It's all about Energy

This post is intended to explore the thesis that it is energy, not money, that "makes the world go round".  Energy dynamics, not financial or economic ones, underly the financial and economic turmoil of the past few years.  Understanding energy dynamics is fundamental to understanding your future.

Let's start with some basics.  In a simple ecological system containing plants and animals there are energy inputs and transfers.  The main energy input is sunlight, which plants capture, and transform into growth and seed for regeneration.  Various animals (herbivores) eat the plants, using the captured energy for mobility, growth and reproduction.  And other animals (carnivores) eat the herbivores to get their energy requirements.  There are considerable energy inefficiencies in the system.  The plants capture only a portion of the energy in sunlight that reaches them, herbivores capture only a portion of the energy available in the plants they consume, and carnivores capture only a portion of the energy available in the animals they consume.  The more links in the food chain, the more energy it takes at the lowest level to sustain the system.  

Man is both a herbivore and carnivore, and tends to be at the top of the food chain, requiring a tremendous energy base in the chain below him for support.  Think of the indigenous North American plains Indians.  They were few in number relative to the land they occupied.  Whenever their population exceeded the available food supply (energy) they either died off, or reduced their population through wars. 

Let's examine the concept of money.  I'm being overly simplistic here, so don't be distracted by the detail you may have knowledge of.  Money is an artificial human construct, and does not form part of any ecosystem.  Money developed as a method to make commercial transactions easier, rather than the more cumbersome barter system.  

But what is money, when you boil it down to its essential elements?  I maintain it is a claim on the energy of others.  When you have money it represents potential energy, like water stored behind a dam.  When you spend the money you obtain goods or services in return, all of which have taken energy to produce.  You have exchanged an energy token (money) for kinetic energy (e.g. roller coaster ride) or embedded energy (e.g. groceries).  While you are reading this blog for "free" someone had to expend money to purchase the computer to read it on, and all the components of the computer contain embedded energy, and it takes energy to operate.  It takes very little energy for me to put pixels on the screen in the shape of (hopefully) legible words, but it took a tremendous amount of energy to raise me from birth to the present day.  

And debt is just reverse (or negative) money.  When you have debt it means others have a claim on your future energy inputs.

Every one of us is a container of embedded energy, all the energy we consumed in our lifetimes less the energy expended.  Even our knowledge and skills are a form of stored energy.  It took energy to get our brain synapses to do their thing to store data in a form that we can recall and use in our daily lives.  When we die we put very little energy back into the system compared to what we consumed in our lifetimes.

So what, you ask?  As long as I have food, a roof over my head, and gas for my car, why would I care?  Well, let's move on to consider energy supply and consumption.

Modern man has moved beyond the constraints of a hunter-gatherer existance.  How?  Through the deployment of energy supplements.  For millenia man has been using animals (or other humans) to transport goods, etc.  He used the energy stored in wood and other flammables for cooking, heating, etc.  At one point every river in Europe was filled with water-powered mills to provide more energy supplement. Then he learned to use windmills, which provided enegy away from waterways.  

Then there came a wood shortage, and coal was used.  Better yet, a more dense energy source (more BTUs per unit of weight).  Then the steam engine was invented, and coal really boomed.  Then whale oil was used for illumination which meant activity could proceed at night as well.  And right on cue, as whale oil was depleting, rock oil became an energy source. We've been in the age of petroleum for the last 150 years.

At each energy transition there were more people demanding more energy in a general trend to improve lifestyle and longevity.  So what?  Who cares (says the teenager text messaging her friend on her iPod)?

The problem is that we have about 6.8 billion people on this earth, in need of energy inputs.  Most are barely above the survival level, struggling to get enough energy to provide food and water for their families for the next week, or even the next day; they use little or no petroleum products.  But a minority in the developed world take for granted a huge energy supplement in the form of petroleum products.  Canadians and Americans each consume about 25-26 barrels of oil per year, not limited to fuel alone, but in the products we use like plastics, fertilizer, pesticides, and pharmaceuticals.

The problem is that  petroleum energy became so cheap that we have taken it for granted.  Cheap energy allowed us to develop a lifestyle that incorporates large detached dwellings, automobile transportation over long distances for daily activities, and an incredibly complex society.  That complexity can exist only in the presence of cheap and abundant energy, primarily in the form of petroleum products and coal.   All other energy sources are minor or miniscule in comparison, and will never replace the energy we currently get from fossil fuels.  (This is pretty much a mathematical certainty that takes time to explain, so I don't intend to expand on it here.)  If you believe all the current hype about alternative energies allowing us to continue our current lifestyles, I would suggest you need some education about energy.

So how does this tie in with the current (relatively minor in my opinion) economic turmoil that we have experienced in the last 2-3 years?  The wealthy Americans will tell you it was all the poor people taking out "liars' loans", and government sponsoring housing for people who can't afford it.  The less wealthy blame it on banks and associated financial sectors taking advantage of their power to enslave the working class in debt.  Economists, most of whom are entirely clueless about how the real world works, have numerous theories. 

