Another analogy for today's economy is that of a bus. Energy inputs are the fuel. Monetary issues are the brake. If the bus is about to run out of fuel, the driver can either press the brake and make the bus stop in a controlled manner at a convenient place or he can keep pressing the gas pedal until fuel runs out and the bus stops by itself a little further. But it will always stop. And the key point is: the further down the road it stops, the worse for the passengers.
Why? Because in the real world, it means more oversized, energy-inefficient McMansions will be built in suburban and exurban locations, requiring huge energy inputs for cooling and heating and very long commutes for every need of their occupants. It also means more fuel-inefficient cars and SUVs will be made and sold. It means in a word digging society into an even deeper hole.
But these are just the MARGINAL adverse effects of a monetary policy geared to propping up demand, and by no means the greatest danger posed by such a policy. As you may know, Richard Duncan's Olduvai theory postulates societal collapse by way of the collapse of the electrical grid. The assumption is completele plausible: it doesn't take a major in engineering to see that a grid collapse would bring about the collapse in societal order. With that in mind, let's quote from the Nov 25 Professor Lawrence Summers' piece in the Financial Times, to ascertain the extent of the current disconnection between economic thinking and the dynamics of key physical realities:
"Single family home construction may be down over the next year by as much as half from previous peak levels."
OK, if that's so bad, we can infer that Professor Summers would like to see home construction remaining near its previous peak levels. But has he ascertained whether the capacity of the electrical grid can accomodate the incremental demand from those new homes? Has he checked the prospects for the US natural gas supplies? Has he checked the timing for decommision of old nuclear powerplants, and for the construction of new ones (if there will be any)? Has he checked where those homes are being constructed, particularly whether a significant share is in naturally unlivable places like Las Vegas where heavy use of air conditioning is a requirement for survival?
Obviously the answer to all those questions is no, and I do not blame him. He is just a member of a generation (actually several generations) of economists that never had to pay any attention to physical constraints for setting their policies because they were not an issue, economists that have spent all their lives on the way up to Hubbert's Peak and that seem unable to realize that we are right there now and that the way ahead is down, not up.
But this shows once more that these paradigm-challenged economists have become unsafe drivers. Because as we can see, fostering home construction does not just place the marginal adverse effects I mentioned in my previous post. It has the potential of loading the electrical grid beyond its capacity. And the grid is either up or down. And if it's down for a long time, societal order falls down too.
Sure that collapse can be prevented by draconian measures. In such an emergency, you can take whole cities like Las Vegas off the grid and let them bake to save the rest of the country. Or you can send the police and National Guard home by home to seek and destroy air conditioners. Or you can set exponential pricing for electricity to force people to skimp on it. All options that make a recession not look so bad after all.
So, just as in a previous post (http://peaktimeviews.blogspot.com/2007/12/are-economists-paradigm-challenged.html ) I proposed that there should be "safety overrides" for setting Fed Funds rates taking into account the levels and trends of inventories of crude oil and petroleum products, here I propose that there should be similar overrides when setting policies that affect home construction taking into account the status and trends of electrical generacion capacity.
And again, a prompt recession is not the long-term solution for the problem. It just provides a window of opportunity for addressing it in a decisive yet orderly way.
Let's finish by dealing with a few other quotes from Professor Summers' article:
"it is hard to believe declines of anything like this magnitude will not lead to a dramatic slowing in the consumer spending that has driven the economy in recent years."
Which would greatly reduce the current unsustainable US trade and current account deficits and help the dollar retain its role as the international trade and reserve currency. Doesn't look too bad, either. At least for the US.
"Then there are the potentially adverse effects on confidence of a sharply falling dollar,"
At this point Professor Summers' thinking gets not only disconnected from physical realities but contradictory too. If he wants to prevent the dollar from falling, bringing down US demand for foreign goods is the only way to do it. On the other hand, US exports would not be affected by a financial crisis.
"rising energy costs, geopolitical uncertainties especially in the Middle East,"
If Professor Summers fears that energy costs will remain high or be even higher, or that energy supplies from the Middle East could become compromised, does it make sense to encourage further suburban and exurban home construction and thus increase energy demand (and the dependence on cheap imported fuel for the long commutes required for every need in life)?
"or lower global growth as economic slowdown and a falling dollar cause the US no longer to fulfil its traditional role of importer of last resort."
No, Professor, after Hubbert's Peak the world is in a new environment where lower global growth will not be the consequence of insufficient demand but of a physical constraint from Nature, namely the peaking and the subsequent relentless decline in the production rate of fossil fuels.
In this new environment, the world no longer needs an importer of last resort, because there is no longer a producer of last resort (or swing producer, as they used to call Saudi Arabia) of the critical energy inputs required for production.
And again, it's not Professor Summers' fault. He is just influenced by the predominant Solow model of growth, which tragically overlooks the role of those energy inputs in economic output. Which is the topic I touched on in a previous post.
2007-12-06
Paradigm-challenged economists: Bernanke and the Solow model
Perhaps the best example of the paradigm challenge affecting most of today's economists that I commented on in http://peaktimeviews.blogspot.com/2007/12/are-economists-paradigm-challenged.html is none other than Professor Ben Bernanke: his whole mindset seems to have been shaped by the study of the Great Depression and how to avoid a relapse into it. Wake up, Professor, the world is in a completely different situation now! Notably, 2007 for the US is timewise the exact opposite point to 1933 with respect to the US Hubbert's Peak: 1933 + 37 = 1970; 1970 + 37 = 2007. But what matters is that the world is now either past or about to reach its GLOBAL Hubbert's Peak. Therefore all the body of Keynesian and more generally demand-side economics is no longer valid: now the limits to growth are set by physical constraints, not by lack of demand.
But there seems to be yet a further theoretical hindrance to Bernanke's adaptation to the new resource-constrained world: the Solow model of economic growth. Besides authoring six papers on the Great Depression, more recently (2001) he coauthored a paper "Is Growth Exogenous? Taking Mankiw, Romer and Weil Seriously" at http://www.nber.org/papers/w8365 . If you open it and search for "energy" or "resource", you will not find a single occurrence of any ot those words. Not one! Pathetic as it is, it just reflects the flaw in the Solow model itself: economic output Y = F(A,K,L) with A aka TFP and loosely defined as "technological progress" depends only of time and accounts for over 80 % of the per capita growth in output. This model suffers from two critical deficiencies:
First, it does not actually explain economic growth. A(t) remains to be explained. It remains "a measure of our ignorance", as shown in Lipsey (2001) "What does total factor productivity measure?" at http://www.csls.ca/ipm/1/lipsey-e.pdf .
