2008: Pause

Time, once again, to engage in my annual predictions and prognostication. This year The Economist has unofficially endorsed my brand of futurology--relatively short term and thematically focused. But first, as usual, a review of how my 2007 predictions panned out:

I didn't get Iraq right--I predicted that the draw-down would begin, whereas in reality there was a "surge." I guess I'm still able to underestimate the incompetence of the Democratic Party. Mental note not to make that mistake again. I won't discuss my thoughts on the surge (e.g. the arming of the Sunni tribes for the future clash with the Shi'a establishment over oil revenues after the inevitable US withdrawal) now, but suffice to say I didn't get it right in '07. For what it's worth, I did get the "no war" call on Iran right.

I'll give myself kudos, however, for nailing the oil prediction. I said that oil would break 90 and flirt with 100, and that "peak oil" would officially break into the mainstream media. Right on all counts, not that I claim any kind of secret formula--it was just an "educated" guess based on what I see as obvious trends. The only area you could quibble was with my prediction that Russian oil production would fall--that isn't entirely clear.

I generally missed the credit crunch and was mildly wrong on housing woes and the Euro. And I overstated the problems facing Mexico--while there were some worrying pipeline attacks, the economy didn't "collapse" as I had predicted. So my 2007 predictions were poor with the notable exception of oil prices. Will this result in an overly cautious outlook for 2008? Yes and no. Yes in the sense that, considering that I fundamentally agree with the long term predictions of the "end is nigh" crowd, I think 2008 will fail to meet their expectations by far (hopes?). No in the sense that, given my fundamental agreement with "them" on the long term direction of our planet, I'm firmly bucking the trend of expecting immediate economic collapse followed by mass starvation by calling for the appearance of normalcy. Emphasis on appearance.

So what will 2008 hold? Let me consult my crystal ball...

Oil Prices: we'll break $100 firmly at some point, but won't hit any sky-high territory in '08 (that looks to be in '09, but now I'm breaking The Economists' rule of only predicting one year out). I think that we'll essentially plateau in production--maybe a small fall or small gain globally--and that increased demand in India and China will be met with efficiency efforts that clear off the low hanging fruit. Basically, I think we'll set ourselves up for a fall by doing the easy efficiency measures (but none of the tough and ultimately necessary ones) and pat ourselves roundly on the backs as production doesn't drop off a cliff and prices don't spike. This, of course, leaves only the hard and slow-to-pay-off efficiency measures remaining just in time for significant global production spikes and "export land" effects to really bring trouble in '09.

Iran & Iraq: slow news year. No troop draw-down of any significance (though possibly something symbolic in August-September time frame to give the appearance of "victory"). No war with Iran. No uptick in violence--in fact, the surge will continue "working" (as long as you define working as laying the groundwork for future bloody civil war).

The most significant story of the year: the economy won't crash. What the hell, I'll go out on a limb--we won't even have a "recession" as officially defined. On an earnest note, there is a lot more resiliency in the American and Global economies than is often accounted for, and there are many "low hanging fruit" measures to stave off the energy and credit wolves for another year. And if those real measures are too politically difficult, there is plenty of appetite for the fiction that the economy is resilient and recovering, as well as people in power who will benefit from the appearance of normalcy through the '08 elections. I'm not talking about Bilderberger/Bavarian Illuminati fairy dust, but rather simple and obvious things that can be done by the current Bush administration to ensure that it doesn't appear that a Republican administration is bad for the economy. So this time next year we'll still be listening with rapt attention to news reports tallying the Christmas shopping season and the resiliency of the American consumer. Unlike oil prices, I don't see this economic stability as a temporary reprieve before we go off the cliff. I think that media and public perception of our economy, as well as our actual economy itself, is already a matter of fiction and wizardry. This wizardry can continue, unabated, for quite some time. I agree with Ran Prieur's version of the "slow crash." That is, we're already crashing. This is what collapse looks like. The middle class gradually shrinks, the value of our pensions and investments gradually declines, things get gradually less affordable--and if it is executed properly this all happens just below the rate at which it reaches the public consciousness. A really sharp cliff in oil production could change this, but I think if we do our realistic best at mitigation efforts in energy use, this, too, will keep just under the "crisis radar." Diesel prices equivalent to $300/barrel oil haven't stemmed the commuting or truck transport industry in Europe, so I don't see why $300/barrel oil by 2010 or 2012 won't be anything more than another contributor to the slow crash. We are evolutionarily adapted to recognize and respond to surprise, short-duration crises, but we aren't evolved to be very good at even recognizing the slow, gradual ones that are visible at a distance.

One more thing--Rudy will win the 2008 presidential election. Why did I pick him? He's the worst possible result that I can think of, so it seems a nice balancing point the the appearance of optimism elsewhere in this post. Besides, none of the candidates will address the fundamental causes of the slow crash, so does it really matter in the long term? IF there was a candidate who could maximize our mitigation efforts, and IF there was a candidate who could slow the slow crash as much as possible, it still only seems that the result would be to push off the matter of dealing with the slow crash on later generations. My ultimate prediction is that we will never deal with our fundamental problems en mass, but rather will let them deal with us.

Observations on a Germany Road Trip

Just back from a trip to Germany, so here are a few observations in the areas of energy, environment, and society. These thoughts compare Germany with America, as well as Germany with itself--at least from the perspective of an American who has visited on average one or two weeks a year for the past 30 years, sometimes as a tourist, sometimes as a student, sometimes spending Summers with my Grandparents in Berlin when I was younger (which probably distorts my view with a fair amount of fantasy).

Over the last two weeks, we drove about 1600 kilometers through Bavaria, in southern Germany. While most of Europe, and Germany in particular, is known for its efficient and high-speed rail service, there was no shortage of trucks on the road. Even with diesel fuel at $7.25/gallon, the freeways were completely jammed with trucks--much more so than America, and much more so than the Germany that I remember on previous road trips since reunification (significant because it made the German highway system a transit point, rather than lying on an edge of Western Europe). The trucks were an even mix of long haul--delivering goods from Romania and Poland through Germany to Netherlands, France, etc., and domestic freight shipment. I guess this surprised me to some degree--I expected the combination of high diesel prices (prices have always been "high" in Europe, but they're much higher now than they were several years ago there just like in America), excellent rail alternatives, and a greater "green" consciousness to lead to the opposite result. Not so.