Only a minority of people recognize the real issue -- an unsustainable increase in debt.  Credit cycles (also known as business cycles) are not new, and generally run 4-6 years peak-to-peak or trough-to-trough.  At the bottom of the cycle economic growth is slow or non-existant, jobs are scarce, people are cautious and pay down debt, and lending institutions are "tight" with their money.  Interest rates are generally high, but dropping as central banks try to stimulate growth.  At some point economic growth improves, jobs return, people spend more money, and lending institutions are "loose" with their money.  Central banks increase rates until the little boomlet slows, and takes us back to the cycle start.

What we are experiencing is a much longer term phenomenon, not just a normal business cycle.  For about the last 40-45 years there has been a gradual erosion of the North American economy (and other developed nations' economies) which was camouflaged by increasing long term debt.  We built a system that is unsustainable in the long term.

But why is debt a problem?  After all, Dick Cheney stated, "Reagan proved deficits don't matter."  (For the record, I consider Reagan and Cheney to be two of the most harmful dumbasses who have held high office in America.) Can't we just readjust a little, and gradually pay it down, without any major sacrifice?  Nope!  Not a chance!

 Here's where it gets interesting.  In 1901 when the Spindletop oilfield in Texas was tapped, it took roughly one barrel of crude oil energy to bring out 100 barrels of crude.  Oil prices dropped to as little as 3 cents a barrel.  See the problem?  Eventually the Railroad Commission of Texas regulated supply to get the price up.  After a while many nations decided that the oil in their countries should belong to them and not the the big international oil companies (the "Seven Sisters").  A group of those countries decided controlling supply, as the Texans did, was a good idea to promote price stability and guarantee profits, and formed OPEC.

In the early 1970s America's oil production peaked at less than 10 million barrels per day, and has dropped back to about 5 million barrels per day.  Current consumption is about 20 million barrels per day. 

Now it gets really interesting.   In the 1970s there were two "oil shocks" due to OPEC curtailing production.  Prices increased and a recession followed both shocks.  Over time the cost of extracting oil has risen, as the cheapest and easiest formations have been depleted.  This rising cost resulted in more of the economy being devoted to energy supply, and less for other things like roads, bridges, sewers, etc.  Of course the infrastructure still got built, and people continued to improve their standard of living.  Instead of "living within our means" we just put the difference on credit.  Jimmy Carter warned us, but he was highly denigrated by most Americans who seem to prefer intellectual lightweights like Reagan and "Baby" Bush.

Someone did a study of recessions and noticed that something like 7 of the last 8 were preceded by a spike in oil prices.  That makes sense.  In the study he stated that it appeared when America spent more than 4% of GDP on oil, a recession followed.  I have no way of knowing if this is true, but it has a "gut feel" of truth to it.  Last year I did a back-of-the-envelope calculation and came up with $83/bbl oil being roughly 4% of American GDP.  Again, it "feels" about right.

So, assuming the above numbers to be about right, what does it mean?  Well, since oil production (including non-conventional oil and liquified natural gas) and demand are both roughly 86 million bbl/day worldwide, any increase in demand or decrease in supply should result in a price rise.  Oil usage in the developed world has flattened, but it is still rising in the developing world.  Economic development cannot  occur without increasing energy inputs; the developed nations have transferred much of the energy-intensive manufacturing to developing nations.

Those who state we will "grow our way out of our deficits" are highly uninformed in my humble opinion.  Growth has ended for the developed nations.  We cannot afford it (other than the fake growth found in government statistics).  From now on the struggle will be to control the rate of deterioration of our lifestyles.

From the $83/bbl number inducing a recession above, I have come up with my own simple hypothesis of predicting the American economy based on oil prices, and by extension Canada's.  Energy underpins everything we do, and oil is a good proxy for the entire energy complex including coal, hydro, nuclear, and the trifling contributors like solar and wind. I'm rounding last year's $83/bbl to this year's $85 (inflation) for a no-growth American economy.  Then, the following would follow:

     $80 oil = growth limited to 2%;

     $85 oil = zero growth;

     $90 oil = recession; and,

    $100 oil = major recession (continuation of current depression in my opinion).

Obviously a sharp spike in oil prices of short duration has no lasting effect on an economy, so I monitor the 50 dma (daily moving average) of oil prices for my purposes.  This is just the average of the oil price for the previous 50 trading days (10 weeks).  If the 50 dma hits $85, I'm reasonably sure the US economy is at zero growth, or just entering recession.

How to monitor oil prices?  The easiest way is to go to stockcharts.com and plug $wtic (West Texas Intermediate Crude) into the "Sharp Charts" box on the home page.  Then look at the value at the left of the chart for the 50 dma (blue line).  You should see something like this partial screen capture (click on image to see on separate screen):

Notice how the 50 dma hit about $83 in early May, then trended down as oil prices dropped.  It very nearly hit the target $85 recession point.  On the legend at the left it shows current 50 dma at $78.00 and 200 dma (40 weeks) at $77.26. 

