Financial Wizardry & Collapse

Bear with me for a second here. This isn't an easy topic. That's because no one understands Credit-Default Swaps (CDSs), or other complex credit-derivatives, but it is important that we try to understand the implications of their exponential increase. Sure, some people claim to understand: hedge fund managers, investment bankers, etc. They understand the derivatives marketplace just like neuroscientists understand consciousness—they know the component parts, they can use them as tools barely under their control, but when it comes to understanding exactly how the greater dynamic emerges from the component parts they are in the dark.

No one really understands the credit-derivative market, but everyone is impacted by it. Credit-derivatives represent the creation of money out of thin air, like some act of financial wizardry. Take a Credit-Default Swap, for example. Here’s how it works: Corp. A needs to raise funds to expand operations, so they issue a $10 million bond. Pension Fund B buys that bond, but is concerned with the risk of Corp. A going bankrupt and defaulting on the bond. So Hedge Fund C offers what is, in effect an insurance policy—Pension Fund B pays Hedge Fund C $200,000, and in exchange if Corp. A defaults on the bond, Hedge Fund C covers the $10 million for Bank B. Here’s the magic: because this insurance policy creates the market for this otherwise too-risky bond from Corp. A in the first place, and because the par-value of the credit-default swap (the insurance policy) that the Hedge fund issues does nothing more than eat up the difference between the risk-premium on this bond, this $200,000 that the hedge fund makes is essentially fabricated out of thin air. Don’t forget to sprinkle in a liberal portion of fractional-reserve-banking fairy dust and viola: now you understand the credit-derivatives market as well as anyone else in the world.

Clear as mud? Try this on for size: there were $25 Trillion dollars in credit derivatives issued so far in 2006. That’s about half the size of the world economy. Oh, and it’s unreported, unregulated, and largely non-transparent. But wait, it gets better:

What is the effect of this absolutely massive trade in credit-derivatives? It has the effect of creating liquidity in the market for credit, but the larger effect is that it spreads risks very, very effectively. Because these credit-derivatives get pooled, sliced up, re-packaged, and re-sold, they have the effect of distributing the risk of default very, very broadly. Because virtually every hedge fund borrows from virtually every bank, which is connected to virtually every mutual fund, pension fund, and corporation, the risk of default is spread among virtually everyone. So this makes the world economy very, very resilient in the face of minor financial crises—say, the Asian Financial Crisis of the mid ‘90s, or the fall-out from September 11^th. In fact, because of this massive trade in credit-derivatives, the world economy is actually far more secure in the face of your garden-variety financial crisis. This resiliency works as long as there’s enough slack, enough “spare capacity” in the world economy to absorb the distributed force of these defaults or crises. But at some tipping point—and because it’s not regulated and not transparent no one knows where this is—the stress cannot be absorbed. At this point, the crisis is no longer just a “recession” or a “depression”—it is a complete global collapse.

The market in credit-derivatives is a “financial weapon of mass destruction.” That’s not just my opinion, it’s a quote from the Oracle of Omaha himself, Mr. Warren Buffett (Berkshire Hathaway 2002 Quarterly Report, sorry, no link). Complex societies such as ours collapse because diminishing marginal returns eventually weaken a society until it cannot overcome periodic stressor events. The continually advancing sophistication of the derivatives markets represent the desperate efforts of the global economic system to climb high enough to reach even the hardest to reach fruit from the marginal-return orchard. The irony of a derivative collapse is that it will afford us the illusion that not only is everything OK, but that it is actually continually improving and expanding right up until the point where the whole house of cards implodes.

Derrick Jensen vs. the Dalai Lama

Talk about a billing for fight night.

This weekend I went to the “Peace Jam,” a gathering that bills itself with the tag-line “Change Starts Here.” Listening to the Dalai Lama, Desmond Tutu, Sharin Ebadi, Rigoberta Manchu Tu, and five other Nobel Peace Price winners speak about how to solve the world’s problems was the perfect frame for reading Derrick Jensen’s latest tome, “Endgame, Vol. II: Resistance.” Their approaches could not be more different, each providing a counter-argument to the other. On top of that, It’s currently 4:30 in the morning and I’ve been sitting in a fluorescent-illuminated tile hallway all night (long story) listening to Rise Against’s latest album. Perhaps a bit of sensory overload.