Other than trucks, there was also no shortage of personal cars on the roads. That isn't particularly interesting, but it is always interesting to see the various "high-mile-per-gallon" cars available in Europe that just aren't sold in the US. VW's Lupo CDI (a smaller version of a VW Golf, mostly) gets 70 miles to the gallon. There are lots of similar high mileage cars available--and they are widely driven. Mercedes makes one (the "A" series), BMW makes one (the "1") series, as does VW, Peugeot, Renault, Citroen, Fiat, etc. Maybe the Mercedes A series is for sale in the US, but I don't think any of the rest are. I think part of the reason is that, in the US, brands don't like to occupy the full spectrum from super-economy to super-luxury, so companies like BMW, Mercedes, and increasingly VW don't want to even offer the super-economy models in the US. Whatever it is, it seemed clear to me that there is no excuse for not having high MPG cars available for sale in the US. On the flip side of this issue, while there are virtually no SUVs on the roads in Europe (you do see some Land Rovers), the number of "cross-overs" seems to have increased dramatically--cars like the BMW X5. Also, there are at least as many high-end (e.g. non very fuel efficient) Mercedes, BMW 7-series, etc. on the road in Europe as there are SUVs in the US. It seems that Europeans just get by with their 7-Series station wagon (which doesn't seem to carry any negative connotations) instead of an Escalade. I guess not having 5 kids helps there--I saw quite a few two child couples, but by far more one child couples and virtually no 3+ child families. Good in one sense, but doom for their ponzi-scheme pension plans.

Another area that I felt my observations bucked the accepted wisdom was in the area of suburban development. There are no (or very little) US-style, suburban mass developments in Germany, but I think that is for lack of huge parcels of undeveloped land. Instead, their development seems to be gradually spreading out along the roadways. Increasingly, Germans shop at "einkaufzentrums" (shopping centers) that are outside town and require a car to get to. Increasingly they work in industrial parks or office centers that are also outside town--more and more, it seems that the stereotypical walking to the store and work is challenging in Germany. It's still certainly more feasible than in the US (by far for most people), but it is getting harder, and even with the rising price of oil, people don't seem to be valuing this in their living/working/shopping choices. While TOD (transit-oriented development) is all the rage (well, somewhat the rage) in US cities today, it seems to be fading in Germany. I even (*Gasp*) saw a huge, faux-Bavarian (this was in Bavaria) "outlet mall" complex (yes, called "outlet mall") along the A7 autobahn nearly Wurtzburg. I'm sure there are many reasons for this, and my observations may be an unrepresentative sampling, but I can't help but wonder if the general European policy of using high fuel taxes as a buffer on price volatility isn't exacerbating this effect to some degree?

Overall, I felt that while it was clear that Germany is currently much more energy efficient than the US, the trend seems to be moving towards greater efficiency in the US much more aggressively than in Germany--in fact, it was my impression that Germany is moving away from efficiency in all areas other than installed solar, though this is certainly only a rough impression and in no way an exhaustive (or even objective) survey. More than anything else, this seemed to be true in the area of built-environment. Current US energy inefficiency is largely the result in our massive sunk capital expenditure in suburbia and an auto-oriented lifestyle. But, we seem to be moving away from this slowly, or at least making some efforts to moderate it. Germany seemed to be putting most of their current capital flow into investments that will calcify an increasingly energy INefficient economy. I have a sneaking suspicion that I've got this all wrong, as it runs so counter to conventional wisdom, but it was my distinct impression...

On a positive note, I saw more new solar installations in Bavaria than I've ever seen in my life. I saw several large Photovoltaic farms near Landsberg--several acres of PV panels each. There must be some serious tax credits for PV, because every little village has many--maybe one in four or one in five houses--with large PV setups (several KW installed) or solar hot water setups. Lots of barns have huge (as in 20-50 installed Kilowatts) panel arrays on them. I think that the last time I drove through Bavaria was 2002, and this certainly struck me as an entirely new development in those past 5 years. There were also many massive wind turbines randomly scattering the countryside, but I remember those clearly from previous visits so wasn't really struck by the change.

The only other observation that I think I'll throw in (only half tongue-in-cheek) is my ongoing conspiracy theory that Germans (and Europeans in general) secretly sit at home behind drawn curtains drinking several bottles of water and eating green vegetables every day, such that they can maintain the public appearance of minimal fluid intake and a diet consisting entirely of refined carbohydrates (and potatoes), meat, and alcohol. Hmmmm...

Narrative Fallacy

CNN reports that oil surges nearly $3 as Thanksgiving weekend is expected to spur demand.

Is CNN suggesting that oil traders woke up this morning and said "Hey, look at this on the calendar--Thanksgiving! People might drive, and stuff, to, like, go places to eat Turkey. I totally didn't expect this major driving holiday to just pop up out of nowhere!"

This is a great example of the Narrative Fallacy--after the fact, it seems easy to explain why something happened. Before the fact it isn't quite so easy. I could have told you yesterday that people may drive places for Thanksgiving--I could have even told you when Thanksgiving would appear on the calendar--but I didn't have CNN's crystal ball to realize that this would be the reason oil is up today.

I wasn't around at the time, but I'm told that in 1938 people thought Neville Chamberlain was doing a fine job--it wasn't until 1945 that it was obvious to those same people that they knew all along that he had royally screwed up.

Peak Oil For Our Time!

On Odalisques and Obelisks (e.g. Bartiromo & Yergin)

Alternate Title: It’s the Demand Inelasticity, Stupid.

Oil prices again. Tapis (Malaysian Crude) just broke $100 a barrel and West Texas Intermediate breached $98 briefly in after hours trading. I can already hear tomorrow’s cries from the pundits and purveyors of financial “news” that the fundamentals don’t support these prices.

Huh?

Let me back up and explain what’s happening here. We have a generation of financiers who were trained in a very specific methodology to analyze stocks. They are now applying that reality tunnel of how stocks behave to deliverable commodities, and in the process are making a huge error. This error culminates in their thinking that speculators and geopolitical threats are artificially inflating the price of oil beyond what the “fundamentals” support as if that’s possible. Here’s the problem: oil futures are deliverable. Every owner of a future contract on the NYMEX can hold that contract to expiration and actually take delivery of 1000 barrels of oil at Cushing, Oklahoma. Admittedly, most contracts will be settled for cash and won’t result in actual delivery, but their value can’t depart from the actual value of delivered crude because, if it did, one party would simply take delivery and collect the difference. So there you have it: the price of oil, as a deliverable commodity, isn’t subject to a speculative bubble like stocks are. The price of oil will always equal that which the end consumers of oil will pay for oil-derived products. If speculators bid the price of a futures contract to $100 when end consumers are only willing to pay, on average, $50 equivalent per barrel for oil-derived consumables, one of two things happens: consumption declines (this is called demand destruction); or someone is taking a bath to the tune of hundreds of billions of dollars settling his expiring contracts because no one is willing to pay $100 at delivery. Neither is happening. Why? Because we are willing to pay $3.00 a gallon for gasoline without reducing our consumption.