Secondly, though perhaps more important, it decouples growth from physical resources consumption.
However, a look at what happened in the real world when economic growth started in earnest (the Industrial Revolution) shows that it was not just any technological progress what enabled it. It was specifically that technological progress which enabled the conversion of raw energy inputs (usually thermal energy from the combustion of fossil fuels) into useful work:
- the steam engine around 1780 (from coal) and its applications,
- the internal combustion engine around 1880 (from oil) and its applications,
- the hydroelectrical turbine around 1880 (from waterfalls)
- and the electrical technology which greatly increased the transportability and versatility of useful work generated from any energy input.
But it does not take a genius to see that all of these technologies will result in increasing economic output if, and only if, there are increasing quantities of raw energy inputs (once conversion efficiency has reached its ceiling).
Therefore, a realistic model of production is that in which Y = F(K,L,U) where U = f x R, and
U = useful work,
R = raw energy input aka exergy, and
f = efficiency with which energy input is converted into useful work.
This model has been developed by Robert Ayres and Benjamin Warr ( www.insead.edu ), building upon earlier work of Reiner Kummel. (Interestingly, Ayres and Kummel hold PhD degrees in Physics.) They successfully tested it first against US data and then against other countries, as shown in their latest presentation athttp://ida.dk/NR/rdonlyres/11027443-C01D-45E2-9D4E-B5A368A692C8/0/SGTCopenhagen22May2006Warr.pdf (*)
So, knowing that Professor Bernanke is an Orthodox Jew, I'd say to him: Keynes is not Moses, Keynesian economics is not the Torah, and Solow is not Isaiah. Get rid of them!
(*) For anyone interested in this topic, a good source of information is David Strahan's book "The Last Oil Shock" http://www.lastoilshock.com/ . Follow the links to a couple of comments on this book's coverage of the topic:
1. http://www.paulchefurka.ca/Economics.html (Too long to paste. BTW, I'm not Paul Chefurka.)
2. http://sandersresearch.com/index.php?option=com_content&task=view&id=1176&Itemid=105
"It is at this juncture that The Last Oil Shock is particularly worth reading, because it sets out why oil is really that important in chapter five, "Last Oil Shock, First Principles". The nub of the issue is actually quite easy to comprehend in an intuitive way: economic “growth” is possible mostly because of energy, and in modern times the exploitation of first coal, then oil and gas, is what has made possible the exponential growth of the last two hundred years. It is quite simple, really. These carboniferous deposits represent the stored energy of ancient sunlight that is being exploited in a go by modern man. Once gone, they are gone. The reason they are so important is because they are energy dense, meaning that their molecules contain a lot of stored energy and they are relatively easy to transport. Nothing else, not nuclear power, solar or wind generation, hydro, nor biomass has these characteristics.
In a more formal manner this can be demonstrated mathematically, as scientists such as Walter Kümmel, Charles Hall and Robert Ayres have done. Don’t worry if your maths are weak; Strahan walks you through the Solow Residual, that fraction of economic growth unexplained (until Kümmel, Hall, and Ayres came along) by the orthodox inputs of capital and labour. The idea that most growth is a function of ever-increasing amounts of energy being used (Kümmel and Hall) that is being more efficiently employed (Ayres) is revolutionary enough, if simple. The fact that the fraction of growth it is responsible for is many multiples of that added by capital and labour is an embarrassment for the exponents of mainstream so-called neoclassical economics. Indeed, this is one of the more exciting prospects raised by peaking world oil and gas production: to tear down the temple that Marshall, Keynes, Friedman and others have built and replace it with an approach to understanding political economy that is intellectually honest, consistent with the basic physical principles of the universe we live in, pragmatic, and accessible to all."
But there seems to be yet a further theoretical hindrance to Bernanke's adaptation to the new resource-constrained world: the Solow model of economic growth. Besides authoring six papers on the Great Depression, more recently (2001) he coauthored a paper "Is Growth Exogenous? Taking Mankiw, Romer and Weil Seriously" at http://www.nber.org/papers/w8365 . If you open it and search for "energy" or "resource", you will not find a single occurrence of any ot those words. Not one! Pathetic as it is, it just reflects the flaw in the Solow model itself: economic output Y = F(A,K,L) with A aka TFP and loosely defined as "technological progress" depends only of time and accounts for over 80 % of the per capita growth in output. This model suffers from two critical deficiencies:
First, it does not actually explain economic growth. A(t) remains to be explained. It remains "a measure of our ignorance", as shown in Lipsey (2001) "What does total factor productivity measure?" at http://www.csls.ca/ipm/1/lipsey-e.pdf .
Secondly, though perhaps more important, it decouples growth from physical resources consumption.
However, a look at what happened in the real world when economic growth started in earnest (the Industrial Revolution) shows that it was not just any technological progress what enabled it. It was specifically that technological progress which enabled the conversion of raw energy inputs (usually thermal energy from the combustion of fossil fuels) into useful work:
- the steam engine around 1780 (from coal) and its applications,
- the internal combustion engine around 1880 (from oil) and its applications,
- the hydroelectrical turbine around 1880 (from waterfalls)
- and the electrical technology which greatly increased the transportability and versatility of useful work generated from any energy input.
But it does not take a genius to see that all of these technologies will result in increasing economic output if, and only if, there are increasing quantities of raw energy inputs (once conversion efficiency has reached its ceiling).
Therefore, a realistic model of production is that in which Y = F(K,L,U) where U = f x R, and
U = useful work,
R = raw energy input aka exergy, and
f = efficiency with which energy input is converted into useful work.
This model has been developed by Robert Ayres and Benjamin Warr ( www.insead.edu ), building upon earlier work of Reiner Kummel. (Interestingly, Ayres and Kummel hold PhD degrees in Physics.) They successfully tested it first against US data and then against other countries, as shown in their latest presentation athttp://ida.dk/NR/rdonlyres/11027443-C01D-45E2-9D4E-B5A368A692C8/0/SGTCopenhagen22May2006Warr.pdf (*)
So, knowing that Professor Bernanke is an Orthodox Jew, I'd say to him: Keynes is not Moses, Keynesian economics is not the Torah, and Solow is not Isaiah. Get rid of them!
(*) For anyone interested in this topic, a good source of information is David Strahan's book "The Last Oil Shock" http://www.lastoilshock.com/ . Follow the links to a couple of comments on this book's coverage of the topic:
1. http://www.paulchefurka.ca/Economics.html (Too long to paste. BTW, I'm not Paul Chefurka.)