Jensen’s “Endgame” is surprisingly direct. After indicting civilization in Volume I, he proceeds to outline his dream of a violent resistance to civilization. It is literally a declaration of war. I found it particularly fascinating because it focuses on a detailed prescription for an all-out campaign to destroy dams, including targeting strategies, how to effectively use explosives, creating cascading failure, identification of critical nodes, etc. Since this is the exact reason why the government sees fit to keep me in their employ, I am not at liberty to comment on this aspect of Jensen’s work. But my aim here is to address Jensen’s broader proposal to address the problems of civilization through direct and violent confrontation. His first chapter, “We Shall Destroy Them All,” begins with this quote from Thomas Jefferson (providing prospective on the then-current conflicts with Native Americans): “In war, they shall kill some of us; we shall destroy them all.” As Jensen points out, this is the approach that our growth-based civilization takes towards its opponents, and by default towards the Earth in general. Jensen recommends adopting that same strategy in defense of the Earth, summarizing the demand of one faction within anarcho-primitivism—the complete destruction of industrialized civilization. Jensen wraps up his introduction by expressing his displeasure with the pacifist approach to solving the problem of civilization, specifically leveling criticism at the Buddhist practitioner who said “what I do for peace is split wood.” It is the failure of this kind of withdrawal approach that Jensen claims validates his “fight back” alternative.

The Dalai Lama, on the other hand, thinks that the problem of civilization can be solved through compassion and a reduction in negative emotions, specifically advocating the personal change path and advising that we follow Ghandi’s advice to “be the change we wish to see in the world.” While I think that this approach is much more sophisticated than Jensen’s simple characterization of “withdrawal,” I don’t find it necessarily superior to “fight back.”

I think that both Jensen’s “fight back” and the Dalai Lama’s “personal compassion” are selectively valuable tools. In truth I think that “personal compassion” is universally valuable, just not universally effective. Ultimately, both strategies only work to the degree that they address the fundamental causes of the problem of civilization. I think that “fight back,” at least as articulated by Jensen, fails to clearly identify these causes, and therefore only has effect to the degree that such action chances upon sources of causation. Differently, “personal compassion” intends to address causation directly but, to use terminology (probably inaccurately) from Buddhism, succeeds only in affecting a makyo of ultimate causation—that is, compassion directly addresses only an ephemeral symptom of the ultimate causes of the problem of civilization. Ultimately, I think that the failures of these very different approaches highlight the actual solution—which is firmly grounded in the need to properly define the problem.

This ultimate source of causation is, in my opinion, the structural underpinnings of civilization. I’ve written at length about this (see A Theory of Power), but in essence hierarchy is structurally unstable, and the symptoms of “Civilization” are in fact symptoms of this underlying, hierarchal structure. A solution that does not specifically and directly address hierarchy as the source of these problems will fail. Jensen’s “fight back” will fail because, for all its military overtones, it does not leverage the fundamental military principle of economy of force—the large portion of its energy wasted in misdirected action takes away from its ability to actually impact our fundamental hierarchy. It would be difficult enough to defeat hierarchy with 100% of the effort that Jensen hopes to muster. With the 20% that may, by chance, actually impact hierarchy-in-itself, it will surely fail to have the desired effect. Likewise, the “personal compassion” advocated by the Dalai Lama will fail because it does not actually address hierarchy. While I think that personal compassion is a valuable tool in affecting change, it must be combined with more before it can actually form a viable alternative to our present, hierarchal system.

One of the Nobel Laureates at “Peace Jam” came very close to articulating this exact problem. Rigoberta Manchu Tu, an indigenous Mayan activist, commented that the US economy is predicated upon the exploitation of other, poorer economies. She further stated that wealth in the rest of the world necessarily required poverty in the US. A bold statement, certainly, in front of a mostly upper-class crowd of “Land Rover Liberals,” but the one comment that most closely identified that the source of the problem lies with hierarchy.

