Peak time views

The end game (Caveat Procreator)

2008-03-14T01:04:00.006-04:00

This will be the last post of this blog. Most of its concepts have already been expressed in previous posts, but I want that if someone by chance stumbles upon this blog, the first thing they see is the most important message I want to convey in it.

I started this blog in Oct 2007 with an analysis of the international monetary system, concluding that the US current account would eventually be balanced by a drop in US imports out of either a US recession or a plunge in the dollar's value, depending on the Fed's monetary policy, and that in my view the first path would be the best. By now it is clear that they are headed down the second (with a twist as explained in the last two paragraphs).

Then in Nov 2007 I analyzed the prospects for the oil market in 2008, concluding that, save for a significant US-led OECD recession, the oil price would be significantly higher by the end of 2008. Even though oil (actually total liquids) production has risen more than I expected back then, by now it is clear which way the oil price is heading and how fast.

Then in Dec 2007 I commented on the huge extent to which current economic thinking (not only of theorists, but of people like Bernanke who make decisions which significantly affect the course of events) was disconnected from physical reality. Specifically on the economists' failure to perceive that now it is the physical limits to growth which are becoming the main constraint to economic output, and that in this new scenario it is most unwise to keep stimulating demand. By now it is clear that the disconnect is still as complete as it ever was.

Finally in Jan 2008 I commented on the threat that biofuels posed to world food production: as biofuels are a direct replacement for petroleum products, their prices are directly proportional to those of the petroleum products replaced, plus or less differential taxes/subsidies. Therefore, a higher crude oil price increases the profitability of biofuel production while at the same time decreasing the profitability of food production. As a result, arbitraging based on profits per acre/hectare drives the allocation of agricultural production out of food and into biofuels. As more agricultural production is diverted into biofuels, biofuel production increases and fuel prices consequently tend to stabilize, while food production decreases and food prices consequently rise, until the profitability of food production becomes once again competitive with that of biofuel production and a new equilibrium state is reached where no further diversion occurs. But the key point is that the food production level at this new equilibrium state is LOWER than that at the original state.

As anyone aware of Hubbert's Peak understands, in the absence of a worldwide voluntary reduction of crude oil demand in line with the future peaking and subsequent decline of crude oil production, the prospects for the oil price are of a relentless rise. That, through the profit-based arbitraging mechanism described above, will drive the world into successive new equilibrium states with higher biofuel production and lower food production. Obviously the process will eventually stop before 100% of the food gets turned into fuel. But along the way a large number of poor people wanting to eat will have been outbid by the rich and middle class wanting to fill their tanks.

On the demand side, it is clear that the current path is the exact opposite of what would be required to prevent a relentless rise of the oil price, as the populations of giant emerging economies, particularly China and India, increasingly adopt the oil consumption patterns of the citizens of OECD nations. For which they obviously cannot be reproached: how could Americans ask the Chinese to keep riding bikes as they keep driving their SUVs? That generalized desire to adopt or keep the happy motoring way of life, together with the determination shown by OECD Central Bankers to avoid or minimize a recession (China will probably not have a recession regardless of what happens in the US), just guarantee the outcome that is clearly seen by now: oil demand will not abate and oil prices will keep their march up, dragging food prices along with them.

In this context, any government-induced price distortion (through differential taxes/subsidies) that increases the profitability of biofuel production over that of food production directly amounts to hastening the appearance and aggravating the degree of the coming food crunch. And here is where the issue in the first post (Oct 2007) comes into play: turning an ever greater share of US corn to ethanol (and then soybeans to biodiesel) will cause in a few years the halving of US agricultural exports in volume and their doubling in dollars (i.e. quadrupling agricultural prices). That will substantially reduce the US current account deficit and give the US a significant strategic advantage.

The US has certainly the right to follow that path. But they also have the duty to tell the world openly that they will do it. Like: "Along the coming years and decades our food exports will become progressively lower in volume, and the same will probably happen to total world food production. It is conceivable that they could be half their current volume in 10 years. People, and particularly poor people, should have it in mind when making procreation decisions."

Basing the approach to AGW on good science

2008-01-26T15:34:00.000-05:00

The issue of anthropogenic global warming (AGW) has been receiving much attention in the last years. This paper tries to show that most of the coverage of the issue, including the policy recommendations produced to deal with it, has just not been based on good science. It then tries to show what good science IS appearing to offer a safe base for those recommendations.

Plainly stated, science which does not take into account facts that are relevant to the issue under study is bad science. Period.

The usually overlooked fact that is relevant to the issue of AGW comes straight from the temperature record for the last 450 ky as measured from the ice cores drilled at the EPICA Kohnen Station in the Dronning Maud Land (EDML) and at the Vostok Antarctic sites. More recently, the EPICA Dome C (EDC) ice core has provided a record for the last 800 ky. (Unless explicitely stated otherwise, time in the charts goes from right to left.)

Figure 1. Antarctic temperature for the last 450 ky from EPICA and Vostok

The temperatures may be seen in a somewhat greater detail in the following chart for just the Vostok measurements.

Figure 2. Antarctic temperature and CO2 levels for the last 450 ky from Vostok

The following is the nomenclature for [interglacial periods (from present to oldest); warming events respectively leading to them]
Present: [Holocene; Termination 1 (TI)]
1st previous, 120 ky ago: [Eemian or Marine Isotope Stage 5 (MIS 5); Termination 2 (TII)]
2st previous, 240 ky ago: [Marine Isotope Stage 7 (MIS 7); Termination 3 (TIII)]
3st previous, 330 ky ago: [Marine Isotope Stage 9 (MIS 9); Termination 4 (TIV)]
4st previous, 410 ky ago: [Marine Isotope Stage 11 (MIS 11); Termination 5 (TV)]

From this record it is clearly seen that, for the last 450 ky, the Earth has been in a cycle where benign interglacial periods like the Holocene (last 11.5 ky) have been more or less brief spikes occurring every 80-120 ky between much longer cold periods with temperatures around 6 ºC, and as much as 9 ºC, lower than today's.

It is also clear that coolings from tops, although not as steep as warmings from bottoms, are nevertheless quite fast.

Therefore, to evaluate the prospects for the global temperature as far as the natural forcings are concerned, we can start by comparing the Holocene with appropriate previous tops. The first choice would seem to be the Eemian: it is the closest in time and its duration is comparable to that of the Holocene so far. MIS 7 and MIS 9 on the other hand should be discarded because of their extreme sharpness, while MIS 11 looks like another good candidate. We'll later see that, in fact, MIS 11 could indeed be the Holocene's appropriate match.

To compare the Holocene with the Eemian, I made the following graph based on the first in Stuart Staniford's post "Living in the Eemian". I took the Holocene's last 12 ky and superimposed it onto the corresponding period of the Eemian, 121 ky ago. This is exactly what Stuart did in the second and third graphs of his post, only that here I show it within the bigger picture.

Figure 3. Antarctic temperature for the last 150 ky from Vostok, with the Holocene shifted 121 Ky and superimposed onto the Eemian

From that chart it is clear that, as far as the natural forcings driving climate change are concerned, and IF those forcings had now the same values as they had in the Eemian, the Earth's temperature would start to drop very soon (in about 3 ky) and be 6 ºC lower than today's in about 15 ky.

It should be noted at this point that the cited Stuart's post of 2006 was about the risk of the global temperature (and sea level) reaching the Eemian's peak values, which for the sea level was 5 (five) meters higher than today's. Here we are focusing on the risk of the global temperature (and sea level) plunging as they did after the end of the Eemian, which for the sea level meant a drop of 50 (fifty) meters in 10 Ky, as from the following chart:

Figure 4. Sea levels for the last 140 ky

This possibility in principle could be viewed as actually good: a sea level drop could mean more arable land to compensate for that lost to advancing ice and colder temperatures. However, a new ice age could bring about yet another problem: drought. Quoting from http://en.wikipedia.org/wiki/Last_Glacial_Maximum

"In warmer regions of the world, climates at the Last Glacial Maximum were cooler and almost everywhere drier. In extreme cases, such as South Australia and the Sahel, rainfall could be diminished by up to ninety percent from present, with floras diminished to almost the same degree as in glaciated areas of Europe and North America. Even in less affected regions, rainforest cover was greatly diminished, especially in West Africa where a few refugia were surrounded by tropical grassland.
...
Most of the world's deserts expanded. ... In Australia, shifting sand dunes covered half the continent, whilst the Chaco and Pampas in South America became similarly dry. Present-day subtropical regions also lost most of their forest cover, notably in eastern Australia, the Atlantic Forest of Brazil, and southern China, where open woodland became dominant due to drier conditions. In northern China - unglaciated despite its cold climate - a mixture of grassland and tundra prevailed, and even here, the northern limit of tree growth was at least twenty degrees further south than today."

The quoted Wiki page cites as reference the studies listed at the Paleoclimate Modelling Intercomparison Project page http://pmip.lsce.ipsl.fr/publications/pub21k.shtml . However, there is the possibility that the Wiki page authors' work strayed from the findings of the referenced studies. And since most of them require a journal subscription for access, I could only have a look at The Paleoclimate Modeling Intercomparison Project, S. Joussaume and K. E. Taylor, proceedings of the third PMIP workshop, Canada, 4-8 october 1999, in WCRP-111, WMO/TD-1007, edited by P. Braconnot, 9-24, 2000.

"According to both sets of PMIP simulations the LGM (Last Glacial Maximum) climate is also more arid over most of the northern continents and in the tropics (Figure 7). Larger precipitation however occurs over tropical oceans, especially over the warmer pools of CLIMAP SSTs. Much smaller changes are found over tropical oceans when computing SSTs since the models simulate colder ocean temperatures than CLIMAP. At the regional scale, the simulations are characterised by a number of common features, including a reduction in the strength of the Afro-Asian monsoon (Braconnot, et al., subm.) and increased intertropical aridity, corroborated by various paleoindicators."

To note, this description of global climate and vegetation is about the Last Glacial Maximum, i.e. the coldest period immediately preceding TI. Now, how can we be sure that the "First Glacial Maximum" after an interglacial period does not share the same features?

And finally, it could be argued that, should the Holocene show signs of ending, the time for mankind to plan and prepare for it would be orders or magnitude greater than that allowed by AGW. Not so, according to this 2006 study: http://www.pnas.org/cgi/content/abstract/104/2/450

Evidence for last interglacial chronology and environmental change from Southern Europe

"Establishing phase relationships between earth-system components during periods of rapid global change is vital to understanding the underlying processes. It requires records of each component with independent and accurate chronologies. Until now, no continental record extending from the present to the penultimate glacial had such a chronology to our knowledge. Here, we present such a record from the annually laminated sediments of Lago Grande di Monticchio, southern Italy. Using this record we determine the duration (17.70 ± 0.20 ka) and age of onset (127.20 ± 1.60 ka B.P.) of the last interglacial, as reflected by terrestrial ecosystems. This record also reveals that the transitions at the beginning and end of the interglacial spanned only 100 and 150 years, respectively."

Therefore, if there were not anthropogenic warming forcings in play, the possibility that natural cooling forcings would bring the Earth into a new ice age within a few millenia cannot be discarded a priori. And since that outcome could set in fast and be most disruptive to civilization, it must be explicitely considered and discarded (or accepted as lesser evil) as part of any scientific study of AGW from which policy recommendations are to be derived.

Plainly stated, any scientific approach to the issue of AGW, particularly with the aim of offering policy recommendations based on it, which does not take into account the temperature record for at least the last 450 ky is bad science. Period.

The recent position statement from the American Geophysical Union is a fine example thereof:

"During recent millennia of relatively stable climate, civilization became established and populations have grown rapidly."

Sure folks, but the record for the last 450 millennia shows that periods like this of benign, stable climate have a length of just a few millenia, and that they are always followed by plunges into much longer ice ages. So prolonging the climate of the recent millenia for much longer may not be an option in the system design specifications, in which case either we do our best to break out of the cycle into a warmer period or we plunge into a new ice age soon.

"In the next 50 years, even the lower limit of impending climate change—an additional global mean warming of 1°C above the last decade—is far beyond the range of climate variability experienced during the past thousand years and poses global problems in planning for and adapting to it."

So, should we do our best to stay within the range of the past thousand years while hoping that the natural forcings will not push us down the slope this time? And if they do, would planning for and adapting to a new ice age pose no global problems?

"Warming greater than 2°C above 19th century levels is projected to be disruptive, reducing global agricultural productivity, causing widespread loss of biodiversity, and—if sustained over centuries—melting much of the Greenland ice sheet with ensuing rise in sea level of several meters."

So, should we opt for the risk of cooling greater than 6ºC instead? Because that path may be way more disruptive and ruinous for global agricultural productivity. Unless you are betting on the ensuing sea level drop of more than 50 meters to solve all those problems.

In contrast, the following position statements (if real, of course) would be examples of good science and sound recommendations:

A. "After having achieved a complete understanding of the natural forcings driving climate change, we have unequivocally determined that, purely out of them, the current interglacial period will have a total duration of around HH Ky - i.e. it will span a further FF Ky into the future - and that, as a result, mankind can safely embark on an aggressive reduction of CO2 emissions without fearing that the onset of a new ice age could take place in the next millenia."
or
B. "After having achieved a complete understanding of the natural and anthropogenic forcings driving climate change, and an accurate quantitative assessment of their relative weight, we have unequivocally determined that, if CO2 emissions are reduced according to the KKK protocol, the anthropogenic warming forcings will exactly compensate for the natural cooling forcings and the Earth will remain in the Holocene for ever after."
or
C. "After having achieved a complete understanding of the potential consequences of global warming versus those of the onset of a new ice age, we see unequivocally that the latter would be much more bearable for mankind. Therefore, we recommend an aggressive reduction of CO2 emissions while stocking up on sweaters."

I will next look at where current scientific knowledge stands relative to the possibility of issuing statements A. or B. above. (I don't think they will dare to state C.!) To that purpose, I will use as reference the reading materials used by Dr Ian Lawson in his 2007-2008 Palaeoclimate course at the University of Leeds, together with his comments on them.

Starting with hypothetical statement B., it is common knowledge that the natural forcings driving climate change are related to the periodical changes in the Earth's orbit around the Sun, collectively known as Milankovitch cycles, of which there are three with their respective periods:

Eccentricity (orbital shape): 413 ky for major component (eccent. variation ±0.012) (*)
Obliquity (axial tilt): 41 ky
Precession (wobble): 23 ky (actually 21-26)

(*) A number of other terms vary between 95 ky and 136 ky, and loosely combine into a 100 ky cycle (variation of −0.03 to +0.02).

Dr Lawson's comments on this subject should be taken seriously...

"Milankovitch is a very complex subject area – Huybers and Wunsch (2005) (*) estimate that there are more than 30 competing hypotheses to explain the relationship between orbital variations and climate! Use the reading materials below to consolidate and broaden your understanding of the topic, but bear in mind that you will only be examined on the subjects discussed in the lecture – the trick here will be to avoid getting bogged down in the complexities of the arguments."

(*) "Obliquity pacing of the late Pleistocene glacial terminations"

... and should lead us to think that scientific knowledge is still far from the point of being able to make an accurate quantitative assessment of the combined effect of natural and anthropogenic forcings that would enable the issuance of statement B.

That leaves us with statement A. Therefore, either science can determine that, purely out of the natural forcings, the Holocene will be much longer than the Eemian (the "Long Holocene" hypothesis), in which case it makes sense to embark on a policy of aggressive reduction of CO2 emissions, or we are left with the possibility that the Holocene, out of the natural forcings, could be just as wide as the Eemian (the "Short Holocene" hypothesis), in which case the outcome of such a policy might turn out to be a new ice age with a substantially lower sea level, an ice-covered North America, and drier climate everywhere. And at a time when there will be no fossil fuels to keep people warm.

The foremost proponents of the "Long Holocene" hypothesis are A. Berger and M. F. Loutre, researchers at the Institut d'astronomie et de géophysique Georges Lemaître, Université catholique de Louvain. They suggested that an orbital analogy could be made between the Holocene and MIS 11. This analogy results from a similar low level of eccentricity (the distance between MIS 11 and today corresponds to the 413 ky period in eccentricity). Notably, their first paper on the subject "Marine Isotope Stage 11 as an analogue for the present interglacial" was received by the Global and Planetary Change journal in 1999 but accepted only in 2002. The comparison was further strengthened by simulations conducted with a two dimensional climate model (the "Louvain-la-Neuve" or LLN model). Such simulations suggested that the orbital forcing would not be triggering a glacial inception until 50 ka after present. Their results were published in the 2003 paper "Clues from MIS 11 to predict the future climate – a modelling point of view" whose abstract says:

"Simulations performed with the LLN two-dimensional Northern Hemisphere climate model have confirmed that climate is largely triggered by changes in insolation forcing although atmospheric CO2 concentration also plays an important role, in particular in the amplitude of the simulated variations. Marine isotope stage 11 (MIS 11) some 400 kyr ago and the future share a common feature related to climate forcing, i.e. the insolation at these times displays small similar variations. MIS 11 can be considered an analogue for future natural climate changes. Different simulations were performed to identify the conditions constraining the length of the MIS 11 simulated interglacial. Clearly its length strongly depends on the phase relationship between insolation and CO2 variations. It is only when insolation and CO2 act together towards a cooling, i.e. they both decrease together, that the climate enters quickly into glaciation and that the interglacial may be short. Otherwise each forcing alone is not able to drive the system into glaciation and the climate remains in an interglacial state. The same situation applies for the future. However, we already know that CO2 and insolation do not play together. Indeed, insolation has been decreasing since 11 kyr BP and CO2 concentration remains above 260 ppmv, with a general increasing trend over the last 8000 yr. Therefore we conclude that the long interglacial simulated for the future is a robust feature and the Earth will not enter naturally into glaciation before 50 kyr AP."

On the other hand, the foremost proponent of the "Short Holocene" hypothesis is William F. Ruddiman. His hypothesis is actually more radical than mine. Let's recall that, from the chart in Figure 3, I had raised the possibility that as far as the natural forcings driving climate change are concerned, and IF those forcings had now the same values as they had in the Eemian, the Earth's temperature would start to drop very soon (in about 3 ky) and be 6 ºC lower than today's in about 15 ky. In contrast, what Ruddiman postulated in his 2003 paper "The Anthropogenic Greenhouse Era Began Thousands of Years Ago" was:

The anthropogenic era is generally thought to have begun 150 to 200 years ago, when the industrial revolution began producing CO2 and CH4 at rates sufficient to alter their compositions in the atmosphere. A different hypothesis is posed here: anthropogenic emissions of these gases first altered atmospheric concentrations thousands of years ago. This hypothesis is based on three arguments. (1) Cyclic variations in CO2 and CH4 driven by Earth-orbital changes during the last 350,000 years predict decreases throughout the Holocene, but the CO2 trend began an anomalous increase 8000 years ago, and the CH4 trend did so 5000 years ago. (2) Published explanations for these mid- to late-Holocene gas increases based on natural forcing can be rejected based on paleoclimatic evidence. (3) A wide array of archeological, cultural, historical and geologic evidence points to viable explanations tied to anthropogenic changes resulting from early agriculture in Eurasia, including the start of forest clearance by 8000 years ago and of rice irrigation by 5000 years ago. In recent millennia, the estimated warming caused by these early gas emissions reached a global-mean value of 10 ppm in the last 1000 years are too large to be explained by external (solar-volcanic) forcing, but they can be explained by outbreaks of bubonic plague that caused historically documented farm abandonment in western Eurasia. Forest regrowth on abandoned farms sequestered enough carbon to account for the observed CO2 decreases. Plague-driven CO2 changes were also a significant causal factor in temperature changes during the Little Ice Age (1300–1900 AD)."

A year later, using simulations with the "GENESIS 2" model, in a co-authored paper "A Test of the Overdue-Glaciation Hypothesis" (2MB PDF) Ruddiman et al reached the conclusion that, were it not for pre-industrial anthropogenic GHG emissions, global temperature today would already be 2ºC cooler. In their words:

"The ~2ºC mean-annual cooling simulated by removing anthropogenic greeenhouse gases is equivalent to roughly one third of the global-mean difference between full-interglacial and full-glacial climates. It also represents 80% of the warming simulated by the GENESIS 2 model in response to a doubling of modern CO2 (Thompson and Pollard, 1997). Without any anthropogenic warming, Earth’s climate would no longer be in a full-interglacial state but well on its way toward the colder temperatures typical of glaciations."

Interestingly, Ruddiman addressed the "Long Holocene like MIS 11" hypothesis in 2004 in "Cold climate during the closest Stage 11 analog to recent Millennia". Even more interestingly, Crucifix, Loutre and Berger published also in 2004 a Commentary on “The Anthropogenic Greenhouse Era Began Thousands of Years Ago” stating:

"We think that the only way to resolve this conflict is to properly assimilate the palæoclimate information in numerical climate models. As a general rule, models are insufficiently tested with respect to the wide range of climate situations that succeeded during the Pleistocene. In this comment, we present three definitions of palæoclimate information assimilation with relevant examples. We also present original results with the Louvain-la-Neuve climate-ice sheet model suggesting that if, indeed, the Holocene atmospheric CO2 increase is anthropogenic, a late Holocene glacial inception is plausible, but not certain, depending on the exact time evolution of the atmospheric CO2 concentration during this period."