2. http://sandersresearch.com/index.php?option=com_content&task=view&id=1176&Itemid=105
"It is at this juncture that The Last Oil Shock is particularly worth reading, because it sets out why oil is really that important in chapter five, "Last Oil Shock, First Principles". The nub of the issue is actually quite easy to comprehend in an intuitive way: economic “growth” is possible mostly because of energy, and in modern times the exploitation of first coal, then oil and gas, is what has made possible the exponential growth of the last two hundred years. It is quite simple, really. These carboniferous deposits represent the stored energy of ancient sunlight that is being exploited in a go by modern man. Once gone, they are gone. The reason they are so important is because they are energy dense, meaning that their molecules contain a lot of stored energy and they are relatively easy to transport. Nothing else, not nuclear power, solar or wind generation, hydro, nor biomass has these characteristics.
In a more formal manner this can be demonstrated mathematically, as scientists such as Walter Kümmel, Charles Hall and Robert Ayres have done. Don’t worry if your maths are weak; Strahan walks you through the Solow Residual, that fraction of economic growth unexplained (until Kümmel, Hall, and Ayres came along) by the orthodox inputs of capital and labour. The idea that most growth is a function of ever-increasing amounts of energy being used (Kümmel and Hall) that is being more efficiently employed (Ayres) is revolutionary enough, if simple. The fact that the fraction of growth it is responsible for is many multiples of that added by capital and labour is an embarrassment for the exponents of mainstream so-called neoclassical economics. Indeed, this is one of the more exciting prospects raised by peaking world oil and gas production: to tear down the temple that Marshall, Keynes, Friedman and others have built and replace it with an approach to understanding political economy that is intellectually honest, consistent with the basic physical principles of the universe we live in, pragmatic, and accessible to all."
2007-12-04
Paradigm-challenged economists: Roubini and the oil market
Professor Roubini has just provided us with a fine piece of economic analysis and policy recommendations at http://www.rgemonitor.com/blog/roubini/230471/ . If only it wasn't so detached from the dynamics of physical reality.
He wrote:
"The central banks current concerns with a rise in inflation are totally misplaced as a US recession will lead to global disinflation (and concerns about deflation as in 2002-2003) via four channels:
...
d) a sharp fall in oil, energy, food and other commodities prices as a global slowdown emerges. We are set for the repeat of the 2000-2003 cycle ..."
To assess the validity of the statement in item d), let's first look at the current situation and prospects of world crude oil (actually "All liquids", i.e. including biofuels) production and demand as depicted in page 48 of the OECD IEA Nov. 13 monthly report at http://omrpublic.iea.org/currentissues/full.pdf
World oil total demand (actual and projected):
1Q06 2Q06 3Q06 4Q06 2006 = 85.5 83.5 84.3 85.7 84.7
1Q07 2Q07 3Q07 4Q07 2007 = 85.8 84.7 85.3 87.1 85.7
1Q08 2Q08 3Q08 4Q08 2008 = 88.2 86.5 87.2 88.9 87.7
World oil total production (actual):
1Q06 2Q06 3Q06 4Q06 2006 = 85.4 84.9 85.5 85.3 85.3
1Q07 2Q07 3Q07 4Q07 2007 = 85.4 85.0 85.0
After looking at these numbers, it takes an extraordinary degreee of optimism to expect that production will "surge" in 2008 to meet the currently projected demand. Even when taking at face value the preliminary IEA October production number of 86.43 MBpd, which Stuart Staniford doesn't in his analysis at http://www.theoildrum.com/node/3306 .
To see what kind of price action can be expected from these projections, I´ll use some material already posted at http://peaktimeviews.blogspot.com/2007/11/assessing-impact-of-current-oil.html .
Let's compare global demand averages for whole years and their increases:
for 2006: 84.7 mb/d
for 2007: 85.7 mb/d (+1.2%)
for 2008: 87.7 mb/d (+2.3%)
with price action from the past year:
On Nov 20, 2006 WTI = $59 and EUR = $1.28, so WTI = EUR 46.
On Nov 20, 2007 WTI = $98 and EUR = $1.48, so WTI = EUR 66.
That's for a WTI price rise of 66% in dollars and 44% in euros in a year.
Thus, if a 1.2% increase in demand against constant production over Dec 2006 - Nov 2007 caused in 44% increase in price in euros, a 2.3% increase in demand against constant production over Dec 2007 - Nov 2008 can be expected to cause a 44 x 2.3/1.2 = 84% price increase in euros, to a price in Nov 2008 of EUR 121. Assuming EURUSD stays at 1.48, that's $180.
Let's now be optimistic and assume that 2008 production will rise 1.1% over 2007, leading to 2.3 - 1.1 = 1.2% as the differential increase of demand vs production in 2008, which is the same value as for 2007. The expected price increase would thus be a further 44% in euros, to a price of EUR 95 and $140.
And obviously, for the oil price to stay at current levels, the world needs for 2008 both an increase in production over current levels AND a decrease in demand from current projections for a combined total of 2.3%. I.e., if demand does rise 2.3% as currently expected, so should production, which looks extremely unlikely.
Therefore, for the oil price to remain in the current range, even optimistic projections for oil production lead to the need of at least a deceleration in global economic growth from current projections. And given the ease and gusto with which OPEC and Russia would cut production levels should a fall in demand take place out of a hypothetical deep recession, it's very unlikely that, even in that case, the oil price would drop substantially.
Now let's take a closer look at where the increases in demand came or are expected to come from, in order to evaluate then the likelihood that they could be prevented or even reversed by way of a hypothetical recession. From page 50 of the OECD IEA Nov. 13 monthly report, annual changes in Mbpd were/are projected to be for the key players:
Player 2005 2006 2007 2008
------------------------------
N.Am. 0.12 -0.21 0.21 0.22
Euro. 0.12 0.01 -0.25 0.21
APac 0.07 -0.16 -0.05 0.18
------------------------------
OECD 0.32 -0.36 -0.09 0.61
FmrSU 0.06 0.18 -0.18 0.14
China 0.27 0.46 0.39 0.42
Ot.Asia 0.17 0.07 0.26 0.19
LatAm 0.14 0.18 0.20 0.16
MEast 0.26 0.29 0.30 0.29
------------------------------
World 1.41 0.84 1.01 1.94
It's evident that the main culprit in the projected jump in demand for 2008 is the OECD, followed by the reversal of the 2007 FSU demand contraction, which the report itself describes as "an outcome that goes against the trend of strong economic growth, but could also reflect efficiency improvements or data quality issues." And within the OECD, the problem is that demand in Europe and Asia Pacific will switch to growth while US demand is staying its growth course.
Thinking now the other way round, if a reduction in global demand growth must be achieved, what are the likely candidates for it? Obviously the OECD, with a recession arising from the unfolding financial crisis. So we have a match here.