It’s like the house near me that has a big “For Sale” sign with a banner saying “Priced Below Market!” No, actually the definition of price is the value at which a buyer and seller come together to affect a transaction—that’s the “market” price. Similarly, the fundamentals support $100 oil because society is happily filling their gas tanks at that price. The issue isn’t geopolitics or speculation, it’s pure inelasticity of demand. Speculator’s can’t drive prices up on a deliverable commodity without highly inelastic demand. Geopolitics can’t create a “threat premium” without highly inelastic demand (setting aside for the moment the issue that we wouldn’t be trying to get oil from Iraq or Nigeria at all if there was plenty of geologically “easy” oil to find elsewhere—e.g. we’re at Peak Oil). So the pertinent question isn’t “what price do the fundamentals support?” because the answer to that is the easy: the market price. The pertinent question IS this: what does the demand inelasticity curve look like going forward? Will we cut back on our consumption at $4 gasoline? $5? They’re already paying close to $10 in parts of Europe. How high will oil have to get before you sell your suburban home to move to a location closer to jobs? Oh, right, you can’t sell your home right now—at least not for as much as your interest only mortgage pay off. How high will oil have to get before you *gasp* car pool? That’s downright un-American, so I’m told. Personally, all things accounted for, gasoline would have to cost $20 a gallon before it would be a financial break-even to use the light rail station (right by my house) to get to work (at the cost of an extra half-hour each way, assuming that I can bill 50% of my time on light rail and 0% of my time driving) than to drive. That doesn’t bode well for demand destruction. We, as a nation, have calcified our demand for oil through our massive, and largely not unloadable (due to refinanced mortgages at or above the actual present values of our homes) commitment to suburbia. We won’t significantly curtail our driving until it is so costly to continue driving that it is worth losing our perceived life “savings” and either sell our house at a fire sale or declare bankruptcy to get out from under our mortgage obligations (assuming this remains possible for much longer). Christ, I’m sounding like James Howard Kunstler today. Then again, doom and gloom is only a bad thing when it’s wrong.

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

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

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

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

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

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

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

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

2015 Futures

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

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

Thoughts on Oil

Oil hits $86.

I was discussing the reasoning behind invading Iraq with a friend. I suggested that there seems to have been a mix of reasons, but that preserving the petrodollar system and some naive notions that there actually was a terrorist threat from Iraq that we would somehow neutralize by removing the government of Iraq from power were probably two core reasons. He suggested that lots of the pressure came from the oil companies. This is really a no brainer, but I thought his rationale was interesting, and certainly not the standard oil-rothschild-skull and bones-conspiracy stuff. He pointed out that, for the second half of the 20th Century, the western oil majors had a simple business model: discover reserves and produce them. With the onset of the peak oil plateau, this model became invalid. The western oil majors were only discovering a fraction of their own production, and were increasingly forced into mythical write-ups of their reserves to maintain the validity of this business model. A new business model was possible, but it would require a geopolitical smokescreen to disguise the geological peaking of oil production. This new business model: increase the value of existing reserves faster than you produce those reserves, allowing the value of your company to continue to grow despite production out pacing discovery. Interesting thought--along the lines of intentional instability. I still think that oil companies are a terrible investment as it seems likely that their costs will continue to rise and that demand destruction will eventually invalidate this new model. But interesting, none the less...

Another thing driving up oil prices today: geopolitical tensions between the Kurds and Turkey. The bottom line is this: will the PKK attack the Baku-Tbilisi-Ceyhan pipeline? I've been arguing for some time now that targeting of energy infrastructure is the way of the future in asymmetrical conflicts. This seems to be playing out in Mexico, and the Kurds are certainly aware of its effectiveness as it is the attack of choice in Iraq. That said, the BTC pipeline doesn't pass through much ethnically Kurdish territory (it seems to clip the corner of Turkey's Kurdish region just southwest of Erzurum (Map 1 showing pipeline, Map 2 showing Kurdish region). Not that it would be that difficult for the PKK to attack this long and largely undefended pipeline outside of their home region, but it makes it arguably "less easy."

Also, take a look at this excellent article at The Oil Drum on the peaking of various minerals...

The Iranian Gambit Opening

Chess analogies are overdone, but chess is a good way to explain the narrative fallacy--the tendency of humans to be able to explain things in hindsight much better than understand them as they unfold. So I'll explain in hindsight how two current events led to our bombing Iran:

Trying to invade and hold Iran is a fool's errand. OK, so was bombing Iran, but it seems that the we didn't understand that at the time. Rather, we opted for a strategy of bombing key sites, and holding and occupying a few other key areas (Khuzestan, Bandar-e-Abbas, etc.), without attempting to occupy the entire country. In order to do that, we needed to address a force problem: all of our ground forces were tied up on the ground in Iraq. Specifically, the US Marines, the force most capable of larger expeditionary actions, was spread thin in a counter insurgency and peacekeeping role. We needed to make a significant chunk of Marine Corps manpower available for use against Iran. The problem was that the American people (before that rather effective PR blitz and those statements by Hillary) were quite opposed to attacking Iran. We couldn't just pull back an entire expeditionary force into a staging area in some Gulf Emirate airbase without raising several red flags. And anything originating out of the Vice President's office would look suspect, as well. BUT, if we got the Commandant of the Marine Corps to say that the Marines are meant to operate in an expeditionary role, and that they should leave Iraq and go to Afghanistan, that would have exactly the same effect, but seem quite legitimate. Suddenly, the Marines would be nicely staged for aerial redeployment within theater when they would be unexpectedly re-tasked (from their trans-shipment point conveniently near Bandar-e-Abbas) before they were actually spread thin on the ground in Afghanistan. It's easy to explain these kind of set-up moves on the chess board eight moves later, but understanding how today's move is intended to set up an attack eight moves down the road is much more difficult.

Of course, we needed more than just ready-to-deploy Marines. There was that sticky issue of American public opinion that was, at the time, against attacking Iran. Discussions of their nuclear ambitions were too speculative after the WMD debacle, we needed something more tangible. We had been issuing press releases to everyone who would listen that Iran was supplying the weaponry used by Shi'a insurgents against our forces in Iraq for months, but it really hadn't galvanized American behind attacking Iran. However, sometimes your enemy is your friend. The insurgency in Iraq had been operating under a model of open-source innovation for quite some time. They had tried many indirect fire attacks against US bases with mortars and rockets, and on occasion had minor success. It was natural to expect them to learn and improve over time. But this time, their tactical improvements (combined with a re-entry of certain Shi'a militias into a more active role) allowed us to point the finger at Iran. Beginning with the relatively minor but accurate attack on Camp Victory that killed 2 and injured 40, and escalating into the string of more deadly attacks that followed, we were able to spin this increase in accuracy to point the finger not at the expected improvements of an open-source enemy, but as a result of training and improved guidance systems and munitions provided directly by Iran. It was surprising, even to the most cynical among us, how quickly the American people rallied around the flag.

The rest, as the saying goes, is history...

Future Planning: Hedging the Solution Space

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

______________________________

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

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

Oil/Dollar/Dow solution space:

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

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

Example:

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

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

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

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

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

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

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

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

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

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

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

Visions of a Biofuel Future

Indentured servitude, a workforce confined to the borders of the plantation by armed guards, being "paid" by being allowed to live in unlit huts and drink water from the pig trough. Violations punished by summary execution and burial in an unmarked pit.