Keeping in mind that these are the foremost proponents of the "Long Holocene" hypothesis, let's pay attention to the emphasized sentence: a delayed onset of the new ice age "is plausible, but not certain, depending on the exact time evolution of the atmospheric CO2 concentration"! (But fear not, for all the wise people currently advocating for drastic cuts in CO2 emissions are certainly aware of the full contents of this and subsequents studies from these researchers, and they have made sure that their recommended policies still allow for ample margin to avoid an early Holocene glacial inception.)

BTW, this is in line with Ruddiman's comment in a Dec 2005 archived discussion: "the fact that Berger’s model produced an extremely long interglaciation if he only used insolation forcing, but a much shorter one if he added CO2 (from Vostok) to the forcing;"

Moreover, the three Belgian researchers published in 2006 "The Climate Response to the Astronomical Forcing" stating:

"The Louvain-la-Neuve climate-ice sheet model has been an important instrument for confirming the relevance of Milankovitch’s theory, but it also evidences the critical role played by greenhouse gases during periods of low eccentricity." (And the Holocene is such a period.)

Therefore, two years ago the struggle between the two hipotheses was still unsettled. Looking now to other researchers for guidance, in Jul 2006 Peter Huybers published the potentially breakthrough paper "Early Pleistocene Glacial Cycles and the Integrated Summer Insolation Forcing" in which he states:

"Long-term variations in Northern Hemisphere summer insolation are generally thought to control glaciation. But the intensity of summer insolation is primarily controlled by 20,000-year cycles in the precession of the equinoxes, whereas early Pleistocene glacial cycles occur at 40,000-year intervals, matching the period of changes in Earth's obliquity. The resolution of this 40,000-year problem is that glaciers are sensitive to insolation integrated over the duration of the summer. The integrated summer insolation is primarily controlled by obliquity and not precession because, by Kepler's second law, the duration of the summer is inversely proportional to Earth's distance from the Sun."

After which a numerous research team, using the EPICA Dome C measurements and the "ECBILT-CLIO" intermediate complexity climate model, in their Oct 2006 paper "Past temperature reconstructions from deep ice cores: relevance for future climate change" reviewed both Ruddiman's and Berger's hypotheses, and building on the just cited Huybers papers, concluded:

We propose that, when the eccentricity is small and therefore the precession minima and maxima are weak, the role of obliquity cannot be neglected in triggering deglaciations and glaciations. In this respect, it is important to see that there is no perfect orbital analog for the presentday and future orbital context (Berger et al., 1998). Today, the obliquity is at an intermediate value, whereas the end of MIS11 occurred when both the summer insolation and the obliquity were minimal. If obliquity is playing a larger than invoked role on ice ages, then it cannot be expected that an ice age would be to occur over the next 50 ka, until minima of obliquity and NH summer insolation coincide.
...
This analysis should be extended by taking into account the obliquity imprint on climate feedbacks such as the atmospheric dust and greenhouse gas content,"

While the conclusions of this study heavily lean towards the "Long Holocene out of just natural forcings" hypothesis, a 2005 study on a completely different area yielded results supporting Ruddiman's case: "Similarity of vegetation dynamics during interglacial periods" Analysing polen records, the authors found that the pattern of relative variation of different bioclimatic affinity groups (BAGs) in the modern records corresponded to that seen at the end of previous interglacials, and they ask:

"Does the pattern we observe in the uppermost part of the Velay pollen record indicate the end of the Holocene interglacial as it was seen in the previous interglacials? If not, then the Holocene would be a unique interglacial period during which either a reexpansion of BAGs 12 and/or 10 would take place or the coniferous forests would persist at the temperate latitude for several thousand years until the onset of the next ‘‘natural’’ interglacial period. Such a situation has not been observed during the prior four interglacials."

To sum up, advancing scientific knowledge seems, by the end of 2006 to have shifted the balance towards the "Long Holocene" hypothesis, although it is still far from reaching a firm consensus. Which leaves the treatment and policy recommendations on the subject of AGW issued before that date looking rather reckless, to say the least.

As for how far science still is from a firm consensus, a newly published paper by Raymo and Huybers is most eloquent:

"It is widely accepted that variations in Earth's orbit affect glaciation, but a better and more detailed understanding of this process is needed. How can the 41,000-year glacial cycles of the early Pleistocene be explained, let alone the 100,000-year glacial cycles of the late Pleistocene? How do the subtle changes in insolation relate to the massive changes in climate known as glacial cycles? And what are proxy climate records actually measuring? The field now faces these important questions, which are made all the more pressing as the fate of Earth's climate is inexorably tied to the vestige of Northern Hemisphere glaciation that sits atop Greenland, and to its uncertain counterpart to the south."

On the Global Risks 2008 Report for Davos

2008-01-14T17:47:00.001-05:00

The approach taken by the Global Risks 2008 Report for the Davos World Economic Forum is a cause for both hope and concern. On the one hand, it is auspicious to see that it includes the world's two most critical and urgent issues, food and energy security, among the four main global risks. But on the other hand the Report fails to assign those issues their real degree of severity, and perhaps more importantly, it does not seem to understand the real dynamics driving them.

To start with, the Report assertion that, of the four issues, "systemic financial risk is the most immediate and, from the point of view of economic cost, the most severe", either has to be construed as revealing a serious lack of understanding of the immediacy and severity of the problems affecting the food supply, or else must be qualified as outrageous. Because the consequences of a systemic financial crisis, however severe, cannot be compared to the starvation of millions.

Notably, the Report states clearly - and correctly - that the growing use of food crops for biofuel production is a key driver of the increasing risk to food security. But although it initially states that "the consequences, particularly for the most vulnerable communities, may be harsh", it ends the treatment of the subject stating that "the consequences of all these trends for perpetuating the escalation of food prices are difficult to predict." Actually, the consequences are not so difficult to predict if the analysis is ultimately focused on food production levels rather than prices, because global food production is a direct determinant of the population level that can be sustained. I.e., if food production drops because of increased biofuel production, it will have as a direct consequence that fewer people will be able to obtain adequate nutrition. And to evaluate the potential share of global food production that could eventually be diverted to biofuels, and the timing for that, it is essential to correctly understand the dynamics driving the diversion process.

Quite simply, the main driver of the growth in biofuel production is the rise in the crude oil price. As biofuels are a direct replacement for petroleum products, their prices are directly proportional to those of the petroleum products replaced, plus or less differential taxes/subsidies. Therefore, a higher crude oil price increases the profitability of biofuel production while at the same time decreasing the profitability of food production. As a result, arbitraging based on profits per acre starts driving the allocation of agricultural production (and in turn of land) out of food and into biofuels. As more agricultural production (and land) is diverted into biofuels, biofuel production will increase and fuel prices will consequently tend to stabilize, while food production will decrease and food prices will consequently rise, until the profitability of food production becomes once again competitive with that of biofuel production and a new equilibrium state is reached where no further diversion occurs. But it is crucial to note that the food production level at this new equilibrium state is LOWER than that at the original state. (Notably, the Report does mention that "others believe that markets will gradually readjust to shortages as higher prices make it profitable again to grow crops for food". But it fails to mention that the new equilibrium state occurs at a lower food production level.)

Not only is the above dynamics entirely logical, it is also supported by facts as shown in the recently published study "Fermenting the Food Supply - Modelling Biofuel Production as an Infectious Growth on Food Production" by Stuart Staniford, PhD, available at http://www.theoildrum.com/node/2431.

Once understood that it is the rise in the crude oil price what drives the biofuel boom through a simple profit-based arbitraging mechanism, the next step in order to assess the potential share of global food production that could eventually be diverted to biofuels is to evaluate the prospects for the oil price. Which must be done on both a short- and long-term basis.

For the short term, the current data and projections from both the US Energy Information Administration (EIA) as of Jan. 08, 2008 at http://www.eia.doe.gov/emeu/steo/pub/contents.html (table 3a) and the OECD International Energy Agency (IEA) as of Dec. 14, 2007 at http://omrpublic.iea.org/currentissues/full.pdf speak quite loudly:

World oil production
year 2005 2006 2007 2008
EIA 84.6 84.6 84.8 87.6 (wishful thinking?)
IEA 84.6 85.4 85.5

World oil consumption
year 2005 2006 2007 2008
EIA 83.7 84.8 85.9 87.5
IEA 83.9 84.7 85.7 87.8

Given the trend in global oil production for 2005-2007, and the fact that both the EIA and the IEA currently project 2008 global demand being respectively 2.7 Mbpd and 2.3 Mpbd higher than 2007 global supply, it is painfully clear that either global oil production breaks decisively from its recent performance and surges in 2008 - which looks improbable at best - or global oil demand will be brought down to convergence with supply, in turn either by a significant recession in the OECD or by an oil price that will surge deep into the triple digits in 2008, in euros as well as in dollars. The last possibility will have a significant short-term impact in global biofuel (and food) production, since, as shown by the cited study, "when oil prices spike up, a year or so later we have a new burst of ethanol capacity under construction (which then comes on stream 1-2 years after that)." And this impact will take place against the background of an already dire situation, as described by the Dec 17, 2007 FAO communique "FAO calls for urgent steps to protect the poor from soaring food prices" at http://www.fao.org/newsroom/en/news/2007/1000733/index.html.

For the long term, the determinant factor is a constraint from physical reality: the fact that global oil reserves are finite, and that as a result global oil production will eventually reach a peak and then commence a relentless decline. The peaking event is termed "Hubbert's Peak" after the late Shell geologist M. King Hubbert, PhD, who in 1956 predicted that US oil production would peak in 1970 as it effectively did. Today, most analysts without vested interests are predicting global Hubbert's Peak to take place in the 2010-2012 timeframe. Therefore, in the absence of a worldwide voluntary reduction of crude oil demand in line with the future peaking and subsequent decline of crude oil production, the long term prospects for the oil price are of a relentless rise. Which through the profit-based arbitraging mechanism described above will drive the world into successive new equilibrium states with higher biofuel production and lower food production. Obviously the process will eventually stop before 100% of the food gets turned into fuel. The question is, at what point? When we have a bidding war between the gas tanks of the global middle and wealthy classes and the dinner tables of the poor, where does that reach equilibrium?