And it is easy to see that, even if that OECD recession materializes, the other players are extremely unlikely to reduce their oil demand. The reason for that being:
- For non-oil exporters like China and East Asian countries, the huge foreign exchange reserves that these players have accumulated over the last years, which make their situation entirely different from that in 2000-2003: having already saved for a rainy day (or rather decade), they can now afford to keep growing their internal consumption even if half of their customers curtail the demand for their products.
- For oil exporters like the FSU, ME and several LatAm countries, the fact that it is just not reasonable to expect they would refrain from growing the consumption of their own product.
To sum up, a prompt OECD recession is the only way to avoid triple digit oil prices in 2008 and will most probably result in oil prices staying in the current range. (This of course does NOT mean that such a recession is the long-term solution to the energy problem. It just provides a window of opportunity for addressing the problem in a decisive yet orderly way.)
As for food, the possibility of a fall in prices is even more remote. In the first place for its low elasticity of demand. Secondly because, with a reasoning analogous as that for oil, it is not reasonable to expect that countries that have amassed huge forex reserves or oil exporters would hesitate to draw from their reserves/revenues and skimp on food. Not to speak of food exporters. And thirdly because, with oil prices staying in the current range, the worldwide implementation of biodiesel production will most likely proceed, keeping the pressure on food prices.
Now, are there any other potential benefits from an OECD recession apart from preventing disruptively high oil prices and a likely consequent collapse in the dollar value and the loss of its role as the international trade and reserve currency? Yes, there are a couple of them, and probably of even greater importance.
1. As shown in the previous post http://peaktimeviews.blogspot.com/2007/12/even-bigger-risk-for-2008.html , allowing demand to follow the current growth path poses a significant risk of shortages in some finished products, likely followed by hoarding behaviour by users, which in turn creates a "run on the petroleum bank."
2. Although a recession would certainly curtail demand for electric cars, energy-efficient houses and solar panels, a cursory look at the real world should be enough to notice that the current profile of aggregate demand includes, in a scale ORDERS OF MAGNITUDE greater than those above, things which not only waste fossil fuels but also leave society in a state of ever greater vulnerability to the unavoidable coming energy decline, suburban and exurban construction being the most conspicuous example, followed by production of inefficient vehicles, precisely the two items whose construction/production would be most affected by a recession. So we have another match here.
And I will end with this paragraph from my previous post, which seems all the more relevant in view of proposals like Professor Roubini's.
There are a few big mountains in the world where you can drive to the very top. Those who have done that know quite well that it would be very unsafe to drive on the way down in the same way as on the way up. They make a driving paradigm change when they start the descent. In contrast, today's economists are severely paradigm-challenged. They have known nothing but the way up (to Hubbert's Peak), and they don't seem to be able to make the mental adjustment to the way down. As a result, their driving paradigms are becoming unsafe.
He wrote:
"The central banks current concerns with a rise in inflation are totally misplaced as a US recession will lead to global disinflation (and concerns about deflation as in 2002-2003) via four channels:
...
d) a sharp fall in oil, energy, food and other commodities prices as a global slowdown emerges. We are set for the repeat of the 2000-2003 cycle ..."
To assess the validity of the statement in item d), let's first look at the current situation and prospects of world crude oil (actually "All liquids", i.e. including biofuels) production and demand as depicted in page 48 of the OECD IEA Nov. 13 monthly report at http://omrpublic.iea.org/currentissues/full.pdf
World oil total demand (actual and projected):
1Q06 2Q06 3Q06 4Q06 2006 = 85.5 83.5 84.3 85.7 84.7
1Q07 2Q07 3Q07 4Q07 2007 = 85.8 84.7 85.3 87.1 85.7
1Q08 2Q08 3Q08 4Q08 2008 = 88.2 86.5 87.2 88.9 87.7
World oil total production (actual):
1Q06 2Q06 3Q06 4Q06 2006 = 85.4 84.9 85.5 85.3 85.3
1Q07 2Q07 3Q07 4Q07 2007 = 85.4 85.0 85.0
After looking at these numbers, it takes an extraordinary degreee of optimism to expect that production will "surge" in 2008 to meet the currently projected demand. Even when taking at face value the preliminary IEA October production number of 86.43 MBpd, which Stuart Staniford doesn't in his analysis at http://www.theoildrum.com/node/3306 .
To see what kind of price action can be expected from these projections, I´ll use some material already posted at http://peaktimeviews.blogspot.com/2007/11/assessing-impact-of-current-oil.html .
Let's compare global demand averages for whole years and their increases:
for 2006: 84.7 mb/d
for 2007: 85.7 mb/d (+1.2%)
for 2008: 87.7 mb/d (+2.3%)
with price action from the past year:
On Nov 20, 2006 WTI = $59 and EUR = $1.28, so WTI = EUR 46.
On Nov 20, 2007 WTI = $98 and EUR = $1.48, so WTI = EUR 66.
That's for a WTI price rise of 66% in dollars and 44% in euros in a year.
Thus, if a 1.2% increase in demand against constant production over Dec 2006 - Nov 2007 caused in 44% increase in price in euros, a 2.3% increase in demand against constant production over Dec 2007 - Nov 2008 can be expected to cause a 44 x 2.3/1.2 = 84% price increase in euros, to a price in Nov 2008 of EUR 121. Assuming EURUSD stays at 1.48, that's $180.
Let's now be optimistic and assume that 2008 production will rise 1.1% over 2007, leading to 2.3 - 1.1 = 1.2% as the differential increase of demand vs production in 2008, which is the same value as for 2007. The expected price increase would thus be a further 44% in euros, to a price of EUR 95 and $140.
And obviously, for the oil price to stay at current levels, the world needs for 2008 both an increase in production over current levels AND a decrease in demand from current projections for a combined total of 2.3%. I.e., if demand does rise 2.3% as currently expected, so should production, which looks extremely unlikely.
Therefore, for the oil price to remain in the current range, even optimistic projections for oil production lead to the need of at least a deceleration in global economic growth from current projections. And given the ease and gusto with which OPEC and Russia would cut production levels should a fall in demand take place out of a hypothetical deep recession, it's very unlikely that, even in that case, the oil price would drop substantially.