This sounds like a historical account of life on a colonial plantation of the 18th century, but is actually the description of the sugar industry, today, in the Dominican Republic. The new film "The Price of Sugar," about the abuses of Hatian migrant workers on a Dominican sugar plantation, tells the story of a Catholic priest trying to organize the workers. (IMDB, NPR story)

Of course, the larger issue here is that biofuel production is dependent on exactly this industry. As long as biofuels are an over-subsidized boondoggle, then industrially raised corn is fine. Well paid farmers driving their John Deere tractors don't present a human rights problem. But as EROEIs decline and we increasingly turn to human labor for biofuels, classical plantation problems will likely resurface in force.

It may be quite some time before Americans are enslaved in the production of fuel for other Americans' cars, but are we so racist/nationalist/blind to accept the enslavement of others to these ends?

Why Oil Will Hit $100/Barrel

Following the recent slide in oil prices, CNN is already jumping on the bandwagon with their story "Why oil won't hit $100." From the article:

"If this market can continue going lower without OPEC disrupting it, it's very possible that by 2010 we could be substantially lower than anyone is imagining," said Peter Beutel, an oil analyst at the consultancy Cameron Hanover. "Four to 8 years from now, we could come down and break $20 a barrel."

Beutel bases his prediction on the fact that oil is historically a cyclical commodity. In the early 1980s it hit $38 a barrel, far higher than today's price when adjusted for inflation, only to fall to $10 a barrel by the late 1990s.

. . .

EIA says by 2010 the amount of oil OPEC can pump should increase by 2 million barrels per day, largely driven by Saudi Arabia. The EIA, like most analysts, does not agree with the view that production has peaked or will soon peak in Saudi Arabia, although a small but growing number of experts say it might.

EIA says more oil from Central Asia and the Gulf of Mexico should offset production declines in the North Sea and and Mexico.

And co-called "non-traditional" fuels, such as oil sands from Canada and corn-based ethanol, are expected to double, going from the current 3 million barrels a day to 6 million barrels a day by 2010.

While demand is expected to continue growing, EIA says conservation measures should slow the rate of growth to 1.3 percent a year from 2 percent.

Let's just ASSUME that all of those assumptions are correct--which, by the way, I strongly question. A quick math exercise: 86 mbpd * (0.013 ^ 3) = 89.4 mbpd in 2010 based on 1.3% increase in demand each year. That's 3.4 mbpd that that needs to appear over the next three years. Where will it come from? The article calls for 3 mbpd to come from increases in "non-traditional" fuels like ethanol and oil sands. The article also expects a 2mbpd increase from OPEC, mostly from Saudi Arabia. IF both of those come true, then there should be 1.6 mbpd more spare capacity than exists today. IF either one of those fails (for example, if Saudi Arabian production has actually peaked), then there will be LESS spare capacity than today.

My opinion is that neither of those projections for new production will pan out. Analysis of Saudi Arabia suggests that they have already peaked, and if anything OPEC production will decrease over the next three years. While it does seem likely that ethanol production will increase--driven by politics and subsidy--when one accounts for the energy needed to produce that ethanol the increase may be meaningless.

There does seem to be good reason for the recent 7% drawback in oil prices. Technical analysis suggests that there will be strong resistance at the prior record level, and this is exactly what happened. The problem with using technical analysis to justify a prediction of the future is that NO ONE understands why, or even IF, technical indicators have meaning--best guess is some combination of group psychology among traders, a kind of self-licking ice cream cone. An economic slowdown--quite likely, in my opinion, in light of the current debt issues--could certainly curb the increase in demand for oil. However, it is my opinion that it would take a major recession to fundamentally change our driving habits, and it is by no means clear that such problems are in the cards in the very near future. In the interim, any savings from energy efficiency will likely be negated by Jevons' Paradox.

So do I think that oil will break $100? Certainly--the only question is whether that happens this year or four years from now, and assumes that we aren't using 2007 dollars to calculate that record. In the absence of a catastrophic economic collapse (which regular readers will know is something that I see as likely in the medium-term), oil prices will keep going up. They will keep oscillating around a steadily increasing supply-demand equilibrium, with a spread of perhaps $20 up or down. So we may hit $55 before we hit $100. But $100 is far, far more likely than $20.

Losing Our Balance?

Interesting times, indeed. Oil (WTI) closed within one penny of the all-time record closing price of $77.03 last Friday. The markets seem shaken, and suddenly people are realizing that the recent explosion of derivatives may have created as much hidden rigidity as resiliency in our financial markets (as I wrote about here).

Mexico continues to reveal how deep its problems run. After my article on Mexico Collapse sparked quite a conversation on this topic, the meme of Mexico collapse spread quickly (though I don't take credit for that--the situation speaks for itself). One little gem was PEMEX's announcement late Friday that they will probably be out of oil in seven years--out of oil, not just beginning to decline. Notice how this came out on Friday afternoon. This is when you issue a press release when you want to bury a story.

And electricity seems to be a growing problem, at least in the third world (and those areas that the US military has transformed into the same). It is interesting to note that Jay Hanson (of dieoff.org notoriety) has always predicted that it would be electricity, not oil, that would be the actual cause of collapse. This seems quite plausible to me, though I still think that it will be fundamentally driven by declining oil production, with the resulting electricity-grid problems being best understood as an "above ground factor" stemming from oil. Oil is driving metal theft to new highs, which impacts the viability of electrical grids everywhere. Oil and natural gas prices makes it more difficult to maintain fuels for peak-generating capacity. Oil prices breathe life into infrastructure insurgencies everywhere, which repeatedly target electrical grids for their high return on investment.

Take a look, for example, of what has happened to the electrical supply situation in Baghdad, despite the impending success (sarcasm) of the current "surge" by US military forces there:


Ryan Crocker, the U.S. ambassador to Iraq, told the Senate Foreign Relations Committee last week that Baghdad residents could count on only "an hour or two a day" of electricity.

Interestingly, John Robb has picked up on this crisis in electrical grids around the world as a possible point of development for Africa--their grids are becoming so unreliable that African communities have the opportunity to lead the world in innovating a mode of modern civilization without grid electricity, and possibly export any success that they may have to the rest of the world. While I don't see Africa finding a profitable export market for their brand of grid-free living (admittedly, that isn't actually what Robb was suggesting), I do agree with Robb's assessment that we need to learn to build resilient communities--I've written about that, as well.

So, while CNN tells us (literally), "Don't freak out about the Dow," civilization seems to be stumbling on its balance beam at the moment. I called 2006 the "year of the balance beam"--meaning that everything would be fine as long as nothing significant happened. I called 2007 "Trending," as it seems to be the period where trends become clear--and, keeping with the metaphor, the balance beam grows steadily narrower. We are drawing precariously close to losing our balance--arms are flailing and we're collectively making those funny gyrations as we try to stay up. I'm guessing that my previous label for 2008, "Breakout," may have been better termed "Fall Off."