A solution to hierarchy must, ultimately, be an alternative to hierarchy. Even if Jensen’s dreams succeed, the resulting anarchy would lack the communication structure to maintain an awareness of the problems of civilization that is necessary to prevent its rebirth (even if only in some patchwork of dystopian micro-agrarian despotisms). It is precisely because a solution must also be an alternative that I think, ultimately, the Dalai Lama’s second message—that of non-violence—is not only a possible attribute of a solution, but a necessity. As Daniel Quinn noted, organized violence is the sine qua non of civilization, and it is uniquely adapted to defeat a challenge that is itself predicated on violence. While, as John Robb has pointed out (and I have often advocated), Fourth Generation Warfare is able to effectively confront the weaknesses of civilization, it remains incapable of providing an alternative to civilization. Ultimately, a fifth-generation conflict moves beyond the current spectrum of insurgencies to provide a fundamental alternative to the hierarchal mode of organization. In a way this comes full circle and embodies both the Dalai Lama and Jensen while rejecting their superficialities: fifth generation “conceptual” warfare will defeat civilization by “fighting back” with “personal compassion,” not acts of violence, to propagate an alternative system of coordinating complexity from hierarchy. As I have written about extensively elsewhere (see Rhizome Theory Directory), this fifth generation “warfare” is the establishment of a rhizome structure to coordinate complexity in human society without the hierarchal symptoms of diminishing marginal returns or the demand for growth. Ultimately, in any world that I can imagine to be worth saving, destruction of civilization is ultimately only temporary. Depending on various theories of collapse, overshoot, resource depletion, and environmental destruction, it is likely that hierarchal civilization will never again rise to its present level. But that does not mean that a still-hierarchal, still-destructive patchwork dystopia cannot soon emerge from the ashes. For this reason, even if Jensen succeeds, his efforts to end domination and the abuses of hierarchy will ultimately fail. Only the maintenance of a sufficient level of organized complexity can perpetuate a sufficiently uniform anthropological self-awareness to prevent the recurrence of hierarchy—an anthropological self-awareness that can be effectively maintained within a rhizome structure.

By “anthropological self-awareness,” I mean an understanding within the general populace of the forces that operate within human society, of the dangers of hierarchy, and of the specific theories that permit rhizome complexity without creating the dependencies that degrade eventually into hierarchal structures. For lack of a better analogy, it is much like the self-awareness of the rules of a horror movie by the characters in the movie “Scream.” This anthropological self-awareness must, itself, become our new mythology. Within such an environment—and I think only within such an environment—a network of rhizome nodes can be established that co-exists with hierarchy, while at the same time out of phase with hierarchy, gradually replacing hierarchy as the latter becomes increasingly irrelevant. It’s a complicated vision—and that is certainly one of its weaknesses—but if the Catholic church can get away with the Trinity for two millennia, it seems like rhizome is worth a shot…

Fasten Your Seat Belts

Well, it may seem like an odd proclamation during the most significant oil price retracement in months, but here it is:

OPEC officially abandons production quotas

"[OPEC's President and Nigerian Oil Minister Edmond] Daukoru said: There is no quota, no, either up or down."

This is a significant move away from the previous 28 million barrel per day quota. While it is largely recognized that the quota has had no meaning for some time now, its formal abandonment is significant. The same action by the Texas Railroad Commission (the Texas oil & gas regulatory body) in the early '70's is viewed, with the benefit of historical hindsight, as the turning point signifying a peak in oil production.

In my opinion, interesting times are ahead. I don't see any catastrophic collapse or similar events in the next few years, but I do think that at current prices there now is a historical buying opportunity for oil. But that's a topic for a future note on post-peak investing strategies...

Brainstorming on Oil Price Manipulation

There is plenty of conjecture and theorizing about why oil prices are dropping at the moment (currently at $63.75). I've certainly engaged in some of it myself. The most popular line seems to be the theory that President Bush is magically pushing down oil prices just in time for the mid-term elections (with the corollary that they'll shoot up again shortly thereafter). If you asked me to guess, I would say that this is exactly what is happening--it certainly wouldn't be a first, after all, considering that Clinton did the same thing by opening the Strategic Petroleum Reserve to drive down prices shortly before the 2000 elections. What bothers me about all of this conjecture is that no one seems to be pointing to details of how this is actually being done. After all, it's not like someone--even the President--can just wish the price of a market-traded commodity lower. So my goal here is to engage in a little honest brainstorming about how this could actually be accomplished. Who knows, it may even lead to the discovery of how it IS being accomplished. As far as I am aware, despite all the talk about oil price manipulation prior to the election, none of these theories have yet been publicly articulated:

Theory 1: Political pressure on, an administrative agency--let's say, just for fun, the Regulatory Commission of Alaska--to drop some cumbersome environmental regulation that is currently keeping a significant amount of oil off the market. For example, approval to skip replacing all the corroded, leaking pipeline from Prudhoe Bay and just build a quick bypass around the broken section, releasing 400,000 barrels of oil back on the market by October. Surprise, BP granted initial approval for bypass.

Theory 2: More political pressure on an administrative agency, this time to expedite the implementation of ultra-low sulfur diesel fuel. Refinery hang-ups in diesel production while they try to implement this new regulation mean that the crude they can't refine into diesel will be refined into gasoline instead. The price of diesel goes up (hurting business), but the price of gasoline drops (voter: "yeah incumbents!"). In addition, the lag-time and uncertainty in swapping refining product leads to some portion of the decrease in diesel production translating to a drop in crude oil demand, and hence lower prices. Surprise, New EPA Diesel Regs closed comment period and became effective June 30th.