Now let's take a closer look at where the increases in demand came or are expected to come from, in order to evaluate then the likelihood that they could be prevented or even reversed by way of a hypothetical recession. From page 50 of the OECD IEA Nov. 13 monthly report, annual changes in Mbpd were/are projected to be for the key players:
Player 2005 2006 2007 2008
------------------------------
N.Am. 0.12 -0.21 0.21 0.22
Euro. 0.12 0.01 -0.25 0.21
APac 0.07 -0.16 -0.05 0.18
------------------------------
OECD 0.32 -0.36 -0.09 0.61
FmrSU 0.06 0.18 -0.18 0.14
China 0.27 0.46 0.39 0.42
Ot.Asia 0.17 0.07 0.26 0.19
LatAm 0.14 0.18 0.20 0.16
MEast 0.26 0.29 0.30 0.29
------------------------------
World 1.41 0.84 1.01 1.94
It's evident that the main culprit in the projected jump in demand for 2008 is the OECD, followed by the reversal of the 2007 FSU demand contraction, which the report itself describes as "an outcome that goes against the trend of strong economic growth, but could also reflect efficiency improvements or data quality issues." And within the OECD, the problem is that demand in Europe and Asia Pacific will switch to growth while US demand is staying its growth course.
Thinking now the other way round, if a reduction in global demand growth must be achieved, what are the likely candidates for it? Obviously the OECD, with a recession arising from the unfolding financial crisis. So we have a match here.
And it is easy to see that, even if that OECD recession materializes, the other players are extremely unlikely to reduce their oil demand. The reason for that being:
- For non-oil exporters like China and East Asian countries, the huge foreign exchange reserves that these players have accumulated over the last years, which make their situation entirely different from that in 2000-2003: having already saved for a rainy day (or rather decade), they can now afford to keep growing their internal consumption even if half of their customers curtail the demand for their products.
- For oil exporters like the FSU, ME and several LatAm countries, the fact that it is just not reasonable to expect they would refrain from growing the consumption of their own product.
To sum up, a prompt OECD recession is the only way to avoid triple digit oil prices in 2008 and will most probably result in oil prices staying in the current range. (This of course does NOT mean that such a recession is the long-term solution to the energy problem. It just provides a window of opportunity for addressing the problem in a decisive yet orderly way.)
As for food, the possibility of a fall in prices is even more remote. In the first place for its low elasticity of demand. Secondly because, with a reasoning analogous as that for oil, it is not reasonable to expect that countries that have amassed huge forex reserves or oil exporters would hesitate to draw from their reserves/revenues and skimp on food. Not to speak of food exporters. And thirdly because, with oil prices staying in the current range, the worldwide implementation of biodiesel production will most likely proceed, keeping the pressure on food prices.
Now, are there any other potential benefits from an OECD recession apart from preventing disruptively high oil prices and a likely consequent collapse in the dollar value and the loss of its role as the international trade and reserve currency? Yes, there are a couple of them, and probably of even greater importance.
1. As shown in the previous post http://peaktimeviews.blogspot.com/2007/12/even-bigger-risk-for-2008.html , allowing demand to follow the current growth path poses a significant risk of shortages in some finished products, likely followed by hoarding behaviour by users, which in turn creates a "run on the petroleum bank."
2. Although a recession would certainly curtail demand for electric cars, energy-efficient houses and solar panels, a cursory look at the real world should be enough to notice that the current profile of aggregate demand includes, in a scale ORDERS OF MAGNITUDE greater than those above, things which not only waste fossil fuels but also leave society in a state of ever greater vulnerability to the unavoidable coming energy decline, suburban and exurban construction being the most conspicuous example, followed by production of inefficient vehicles, precisely the two items whose construction/production would be most affected by a recession. So we have another match here.
And I will end with this paragraph from my previous post, which seems all the more relevant in view of proposals like Professor Roubini's.
There are a few big mountains in the world where you can drive to the very top. Those who have done that know quite well that it would be very unsafe to drive on the way down in the same way as on the way up. They make a driving paradigm change when they start the descent. In contrast, today's economists are severely paradigm-challenged. They have known nothing but the way up (to Hubbert's Peak), and they don't seem to be able to make the mental adjustment to the way down. As a result, their driving paradigms are becoming unsafe.
Are economists paradigm-challenged?
From http://www.pkarchive.org/theory/hotdog.html
"But wait--what entitles me to assume that consumer demand will rise enough to absorb all the additional production? One good answer is: Why not? If production were to double, and all that production were to be sold, then total income would double too; so why wouldn't consumption double? That is, why should there be a shortfall in consumption merely because the economy produces more?
Here again, however, there is a deeper answer. It is possible for economies to suffer from an overall inadequacy of demand--recessions do happen. However, such slumps are essentially monetary--they come about because people try in the aggregate to hold more cash than there actually is in circulation. (That insight is the essence of Keynesian economics.) And they can usually be cured by issuing more money--full stop, end of story."
Keynesian economics, whose essence Paul Krugman thus summarized in January 1997, was valid when the world was far from the physical limits to growth (or in other words, when the world was on the way up to Hubbert's Peak), and lack of aggregate demand was the factor that prevented economic output (and employment) from growing at their potential sustainable levels. That was indeed the case for the Depression and all recessions up to and including the brief one in 2001 (and Argentina 2001, which was a neat Great Depression redux with the dollar playing the role of gold), with the exception of the 1970's oil shocks, which could be viewed as a drill for Peak Oil.
But now the world economy is bumping against the physical "limits to growth" - most notably, but not exclusively, in oil production -, with Hubbert's Peak either having been in May 2005 or being in the best case in 2012, and on the way down from it the foreseeable negative growth rates in economic output (until stabilizing at a lower REALLY sustainable level(*)) will not be the consequence of insufficient demand but of a physical constraint from Nature, namely the relentless decline in the production rate of fossil fuels. In this new scenario, stimulating aggregate demand with ANY policy (be it monetary, fiscal, or any other kind), however progressively distributive of wealth and/or income it may be, will not be able to increase output at all, as no monetary or fiscal stimulus can reverse the decline of an oil field, and no such stimulus will be necessary to increase oil exploration efforts since the price of fossil fuels will be high enough to do the job by itself. Monetary stimulus in this context only raises the price of the critical limiting resource.
An apt analogy is that of a pub. When there's plenty of beer, giving purchasing power to the customers if they do not have it (Eccles' income distribution proposal), or turning heating on to make them thirsty, in case they do have money (Krugman's inflation proposal for Japan) will make the trick of increasing beer sales (demand is the limiting factor). But when beer is running out, neither strategy will increase sales (supply is the limiting factor).
There are a few big mountains in the world where you can drive to the very top. Those who have done that know quite well that it would be very unsafe to drive on the way down in the same way as on the way up. They make a driving paradigm change when they start the descent. In contrast, today's economists are severely paradigm-challenged. They have known nothing but the way up (to Hubbert's Peak), and they don't seem to be able to make the mental adjustment to the way down. As a result, their driving paradigms are becoming unsafe.
Now, how could be a monetary policy be "safe" in this brave new world? E.g. by applying the following "safety overrides". Defining stocks as those of crude oil, gasoline or distillates:
- If any stock is in the lower quintile of its average range, do not cut rates.
- If any stock is in the lower decile of its average range and going down or flat, raise rates.
- If any stock is below its minimum operating levels, raise rates.
Sure enough, a matching "safe" fiscal policy should exempt inventories of crude oil and petroleum products from any tax.
(*) Since fossil fuels are an absolutely exhaustible resource, any economic activity based on them is by definition unsustainable.
Proposals for dealing with Peak Oil - Kunstler
Another proponent of radical yet feasible solutions for facing the oncoming decline in oil production rates is James Howard Kunstler, author of "The Long Emergency".
His page is http://www.kunstler.com/ and his blog http://jameshowardkunstler.typepad.com/ .
In fact, because of his personal style and his being a Democrat - though vocally critical of the inability of his party's leaders to grasp the dynamics of key physical realities - Kunstler may cater to a public that may not find Simmons much to their liking, out of his big business style and his being a well-known Republican (and advisor to Mitt Romney, who is not my preferred candidate - Ron Paul is).
It should be noted, however, that their views on how to deal with the Peak Oil challenge are not really conflicting with each other, as can be seen from a joint interview of both which took place on November 1, 2005, whose transcript is at http://www.energybulletin.net/19686.html . Worth reading if you have time.
His page is http://www.kunstler.com/ and his blog http://jameshowardkunstler.typepad.com/ .
In fact, because of his personal style and his being a Democrat - though vocally critical of the inability of his party's leaders to grasp the dynamics of key physical realities - Kunstler may cater to a public that may not find Simmons much to their liking, out of his big business style and his being a well-known Republican (and advisor to Mitt Romney, who is not my preferred candidate - Ron Paul is).
It should be noted, however, that their views on how to deal with the Peak Oil challenge are not really conflicting with each other, as can be seen from a joint interview of both which took place on November 1, 2005, whose transcript is at http://www.energybulletin.net/19686.html . Worth reading if you have time.
Proposals for dealing with Peak Oil - Simmons
For those interested in delving into the Peak Oil issue from an oil industry perspective, a good primer may be the work of Matthew Simmons, Chairman and CEO of Houston-based Simmons & Company International, the leading investment bank specializing in the energy industry, CFR member and author of "Twilight in the Desert - The coming Saudi oil shock and the world economy." (Notably, when the book was published in mid-2005 Saudi production was 9.6 Mbpd, and it soon started to decline until stabilizing at 8.6 Mbpd in 2007, although it appears to have picked up since last August to 9 Mbpd in November, as commented in http://www.econbrowser.com/archives/2007/11/relief_on_oil_s.html). And no, I'm not on Simmons' payroll.
His presentations can be found at
http://www.simmonsco-intl.com/research.aspx?Type=msspeeches
and his interviews by Jim Puplava at
http://www.financialsense.com/Experts/2007/Simmons.html .
To start, I suggest the following two recent presentations:
At CalTech in Pasadena, October 23, 2007.
http://www.simmonsco-intl.com/files/CalTech.pdf
At ASPO World Conference in Houston, October 18, 2007
http://www.simmonsco-intl.com/files/ASPO%20World%20Conf.pdf
A summary of his views on how to deal with Peak Oil is quoted below from his August 18, 2007 interview at http://www.financialsense.com/transcriptions/2007/0818.html
JIM: If all the canaries have stopped singing – I guess as you look at this, and how important energy is to all economies – what’s plan B?
MATT: We don’t have a plan B. I’ll tell you several things that we could do that create sort of a very viable semi-plan B. But the problem is no one is doing them yet. And they have to take some sort of coordinated effort. Now, I think there’s an enormous amount of things that we could do to significantly reduce the way we drive. There are enormous amounts of things we could do to significantly reduce the amount of food miles embedded in our whole food distribution system. There’s an enormous amount of things we could do to change the way we transport goods and get things on water versus roads. But all those things basically take coordination, and somebody needs to start doing them, and we’re starting to run out the clock on that. ...
So there are some things we could do but the problem is that they’re being hindered by so few people understanding that this isn’t a feel good thing or let’s do this to reduce the carbon footprint, which might or might not be an issue. This is basically a crisis because demand can’t basically grow anymore; (emphasis added)
He had previously expanded on the three basic points in his proposed solution in his Aug 6, 2005 interview by Jim Puplava at
http://www.financialsense.com/transcriptions/2005/Simmons.html
JIM: Matt, what comes afterwards? One day, as I mentioned, we’re going to wake up and find out that peak oil is here, we’re going to be dealing with it. Do we go to oil rationing? Do we go to a major, national conservation program? And I guess even more importantly than that, given the high demand on oil today – not only just from the United States and Europe, but India and China – how do we ration oil without going to war?
MATT: We have to figure out a way to do that because if we go to war, it will actually be the worst war we’ve ever fought. And if we don’t address the problem, we will be in an energy war. What I find interesting is I actually think we can solve this problem, but I also think if we ignore it, you can’t create a scenario that is too awful. What we have to do is first of all, long term, create some new forms of energy that don’t exist today. That might or might not be possible. I suspect that actually it will be possible because we haven’t worked on it for a hundred years. While we’re doing that though, we have to figure out a way that allows the world to prosper and not shrivel up while we’re using a lot less oil per capita. And figure this out quickly enough so we educate the China and India’s of the world on how to create a sustainable society so they don’t build a society like ours. Because it’s going to be easier for them to do some of these things than it is for us.
And I’ll give you just a quick shopping-list of some of the things that we are actually going to need to do. In the shipment of goods, we use worldwide about as much, or a little bit more, diesel fuel than we do motor gasoline, and most of the diesel fuel is used by the truck fleets moving goods. If you could wave a magic wand and in a 5 year period of time and get all of the goods off the highway system going long distances by trucks, and put them on either railbeds or water transportation: on the railbeds – railroads – as long as you have long distance transportation, and long trains versus short trains, and short distances, you can get an energy efficiency savings of somewhere between 3 and 10 times – that’s not 3 and 10%, that’s 3 and 10 times; if you can get them on boats versus trains, it has an additional energy efficiency savings of another 2 to 5 times. So by getting trucks off our highway system we have a major impact on removing traffic congestion. And traffic congestion is public enemy number 1 through 5 on passenger car fuel efficiency. So it’s a real win, win, win.
At the same time we have to alter our distribution of food. You know, the average thing we eat today comes from, I believe, an average of 1500-2000 miles. But there are a lot of items, like the first time I ever heard of this concept of food miles was a speaker in London, last Spring, who pointed out that in the Summer in the UK ,almost all the apples come from New Zealand, and they have embedded in them 22,000 miles of travel of a vessel, half coming from New Zealand, and the others going back. When they’re onboard the vessel they’re refrigerated. So it’s a very energy intensive process. We actually can grow stuff close to home in most parts of the world. We just got lazy and thought it was really fun to just go into a grocery store and see all this produce: it doesn’t taste very good, but it looks nice.
And then finally we can basically go to distributed work. Because I found being in Maine in the Summer is a lot more pleasant than being in Houston, I taught myself 10 years ago how to be up here and be more efficient than when I’m in Houston. I think there are lots of corporations that have a thousand people working together; there’s no need for a thousand people to be working together, other than the fact it was just a historical coincidence. We now have the technology that people can actually either work at home or work in their village, and by saving 2-4 hours of commuting they will be far more productive. And then we basically end globalization as we know it today, which is effectively a really flawed plan of breaking manufacturing components down into their smallest parts, and finding the cheapest place in the world to manufacture the parts, and then zinging them around the world to be assembled into bigger, and bigger units, until they finally arrive on the showroom as a piece. If you make stuff close to home, you can have a major savings in fuel efficiency. That sort of a plan put in place over 5-7 years would take a lot of coordination; not a single one of those things are impossible to do.
His presentations can be found at
http://www.simmonsco-intl.com/research.aspx?Type=msspeeches
and his interviews by Jim Puplava at
http://www.financialsense.com/Experts/2007/Simmons.html .
To start, I suggest the following two recent presentations:
At CalTech in Pasadena, October 23, 2007.
http://www.simmonsco-intl.com/files/CalTech.pdf
At ASPO World Conference in Houston, October 18, 2007
http://www.simmonsco-intl.com/files/ASPO%20World%20Conf.pdf
A summary of his views on how to deal with Peak Oil is quoted below from his August 18, 2007 interview at http://www.financialsense.com/transcriptions/2007/0818.html
JIM: If all the canaries have stopped singing – I guess as you look at this, and how important energy is to all economies – what’s plan B?
MATT: We don’t have a plan B. I’ll tell you several things that we could do that create sort of a very viable semi-plan B. But the problem is no one is doing them yet. And they have to take some sort of coordinated effort. Now, I think there’s an enormous amount of things that we could do to significantly reduce the way we drive. There are enormous amounts of things we could do to significantly reduce the amount of food miles embedded in our whole food distribution system. There’s an enormous amount of things we could do to change the way we transport goods and get things on water versus roads. But all those things basically take coordination, and somebody needs to start doing them, and we’re starting to run out the clock on that. ...
So there are some things we could do but the problem is that they’re being hindered by so few people understanding that this isn’t a feel good thing or let’s do this to reduce the carbon footprint, which might or might not be an issue. This is basically a crisis because demand can’t basically grow anymore; (emphasis added)
He had previously expanded on the three basic points in his proposed solution in his Aug 6, 2005 interview by Jim Puplava at
http://www.financialsense.com/transcriptions/2005/Simmons.html
JIM: Matt, what comes afterwards? One day, as I mentioned, we’re going to wake up and find out that peak oil is here, we’re going to be dealing with it. Do we go to oil rationing? Do we go to a major, national conservation program? And I guess even more importantly than that, given the high demand on oil today – not only just from the United States and Europe, but India and China – how do we ration oil without going to war?
MATT: We have to figure out a way to do that because if we go to war, it will actually be the worst war we’ve ever fought. And if we don’t address the problem, we will be in an energy war. What I find interesting is I actually think we can solve this problem, but I also think if we ignore it, you can’t create a scenario that is too awful. What we have to do is first of all, long term, create some new forms of energy that don’t exist today. That might or might not be possible. I suspect that actually it will be possible because we haven’t worked on it for a hundred years. While we’re doing that though, we have to figure out a way that allows the world to prosper and not shrivel up while we’re using a lot less oil per capita. And figure this out quickly enough so we educate the China and India’s of the world on how to create a sustainable society so they don’t build a society like ours. Because it’s going to be easier for them to do some of these things than it is for us.
And I’ll give you just a quick shopping-list of some of the things that we are actually going to need to do. In the shipment of goods, we use worldwide about as much, or a little bit more, diesel fuel than we do motor gasoline, and most of the diesel fuel is used by the truck fleets moving goods. If you could wave a magic wand and in a 5 year period of time and get all of the goods off the highway system going long distances by trucks, and put them on either railbeds or water transportation: on the railbeds – railroads – as long as you have long distance transportation, and long trains versus short trains, and short distances, you can get an energy efficiency savings of somewhere between 3 and 10 times – that’s not 3 and 10%, that’s 3 and 10 times; if you can get them on boats versus trains, it has an additional energy efficiency savings of another 2 to 5 times. So by getting trucks off our highway system we have a major impact on removing traffic congestion. And traffic congestion is public enemy number 1 through 5 on passenger car fuel efficiency. So it’s a real win, win, win.
At the same time we have to alter our distribution of food. You know, the average thing we eat today comes from, I believe, an average of 1500-2000 miles. But there are a lot of items, like the first time I ever heard of this concept of food miles was a speaker in London, last Spring, who pointed out that in the Summer in the UK ,almost all the apples come from New Zealand, and they have embedded in them 22,000 miles of travel of a vessel, half coming from New Zealand, and the others going back. When they’re onboard the vessel they’re refrigerated. So it’s a very energy intensive process. We actually can grow stuff close to home in most parts of the world. We just got lazy and thought it was really fun to just go into a grocery store and see all this produce: it doesn’t taste very good, but it looks nice.
And then finally we can basically go to distributed work. Because I found being in Maine in the Summer is a lot more pleasant than being in Houston, I taught myself 10 years ago how to be up here and be more efficient than when I’m in Houston. I think there are lots of corporations that have a thousand people working together; there’s no need for a thousand people to be working together, other than the fact it was just a historical coincidence. We now have the technology that people can actually either work at home or work in their village, and by saving 2-4 hours of commuting they will be far more productive. And then we basically end globalization as we know it today, which is effectively a really flawed plan of breaking manufacturing components down into their smallest parts, and finding the cheapest place in the world to manufacture the parts, and then zinging them around the world to be assembled into bigger, and bigger units, until they finally arrive on the showroom as a piece. If you make stuff close to home, you can have a major savings in fuel efficiency. That sort of a plan put in place over 5-7 years would take a lot of coordination; not a single one of those things are impossible to do.
An even bigger risk for 2008
I'm amazed at the degree the discussion on the unfolding financial crisis misses a very basic, critical physical reality: that the world is hitting its physical limits to growth, most notably in crude oil production.