Mexico Collapse?

My article on the Decline of the Mexican Nation-State is now up at The Oil Drum. This comes, as promised, as an update to my New Years prediction that 2007 would see the collapse of the Mexican economy. This article comes on the heels of a very significant--and largely ignored by the MSM--event: a string of rebel attacks on oil infrastructure in Mexico. Significantly, these attacks shut down production at several "just-in-time" production facilities of major international companies such as Honda, Kellogg's, Hershey's, and Nissan. It is not yet clear whether this was the goal of a highly advanced, effects-based targeting plan by these guerrillas, or just luck on their part. However, as the effects from these shut-downs ripple through the logistics chains of these multinationals, the ultimate economic impact of this attack will likely be enormous. The greatest danger is that the rebel group's own evaluation of this new targeting focus drives them to continue a campaign of attacks against oil infrastructure--the significant, if partially unintended, impact of these first attacks will strongly support exactly that conclusion.

The discussion on my article at The Oil Drum is already proving quite interesting, with some particularly important graphs courtesy of Khebab:





From the looks of things, unless something miraculous happens with production out of Chincopec and Ku-Maloob-Zaap fields in the next two years to offset decline in Cantarell, the situation is about to get much worse...

Updates

This summer has been unusually busy for me, but my work issues certainly haven't slowed the flow of oil-driven geopolitics. For just one recent example, see my recent article at The Oil Drum on the strike in Nigeria. Bottom line: news of a strike makes headlines, but the real news is still the inequality-driven infrastructure disruption. The fact that the Nigerian government caved to the unions (modest) demands has had no effect on this underlying problem.

One other situation that I'm following closely, and that I hope to post on shortly, is Mexico. I made the (I thought) bold prediction that Mexico may collapse into a failed state in 2007 at the beginning of this year. Lots of interesting events related to Mexico lately: classic "export-land" declines in their oil sector; mass desertions in their military to the point that the Federal Government can't honestly claim to control several states; constitutional end-runs to try to get foreign investment to prop-up their oil sector; and the failure of any serious immigration legislation in the US. I was probably a year premature in my prediction for Mexico, but the signs are certainly popping up.

Also an article in the works on EROEI, specifically the criticality of aggregate societal EROEI, and a discussion of the difference between "economic collapse" (where reversion to a lower level of societal complexity is actually an economizing process) and "uneconomic collapse" (where EROEI driven reduction in complexity reduce the overall size of the pie, without reducing the burden of complexity within that pie). More to come...

Rhizome: Beta

Coming soon: a directory of posts chronicling my efforts to create a rhizome node and network.

Geopolitical Vocabulary: Cabinda

Energy Intelligence Note: 12 May, 2007

A recent trend at Energy Intelligence has been assessing the geopolitical impacts of Peak Oil. While it is easy to discern these impacts today in places like Nigeria and Iraq, it may not be long before we must add a new term to our collective geopolitical vocabulary: Cabinda.

Cabinda is a small ethnic exclave of Angola. It is where most of Angola's oil is produced, and where most of Angola's future production increases will come from. It is also the only Angolan province with an active insurgency and independence movement. In my opinion, Cabinda--and Angola's oil production along with it--may be the next geopolitical casualty of Peak Oil. There haven't been any attacks on the oil infrastructure yet (unless Thursday's "suspicious fire" at a Total platform in next-door Congo turns out to be the first such incident), but the situation is the perfect tinder-box.

For more information on Cabinda, and on the potential for an "Oil Insurgency," see my article in today's Oil Drum: Cabinda: Prospects for an Oil Insurgency in the Angolan Exclave.

Nigeria Escalation

Energy Intelligence Note: 9 May, 2007

The situation in Nigeria is escalating--as expected, geologically-driven declines in oil production are spawning geopolitically-driven increases in disruptions from "above-ground factors." The recent attacks on major oil pipelines in Nigeria cut all oil flow to AGIP's Brass Export Terminal, taking a further 200,000 barrels per day off the market. On top of that, take a look at the latest unclassified figures on kidnappings in Nigeria, courtesy of the CIA:

2006:
Total Hostages (Unresolved): 66 (0)
American Hostages (Unresolved): 0 (0)

2007:
Total Hostages (Unresolved): 106 (17)
Amercan Hostages (Unresolved): 17 (5)

And 2007 is only half over! That represents a rougly 200% year-on-year increase in total hostages, and a huge leap in the "value" of these hostages, as reflected by the sudden shift toward higher-skill and western workers, as shown by the sudden prevalence of American hostages.

The coordinated nature of the recent triple pipeline attack suggests that broader, hierarchal organizations such as MEND are alive and well. This doesn't, however, mean that the kind of localized criminal organizations that I spoke of in my recent Oil Drum article on Nigeria are going away. On the contrary, it means that politically-motivated groups such as MEND must now differentiate themselves from the criminal gangs if they wish to put weight behind their political demands. If MEND and criminal gangs resort to the same tactics, there is no motivation on the part of either the Nigerian government or foreign oil companies to cave to MEND's political demands when this won't end the disruption caused by criminal gangs. MEND must pursue increasingly coordinated, high-impact attacks to give them a bargaining chip that is unique, a bargaining chip that is not shared by criminal gangs who won't participate in a cease fire. Logic dictates that differentiating themselves from criminal gangs requires a new targeting focus: offshore oil facilities. MEND has demonstrated a limited ability in the past to operate in the offshore environment. The Nigerian navy is certainly in no shape to effectively counter them. Expect a wave of significant offshore attacks to be the next major development in Nigeria. Offshore facilities are highly vulnerable and minimally defended--consider the destruction caused by mistake or malfunction at the Piper Alpha platform. Now consider how long it takes to repair a major offshore facility in today's economy. An attack on a major offshore facility is the next logical targeting choice, and MEND is at a critical juncture where it must demonstrate its political relevance or fade away as a centralized, unified organization.

A recent commen was right on the money: the geopolitical distruptions caused by geological peaking in oil production may provide exactly the cover necessary to avoid recognition of the geological forces driving these events. It's a challenge to make a scapegoat out of geological reality, but foreign terrorists and resource nationalism are easy marks!

Gas Gouging Legislation

Peak Oil Law Center: Gas Gouging Legislation

Summer driving season is almost upon us, and with low gasoline inventories (especially in some areas like Denver) we can expect two things this Summer—higher gas prices, and calls for the government to “do something” about gas gouging. 81 percent of consumers seem to think that gas prices are "unreasonable."