Regarding global crude oil demand, the current path is the exact opposite of what would be required to prevent a relentless rise of the oil price, as the populations of giant emerging economies, particularly China and India, increasingly adopt the oil consumption patterns of the citizens of OECD nations. For which they obviously cannot be reproached: how could Americans ask the Chinese to keep riding bikes as they drive their SUVs?

To sum up, the prospects for global crude oil production - based on geological constraints -, plus the prospects for crude oil demand - based on human nature-, plus the profit-based arbitraging mechanism for diverting agricultural production into biofuels, all make for a very bleak picture for the global food supply. Indeed, as shown in the cited study, global biofuel production could be consuming half the global food supply within about six or seven years.

Of the three factors powering the process, increasing global crude oil production in the long term is physically beyond the reach of policy-makers (and while it could be increased in the short term, given the finiteness of reserves that would imply a steeper decline later). But acting in a concerted and collaborative way to stop and reverse growth in global oil demand is not. And while the bulk of this growth comes from emerging economies, it is not conceivable to expect it to stop without the developed economies setting the example by drastically reducing their own consumption. As for the food/biofuel arbitraging mechanism, any government-induced price distortion that increases the profitability of biofuel production over that of food production through differential taxes/subsidies directly amounts to hastening the appearance and aggravating the degree of the coming food crunch.

Again, this is not an issue which the world can take years to study: it is already hurting, as per the FAO communique, and the factor that drives it - rising crude oil prices - is poised to surpass its 2007 strong performance in 2008 if a significant OECD recession does not materialize promptly.

And if world leaders decide that - while physically feasible - it is politically impossible to act in a concerted and collaborative way to stop and reverse global oil demand growth, whereby the prospects for world food production will be to decline to a level substantially lower than today's, they must at the very least make those prospects openly and plainly known to everyone. For even if it could be argued that it is politically impossible to prevent the third horseman from coming back - this time driving a biofuel-powered SUV -, there can be no excuse for keeping people ignorant of the fact that he is coming for dinner. For their dinner.

The biofuels case as the coming of the third horseman

2008-01-08T14:40:00.000-05:00

Stuart Staniford has just posted at http://www.theoildrum.com/node/2431 a remarkable piece of work that covers, at an academic level, an issue I have been raising for some time in TOD comments like
http://www.theoildrum.com/node/3412/286090 and
http://www.theoildrum.com/node/3124/253090 . After making a couple of IMV important observations, I will try to express the concepts involved as a simple business case.

First, although current global annual production of ethanol is much higher than that of biodiesel, due to US corn ethanol, biodiesel (mostly from soybean) will probably play an increasingly larger role because of the following reasons:

1. Soybean biodiesel has a much more robust EROEI than corn ethanol.

2. Soybean has lower fertilizer and pesticide requirements than corn, in absolute terms and even more when taking EROEI into account. "Per unit of energy gained, biodiesel requires just 2 percent of the N and 8 percent of the P needed for corn ethanol. Pesticide use per NEB differs similarly." (Quoted from the National Academy of Sciences recent report titled "Water Implications of Biofuel Production in the United States" at http://www.nap.edu/catalog.php?record_id=12039 .)

3. Outside the US, and particularly in Europe and in South American major grains and soybean exporters, the liquids fuels usage profile has a much higher share of diesel fuel relative to gasoline, with diesel fuel powering many personal vehicles.

4. Anywhere, diesel fuel's availability is more critical than gasoline's. No gasoline means it will be a pain to get to the supermarket, but no diesel fuel means there will be no goods in the supermarket.

5. Should a shortage of NG develop, most of today's NG-fired power plants can burn diesel fuel as well.

6. Finally, although I don't have a reference at hand to support it, I remember learning that the investment costs for a corn ethanol distillation plant are three times higher than those for a biodiesel plant of similar capacity.

Second, the fact that "the biofuel potential of the entire human food supply is quite a small amount of energy compared to the global oil supply - somewhere between 15-20% on a volumetric basis, so 10-15% on an energy basis -", although conceptually undisputable, is effectively irrelevant. Because the decision about how much agricultural production will be diverted into biofuels will not be made for the whole world by a hypothetical good-willed council that considers the world as one unit and balances the energy and food needs of the world's population. Rather, the decisions will be made by the countries which today are big agricultural exporters taking into account THEIR needs. And the key point here is that the countries with more biofuel production potential (e.g. Brazil, Argentina, Paraguay) have much lower liquid fuel (and energy in general) usage per capita than OECD countries. Therefore if they maximize the allocation of THEIR agricultural potential into biodiesel production (plus sugar cane to ethanol) for THEIR own use, they will be able to keep running the most important parts of THEIR current economies in the face of a future decline of global oil production (and a much harder decline of global oil exports), and it is just not realistic to expect they will forego that possibility.

Since it's essential to understand this issue, I feel it is warranted to emphasize its explanation: even while it's true that, if all vegetable oil in the world were converted to biodiesel, it would only cover 8% of GLOBAL diesel fuel demand, the key point is that Brazilians, Argentinians, etc. will not scale up biodiesel production (from soybean, sunflower or rapeseed, that's not the point) to satisfy GLOBAL diesel fuel demand. They will do it to satisfy THEIR OWN demand. So the relevant analysis that has to be made is, e.g. for Argentina:

- How much land they need to provide wheat, etc. for THEIR OWN population.

- How much biodiesel they would produce if the rest of their arable land were devoted to biodiesel production (pick the oilseed you want).

- How that potential biodiesel production compares to THEIR OWN current diesel fuel consumption.

Basically, if Argentina allocates ALL their current arable land to soybean (currently they allocate 53%), they would generate biodiesel to cover ALL their current diesel fuel consumption. If they used sunflower instead, they would need to allocate only 50% of the current arable land for that (using yield figures from http://en.wikipedia.org/wiki/Biodiesel). Given that Argentina today is a big grains exporter, it is clear that they can provide food for their current population while at the same time producing enough biodiesel to avoid experiencing a dramatic impact from the coming relentless decline in global crude oil production.

Of course, they will not say as much in their presentations, which can be found at:
http://www.argentine-embassy-uk.org/biofuels/presentaciones/panel1.ppt and
http://www.ars.usda.gov/meetings/Biofuel2007/presentations/IP-B/Almada.pdf .

Therefore the most probable outcome is that, as oil prices go higher, a growing share of agricultural production will be diverted into biodiesel production. Land arbitraging based on profits per acre will drive the allocation of land out of wheat and corn production and into soybean production. Food exports will drop, food prices will rise, and poor people will be priced out of food.

I will try to express the above dynamics as a simple business case. Let's assume a farmer has the option of producing any of the following:

Wheat (W)
Corn (C)
Soybean (S)
Soybean Oil (BO) (using a co-owned mill from a local co-op), yielding Soybean Meal (SM) as by-product.
Soybean biodiesel (SBD) (further processing BO at a co-owned refinery from a local co-op).

Let's use the suffix "a" to denote "per acre" (non-US folks can use "h" for "per hectare"). Thus, Wa = Wheat yield per acre. Each option yields a different profit per acre. Some key components of profit per acre for W (and C and S) are (the currency is shown as dollar but could be any):

Profit(Wa) =
= $ Wa
- $ fuel (for sowing, harvesting, etc.)
- $ fertilizer, herbicides and pesticides

While the key components of the profit per acre for the full chain of production of soybean biodiesel (SBD) are:

Profit(SBDa) =
= $SBDa
- $ fuel (for sowing, harvesting, etc. the soybean)
- $ fertilizer, herbicides and pesticides
- $ milling operations energy input
+ $SMa by-product
- $ refining operations energy input
- $ methanol
+ $ glycerin by-product

The case for allocating the land to biodiesel production occurs when:

Profit(SBDa) > Max[Profit(Wa), Profit(Ca), Profit(Sa), Profit(BOa)]

Now, since BD (from any oilseed) is functionally equivalent to diesel fuel (DF), except for the fact that the volumetric energy density of BD is about 9 % lower than regular Number 2 petrodiesel (http://www.biodiesel.org/pdf_files/fuelfactsheets/BTU_Content_Final_Oct2005.pdf) in the absence of any government-induced price distortion (through a difference in taxes/subsidies) the price equivalence condition for any biodiesel to substitute diesel fuel is:

$ BD = 0.9 x $ DF (per gallon/litre)

And, since the prices of most cost items for BD are more or less directly linked to the prices of fossil fuels (including methanol, which is currently made out of coal in China, waste in Germany, and NG elsewhere, according to http://www.methanol.org/pdf/WorldMethanolPlantsEndOf2006.pdf), which most probably will all rise along with the price of crude oil, though at different speeds, then Profit(BDa) will rise with the crude oil price in, at the very least, a roughly directly proportional fashion. In contrast, for W (and C, etc.) the oil price has an impact only on the cost items. Therefore, the higher the crude oil price, the higher Profit(BDa) and the lower Profit(Wa), Profit(Ca), etc.

At this point, arbitraging starts. As more land is diverted into BD production and less into grains, BD production will increase and its price will stabilize (I wouldn't say fall) while grains production will decrease and their prices will rise, until Profit(Wa) becomes competitive with Profit(BDa) and no further land is diverted into BD. However, since the prospects for world crude oil production is to experience a relentless decline after its near (2012?) peak, if demand for crude oil does not fall correspondingly on its own, crude oil (and diesel fuel) prices will keep rising, having a further diverging impact on Profit(BDa) and Profit(Wa), etc., and driving the land arbitraging mechanism to successive new equilibrium states with more land allocated to BD and less land to grains.

Therefore, in the absence of a worldwide voluntary reduction of crude oil demand in line with the evolution of crude oil production (as proposed by the Oil Depletion Protocol), the prospects for world food production are quite bleak.

A similar analysis as that for soybean biodiesel can be made for corn ethanol, the main difference being that the energy and fertilizer, etc. costs are so much higher for corn ethanol that it wouldn't yield a profit in the absence of huge government subsidies. Similar analyses can also be made for sunflower biodiesel and rapeseed biodiesel. These options have on the one hand the advantage of higher oil and biodiesel yields per acre/hectare, and on the other the disadvantage of lacking a by-product of significant nutritional value as livestock and poultry feed as Soybean Meal.

Now it could be useful to refine a bit the expression of the business case.

As said above, Profit(BD) refers to the profit for the full production chain, because full vertical integration was being assumed (i.e. farmers owned the mill and the refinery through a co-op). Even if there were no such integration, it still makes sense to look at the profit for the full chain because it has to be higher than that for just producing soybeans. But it might be more useful to separate the profits for each stage, e.g. for soybeans:

- Farming - Output: soybeans (S)
- Milling and oil refining - Input: S; Output: Soybean oil (BO) + Soybean Meal (SM)
- Transesterification - Input: BO; Output: SBD

Thus, the profit for the full chain can be expressed as:

Profit(SBD) =
= Profit(S)
+ Profit(BOmill)
+ Profit(SBDref)

For prices, it is necessary to specify whether they are retail or collected by the refiner, the difference being taxes (ignoring gas station margin by assuming that gas station profitability is the same for biodiesel and diesel fuel). Because the price equivalence condition with diesel fuel (DF) holds at the retail level. Therefore, for ANY biodiesel:

$BDretail = 0.9 x $DFretail

$BDref + $BDtax = 0.9 x ($DFref + $DFtax)

$BDref = 0.9 x ($DFref + $DFtax) - $BDtax

For corn ethanol, the price equivalence condition with gasoline (RB) would be:
$CEref = 0.66 x ($RBref + $RBtax) - $CEtax

Clearly, the business case for a biofuel is heavily dependent on both the tax/subsidy on the biofuel itself and the tax/subsidy on the substituted petroleum product (subsidy being a negative tax), so that if the petroleum product has a higher tax/lower subsidy than the biofuel the business case is improved. The level of taxation/subsidising on petroleum products varies wildly across different countries, as shown in the "International Fuel Prices 2007" document available from http://www.gtz.de/en/themen/umwelt-infrastruktur/transport/10285.htm .

It should be noted, however, that the case for biofuel production in a country does not necessarily arise out of the price equivalence condition holding in the producing country, because the biofuel can be produced for exporting to another country where the condition holds. Thus, while in November 2006 retail diesel prices in Argentina ($0.48 per litre) or even Brazil ($0.84) would not make the case for biodiesel production for local use, retail diesel prices for France ($1.33), Germany ($1.38), Italy ($1.49) and the UK($1.73) would paint a different picture for exports. And that was in November 2006, with a WTI price of $60. So it is reasonable to assume that the scaling up of biodiesel production will initially be driven by exports and only later - as domestic crude oil production declines significantly - be diverted to supply the local market. This prospect is supported, at least for Argentina, by an excellent study on their biofuels market available at http://www.biodiesel.com.ar/download/emerging_liquid_biofuel_markets.pdf

Therefore, using the price collected by the biodiesel refiner, the profit for the transesterification stage is, for soybeans:

Profit(SBDref) =
= $BDref
- $BOmill
- $ refining operations energy input
- $ methanol
+ $ glycerin by-product

The profit formula uses $BOmill and not $BOretail because typically the owner of the milling and oil refining facility also owns the biodiesel refinery. So the profit is related to the price they get for BO, which is its cost for the transesterification stage.

It should be noted that the difference in profits for the transesterification stage using different vegetable oils as feedstock depends only on the price of the vegetable oils. However, this should not be expected to lead to instantaneous arbitration between oilseeds. Because, in contrast with transesterification facilities which can equally process any vegetable oil, milling facilities are specific for each oilseed. Therefore, oilseed arbitration would depend on the combination of Profit(*OILmill) + Profit(*BDref).

Oil and food 2007 milestones and 2008 prospects

2008-01-02T17:23:00.000-05:00

For crude oil, the 2007 milestone could best be described as "the third straight year of practically stagnant supply in the face of higher demand (and prices)."

This comes from both
EIA data as of Jan. 08, 2008 at http://www.eia.doe.gov/emeu/steo/pub/contents.html (table 3a), and
IEA data as of Dec. 14, 2007 at http://omrpublic.iea.org/currentissues/full.pdf.

World oil production
year 2005 2006 2007 2008
EIA 84.6 84.6 84.8 87.6 (wishful thinking?)
IEA 84.6 85.4 85.5

World oil consumption
year 2005 2006 2007 2008
EIA 83.7 84.8 85.9 87.5
IEA 83.9 84.7 85.7 87.8

Clearly 2008 will be "interesting times" in the Chinese sense for the oil market, since, for the {EIA IEA}, projected 2008 global demand will be {2.7 2.3} Mpbd higher than 2007 global supply (*). So,

either world oil production experiences a "surge" in 2008 (do you feel lucky?),
or a good recession is allowed to take place in the OECD,
or the oil price will surge deep into the triple digits in 2008 (and not only in dollars).

(*) The trend in EIA projections is in fact for worse, since as of Dec. 11, 2007 they were also predicting 2008 demand "only" 2.3 Mbpd higher than 2007 supply.

For food, the 2007 milestone is best described by the FAO in their November 2007 Food Outlook at http://www.fao.org/docrep/010/ah876e/ah876e00.htm

"The FAO food price index ... in September 2007 ... stood at 172 points, representing a year-on-year jump in value of roughly 37 percent. The surge in prices has been led primarily by dairy and grains, but prices of other commodities, with the exception of sugar, have also increased significantly.

... What distinguishes the current state of agricultural markets is rather the concurrence of the hike in world prices of, not just a selected few, but of nearly all, major food and feed commodities. As has become evident in recent months, high international prices for food crops such as grains continue to ripple through the food value/supply chain, contributing to a rise in retail prices of such basic foods as bread or pasta, meat and milk. Rarely has the world felt such a widespread and commonly shared concern about food price inflation, a fear which is fuelling debates about the future direction of agricultural commodity prices in importing as well as exporting countries, be they rich or poor."

And the linked Market summaries page (.../ah876e01.htm) adds, for cereals:

"For most cereals, supplies are much tighter than in recent years while demand is rising for food as well as feed and industrial use. Stocks, which were already low at the start of the season, are likely to remain equally low because global cereal production may only be sufficient to meet expected world utilization. International prices of cereal have risen, fuelling domestic food price inflation in many parts of the world. Trade is expected to contract because of high and volatile prices, coupled with soaring freight rates."

Therefore, price action for wheat, rice and soybeans as well as the evolution of global cereal stocks (dropped to 428 Mt for 2006/2007) look like important milestones to include.

Particularly since, from the December 17 FAO communique at http://www.fao.org/newsroom/en/news/2007/1000733/index.html

"FAO is urging governments and the international community to implement immediate measures in support of poor countries hit hard by dramatic food price increases. Currently 37 countries worldwide are facing food crises due to conflict and disasters. In addition, food security is being adversely affected by unprecedented price hikes for basic food, driven by historically low food stocks, droughts and floods linked to climate change, high oil prices and growing demand for bio-fuels. High international cereal prices have already sparked food riots in several countries."

Paradigm-challenged economists: Summers, housing and the grid

2007-12-07T10:16:00.000-05:00

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.

Paradigm-challenged economists: Bernanke and the Solow model

2007-12-06T18:26:00.000-05:00

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."

Paradigm-challenged economists: Roubini and the oil market

2007-12-04T22:59:00.000-05:00

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.

Are economists paradigm-challenged?

2007-12-04T22:33:00.001-05:00

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

2007-12-04T21:32:00.000-05:00

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.

Proposals for dealing with Peak Oil - Simmons

2007-12-04T21:10:00.000-05:00

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.

An even bigger risk for 2008

2007-12-04T20:52:00.000-05:00

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.

Assessing the impact of the current oil situation and 2008 prospects

2007-11-21T12:11:00.000-05:00

Let's consider the following points:

Re the USD (part 1):

1. The fall in the dollar's value since August 2007 has taken place against a backdrop of a slightly improving US trade deficit.

2. From point 1., it is just logical to deduce that, if the US trade deficit had instead worsened during that period, the dollar would have fallen further.

Re crude oil prices and supply/demand balance:

3.
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.

4. This yearly WTI price rise cannot be explained by Iran-related geopolitical tensions, which were actually higher a year ago. It cannot be explained by speculative pressure either, since NYMEX net positions a year ago and now are fairly similar. Therefore the price rise can only be explained by a deterioration in physical supply and demand balance.

5. To support the inference in point 4., it's worth noting that,
on Nov 21, 2005 WTI = $58 and EUR = $1.18, so WTI = EUR 49.

However, on Nov 2005 speculative positions at NYMEX were net short at historic record levels, so a year later we had both increased speculative pressure and increased geopolitical tensions, yet the oil price was roughly the same. Therefore, reasoning like in point 4., we deduce that supply and demand balance should have improved during 2006. And indeed, as we see in the IEA Oil Market Report (OMR) at http://omrpublic.iea.org/, total OECD closing stocks were:
for 4Q2005, 4083 mb amounting to 81 days of forward demand
for 4Q2006, 4180 mb amounting to 84 days of forward demand

6. In contrast, and adding support to point 4., OECD closing stocks for 2Q2007 were the same as for 2Q2006 (in mb and days). But more importantly, OECD stocks experienced a net *draw* of 380 kb/d during 3Q2007, contrasting with a 1160 kb/d net *build* in 3Q2006, and an average 280 kb/d 3Q net *build* over the past five years (and anecdotically, with Japanese crude stocks falling to their lowest level in at least 20 years.) Which clearly shows the worsening in supply/demand balance over 2007.

Re oil production:

7. According to the EIA, world oil production peaked on a monthly basis on May 2005 for (Crude Oil + lease condensate = CO) as well as for (Crude Oil + lease condensate + Natural Gas Plant Liquids = CO + NGL). If we consider All Liquids (which includes biofuels) then the peak month was July 2006.

8. Also from the EIA, for all 3 categories (CO, CO +NGL and All Liquids), production for the first half of 2007 has been the same as (actually slightly lower than) that for the first half of 2006 (73.23 vs 73.48, 81.20 vs 81.26, and 84.28 vs 84.35 mb/d respectively).

9. There are strong reasons that expect that 2008 world oil production will not be higher than in 2007, as shown by Stuart Staniford at
http://www.theoildrum.com/node/3236

Re oil demand and price projection:

10. According to the latest (Nov 13) IEA OMR, average global oil demand was/is expected to be:
for 2006: 84.7 mb/d
for 2007: 85.7 mb/d (+1.2%)
for 2008: 87.7 mb/d (+2.3%)

11. Therefore, with constant production over the 3 years, if a 1.2% increase in demand caused in 44% increase in price in euros, a 2.3% increase in demand 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. (Realistically, it is very unlikely that stocks experience such big drawdowns during 2008 as to meet all of the projected demand. Rather, the estimated price can be reasonably thought of as that needed for causing the amount of demand destruction that will allow stocks to remain at acceptable levels.)

Re the USD (part 2) and the US economy.