Theory 3: More political pressure on an administrative agency--let's say the Commodity Futures Trading Commission--to change some little noted regulation on speculative limits on crude trading. For example, reducing the number of contracts that large players can hold at one time in crude oil down to 2,000 for the spot month. This means that anyone holding more than that would need to sell the excess in near-month contracts, making the price of those contracts go down. Surprise: Here's the current limit, and here's the request in the Federal Register to reduce those limits from last year. I was unable to find confirmation of when the new limits took effect, but note that the current limit advisory was published in August 2006.

Theory 4: Pressure on Nigerian President Obasanjo to add an ethanol component requirement to domestic gasoline, similar to in the US. As Nigerian refiners try to implement such a requirement there would be two results: 1) lower domestic demand for their own crude oil production as 10% of existing gasoline demand would now be ethanol, and 2) increased price of domestic gasoline, further decreasing demand. both of these have the result of freeing up more Nigerian crude oil production for export to the world market, thereby lowering the price of crude internationally. Looks like that just happened, too.

Theory 5: Encourage more production from Iraq to lower the price of crude oil. Sure, you can't actually produce more under constant attack from insurgents, but in a zero sum fashion you can take production that was being consumed by the Iraqi people and put it on the world market. Iraq has very low fixed oil prices, so smugglers have a great incentive to smuggle crude out of Iraq to other gulf states--and there is a long history of exactly this happening. The relatively effective US Navy was patrolling Iraq's coast for maritime smuggling, but last week that responsibility was turned over to the far less effective Iraqi navy. In fact, this transition has been underway for some time, leading to the steady increase in crude smuggled out of Iraq--perhaps as much as 100k-200k barrels per day. That can have a significant effect on the market.

Or, you could just hype up a "big oil find" that was actually registered with the Mineral Management Service in 2004 (the 6,000 barrel per day Jack 2 test flow was recorded with MMS in May 2006). Talked about that one last time.

I'd love to hear other people's theories about how oil prices are actually being manipulated downward. For now, I certainly can't prove malicious intent, or even intent to influence elections, by pointing out all of these coincidences. But they certainly are interesting...

EXTRA: Oil Discovery Saves Civilization!

For 35 days.

In 2013.

Except for decline in other fields.

Maybe.

The huge news today is that Chevron, Norway's Statoil, and Devon Energy have jointly discovered our collective salvation in the "Jack 2" deepwater oil platform in the Gulf of Mexico. CNN, Fox, and ABC have all been carrying this as the top story all day.

MSNBC and CBS have relegated it below the much more significant story of the Crocodile Hunter Steve Irwin's death--where it belongs.

Before we discuss conspiracy theories of why this news is coming out now, let's first look at the facts in the absence of cable-news hype. This larger field, of which Jack 2 is just a small part, may someday yield between 3 and 15 billion barrels of recoverable crude. It won't even start to produce oil until 2013, if everything goes according to schedule. Then, it (the entire tertiary GOM zone) may eventually produce 400,000 barrels per day. That's about how much Mexico's Cantarell field declined in production this year. And how much it will decline next year. And the year after. Ultimately, 3 billion barrels of oil will fuel the world--at current consumption levels--for about 35 days.

Did I forget to mention? Chevron first confirmed Jack 2's viability in 2004. They've known all along the expected size of the field's reserves, and this figure has long been part of Peak Oil calculations. In fact, the 6000 barrel per day flow rate of the test well was finalized and published in May of this year. There is absolutely no new information about this event to surface in the past three months. So why all the hype now?

One theory--and I should be the first to admit that I cannot prove motive or intent here--is the upcoming November election. Lower gas prices equal less anti-incumbent sentiment--while this may help the Republicans the most, it also helps the incumbent Democrats who are also facing stiff re-election challenges in light of their failure to propose any viable energy policy alternatives. And this Jack 2 "discovery" is not the only place where the pre-election market manipulations are taking place. None of the drawdown from the Strategic Petroleum Reserve over the past year has been replaced. Oil majors and refineries are skewing their refining output away from diesel and heating oil and towards gasoline in an effort to keep gas-price hysteria from leading to new regulations or investigations. And there is negative price pressure based on some "hurricane season speculators" dropping their positions. All taken together and it looks to me like gas prices will remain stable or fall slightly for the next few months, then begin another round of significant increases. The more pertinent question is this: will such temporary manipulation have the intended effect of keeping the incumbents in power, or will the post-election counter swing make Peak Oil itself a front page story?