It’s becoming an annual exercise in trying to explain the basics of free market economics. Don’t get me wrong—our global economy is anything but a perfectly free market, and often free market rationale is simply wrong (though usually for failure to properly account for future costs, structural costs, and marginal values in pricing, but don’t get me started on that). One case where the free market works admirably well on a micro-level: distributing a scarce resource to those who most need it through dynamic pricing of that resource. In the case of gas, so-called “gas gouging” is one of two things: price-fixing, or free market pricing. Price-fixing is certainly anti-competitive, and is exactly the kind of thing that governments should address—for example, if all the gas stations in an area formed a cartel and agreed to raise prices by 50%. The kind of coordination required to pull off such a feat is quite visible, however, and would immediately run afoul of existing anti-trust laws. There is no need for new legislation to address this, and quite frankly, this is not why gas prices will be high this summer. The other kind of pricing—when a free market raises prices to reach an equilibrium between supply and demand—is highly beneficial to consumers. It ensures that gas is available—you may have to pay more for it, but if it isn’t worth the price to you, then don’t drive. At least if it is worth the price, you won’t find yourself in a two-hour line because of rationing, or simply find the pumps out of gas.

With rising energy scarcity, and the ongoing failure of America to take adequate measures to address the problem of Peak Oil, we can expect this annual exercise in populist proposals for gas gouging legislation to intensify. While there are some signs that politicians will resist the pressure—witness former Colorado Governor Bill Owens’ veto of just such a bill last June—these populist flames are already being fanned by local news reporting. Maybe journalism majors should be required to take a course in economics? I wonder who they’ll blame when they begin reporting on the plastic yellow “out of gas” bags covering gas pumps? My guess is that it won’t be the consumer, though that’s where the blame belongs. Gas gouging legislation only substitutes one negative—high gas prices—with a worse negative—no gas.

On a "canary in the mineshaft" note, energy investment banker Matt Simmons seems to think that a full-blown gasoline crisis this summer will be the opening bell for true Peak Oil-related problems (Warning, PDF. See page 40). Also of interest, another refinery fire yesterday--it's as if these places are full of flammable liquids or something... at least no one is actively trying to blow them up in the US. Yet.

Have the Kurds Abandoned All Hope of a Stable Iraq?

Energy Intelligence Note: 1 May, 2007

Salman Banaei recently published an analysis of Iraq’s draft Oil & Gas Law in the Association of International Petroleum Negotiator’s March issue of "Advisor" (also available via his Western Energy Blog). He shows how the draft law allocates control over production from “current” fields to the Iraqi National Oil Company, and that regional governments retain control over “undiscovered” fields. While regional governments can sign contracts with international oil & gas firms, the draft law ensures federal oversight by requiring approval of these contracts by Iraq’s Federal Oil & Gas Council (FOGC).

Recent events in Kurdistan, however, suggest that the Kurds may have other plans. UAE-based Dana Gas announced recently that they have agreed with the Kurdish Regional Government (KRG) to develop the Kormor gasfield (see graphic). The Kormor Field clearly falls under the draft law’s envisioned federal control, as it is a “current” field, discovered in 1928. The contract has not received FOGC approval, and it breaks the KRG’s promise to avoid signing new contracts until the end of May, to give the federal government time to pass the Oil & Gas Law.

What does this signify? It seems that the KRG is not satisfied with the division of gas fields between federal control (“current” fields) and regional control (“undiscovered” fields). This “current” vs. “undiscovered” designation seems to have little basis in geological reality, but rather is the political gloss given to the apportionment of existing fields, which is detailed in an annex to the draft law. Petroleum Intelligence Weekly reports that the KRG will reject the law if this annex remains as is. The decision to contract for development of the Kormor Field with Dana Gas prior to the official vote on the law suggests that the KRG believes the annex will not be changed, and that the law will not pass the end-of-May vote.

While none of this should come as a shock—Iraq is a sham Nation-State where mutually exclusive minimum requirements by the component national groups will prevent cooperation—it does carry significance. The prospects for a military solution in Iraq are as slim today as ever, and this failure to bridge the competing demand of Iraq’s many nations suggests that a political solution is no more likely. This reality may not seriously deter oil & gas production in the Kurdish region, where there is relative unity and security, but it will likely present a geopolitical barrier to developing the highly theoretical reserves of Iraq’s Western Desert. Furthermore, while it may be possible for the KRG to produce from their oil & gas fields, their export market is highly limited—the pipeline through Syria is non-functional, and the Turkish government is unlikely to help their rival with a viable export channel. The most viable market for Kurdish oil & gas is Iraqi domestic consumption, but reaching this market requires relying on a handful of critical pipelines that are frequent targets of insurgent attacks. It may be impracticable to market any increase share of oil & gas that the KRG may be able to exploit. Will this fact alone be enough to force them to compromise on their short-term selfish interest to form a viable Iraqi state that will benefit them in the long term by way of a valid export route? Is a willingness by the Kurds to compromise enough to bring together the rest of Iraq’s disparate factions in a similar spirit? Probably not—and the Kurds have probably considered exactly these issues in arriving at their decision to go it alone with regional production. Probably a wise choice for the Kurds, but an ominous sign for the future of the figment of Colonial Cartography that we call Iraq.

Jevons' Redux

Peak Oil Law Center: Jevons’ Redux & Efficiency Policy

Yesterday my article on Jevons’ Paradox was posted at The Oil Drum, and it led to quite a lively debate. Due to the complexity of the issue, I make no claims that I’m “right” on the topic, but by taking a position and defending it I certainly enhanced my understanding—hopefully others at TOD learned as well. Probably the greatest conclusion that I draw from the debate is that Jevons’ Paradox, like all other “real-world” economic phenomena, is incredibly complex and interconnected, and cannot easily be reduced to a “this is a good idea” or “this is a bad idea” dichotomy. Not coincidentally, this was exactly the point that I was trying to make by highlighting the “shadow rebound effect” caused by Jevon’s Paradox, but I ended up learning about several additional unanticipated effects as well.

So what are my conclusions about the validity of efficiency policy in light of a full consideration of Jevons’ Paradox? My ultimate conclusions—though this is a bit out in left field—is that our economic system has grown too complex for us to accurately implement policy with a full understanding of all effects of that policy. The system is simply too complex, too non-linear, and as a result I have to question the rationality of economic policy in the first place. Anyone who says that they understand how the economy works is flat-out lying. We have lots of theories. They work sometimes. But as the debate on Jevons’ Paradox, and the nesting Matryoshka dolls of paradoxes that spin off from Jevons’, we are not capable of identifying and accounting for all the ramifications of any economic policy. We are often unable to even predict the big-picture direction or impact that will be the result of a policy. What to do? The only proposal that seems rational at this point is to advocate a reduction in societal complexity. That is, unfortunately, the very policy choice that stands the least chance of ever being implemented in our current political system.

So from a policy perspective, what do we do? Does efficiency legislation or rule promulgation make sense? To reduce energy consumption, probably not. To enhance resiliency to systemic shocks, probably not. To reduce the vulnerability of critical sectors of our national, social, or personal economies—probably. This seems to be the most valid rational to back efficiency. If we, as individuals, enhance our energy efficiency in core areas of energy use (areas we can least afford to do without), we are more resilient to future scarcity. The same is true on a larger scale—this is probably the most valid reason to support electrified rail, for example.