Take a look at these numbers from page 48 of the OECD IEA Nov. 13 monthly report at http://omrpublic.iea.org/currentissues/full.pdf
World oil total demand (actual and projected):
1Q06 2Q06 3Q06 4Q06 2006 = 85.5 83.5 84.3 85.7 84.7
1Q07 2Q07 3Q07 4Q07 2007 = 85.8 84.7 85.3 87.1 85.7
1Q08 2Q08 3Q08 4Q08 2008 = 88.2 86.5 87.2 88.9 87.7
World oil total supply (actual):
1Q06 2Q06 3Q06 4Q06 2006 = 85.4 84.9 85.5 85.3 85.3
1Q07 2Q07 3Q07 4Q07 2007 = 85.4 85.0 85.0
It's clear as water that, for the convergence of oil demand to supply in 2008 not to take place out of MUCH higher oil prices, oil production in 2008 must - contrary to its 2006 and 2007 behavior - experience a "surge". As Dirty Harry would say: Do you feel lucky?
In the previous post I mentioned that a further doubling of the oil price in 2008 (which comes right out of these projections) could be the final triggering factor of the collapse of the dollar value and its abandonment as the international trade and reserve currency (the Russians apparently aren't waiting for that). But then I learned from Matthew Simmons Oct 23 presentation at CalTech ( http://www.simmonsco-intl.com/files/CalTech.pdf ) that there is an independent and even bigger risk.
The analysis in my previous post had assumed that it was very unlikely that oil stocks would experience such big drawdowns during 2008 as to meet all of the IEA projected demand. Rather, the estimated price rise could be reasonably thought of as that needed for causing the amount of demand destruction that would allow stocks to remain at acceptable levels. But what if that were not the case? What if stocks were drained beyond critical levels? The following are bullets from pages 35 and 36 of the presentation:
***
Rapid rise in oil prices has yet to dent demand growth.
As supplies falter, demand drains key stocks.
When oil inventories reach minimum operating levels it is the equivalent of fuel tank reading empty.
If "min-op" inventories are breached, risk of shortages in some finished products is high.
Once shortages begin, likely reaction is for users to hoard.
Hoarding then creates a "run on the petroleum bank."
The problem then morphs into a nightmare.
***
Judging from 2007 events, this scenario doesn't seem too far-fetched. At end-of-August, start-of-September, US gasoline inventories in terms of days of supply were the LOWEST EVER recorded (the days of supply data goes back to March 1991), reaching just 20 days. This was even fewer days than seen following the hurricanes in 2005. In absolute terms, the Sep 7 value of 190.4 Mb was just slightly higher than the lowest number on record, which was on August 29, 1997 at 185.6 Mb.
So, ironically but logically, an easing of monetary policy aimed at preventing a run on financial banks will very likely enable a run on critical physical banks, with a much worse disruption in society. Of course, any particular country may bet on their being able to outbid others and thus avoid being the ones having the shortages. Again, do you feel lucky?
As I see it, the only way to prevent this IMMINENT collision is to enable a US-led OECD recession through a tight US monetary policy aimed (explicitely or implicitely) at preserving the dollar value for international transactions through checking its global supply growth.
This of course does NOT mean that a recession is the long-term solution to the energy problem. It just provides a window of opportunity for addressing the problem in a decisive yet orderly way.
Which should be the subject of the next post.
Take a look at these numbers from page 48 of the OECD IEA Nov. 13 monthly report at http://omrpublic.iea.org/currentissues/full.pdf
World oil total demand (actual and projected):
1Q06 2Q06 3Q06 4Q06 2006 = 85.5 83.5 84.3 85.7 84.7
1Q07 2Q07 3Q07 4Q07 2007 = 85.8 84.7 85.3 87.1 85.7
1Q08 2Q08 3Q08 4Q08 2008 = 88.2 86.5 87.2 88.9 87.7
World oil total supply (actual):
1Q06 2Q06 3Q06 4Q06 2006 = 85.4 84.9 85.5 85.3 85.3
1Q07 2Q07 3Q07 4Q07 2007 = 85.4 85.0 85.0
It's clear as water that, for the convergence of oil demand to supply in 2008 not to take place out of MUCH higher oil prices, oil production in 2008 must - contrary to its 2006 and 2007 behavior - experience a "surge". As Dirty Harry would say: Do you feel lucky?
In the previous post I mentioned that a further doubling of the oil price in 2008 (which comes right out of these projections) could be the final triggering factor of the collapse of the dollar value and its abandonment as the international trade and reserve currency (the Russians apparently aren't waiting for that). But then I learned from Matthew Simmons Oct 23 presentation at CalTech ( http://www.simmonsco-intl.com/files/CalTech.pdf ) that there is an independent and even bigger risk.
The analysis in my previous post had assumed that it was very unlikely that oil stocks would experience such big drawdowns during 2008 as to meet all of the IEA projected demand. Rather, the estimated price rise could be reasonably thought of as that needed for causing the amount of demand destruction that would allow stocks to remain at acceptable levels. But what if that were not the case? What if stocks were drained beyond critical levels? The following are bullets from pages 35 and 36 of the presentation:
***
Rapid rise in oil prices has yet to dent demand growth.
As supplies falter, demand drains key stocks.
When oil inventories reach minimum operating levels it is the equivalent of fuel tank reading empty.
If "min-op" inventories are breached, risk of shortages in some finished products is high.
Once shortages begin, likely reaction is for users to hoard.
Hoarding then creates a "run on the petroleum bank."
The problem then morphs into a nightmare.
***
Judging from 2007 events, this scenario doesn't seem too far-fetched. At end-of-August, start-of-September, US gasoline inventories in terms of days of supply were the LOWEST EVER recorded (the days of supply data goes back to March 1991), reaching just 20 days. This was even fewer days than seen following the hurricanes in 2005. In absolute terms, the Sep 7 value of 190.4 Mb was just slightly higher than the lowest number on record, which was on August 29, 1997 at 185.6 Mb.
So, ironically but logically, an easing of monetary policy aimed at preventing a run on financial banks will very likely enable a run on critical physical banks, with a much worse disruption in society. Of course, any particular country may bet on their being able to outbid others and thus avoid being the ones having the shortages. Again, do you feel lucky?
As I see it, the only way to prevent this IMMINENT collision is to enable a US-led OECD recession through a tight US monetary policy aimed (explicitely or implicitely) at preserving the dollar value for international transactions through checking its global supply growth.
This of course does NOT mean that a recession is the long-term solution to the energy problem. It just provides a window of opportunity for addressing the problem in a decisive yet orderly way.
Which should be the subject of the next post.
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