binding contract to deliver oil for $10 a barrel in the year 2099 if you want. The value of an exchange-traded, negotiable instrument is that there is great volume, liquidity, and transparency (here on the NYMEX crude oil pit), and this sets the effective price. The comment above essentially concedes this point in stating that swaps are settled against an index, such as NYMEX. The ultimate point is that the availability of futures out to 2015 (8 years out) is significant because it acts to more effectively fix a value on oil at that distant time, and therefore makes any instrument to “lock in” that price—whether that is a future, swap, forward, etc.—more accurately to the extent that it can index against the value of the NYMEX future.

I should also point out that my choice of “Canadian Tar Sands” as an example was poor, as it is already being produced in significant quantities. I think that the 2015 futures remove one obstacle from producing more expensive tar sands reserves, but the far better example is Colorado oil shale. The oil shale deposits on the Western Slope of the Rockies have been, with some hyperbole, said to be the “Saudi Arabia of Oil Shale.” Well, with the NYMEX December 2015 crude oil contract currently trading at $80.92/barrel (on 619 contracts volume), where are the Colorado oil shale projects??

Well, in a timely enough manner, CNN has an article out yesterday claiming that "Oil Shale May Finally Have its Moment." They claim that Shell is nearing the ability to use a secret new technology to produce oil from kerogen in an economical manner. The article suggests that Shell has been working on this technology for years, and that they may be profitable at $30/barrel oil. Critically, they don't mention when that $30/barrel profitability estimate was made. Princeton Professor and peak oil scholar Kenneth Deffeyes commented in "Beyond Oil: A View from Hubbert's Peak" that "When oil was $3 per barrel, many people said that if oil ever reached $8 per barrel, Green River oil shale would have its revenge on Spindletop and shut down the oil industry." Hmmm... sounds like there may be a sliding scale at work here. Why? Well, the crux of Shell's "secret" technology is to insert probes into the kerogen and heat it over a long period of time, and to surround those heater probes with freezer probes that trap the liquefied kerogen within an ice shield. Sounds energy intensive, doesn't it? If it was an energy-positive process at $8 a barrel when the energy used cost $3 a barrel, and it was energy positive at $30 a barrel when the energy used cost $15 a barrel, it doesn't sound too promising to me. Surely Shell has made improvements, but even IF they get the EROEI of the process all the way up to 1:1, or even 3:1, that is nowhere near the EROEI of our current, depleting sources of energy.

Technology under development in a laboratory is great. Show me the projects.

2015 Futures

I don't remember seeing any press release on this, but for several months now it has been possible to buy December 2015 futures on NYMEX. That's a full 8 years out. Prior to this it was only possible to buy futures 5 years out (CLZ12). Why is that significant? Conventional wisdom is that it takes about 5 years from discovery to commercial production in an oil development, so when you could only accurately price and fix your revenue five years out, you really couldn't hedge against a price drop. Even with oil at $90 a barrel, it was still risky (essentially a peak oil bet) to produce oil that would cost you $50, $60 or more a barrel. Now that it is possible to sell futures 8 years out (currently the CLZ15 is trading at $77/barrel), it becomes a much more conservative financial move to start a project with a projected cost/barrel to produce of $50. On the flip side, this distant future allows fuel consumers to better hedge against future fuel costs.

So, if there are alternatives or expensive-to-produce oil reserves out there, there seems to be less of an excuse than ever. Lots of alternatives claim to be profitable at $50/barrel oil (though I have my doubts based on simultaneously rising metal prices, etc.). If this is true, the ability to sell 2015 futures means there are no more valid excuses to getting those into production today. I've heard people talk about Canadian tar sands, or Colorado oil shale. If these really are profitable at $50/barrel oil, why aren't we seeing more projects starting up? Where are they? Have these people realized that the ability to produce Colorado oil shale at less than $50/barrel is in part predicated on $30/barrel oil as an input (hence a constantly sliding 40% differential on the value above oil that oil shale is profitable)?? Maybe I'm just being pessimistic, but show me the projects!