The ultimate take-away that I hope most people gained from the essay on Jevons’ Paradox is that simplistic answers or solutions, and simplistic models of our predicament in the face of Peak Oil, are the most likely to be wildly inaccurate. Our predicament is highly complex, but that in no way justifies ignoring the complexity and arriving at policy choices based on simplified, and inaccurate, economic models.

Five Geopolitical Feedback-Loops in Peak Oil

Energy Intelligence Note: April 23, 2007

It is quite common to hear “experts” explain that the current tight oil markets are due to “above-ground factors,” and not a result of a global peaking in oil production. It seems more likely that it is geological peaking that is driving the geopolitical events that constitute the most significant “above-ground factors” such as the chaos in Iraq and Nigeria, the nationalization in Venezuela and Bolivia, etc. Geological peaking spawns positive feedback loops within the geopolitical system. Critically, these loops are not separable from the geological events—they are part of the broader “system” of Peak Oil.

Existing peaking models are based on the logistics curves demonstrated by past peaking in individual fields or oil producing regions. Global peaking is an entirely different phenomenon—the geology behind the logistics curves is the same, but global peaking will create far greater geopolitical side-effects, even in regions with stable or rising oil production. As a result, these geopolitical side-effects of peaking global production will accelerate the rate of production decline, as well as increase the impact of that production decline by simultaneously increasing marginal demand pressures. The result: the right side of the global oil production curve will not look like the left…whatever logistics curve is fit to the left side of the curve (where historical production increased), actual declines in the future will be sharper than that curve would predict.

Here are five geopolitical processes, each a positive-feedback loop, and each an accelerant of declining oil production:

1. Return on Investment: Increased scarcity of energy, as well as increased prices, increase the return on investment for attacks that target energy infrastructure. Whether the actor is an ideologically driven group (al-Qa’ida), or a privateer (youth gangs in the Niger Delta), the geologically-driven declines increase the ROI for attacks on energy, which will drive both decisions to act, as well as targeting decisions for that action. This is a positive feedback-loop because attacks on energy infrastructure and supply drive up the price, which further increases the ROI for such attacks. John Robb's analysis of the September attacks on Mexican oil and natural gas pipelines suggest an ROI as high as 1.4 million percent.

2. Mercantilism: To avoid the dawning “bidding cycles” between crude oil price increases and demand destruction, Nation-States are increasingly returning to a mercantilist paradigm on energy. This is the attitude of “there isn’t enough of it to go around, and we can’t afford to pay the market price, so we need to lock up our own supply.” Whether it’s the direction of a pipeline flow out of Central Asia, defending only specified sea lanes, or influencing an occupied nation’s laws on Production Sharing Agreements, there are signs of a “new energy mercantilism” all around us. This is a positive feedback-loop because, like an iterated “prisoner’s dilemma” game, once one power adopts or intensifies a mercantilist attitude all others must follow suit or lose energy share. It will act to accelerate oil production declines because mercantilism prevents the most economically efficient production of a resource, accelerating the underlying problem of diminishing marginal returns. The rise of mercantilism is highlighted by the recent coverage of the race to control the Arctic, and its potentially vast hydrocarbon reserves.

3. “Export-Land” Model: Jeffrey Brown, a commentator at The Oil Drum, has proposed a geopolitical feedback loop that he calls the “export-land” model. In a regime of high or rising prices, a state’s existing oil exports brings in great revenues, which trickles into the state’s economy, and leads to increasing domestic oil consumption. This is exactly what is happening in most oil exporting states. The result, however, is that growth in domestic consumption reduces oil available for export. In states, such as Mexico, where oil production is also in decline, the “export-land” model predicts that oil exports will decline much faster than oil production—and this is exactly what is happening, with the latest PEMEX report showing 5% production decline year-on-year, but 11% export decline. Ultimately, the effects of the “export-land” model itself suffers from diminishing marginal returns—when exports shrink sufficiently, the oil-export revenue per capita will actually begin to decline (eventually reaching zero, no matter how fast prices rise), at which time the force behind rising domestic consumption will be eliminated. The likely unwillingness of governments to allow their valued oil export revenues to be totally consumed by rising domestic consumption will create pressure for domestic rationing, price-hikes, or uneven distribution of oil and gas domestically. We are already seeing this as many oil exporting countries are scaling back the subsidized pricing of domestic gasoline. The inequalities that will arise out of domestic rationing will act as a catalyst and accelerant to the last two feedback loops...

4. Nationalism: Because our Westphalian system is fundamentally broken, the territories of nations and states are rarely contiguous. As a result, it is often the case that a nation is cut out of the benefits from its host state’s oil exports. This will be especially apparent when the “export-land” effect reduces the total size of the pie to be divided, or as domestic rationing is introduced to maintain export revenues. As a result, nations or sectarian groups within states will increasingly agitate for a larger share of the pie. We see this already within Iraq, Iran (Khuzestan), Nigeria (Delta State), Bolivia (indigenous groups), etc. This process will develop local variants on the tactics of infrastructure disruption, as well as desensitize energy firms to ever greater rents for the security of their facilities and personnel—both of which will drive the next loop…

5. Privateering: Nationalist insurgencies and economies ruined by the downslide of the “export-land” effect will leave huge populations with no conventional economic prospects. High oil prices, and the willingness to make high protection payments, will drive those people to become energy privateers. We are seeing exactly this effect in Nigeria, where a substantial portion of the infrastructure disruption is no longer carried out by politically-motivated insurgents, but by profit-motivated gangs. This is the ultimate positive feedback-loop: infrastructure disruption further degrades any remnants of a legitimate economy, increasing the incentive to engage in energy Privateering, and compensating for any diminishing marginal returns in Privateering caused by enhanced security or competition from other privateers.

We may see some or all of these effects in any given area, and are already seeing this in some trouble spots. Some states, like Iraq, have been thrown into full-fledged “Nationalism” and “Privateering”-driven geopolitical disruption by the actions of an outside power—in this case, the US invasion was itself largely the byproduct of a shift towards energy mercantilism. This is just one illustration of the synergistic interrelationship among these feedback loops. The important take-aways are these:

1. So-called “above-ground factors” are driven by the geological reality

2. These geopolitical processes are positive feedback-loops

3. They will accelerate the decline in global oil production beyond that predicted by models derived from logistics curves.

Geologically driven decline follows a classic logistics curve, with a "long tail" of declining production continuing indefinitely. Geopolitical positive feedback-loops not only have the potential to accellerate that rate of decline, but can potentially drive it to zero in short order. Oil production requires certain threshold levels of economic functioning, security, and rule of law to proceed. These positive feedback-loops have the potential to cut off the "long tail" of declining production abruptly. It practically dogma in peak oil circles that peak oil doesn't mean the end of oil production, just the beginning of inexorable declines. In light of the potential impact of geopolitical feedback-loops, it may be time to reassess that idea, at least on a regional basis.