12. However, the EURUSD = 1.48 (and consequent WTI = $180) assumption in point 11. may not be realistic for the following reasons:

a. If US oil and petroleum products imports remain constant, an 84% increase in the oil price can be expected to cause the US trade deficit to worsen, which in turn can be expected to cause a further fall in the dollar (as per points 1. and 2.).

b. An 84% oil price rise will greatly increase the current account surplus of oil exporters and as a result their foreign exchange reserves, very likely to the point of compelling them to at last unpeg their currencies from the dollar and further diversify their foreign exchange reserves from it.

c. Moreover, the $200+ oil price expected to result from factors a. and b. can in turn be expected to increase the pressure for oil exporters to start pricing and trading their resource in other currency/ies, thus adding further downward pressure to the dollar and conceivably taking it to its "Wily E. Coyote moment".

13. In assessing the impact of a doubling of the oil price on the US economy, (neo)classical economic analysis can be expected to point out that the share of energy in US GDP is still low. Recent oil price action, however, shows how easy it is for the oil price to double, and a doubling here, a doubling there, and pretty soon you're talking about real share. Therefore a $200+ oil price (which BTW assumes peace and love between the US and Iran) can be reasonably expected to add significant inflationary pressures in the US. If, however, the US Federal Reserve adjusts its monetary policy REACTING to those inflationary pressures once they are manifest, it is very likely that by then the dollar will have already lost a substantial part of its international trade and reserve currency status.

Conclusion:

The currently expected oil supply and demand situation for 2008 portends at least a doubling in the dollar oil price and poses a significant risk of triggering the much-feared collapse in the dollar value. The only alternative is a significant "endogenous" (i.e. not due to higher oil prices) reduction in oil consumption in the main consumers (US, Europe and China, in that order). Which in turn can be reasonably expected to occur only as a result of a US-led OECD recession (causing a Chinese deceleration of economic growth). A new Fed monetary policy focused on the preservation of the dollar value for international transactions through checking its global supply growth can do the trick.

If the ECB does not have the nerve to follow a similar path, and issues whatever amounts of euros are needed e.g. to prevent any recession to happen or any bank from falling, that will lay to rest the expectations of the euro challenging the dollar status as the main international trade and reserve currency.

A realistic view of the international monetary system and its prospects

2007-10-26T18:04:00.000-04:00

This essay explores, in a math-free language, the essence of the current international monetary system and its prospects. It discusses the real meaning of the worldwide use of the fiat currency of one particular country as the international trade and reserve currency, why the US Federal Reserve's policy is fostering the conditions for a deep and fast plunge in the value of the US dollar, what fair and logical framework can be used to assess the relative intrinsic value of currencies, why the dollar is grossly overvalued according to that framework, and why the loss of privileged status for the dollar could be extremely disruptive for the US. It finally adds the issue of Hubbert's Peak to the analysis whereby making it even more cogent.

1. A tale on the evolution of the international monetary system to this day

Once upon a time, in a planet with countries A to Z, precious metals were the medium of exchange used for all economic transactions, both within a country and across national borders. Later on, transactions within a country were increasingly conducted using paper notes, which were originally redeemable for precious metals but eventually lost that property, when it became clear that internal monetary policy had to be unleashed from the "golden fetters" if "patriotic housewives" were to be persuaded not to postpone their purchases of non-essential items. However, transactions between countries were still conducted using gold or at least a paper currency that could be redeemed for gold by foreign holders. (In the meantime, silver had fallen out of the world's monetary favor.) That system was universally viewed as fair, in that it prevented any country from getting an unfair advantage, something for nothing, a "free lunch". In the last stage of that system, it was country A's currency that which was redeemable and used for international trade.

Over the years, country A developed a deficit in its balance of payments, sending more of its currency abroad than what could be backed up by country A's gold reserves. Noticing that, foreign holders of its currency became increasingly uneasy and started to redeem its holdings for gold at such a pace that it quickly became evident that country A's gold reserves would soon be exhausted. Faced with that prospect, the government of country A ended the convertibility of its currency for gold at a fixed exchange rate - if foreigners wanted to exchange its currency holdings for gold, they could now do so on the open market (at a much higher price, of course). After that moment, all national currencies were just fiat peers on an equal standing, whose intrinsic value outside the issuing country arose exclusively from the possibility of using it for purchasing goods and services FROM THAT ISSUING COUNTRY, or for acquiring property rights wherein, in a reasonable timeframe. This is a key concept we need to have in mind to understand the real implications of the evolution that the international trade system underwent thereafter. (In this essay, "intrinsic value" of a fiat currency refers to its "intrinsic fiat value", not to the value arising from the rather limited direct usefulness of the physical piece of paper.)

As could be expected, after the severance of its linkage with gold, country A's currency was still the only one used for bilateral transactions between country A and the other countries. Though that arrangement gave country A a slight advantage, in that the other countries first had to sell something to country A and only then were able to buy something from it, that was not a big deal. Let's say that it gave country A a free beer.

It should be found surprising, however, that countries B to Z continued to use country A's currency for their bilateral transactions. That arrangement did give country A a significant advantage, in that all other countries needed to first sell goods, services and/or property rights to country A, directly or indirectly, in sufficient quantities to acquire the amount of its currency that was necessary to conduct trade with the other countries. Following the analogy, we could say that this amounted to giving country A a free lunch.

As time passed, a trend developed called "globalization" whereby production of different goods was increasingly relocated to different countries to profit from their competitive advantages. A side effect of this phenomenon was that, as a result, countries B to Z now needed increasingly higher quantities of country A's currency to conduct their trade. (To see why, let's say that countries B and C used to produce their own bread and butter, so that those goods were traded within their boundaries using their respective currencies. After globalization, country B produced only bread and country C only butter. Now all bread consumed by country C and all butter consumed by country B were traded across borders, using country A's currency.) That implied a corresponding increase in the amount of goods, services and/or property rights that countries B to Z needed to sell to country A, directly or indirectly. In our analogy, we could say that globalization gave country A a free ride (on top of the free lunch).

And finally some countries, with at least rather dubious wisdom, started to accumulate reserves of country A's currency [1] in much higher quantities than those reasonably needed as buffer for their international transactions. Rounding up the analogy, that was like giving country A free housing (on top of all the above).

2. What the world would expect to see from the US, and what it is actually seeing instead

Given the circumstances described above, a reasonable observer would expect country A to behave smartly with the aim to preserve a system that gave it such an incredibly advantageous position. He would expect country A's Central Bank to acknowledge the important role its currency plays in global trade and to assure all countries that its monetary policy would be geared first and foremost to preserving the purchasing power of its currency for international transactions, so that they could confidently hold it (or debt denominated in it) as a store of value.

Imagine then the observer's surprise when he sees country A's Central Bank openly set its monetary policy with the only objective of avoiding the possibility of any internal recession, however slight and brief - not getting out of a deep or prolonged recession, which would be understandable, but preempting the occurrence of an arguably remotely probable one. And moreover do that at a time when the purchasing power of its currency, when measured in internationally transacted goods such as crude oil, industrial metals, grains, and of course gold, the barbarous relic, has already declined considerably over the last years and is lately doing so at an accelerating rate. He would see such monetary policy as amounting to country A telling the world: "Look, the only thing we care about when setting our monetary policy is the level of our internal economic activity. And by that we mean mainly the production of goods and services that you can't buy from us. We don't care much about our currency holding its purchasing power internally, [2] let alone when measured in internationally traded goods. So, if you use our currency to trade between yourselves, it's your problem. And if you are so stupid as to use it (or debt denominated in it) for holding your savings, you do need professional help."

3. What can now be expected to happen

What could then be expected as a response from countries B to Z? A straightforward possibility would be to switch to country's E currency for foreign trade and reserve purposes, totally or partially. But that does not really solve the problem. Because if the root of the problem is the fact that country A is getting a free lunch, ride and housing, the solution cannot possibly be to take that from country A and give it to country E (much less so when E's Central Bank has lately shown its willingness to print whatever quantities of its currency are needed not just to prevent a recession but to prevent any bank from falling!) The only radical solution is to set up a system in which no country has an unfair advantage, which means to adopt for international trade and reserves a currency that cannot be printed by any country: gold. (Silver could be used in addition for reserve purposes only, but it is clear that changing industrial demand makes it impossible now to fix the ratio between the values of both metals.)

Back to Earth 2007, the likelihood of this radical solution being implemented in the short and medium term is very low, mainly because worldwide official adoption of gold as international currency would strongly encourage private citizens all over the world to adopt it too as store of value for their savings, in a "harder" version of the well-known dollarization phenomenon which could be called "metallization", and it is well known that a consequence of dollarization is the loss of effectiveness of monetary policy, hardly a desirable outcome for central bankers at this stage of economic thinking. Because the level of acceptance (at least domestically!) of their little printed papers as both medium of exchange and store of value holds the key to the effectiveness of Keynesian monetary policies to stimulate aggregate demand and thus foster maximum sustainable growth in output and employment [6], or, in a more cynical view, the key to the power of central bankers and to the spending possibilities of governments.

Therefore the most probable outcome is that central banks all over the world start to gradually switch part of their dollar forex reserves to currencies of countries having large current account surpluses, such as China, and particularly of those countries that are exporters of critical items like oil, natural gas and food [3], such as Gulf countries, Russia and Canada, and that these countries allow their respective currencies to appreciate against the dollar (for which they just have to stop their current intervention in the forex market, whereby they buy dollars to keep their currencies from appreciating against it, which is why they were accumulating so many dollars lately). [4] [5]

This outcome obviously implies a gradual devaluation of the dollar against those other currencies. Which in turn, to the extent that these countries adopt monetary policies conducive to price stability in their currencies, implies a gradual loss of purchasing power of the dollar against the previously mentioned internationally traded goods. That will make foreign goods (and those US goods that can be readily exported) preogressively more expensive to US citizens, which will lead to a fall in US imports (and a rise in US exports) and a consequent reduction in the US trade deficit.

As described, this looks like the right medicine for the US trade imbalance problem. And it certainly is. But, as will be seen below, it could turn out to be a very painful medicine for US citizens. The severity of the pain will depend on the speed and extent at which the dollar devaluates against the other currencies, which in turn will depend on the lack of regard of US monetary policy for the international purchasing power of the dollar. Greenspan's 2001-2003 monetary easing was painless because it began with the value of the dollar at its highest point in 15 years, though it eventually succeeded in taking it to near its historical low point by the end of 2004. Since that's more or less where it is today, it can be easily seen that going along a similar monetary policy path this time would have much more serious consequences.
This topic has been touched on by two interesting papers lately. One is from Benn Steil, the Director of International Economics at the Council on Foreign Relations, who in "Monetary Sovereignty as globalization's Achiless heel" wrote:
"The status of global money is not heaven-bestowed, and there is no way effectively to insure against the unwinding of "global imbalances" should China, with more than a trillion dollars of reserves, and other asset-rich central banks come to fear the unbearable lightness of their fiat holdings."

The other is from Paul Krugman, who in "Will there be a dollar crisis?" at
http://www.economic-policy.org/abstract.asp?vid=22&iid=51&date=16/08/2007&aid=183
wrote:

"So it seems likely that there will be a Wile E. Coyote moment when investors realize that the dollar’s value doesn’t make sense, and that value plunges. The case for believing that a dollar plunge will do great harm is much less secure. ... The United States in 2007 isn’t Argentina in 2001."

The rest of the essay will develop the ideas in the quotation from Krugman's paper, using a conceptual model model from Steil's.

4. Why exactly "the dollar’s value doesn’t make sense".

As said above, the only fair and logical conceptual framework in which to assess the relative value of national fiat currencies is one in which all of them are peers on an equal standing. Within that framework, the intrinsic value of any national fiat currency outside the issuing country arises exclusively from the possibility of using it for purchasing goods, services and property rights FROM THAT ISSUING COUNTRY in a reasonable timeframe. And it is logical that, the more essential the goods a country can export, the more valuable its currency can be.

Therefore, in a fair and logical international monetary system, for all relatively debt-free countries that are exporters of essential items such as fossil fuels and food, the following ratio should be in the same order of magnitude:

amount of currency (and debt denominated in it) circulating outside the issuing country
/
issuing country's annual exports.

Within that framework, then, the relative intrinsic value of the US dollar versus the Brazilian real and the Russian rouble comes exclusively from the possibility of using the mass of dollars outside the US for buying something from the US versus the possibility of using the mass of reals outside Brazil for buying something from Brazil and the mass of roubles outside Russia for buying something from Russia. And this is enough to tell us that today's valuation of the dollar has nothing to do with its relative intrinsic value, because, while it would take a very long time to use the enormous mass of dollars (and of dollar-denominated debt) floating outside the US to buy real things from the US at their current prices in dollars, there are simply no reals outside Brazil and no roubles outside Russia.

Therefore, the relative value of the dollar today is far higher than its intrinsic value, and it depends on economic actors worldwide accepting (outside of any fairness, logic and reason) that it is valid tender for goods, services and property rights from any country, not just the issuing one.

A couple of objections could be raised at this point. First, that the international reserve status of a currency depends on the development of the financial markets in the issuing country. This is proved otherwise by history, because in the 1950's, when the dollar reigned supreme, countries all over the world had capital controls in effect and therefore financial operators worldwide could not take advantage of US financial services. Notably, at that time the US had a hefty current account surplus, was the first world exporter, and moreover its currency was convertible to gold.

Secondly, the current lack of use of the currencies of countries with large current account surpluses and at the same time exporters of essential products might be due to the fact that those countries are in no condition to send their currency abroad because they are still heavily indebted to the world. To evaluate if that is actually the case, we calculate for each such country, using data from the CIA World Factbook, the following two ratios:

external debt (in all currencies) / exports ; external debt (in all currencies) / current account surplus
United States: 9.8 ; (deficit)
Argentina: 2.3 ; 13.5
Canada: 1.7 ; 33.3
Brazil: 1.3 ; 13.1
Russia: 0.9 ; 2.7
Venezuela: 0.5 ; 1.1
Saudi Arabia: 0.2 ; 0.5

Quite clearly this comparison shows exactly the opposite, namely that if there is one country that, due to an outsized external debt, is in no condition to send its currency abroad it is the US, precisely the very only country in the table that is doing it, and massively at that. Thefore we must conclude that - unless we expect the exports of Saudi Arabia, Venezuela, Russia, Brazil, Canada and Argentina to plunge in the near future and at the same time those of the US to surge, which is quite unlikely to say the least - the world's current monetary system accords to the US dollar a status that does not fit at all into the fair and logical framework we defined above (i.e. is unfair), is based in no objective reason (i.e. is completely arbitrary), and implies a gross overvaluation of the dollar with respect to its intrinsic value. The only plausible cause of this state of affairs is historical inertia: as said before, after WWII the US was for some years the largest oil and food exporter, did have a current account surplus, and moreover its currency was redeemable for gold. Evidently those past features, having gone away and actually reversed long ago, cannot possibly justify the continuation of the dollar's privileged status.

Now, the fact that the "generally accepted" fiat value of the dollar today is (unfairly, illogically and unreasonably) far higher than its intrinsic fiat value does not mean that US dollars as valued today are not "real" money. They definitely are, because the reality of the status of something as money exists (just as vanishes) in the minds of the people involved. I.e., what enables an entity to function as money is the social acceptance of its role as medium of exchange, store of value and unit of account. Money is a social psychological construction. It is within the minds of the members of a society (be it the world or a concentration camp) where a specific entity becomes a currency, where the main factors that prompt those members to reach such a consensus are the perceived intrinsic usefulness and scarcity of the entity (along with its durability). Thus, gold and silver were real money worldwide for many centuries, cigarettes were real money in concentration camps, and dollars as valued today are real money wordlwide.

In exactly the same way, it is within the minds of the members of a society that an entity can cease being a currency. Thus, just as central bankers worldwide agreed to demonetize silver in the 1870's, whereupon the value of silver against gold fell by 60% during the next 30 years, and just as, after being freed from the concentration camp, non-smoking former interns stopped accepting cigarettes in exchange for anything, so it is entirely plausible that in the very near future - prompted by the perception that the Fed's chosen monetary path is making the dollar less and less scarce - economic actors worldwide reach a new consensus whereby they agree to assign the dollar just its intrinsic fiat value.

Since this intrinsic value is far lower than the "generally-accepted" current value, the transition will cause significant losses to current holders of dollars (or of promises to receive dollars in the future). Thus, once the process starts, it is highly likely that a worldwide race develops to get rid of dollars and dollar-denominated debt, whereby foreign holders dump them into the US (the only place where they would still be accepted) in an attempt to get something real in exchange for them before its value falls even further. It is even likely that such a panic could temporarily drive the value of the dollar far below its fair intrinsic value (overshoot). Should the US institute capital controls to stem the tide, that could further feed the panic. (Notably, those capital controls would restrict bringing dollars into the US. In the past, capital controls instituted by other countries restricted taking dollars out of those countries.)

5. In what way "the United States in 2007 isn’t Argentina in 2001."

Surprisingly, the last statement in the above quote is literally true, but in exactly the opposite way its author meant it: the present situation of the US has far more downward potential than that of Argentina in 2001. This might be shocking for anyone familiar with the magnitude of the adjustment that Argentina underwent at that time, best illustrated by the fact that imports dropped from 20 billion USD in 2001 to 9 billion USD in 2002. Why and how could possibly the US face an even harder adjustment?

To understand why, we will use Jacques Rueff's tailor metaphor as quoted by Steil (2007), after making a couple of observations to it. In the first place, it is just not true that dollars are of no use outside the US, at least today. Because as we have said, the dollar today is regarded as valid tender for goods, services and property rights from any country. So, in order to pay for Saudi oil or Brazilian soybeans, China must have in hand and tender US dollars, not bonds or stocks. Secondly, and related to the above, to use the metaphor in a more realistic way, we need to include, along with Steil's Chinese tailor, an Arabian shoemaker.

So, here we have a customer (the US) to whom a number of providers sell real things (suits, shoes) in exchange for IOU's. (And by IOUs we mean US dollars themselves, not US bonds, because as we have said, a fiat currency abroad is intrinsically a promise to the holder that he will be able to exchange it for goods, services or property rights from the issuing country. A bond is just a promise to get more promises.) The providers have been doing that for some time and by now have piled up a huge stack of IOUs, to the point of starting to worry whether they will ever be able to exchange the IOU's for real things from the customer. And as they see that the customer is showing no sign of lowering the amount of IOU's he issues per year (and much less stopping issuing them, and even less starting paying them out!), they can be reasonably expected to take action about the situation. What kind of action? Basically, stop selling anything to the customer until they have cashed out (exchanged for real things from the customer) at least a large part of their stacks of IOUs. Which in the real world is particularly important for the shoemaker because the product it sells (oil) comes from a finite, absolutely exhaustible endowment.

And this makes the first difference between the US in 2007 and Argentina in 2001. Even if some of the products the US sells to the world are absolutely essential (e.g. grains), there are enough dollars (and dollar-denominated debt) outside the US to pay for those products for an extremely long time. So the world can buy those products from the US without the need to sell anything to the US for that time. In contrast, there were no Argentinian pesos circulating outside Argentina in 2001 or anytime. Therefore, if someone wanted to buy Argentinian soybean or wheat, they had to tender the international means of payment (US dollars) for that. Argentina repudiated their debt, not their currency.

The second difference lies in the respective quality of imports. In 2001 Argentina was an exporter of not only food, but also of oil and natural gas. So the drop in imports did not involve anything essential for running their infrastructure. In contrast, today the US imports 59 % of their consumption of crude oil and petroleum products. The disruption its stopping could cause is mind-boggling.

Now as to how this could happen, to apply Rueff's metaphor to today's world we have to take into account that the tailor and the shoemaker have been using the IOU's of their customer for trading between themselves for some time. So, if they decide to get rid of their stacks of IOUs, they must agree on another means of exchange. Which brings us to a very important point: we said above that a fair international monetary system would be one in which, for all relatively debt-free countries that are exporters of essential items, the ratios of (the amount of currency circulating outside the issuing country / the issuing country's annual exports) was in the same order of magnitude. It follows then that in a fair international monetary system there would be Canadian dollars circulating outside Canada, Brazilian reals circulating outside Brazil, Russian roubles circulating outside Russia, etc. etc. In other words, in a fair international monetary system all those currencies would be international trade and reserve currencies. How could that possibly be?

Just by means of assertiveness. Of Russia one day telling the European and Chinese: "Look, starting a year from now, you will have to pay for our oil and gas in roubles. You don't have roubles? Good, you have a year left to sell us cars, electronics, and other niceties in exchange for roubles. You don't like it? Good. Try living without our oil and gas for a couple of years then. We can perfectly live without your goods for that time."

The perceived remoteness of this development was felt by the essay's author as the weakest point of the essay until
this Reuters news item appeared on October 12:

Fund sees move away from dollar-based commodities

LONDON (Reuters) - Resource-rich countries will move away from the dollar as a base for the commodities they produce to protect their earnings as the dollar's slide accelerates, UK-based Emergent Asset Management told Reuters.

The debate about commodity denomination has heated up over the past few months because the dollar has come under persistent selling pressure as markets started to price in economic slowdown and falling interest rates in the United States.