Future Planning: Hedging the Solution Space

NOTICE: The following is not financial advice, and is solely my opinion. If you follow the plan laid out below you will probably lose money. In fact, by following this plan, I hope to lose money. By the end of this post, hopefully, you will understand why.

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I tend to think that we are on the verge of a global economic and societal collapse driven by diminishing marginal returns on civilization’s investment in complexity—especially by the declining availability of surplus energy. I don’t think that this will result in a single, catastrophic collapse event, but rather in a slow, grinding decline that is masked by epiphenomena and the confusion of symptoms and causes, effectively negating our ability, as a society, to muster the will to take effective mitigation measures. I also think that there is a reasonably high probability that I am dead wrong. I don’t have a crystal ball—all I can do is attempt to project trends into the future, and guess at the outcomes of our massively non-linear planetary-societal system. Humans tend to have a very poor track record at predicting the long-term future—why should I not be subject to the same limitations? After all, conventional wisdom says that things will keep on much as they always have, that we will find a way to overcome. Here’s the grand challenge: if individual or societal plans for the future focus only on collapse, or only on continuation of the status quo, then the high probability that the alternative occurs will be catastrophic. Further complicating matters, there are certainly more than two possible future scenarios. How does one hedge against the multi-dimensional future solution space?

I am beginning this discussion with the assumption that none of us know what the future holds. We can, however, identify possible future scenarios. Not all of them, of course. Rather, I am proposing a “future solution space” methodology that uses current trends or indicators as dimensions. Then, based on my belief that risk is mispriced (based largely on continued reliance on variations of the Gaussian-derived Sharpe Ratio for portfolio risk management and Black-Scholes method of option pricing) and that returns for options on extreme price movements are highly scalable, it should be possible to hedge against movement in any vector in the future solution space simultaneously. Let me offer a simplified illustration:

Oil/Dollar/Dow solution space:

Here is a solution space with three dimensions: dimension 1: NYMEX Crude Oil rise/fall, dimension 2: US Dollar rise/fall, dimension 3: Dow Jones Industrial Average rise/fall.

These three dimensions are an extreme simplification of the possible sets of future scenarios, but are useful as an example and because it is relatively simple to hedge against extreme movements in any direction from the status quo through out of the money options on established futures exchanges. In fact, I think that a multi-dimensional hedge can effectively address this solution space with only 3 options: crude oil call option (betting on extreme rise in price), dollar put option (betting on extreme loss of value), and DJIA put option (betting on extreme loss of value). As a hedge, this set seems to address most of the risk scenarios where a “conventional” investment in a career and home won’t pay off. Can you describe a scenario where one of these three options doesn’t pay, but the economic status quo doesn’t continue? This simplification isn’t meant to address sudden collapse scenarios where the markets simply cease functioning (an identified weakness, which we can also hedge against). But I have a difficult time explaining in advance how the economy could collapse while none of the following—spike in crude oil, drop in the dollar, OR drop in the Dow—occurs. Under most scenarios, at least one, probably two of the options pays off (e.g. Dollar drops causing a spike in the price of dollar-denominated oil but a rise in the numerical value of the Dow).

Example:

Sudden Peak: Oil prices will spike. IF they spike sufficient to cause enough demand destruction to actually fall, that will cause the Dow to collapse. It will likely be accompanies by either high inflation (dollar collapses) or deflation. While deflation is also possible, that would cause the numerical value of the Dow to collapse. Not perfect, but nothing is…

Now expand this multi-dimensional hedge beyond purely financial market considerations. Accept for a moment that the above hedge system is a perfect hedge against any movements in the financial markets (it is not). What could still cause it to fail? Two thoughts immediately come to mind: 1) collapse/conflict is so sudden that markets shut down completely, or 2) popularist laws are enacted that negate the hedge, say by penalizing people who “exploited” the dramatic market swings through options. Under scenario 1, the classic survivalist advice along the lines of “beans, bullets, and gold” may suddenly prove extremely valuable. Under scenario 2, hedges that operate outside the purview of established exchanges may suffice—again, perhaps gold or silver coins. Moving beyond the fixed game-rules of financial markets makes defining and addressing the future solution-space far more difficult, but no less necessary.

Of course, these are intended as hedges AGAINST the continuation of the status quo. You still need a viable plan if things continue as conventional wisdom suggests they will. So, here is a potential outline of a “complete” future plan. It also happens to be what I am presently doing. It is certainly imperfect, but its imperfections should be illustrative:

1. Job for the Status Quo: invest in/prepare for a job that will pay well under the status quo. Personally, I’m studying law, even though I already have a “good job.” I find it fascinating and actually enjoy the area that I hope to be working in—litigation/appellate work with a subject matter focus on energy law. That said, law is probably a terrible choice for most people, but I have been very fortunate thus far in that things are working out according to my master plan:) —as general advice nursing or engineering seem the most prudent. I already have an engineering degree, but I want to be involved at the nexus of anthropology, politics, and the future of energy (an odd combination, isn’t it?), so I have chosen law.

2. Plan for a resilient and flexible “End Game”: I hope to continue to practice law in a capacity that I enjoy for the rest of my life, but I certainly want to be in the position that this is a choice, not a requirement. Therefore I plan to invest some of my income in creating a flexible and resilient “end game”—for me, this is a sustainable, self-sufficient home for my family that will excel in future roles as disparate as a vacation home, retirement location, or a survival retreat. This will be my principal investment, as I think that it will most effectively hedge against the vast majority of scenarios for which there is no effective market hedge.

3. Financial hedge: If the economic status quo continues, the home described above will become my version of a 401(k). If not, my financial hedges are intended to ensure that I can still complete that plan. I plan to follow a variant of the oil-dollar-dow hedge described above—at least until I can think of a better system. I currently have long-term call options on oil and short term puts on the dollar. I think that an investment of roughly 5% of my income will be able to effectively hedge against most financial catastrophe.**

4. The Black Swan: While I think that this future plan effectively hedges against many possible future scenarios, and will increase the probability that I achieve my goals under a variety of scenarios, it is important to recognize that there is always the possibility of something totally unexpected happening that will derail all of these plans. That probability is likely much greater than most people anticipate. Some investment in stored food and water, gold, etc. is probably a prudent way to hedge against at least some unanticipated dimensions of the future solution space. Like a far out of the money option, investment in a few gold or siver coins or a shotgun is a small price, probably won’t be necessary, but has a highly scalable value in certain possible futures. A broad base of knowledge, fitness, and health may be even more valuable.

My intent here is not to slide into self-help or prophecy. Rather it is to suggest that, if you think you know exactly what the future holds, you are probably deluding yourself. If you are not preparing for multiple contradictory future scenarios, then you are not preparing but gambling. What is the optimal hedge—the simplest, cheapest, and most complete coverage against radical departures from the status quo? I’ve proposed the following set: crude call options, dollar put options, Dow put options, 30 days food and water and a shotgun. Call it a future first-aid kit. My proposal is only a starting point, and certainly imperfect. How can it be improved?

It is also worth pointing out that such a hedge is only viable if it helps to achieve a future end-game vision that functions under both the status quo and collapse. In some Mad Max future, 30 days of food and a shotgun is a start, a broad base of knowledge is even better, but the point of the hedge is to get ensure existing plans come to fruition. Taking out a loan now to create that end-game vision in the near future, and then hedging against scenarios that would make you unable to repay that loan over the long term might be (contrary to “conventional wisdom”) more prudent than saving to get there some day…

**This financial hedge is, unfortunately, a bit more complex than simply buying one of each of these three options. For now I’m not going to delve into the intricacies of coordinating the strike prices and expiration dates of multiple options necessary to create a smooth hedge against risk through time. The general advice, though trite, is that if you don’t understand how to invest in options, you shouldn’t invest in options.

Parting question: I think this is a viable methodology for creating an individual plan of action. Can it be extended to a broader, societal plan? Financial hedges tend to be zero-sum in nature, so can't serve as the basis for a societal hedge--would any societal hedges necessarily pay "fair value" for risk, and therefore make hedging against multiple, contradictory future scenarios impracticable??