Social Networking & “Small-Worlds” Theory

“Social Networking” is more than just a virtual party-coordination-system. It’s big business, and the rapid success of profession-networking site LinkedIn is leading the way. As a long-time writer on the theory of non-hierarchal networks, what I call "rhizome," I’ve decided to throw my hat in the ring and join LinkedIn. So now that I’m there, what do I do? Conventional wisdom says to add your close associates to your network, and then expand outward in some logical manner by leveraging their network connections, gradually building a large and powerful network of contacts.

The “Small-Worlds” theory of networks, however, suggests a very different approach. According to this theory of organization, which I first wrote about in my 2004 book “A Theory of Power,” the true leverage in tying together a vast network lies in weak and distant connections. Borrowing an example from Mark Buchanan’s “Nexus: Small Worlds and the Groundbreaking Theory of Networks,” I stated:

“If…ten students had started some rumor that moved only between the best friends, it would have infected their own social group, but not much more. In contrast, a rumor moving along weaker links would go much farther (to more diverse social groupings). As in the case of people seeking jobs, information spreading along weak ties has a better chance to reach a large number of people.”

Figure 1: Network topology graphic demonstrating the power of “weak” connections

From a social networking perspective, effort spent cultivating “near” connections online may be a waste—that is more properly the province of “real-world” connections, and doesn’t leverage the power of social networking systems (though capturing these existing “near” connections in a virtual context is critical). Effort spent cultivating “distant” contacts may yield the greatest reward. Perhaps the best measure of value from a “small-worlds” perspective is how FEW second or third-level connections two people share--a few distant contacts can span network space more efficiently, as fewer signal-distorting relays are required to connect any two nodes. Of course, just connecting to some random and “distant” person is of little value, as there is little weight behind recommendations or introductions, nor much incentive to provide the same. However, when the opportunity arises to make a “distant” connection, effort spent maintaining and deepening that connection is time well spent.

My Linkedin Profile

Has Russian Natural Gas Peaked?

Energy Intelligence Note: April 19, 2007

The US State Department’s Bureau of Intelligence and Research (INR)
reports that Gazprom Chairman (and Russia's Deputy Vice President) Dmitriy Medvedev is demanding Russia’s electric monopoly UES substitute coal-generation for gas generation. This is a reversal of the “gasification” policy of the ‘70s that attempted to reduce the environmental damage and transportation costs of coal-fired power plants. The obvious rationale for reducing domestic consumption is to make more natural gas available for export to Europe and elsewhere. Is this intended to obscure production declines, evidence that Russian natural gas production has peaked?

Gazprom’s existing fields are currently in decline:

The most realistic strategy to offset the sharp decline in production from existing fields is to bring production online from new fields at Yamal, Shtokman, and Sakhalin. These mega-projects, however, have experienced repeated delays and complications. Gazprom is bridging the gap by acquiring producing fields, masking the decline of existing fields. This may preserve the appearance of normalcy, but it doesn’t actually replace declining gas production.

Gazprom’s demands that UES shift to coal-generation can also be explained by simple profit maximization—more gas to sell on the foreign market, where it commands a higher price than under domestic price controls. This explanation, however, fails to explain the timing of Gazprom’s demand. It seems logical that if profit maximization was sufficient rationale to switch back to coal-generation, we would have heard of these demands years ago when this rationale would have been equally valid. Is the more reasonable rationale that Gazprom is scrambling to compensate for plummeting production, under the realization that their mega-projects will not live up to expectations? Europe may have an answer to this question next Winter.

Peak Oil Law Center: Surveying the Future Landscape

The peaking of global oil production, or Peak Oil, will cause major changes in every facet of society, to include changes to the legal environment. As a brainstorming exercise, here is a survey of probable legal ramifications of Peak Oil:

Corruption Competition: The Foreign Corrupt Practices Act (FCPA) prevents US businessmen from bribing foreign government officials. Chinese businesses have no such burden. Will a scarce energy environment force modifications to the FCPA out of recognition of the need to compete with unrestrained actors such as China and India?

Infrastructure Attacks and Private Military Corporations: Peak Oil will increase the ROI for energy infrastructure attacks. While this will increase cost and risk to energy exploration and production companies, it will also increase the willingness to take on these costs and risks. One result will be an increase in demand for the services of Private Military Corporations (PMCs). The laws governing PMCs are ill-defined and changing quickly.

Regulation Juxtaposition – Peak Oil vs. Global Warming: In the broadest terms, the regulatory response to global warming will be to increase regulatory burden on energy exploration & production, whereas the response to Peak Oil will be to loosen the reigns. Which will win out? The one area that seems to win under either scenario is “efficiency,” though Jevon’s Paradox suggests that may not be a wise response.

Exploration in the Arctic, Antarctica, and Beyond-Continental-Shelf Regions: International-law issues surrounding newly joined contests for scraps of rock in the arctic will heat up, as will the debate surrounding resource extraction from Antarctica. Did you know that Canadian and Danish warships came face-to-face over this issue a few years back? And what law governs beyond-continental-shelf oil reserves, anyway?

Nationalist Energy Subsidies and “Free-Trade”: Can Mexico’s protectionist constitutional clause that grants PEMEX a monopoly withstand a WTO challenge? Does US selective protection of sea lanes, or re-denomination of Iraqi oil in dollars represent a non-tariff barrier to trade? What about “diplomatic” and “political” pressures that end up piping oil or gas toward one market, and away from another? What about bio-fuel subsidies, or Venezuela’s increasing moves towards nationalization? What about Chinese development aid in Africa or US subsidy of an LNG terminal? The phrase “non-tariff barrier to trade” is a potentially malleable legal tool. Peak-Oil is an inherently mercantilist phenomena, and it will spawn legal conflict with free-trade treaties and policies.

Geo-Political Risk Insurance: Energy scarcity and rising energy prices will drive exploration and production in increasingly unstable environments. Geo-political risk insurance is emerging as a result, but the legal issues involved are often novel and always complex. Force Majeure clause, anyone?

Futures & Derivatives Markets: There is a huge, untapped domestic & international market for “consumer derivatives”--combinations of traditional energy futures bundled together and then sliced into very small packages to be sold to individual consumers to hedge against personal or small-business exposure to energy price changes. Want to lock in $3.00-a-gallon gasoline for your Suburban until 2012? Or heating oil, natural gas, even electricity? This may be the next financial instrument phenomenon along the lines of the “sub-prime mortgage” revolution, complete with all the legal issues of selling complex financial instruments to “Joe Commuter.”

Is the legal community prepared for the changes that Peak Oil will bring? I don’t think so. In a quick survey of all 11 law review articles every written (at least according to LexisNexis) containing the phrase “Peak Oil,” two have earnest discussions of Peak Oil (but don’t discuss any legal ramifications), five have off-hand references, and four only mention the term in a footnote. Peak Oil will change the legal landscape… expect a regular stream of “Peak Oil Law Center” articles in the future.