David Murrin, chief investment officer at Emergent thinks the chances of a re-denomination are high, but that it could take some time.

"I can see countries like Russia trying to price commodities in some other currency, possibly roubles," he said. "Keep your eyes open for when and how rebasing starts to creep in."

6. The two paths to rebalancing.

The bottom line is that the US current account WILL eventually be balanced, but, depending on the US Federal Reserve's chosen monetary path, it will happen in either of two ways, which could be envisaged as follows:

A) The Fed follows a tight monetary policy focused on food and energy inflation and the US government adopts a sound fiscal policy, sharply curtailing its military spending and starting an orderly retreat of the troops in Iraq and Afghanistan. The housing market implodes and unemployment rises. Most "structured investment vehicles" and "conduits" fall as banks cut their credit lines to them, honoring their status as "off-balance sheet" entities. The illegal immigration problem solves by itself as millions of former construction workers return to their home countries. The recession causes a substantial drop in non-essential imports (mainly from China) and in the trade deficit. The dollar manages to remain one of the main world trade and reserve currencies.

B) The Fed relaxes its monetary policy as necessary to try to avoid a US recession. Countries with current-account surpluses allow their currencies to appreciate against the dollar - first their central banks stop buying dollars and then, as the dollar loses more and more value, they start dumping them. There is a race to get rid of the dollar whereby its value plummets against those currencies (Paul Krugman's "Wile E. Coyote moment"). Producers of oil and other commodities start pricing them in their own currencies, and consequently their prices shoot up in dollars. As a result, both imported goods (including oil) and US-produced goods that can readily be exported (including grains and most food items) become much more expensive to US consumers, who have to sharply cut their consumption thereof. All imports drop sharply and the trade deficit switches to surplus. Subsidies to farm products are terminated, and there might even be taxes and quotas imposed on agricultural exports to try to moderate the rise in their domestic prices.

The unwillingness of foreigners to buy further dollar-denominated debt causes a surge in long-term rates and renders the cost of funding from the open market prohibitive. As a result, the Fed becomes the buyer of last resort for all new issues of US government debt. The massive inflation arising from debt monetization reduces the real burden of both public and private US debts, but feeds a further abandonment of the dollar as international reserve currency and a further plunge in its value. Developing countries indebted in dollars party big time.

In reprisal to oil exporters not accepting dollars and demanding to be paid in their own currencies, the US mandates that US food exports cannot be paid in dollars and can only occur within a "food for oil" framework, whereby a country will be able to buy US food only for the value of the oil and natural gas it has sold to the US during the previous year. Such a de facto repudiation of the dollar puts the last nail on the coffin of its international status. Canada, not needing US food, cuts all exports of oil and natural gas to the US. Out of oil and natural gas scarcity, electricity prices skyrocket. Cities heavily relying on air conditioning and far-fetched supplies like Las Vegas become forsaken. As the rise in gasoline prices makes commuting progressively more expensive, the price of suburban houses falls and their construction stops altogether.

Unable to procure supplies for its network of military bases around the world, the US decides to dismantle it (the network, i.e.) The withdrawal of US troops from Iraq and Afghanistan starts as gradual but turns into a rush out of popular pressure after the TV shows images of soldiers lacking all kinds of supplies. In the US, food and fuel price rises trigger a wave of riots and looting. Martial law is enacted and troops just arrived from abroad are posted to gasoline stations and supermarkets to keep order.

Peak Oilers must have immediately noticed that scenario B looks exactly like the doomerish kind of scenarios forecasted for after PO. And that is because scenario B is "Peak Oil now" for the US only, not because of the peaking and subsequent decline of world oil production, but because of the peaking and hard decline of the US' purchasing power for oil (and everything else), brought about by the loss of value and rejection of its currency.

If the US wants to avoid scenario B and retain at least part of its monetary most advantageous position, it needs to do some serious shock and awe. Not of military power, but of monetary and fiscal soundness. In the words of an earlier version of Steil's paper: "This is the only sure way to keep the United States' foreign tailors, with their massive and growing holdings of dollar debt, feeling wealthy and secure. It is the market that made the dollar into global money -- and what the market giveth, the market can taketh away."

And since, as said before, the key factor that prompts the members of a society (which may be the world) to regard an entity desirable as a currency is its perceived scarcity, it follows that the required monetary policy to avoid scenario B consists simply of making the dollar more scarce, by targeting (at least indirectly) money supply growth. Specifically M3 because dollars abroad are not in M2. (And it would help if the Fed restarted publishing M3, to send a signal that they are targeting the real thing and not a possibly fake perception of it.) Which is wholly in line with the words of Professor Bernanke in his famous 2002 speech:

"Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services."

Obviously such monetary discipline entails a price: if the Fed sticks to a direct or indirect money supply growth target, it must be willing to refuse to print dollars whoever asks for them. Which includes be willing to:

a. let banks fall if they have a run
b. let the government default if it cannot roll over its debt
c. let foreclosures rise and the housing market implode as more ARMs reset their rates.

Comments on each of these:

a. Most banks will not fall if they just cut their credit lines to "structured investment vehicles" and "conduits", honoring their status as "off-balance sheet" entities. (SIVs and conduits would fall, of course.)

b. The US government can prevent this through a fiscal shock, raising taxes while cutting spending. The obvious candidates are reversing the Bush cuts, instituting a gasoline tax, and withdrawing from Iraq, etc. A long-term solvency shock is also needed, basically ending the entitlement illusion.

c. As said above, that could contribute to solve the illegal immigration problem. Additionally, from a Hubbert's Peak-aware perspective, it is clear that further suburban and exurban construction whereby even more people become dependent on long commutes for everything (and further arable land is lost) is a real tragedy that must be stopped for its own reasons.

7. How Hubbert's Peak fits into this picture.

The above analysis has intentionally ignored the issue of Hubbert's Peak, and as such is valid irrespective of how many years away the world's economy is from bumping against one of the toughest physical "limits to growth". The fact that, according to current data from both the IEA (OECD) and EIA (US), the world is doing that right now [7], reinforces the argument in this paper in two ways.
In the first place, it strengthens the case for oil and natural gas exporting countries to stop exchanging their ever more precious, finite, absolutely exaustible resources for paper which they will never be able to exchange for anything as valuable.

Secondly, since oil supply will not grow, oil demand cannot either. And there are basically two mechanisms whereby that can happen:
1. endogenously, by way of recession, or
2. exogenously, by way of high enough oil prices.

These mechanisms are not mutually exclusive, in that in any particular situation both could be playing with different relative weights. But before proceeding with the analysis, we must take into account a couple of additional facts.

First, according to the IEA July 2007 report, "direct" US oil demand for 2007 averages 21 Mbpd, which is 24% of world total oil demand of 86 Mbpd.

Secondly, the huge trade surplus of China with the US means that an important part of the Chinese consumption of oil and its products, as both energy source and feedstock, ends up "embedded" in goods subsequently shipped to the US, making up which can be called "indirect" US oil demand since there are no matching products being sent back from the US to China (hence the trade surplus). While we single out China because of its weight in world oil demand and its outsized trade surplus with the US, an identical consideration can be applied to other non-oil-exporting countries having significant trade surpluses with the US, such as Japan. Which means that the total share ("direct" + "indirect") of world oil consumption arising from US aggregate economic demand is significantly higher than 24%. (Trying to quantify the "indirect" demand from the ratio of US trade deficit to US GDP would severely underestimate it because a significant part of US GDP consists of services which are very low energy-intensive.)

From these two facts it is clear that the US economy holds the key for the convergence of (until now) growing world oil demand with stagnant world oil supply. Basically, the total ("direct" + "indirect") US oil consumption must go down. Which can happen as a result of each of the two mechanisms mentioned above (or of any mix thereof), where each mechanism corresponds respectively to each of the scenarios described above. The peculiarity of scenario B is that the drop in US oil consumption would take place even if world oil production were still far from its peak.

Notes:

[1] The fact that those countries actually exchanged a large part of their reserves of country A's currency for bonds (= promises to get even more of that currency in the future) is irrelevant in this analysis. What matters is that they were trading real things for printed paper. It does not matter that subsequently part of that printed paper was exchanged for promises to get even more printed paper in the future.

[2] Beyond "hedonically adjusted" official US CPI statistics, this can be verified by The Economist's Big Mac index for the US. In April 2001 it stood at $2.54 while in July 2007 it was $3.41. That implies an effective annual inflation rate of 5% over the 6 years.

[3] The US is in fact an important producer and exporter of food and other critical items such as aircraft and large data processing systems. The problem is that the amount of dollars already outside the US is orders of magnitude larger than what the world would need for decades for buying these items from the US at their current prices.

[4] It is possible that, even in this case, private citizens will increasingly turn to precious metals to park their savings and even as medium of exchange for transactions involving very expensive items. Such possibility was suggested in the quoted 2007 papers from Steil.

[5] As this case, later called "scenario B", can develop into extremely painful conditions for the US, it is conceivable that the US themselves could eventually push for the adoption of gold as international currency, because of two reasons. In the first place, they would start from an initial advantageous position, provided the US actually holds the gold reserves they officially claim to have (a point disputed by many gold bugs). Secondly, when one can no longer have advantage in a game (as the dollar has today), it is preferable to play in a level field than in one in which other players have advantage.

Notes specifically related to Hubbert's Peak:

[6] Economic growth based on increasing rates of consumption of absolutely exhaustible resources like fossil fuels is not sustainable in the long run. Therefore fostering such growth was (and is) most unwise, and even tragic when such growth brings society into a state of ever greater dependency on those resources for its basic functioning. It is probable that economists will realize this only well after Hubbert's Peak has become evident to most. Then they will see that Keynesian monetary policies intended to stimulate aggregate demand are no longer of any benefit (if they ever were). Because it will be obvious that the by then negative growth rates in economic output are not the consequence of insufficient demand but of physical constraints imposed by Nature, and that stimulating aggregate demand with monetary policy is no longer able to increase output at all.

[7] In the IEA June 2007 monthly report, the message was encoded as: "The evolving 2007 global oil balance presents a more immediate challenge. The stark conclusion from our supply/demand balance is that the call on OPEC crude and stock change rises by 2.5 mb/d from its 2Q low to the 4Q07 high point. In contrast, without substantial recovery in Nigerian production capability by the end of the year, OPEC net crude capacity gains amount to only some 700 kb/d."

On the other hand, EIA statistics show that:
- the peak production rate of both (Crude oil + lease condensate) and (Crude oil + Natural Gas Liquids) was in May 2005, and
- the average production rate for both aggregates, as well as for "all liquids" (which includes biofuels), is down in 1H07 when compared to 1H06.