My numbers are approximations only, but I think we can be quite certain $100 oil will kill the US economy big time, while $50 oil will curtail new drilling.  I think the range will be mostly $60-90, with only brief spikes outside that range.  So all these goofballs talking about $200 oil are probably ignorant in other areas as well.  (Sorry, Jeff Rubin, but I thought your book was basically a summary of other peoples' hard work -- OK for beginners on "energy learning training wheels" but not for serious education.)  When oil hit $147 in the summer of 2008 the American economy was already convulsing like an epileptic hit with a Taser.  That economy is much weaker now, so the same result can be obtained at a lower oil price.

Think of energy prices like the ball in a slow motion pinball machine.  When it hits a low numbered post it's a good thing, and you gain economic points.  When it hits a high numbered post it's a bad thing, and you lose economic points.  When America takes a hit, everyone feels the pain -- all economies are linked through the international bankster network of fraudulent paper instruments.  As the cost to find and produce oil rises, and the ability to afford it drops in the developed nations, the price will become increasingly erratic.  OECD countries will bounce in and out of recessions more rapidly.  Those economies will be in recession more than they will be in growth periods.  At the same time the developing nations will continue growing until they, too, are too dependent on oil.

There is considerable debate on whether world oil production can be increased from the present 86 million bbl/day, and if so by how much, and when.  Those who say production will increase tend to rely mostly on their belief systems -- production has always increased so far, and technological advances will ensure there will always be adequate supply.  Those who say we are at or near peak production tend to have reams of data on supply/demand/cost/storage from which they draw their conclusions.  My views are with the latter group.

What general conclusions can we draw from energy consumption trends and the upward trend in oil prices?  Here are some obvious ones:

1. As cheap oil fields are depleted, the cost to develop new fields rises, bringing prices up permanently.  
2. Rising energy prices act like a tax on economies.  The economies most dependent on cheap oil like Canada and the USA will feel the effect of rising prices the most.
3. Developing nations have hundreds of millions of people with increasing incomes who intend to use more energy of all types, and can afford it because they use very little now. 
4. Rising energy costs in North America will cause those in the middle and lower economic classes (the large majority of the citizenry) to cut back on expenditures on everything.  Their credit is pretty much maxed out.  Canadians and Americans have roughly the same household debt ratios.
5. As citizens cut back on energy usage, they will buy fewer cars.  I suspect there never again will be as many cars in North America as there were in 2007.  Governments will continue to waste taxpayer money on failed companies like GM.  I suspect the Chevy Volt will be a collosal flop.  We have too many auto manufacturers; GM and Chrysler should have been euthanized via the bankruptcy process so those who know how to run a business could take over the assets.
6. Housing is the largest single expense for most people in developed nations.  This has been compounded in many countries in the world with housing bubbles, created by artificially low interest rates and easy credit. Millions of North Americans are trapped in over-priced McMansions; Americans are painfully aware, most Canadians remain blissfully ignorant ("it's different here").  The inevitable will happen: McMansions will be sub-divided to hold 2-3 family units rather than one.  Did I mention we have all the housing we will need in North America for at least the next 20 years?  That hasn't stopped the federal government in the United Subsidies of America from supporting homebuilders with tax breaks, encouraging them to build more homes, rather than enter bankruptcy as they should. The twisted logic behind that subsidy (and others) is partly why America is accelerating its decline to third world status.
7. Unemployment will remain permanently high in North America.
8. Wages will stagnate, and probably drop in terms of purchasing power.
9. Most pensions will be downgraded; existing payment schedules are mathematically impossible, especially for public sector employees with defined benefit plans.
10. Social unrest will become more prevalent, and will involve escalating levels of theft, vandalism and violence.  Police will be less prevalent (unaffordable) while private security will boom (for those who can afford it).  Vigilantism will return and they won't always get the right person(s).
11. Governments will attempt to increase their revenues by increasing existing taxes, and by introducing new ones (levies, licenses, user fees, tolls, surtaxes, windfall profits taxes, speculative gains taxes, value added taxes, etc.)
12. America is trending toward third world status, and will be there before 2020 unless there are some major intervening events.  Highly complex societies tend to collapse rather suddenly after a resource depletion event.
13. I have been maintaining since 2005 that we are due for an international currency collapse in 2012, based on demographics, debt accumulation, and resource depletion.  I see no reason to adjust that forecast; the central bankers are currently strategizing on what will replace the USD as the world reserve currency.
14. Major wars will occur as the reality of Point 12 sinks in, the most likely flash point being somewhere in Pipeline-istan.  There's a reason the Americans are building permanent military bases in and around Pipeline-istan; they aren't entirely stupid.  They expect "first dibs" on the hydrocarbons and other resources.  He who controls the oil controls the world. 
15. If the human population hasn't already been considerably reduced by famines and diseases, the wars will have to be destructive enough to reduce the population by billions, back to a more sustainable level.   Many people who study these things maintain that the long term carrying capacity for people on this earth is 1-2 billion people.  I think there have been four major population die-offs in the history of mankind and the signs indicate we are due for the fifth.

There is always the possibility that some of these events can be postponed, but that is just "kicking the can down the road".  Resource depletion, and energy depletion in particular, will trigger a collapse of the human population at some point.  It's a matter of when, not if.

With that definitely uncheerful thought, let's turn our attention to someone who looks like he is suffering from energy depletion: