Economic Outlook

Energy Consumption and Emerging Markets (Part 4)

jeffreykramer@econoutlook.com (Jeffrey Kramer) — Thu, 05 Nov 2009 01:36:00 +0000

The previous three entries in this series have demonstrated that energy consumption patterns will change as emerging markets develop. This entry will explain how these changes manifest themselves in the global economy and provide an analysis of possible implications for both the developed world and emerging markets.

Implications for the Developing World

The results of the per capita energy analysis help complete the picture of where energy consumption will shift in the developing world.

Industrial Growth Will Become More Energy Intensive

By definition, more developed economies employ automation and technology in the place of human labor for industrial manufacturing. Right now, the developing world (especially China) relies upon labor-intensive manufacturing for its industrial output.

Eventually, these economies will begin the slow transition away from a singular focus on exports. Currency appreciation will make imports more affordable and bolster domestic consumer spending. As this process takes hold, the economies of developing nations will begin to more closely resemble those of today’s developed markets.

The proportion of energy consumption for industry will decline. However, the actual amount of energy spent in the sector will stay the same or even increase if the country adopts more advanced production techniques which are more energy-intensive. This means that the developing world will increasingly rely on fossil fuels like coal and other sources of electricity to power their industrial infrastructure. Additionally, the production of automobiles, computers and electronics often requires increased amounts of petroleum.

An important side effect of economic modernization is a shift in production. Today’s labor-intensive manufacturing capacity will still be present, but in a different country or region. Wherever this manufacturing occurs (Africa?) energy consumption will grow in proportion to the demand for the goods produced. This creates a net shift in energy usage, not a decline. Aggregate global consumption will continue to increase as today’s emerging markets modernize and use energy-intensive processes and more labor-intensive activity grows elsewhere.

Consumer Spending Will Increase Commercial and Residential Consumption

When modernization increases per capita energy consumption in the industrial sector, it will alter the behavior of the people living in developing states. Greater prosperity will allow people to make discretionary purchases. The commercial sector will grow relative and gross energy consumption. Residential consumption will increase as well. Consumers will be able to afford better housing with more amenities like air conditioning. Consumer electronics will become more widely available. Increasing prosperity will inevitably increase gross energy consumption for households. However, gains in other areas may offset this growth in relative terms.

Transportation is the Most Important Source of Increased Demand

Transportation is one of the most important considerations for emerging economies. It represents the most energy-intensive activity of developed economies on a per capita basis. It is also the sector most dependent on petroleum as a source of fuel for automobiles. Fortunately, it is also the sector within which effective public policy can play the greatest role in reducing consumption.

The magnitude of the potential for growth in the transportation sector is clear: the developing world currently spends one-twelfth of the developing world’s energy use per capita for transportation. The developing world will lower this ratio as it spends more to move its goods to domestic consumers. Additionally, greater affluence will bring about greater demand for mobility among consumers.

The demand for mobility will require investments in infrastructure. This is where governments have the most ability to begin to shape future energy consumption today. The emerging world needs to learn from the mistakes made in the United States and invest in an infrastructure that promotes public transportation and lessens the importance of the personal automobile. This will help reduce dependence on petroleum (although energy needs will manifest in other areas, like electric power or natural gas.)

Many of Asia’s most important developing economies (including China) are taking proactive steps to promote public transportation and support environmental initiatives. However, their efforts must be accompanies by an increased commitment from the developed world to lessen its own emissions and reduce dependence on hydrocarbon resources.

Conclusion

The development of emerging markets into advanced economies promises to increase energy demand on both a gross and per capita basis across many sectors of the economy. Effective planning and infrastructure development are critical to help these countries meet growing demands for energy.

Ultimately, global economic expansion depends upon stable supplies of energy in a variety of forms. The prosperity of the developed world depends upon high-density energy consumption. Today’s emerging markets will follow a similar development pattern to their more advanced counterparts. Demand for energy and petroleum will rise alongside increasing prosperity. Shortages will threaten economic growth and create social instability.

It is the responsibility of both the developed world and developing nations to begin to analyze future energy use and make better decisions about infrastructure before consumption habits become intrinsic to economic development. Developed nations like the United States must commit to more sustainable practices and find common ground on environmental issues with the developing world. Without cooperation and effective policy leadership from both sides, future demand for energy will create conflict, inhibit economic expansion and threaten the environment.

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Energy Consumption and Emerging Markets (Part 3)

jeffreykramer@econoutlook.com (Jeffrey Kramer) — Thu, 05 Nov 2009 01:36:00 +0000

Although relative energy consumption is important, it is also helpful to examine energy usage in absolute terms.

Aggregate Energy Consumption

It is possible to compare the aggregate energy usage of the BRIC countries and their developed counterparts using equivalent energy. Equivalent energy converts a country’s total energy usage to a common unit, in this case millions of tons of oil.

[Note: The following figures do not reflect petroleum consumption alone. All of a country’s energy expenditures are converted to the mass of oil that would produce the same amount of energy. Because the oil is measured as a mass and not a volume, conversion to barrels is difficult since the density of oil varies. One ton of oil is roughly seven barrels, but this measure can change depending on the quality of the oil in question.]

The results of the comparison between BRIC and developed country gross consumption in 2005 reinforce earlier observations and reveal new insights.

First, the gap between BRIC and developed countries’ transportation energy consumption increases. The developed world used almost twice as much total energy on transportation as the BRIC countries. Similar gaps exist for residential and commercial energy use. Gross energy consumption amplifies the gap between developed and emerging countries.

Another important observation relates to industrial energy consumption. The previous charts showed that emerging countries spent more of their energy resources on industrial production. However, advanced economies use more energy in their own industrial production than do the BRIC countries. This reflects the difference in overall energy usage between the two groups. Developed countries are extremely energy-intensive. Even though their proportional expenditures are below levels of the BRIC countries, they still use more energy to support their existing industrial infrastructure.

The density of energy usage is a critical issue when assessing the prospects for consumption in developing markets.

Per Capita Energy Consumption

The differences in gross energy consumption are magnified when countries are compared on a per capita basis.

Per capita consumption reflects the density of energy usage in the developed world. For example, the United States, European Union and Japan used almost twice as much energy for transportation than the BRIC countries in 2005. On a per capita basis, the gap increases: The developed states used twelve times the energy per person for transportation needs. (The developed world used the energy equivalent of 1.25 tons of oil per person. The BRIC countries used only 0.1 tons per person.)

Residential and commercial energy consumption is also much higher on a per-person basis. This reflects a more energy-intensive, higher standard of living in the developed world, as well as a more robust consumer sector. Commercial services in the developed world used thirteen times as much energy per person as they did in the BRIC countries.

Another important quality the per capita analysis reveals is the disparity in industrial energy usage. Developed countries used 3.3 times as much energy per capita on industrial production. Remember, on a relative basis, developing countries used 1.5 times as much of their energy in the industrial sector.

The density of energy usage in the industrial sector is of critical importance to developing economies. The developed world has shifted its industrial focus to more energy-intensive production activities associated with high-value manufacturing processes. These include industries like automobile manufacturing (Japan), computer and defense technology (US) and industrial machinery (EU). It is important to note that these processes are energy-intensive but not necessarily people-intensive. Developing countries allocate more workers to manufacturing processes that require more labor; the developed world uses more automation and more energy.

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Energy Consumption and Emerging Markets (Part 2)

jeffreykramer@econoutlook.com (Jeffrey Kramer) — Thu, 05 Nov 2009 01:35:00 +0000

The consumption patterns in developed economies provide a useful context from which to view emerging markets.

The Developing World

China is the most notable developing country because of its spectacular record of economic growth. Chinese energy consumption reflects the policy decisions which have led to this growth.

In 2005, industrial activity consumed almost two-thirds of China’s energy expenditures. Transportation and commercial activity consumed another quarter of the total, while commercial activity and agriculture each used five percent of China’s energy.

This distribution of energy use reflects China’s commitment to industrial development. China is a model for other developing economies because of its ability to build industrial capacity to export to the rest of the world. This strategy, paired with skillful management of the renminbi, has made China the world’s foremost manufacturing center.

Many other developing economies follow a similar model, albeit on a smaller scale than China. Emerging markets frequently rely on weak currencies and exports to build current account surpluses. This strategy necessitates a focus on industrial growth at the expense of domestic consumption, because the weakness of the country’s currency makes imports expensive. The cycle creates vastly different patterns of energy usage than those found in more developed countries.

A comparison between China and the United States is especially instructive. As expected, there was a substantial gap between China and the United States’ relative industrial energy consumption. [Per-capita consumption is addressed later.]

The corollary to China’s focus on industry is the United States’ transportation situation. However, the United States also used more energy for commercial and residential purposes than China. This is likely a result of greater consumer affluence in the United States, along with its focus on a service-based economy.

Agricultural consumption also displays a marked difference between the two countries. Proportionally, China spent four times as much energy on agriculture. This reflects the gap in efficiency between developed nations’ agricultural programs and those in most emerging nations.

The relationship between China and the United States’ energy consumption is typical of countries at different stages in their development cycle. Other developing countries like India, Brazil and Russia display similar consumption patterns relative to more developed markets like the European Union or Japan.

Although the proportion of energy spent on industry is highest in China, India, Brazil and Russia all use a higher percentage than the three developed nations. With the exception of Brazil, the emerging markets all use less energy on transportation.

Trends in agriculture and commercial development are also similar. Agriculture is far more energy intensive than in developed markets, as is commercial consumption. This is not surprising given the efficiency gap in agricultural production. Additionally, the reduced consumption in the commercial sector among developing nations fits within the context of building an export-led economic system that inhibits consumer spending.

Brazil, Russia, India and China

Taken as a unit, Brazil, Russia, India and China exemplify emerging markets’ typical patterns of energy consumption relative to the developed world.

Together, the BRIC countries and the developed world reflect the same patterns seen between China and the United States. The developed economies spent twice as much of their energy resources on transportation as did the emerging markets. Similarly, the BRIC states used almost twice as much of their energy on industrial activity.

Agricultural consumption for the BRIC countries was more than twice the rate of consumption for the developed world. This shows that different levels of agricultural development is not unique to the United States or China. The developed world used more of its energy to produce food but suffered from inefficiency.

The lack of consumption for commercial purposes again supports the idea that developing nations have smaller commercial sectors as a result of the export-oriented monetary policy many of the states practice.

To summarize, the results of the comparison between the BRIC states and the developed world are similar to those found when comparing the United States to China. The developed world uses more of its energy resources for industrial and agricultural production. The developed world uses more for transportation and commercial activity.

Up to this point, the discussion of energy usage has used purely relational figures. The data has been presented as a proportion of the country or countries’ aggregate energy usage. It is also useful to look at actual usage by sector.

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Energy Consumption and Emerging Markets (Part 1): Global Outlook

jeffreykramer@econoutlook.com (Jeffrey Kramer) — Thu, 05 Nov 2009 01:27:00 +0000

Although experts disagree on the future of oil production, there is considerably more consensus about demand. Most agree that the demand for oil will increase with economic expansion. There is a strong historical relationship between aggregate oil consumption and GDP growth.

Experts also agree that the developing world is the most likely catalyst for future global growth. More advanced economies will continue to expand, but emerging markets will grow at a faster rate and provide a greater return for investors (albeit with greater risk.)

Economic expansion in the developing world will translate into a greater demand for oil in developing nations. Oil consumption is closely tied to a more general demand for energy.

One of the hallmarks of “modernization” is an increasing per capita demand for energy from both the manufacturing and consumer sectors. As economies develop and domestic consumption increases, consumer demand for transportation, modern housing and entertainment all grow. This presents a compelling question: How will the development of countries like China shape the global demand for energy?

Global Energy Consumption

To understand the path developing nations may take, it is important to consider how global energy consumption is distributed. One of the best breakdowns of global consumption can be found in the Peterson Institute’s China’s Rise: Challenges and Opportunities.

China’s Rise provides information on total energy consumption (not just oil) for sets of developing countries and more advanced economies in 2005. To illustrate how each country utilized energy, consumption is divided among six sectors: agriculture, industry, commercial, residential, transportation and other.

This breakdown is important because countries consume energy in different ways as their economies develop. The relative allocation of resources shifts as nations become wealthier.

An examination of global consumption by sector is a useful reference point to understand these shifts. Global energy consumption acts as a weighted average for all of the world’s countries’ activities. It reflects the aggregate use of energy across the world’s spectrum of economic development.

A plurality of the world’s energy in 2005 went toward industry. The second highest use was in transportation, followed by residential and commercial. Agriculture and other uses each consumed only 2% of the world’s energy.

The industrial, commercial and transportation sectors are critical to economic growth. Not surprisingly, they comprised over 85% of global energy consumption in 2005. However, this distribution does not necessarily reflect the usage patterns in any particular country. Some areas may have higher concentrations of industrial use; others may consume more energy for transportation. These distinctions reveal useful patterns to predict future usage trends in emerging economies.

Usage in Advanced Economies: The United States and the European Union

The goal for most developing economies is to grow and emerge as “modern” states. Although they may eschew a traditional Western capitalist orthodoxy, government planners, industrialists and business leaders want to grow the wealth of their nation.

For developed states, the process of wealth generation has created consumer-driven economies. Whether or not this paradigm holds for developing countries like China or Brazil remains to be seen. However, it is fair to say that these countries are likely to follow a similar pattern of development as more advanced economies like the United States, if only a general sense.

To see how developing countries may consume energy as they become more advanced economies, it is helpful to look at usage patterns in countries like the United States or those in the European Union.

The United States is the world’s largest individual consumer of energy. In 2005, the United States devoted two-fifths of its total energy consumption to transportation. This was followed by industrial production at roughly one-quarter of total consumption, and commercial and residential usage equal to thirty percent of the total.

Interestingly, the United States “spent” only one percent of its total energy consumption on agriculture, despite the country’s status as one of the world’s largest producers of a number of staples.

The European Union, which is comprised of 27 member states, displayed similar consumption habits as the United States in 2005. The EU used the most energy for industrial production (32%) followed by transportation (30%), commercial (22%) and residential (11%) usage. Again, agriculture took only a small proportion of the EU’s total energy use.

Although the United States and the European Union display similar consumption patterns, there are also important differences. These differences show that there is not one particular pattern that developing nations are preordained to follow. Deviations in US and EU consumption show how infrastructure and social preferences can drastically affect energy use.

The most important difference between EU and US consumption is in transportation. The United States devoted ten percent more of its total energy resources to transportation than the European Union. There are many reasons for this difference. The US and the EU have vastly different infrastructures. The European Union is spread over a smaller geographic area than the United States and has a vastly superior public transportation system. The United States covers more land area than the EU, making it more costly (in energy terms) to transport people and goods across the country. Additionally, an abundance of land allowed cities in the United States to grow outward. Suburbs and commuting became the archetype for American living after World War Two.

In contrast, Europe’s infrastructure is limited by geography. Rather than expand outward, cities have grown upward. Since most major European metropolitan areas existed before the car, automobile transportation is not as practicable as in the United States, whose cities developed around the commuter lifestyle.

The United States’ skewed usage of energy for transportation affects its distribution in other areas. Proportionally, Europe uses more energy for industrial and commercial purposes than the United States. There is less difference on a per capita basis; the relative differences stress the United States’ overwhelming consumption for transportation.

These differences are important because they reflect ways in which other countries may choose to spend their energy resources. Sectors rely upon different types of energy resources; therefore, countries which develop more like the United States or the European Union may increase the demand for a certain kind of energy over others.

For example, both the United States and the European Union are world leaders in petroleum consumption. However, the United States uses far more oil on a per capita basis than the EU because of its transportation infrastructure. If a country like China follows the development pattern of the United States (with its heavy emphasis on automobiles and little public transportation), it will become similarly dependent on oil.

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Book Review #1: The Miracle

jeffreykramer@econoutlook.com (Jeffrey Kramer) — Tue, 03 Nov 2009 03:33:00 +0000

For my first book review, I would like to give my thoughts on The Miracle: The Epic Story of Asia’s Quest for Wealth by Michael Schuman.

As its title suggests, The Miracle details the remarkable post-war economic boom in Asia. Schuman’s years of experience as a business journalist in Asia are evident: his account boasts impressive depth and breadth. The Miracle is a sound introduction to the people and policies which shaped Asia’s rise to economic prominence.

Target Audience: Anyone interested in business, history and economic policy.

Although the book focuses on development in Asia, the economic and monetary lessons are important to anyone who wants to understand global finance. The book offers enough detail to be of value to financial specialists while maintaining a readable style that is accessible to a more general audience.

Best Feature: Country-by-country examination of economic policy

Worst Feature: Occasionally lacks specific figures

Quality: 4.5 / 5.0

The Miracle is well-researched and covers all of the important topics a reader would expect from a book chronicling growth in Asia. Schuman tests a number of theories about why Asia was able to excel while other regions saw growth stagnate. His conclusions vary depending on the country in question, and Schuman is careful to note the region’s many differences.

Applicability: 4.5 / 5.0

Past and future economic growth in Asia is an essential topic for anyone interested in global business. The Miracle provides a solid foundation to understand the unique characteristics of Asia’s diverse rise to prominence. Readers who already have a strong background in Asia’s history will still enjoy the book’s many personal anecdotes collected from some of the region’s most important leaders.

Writing: 4.5 / 5.0

Schuman’s writing is lively and precise. Despite the number of countries featured in the book, The Miracle never feels repetitive or disjointed. Schuman adds personality to his narrative by introducing each country from the perspective of its leaders or economic innovators. Often, these personalities were instrumental in shaping their country’s economic policy. Schuman deftly weaves stories ranging from the early days of Wipro to Indonesia’s “Berkeley Mafia.” Most importantly, The Miracle is always lively and easy to read.

Analysis: 4.0 / 5.0

The Miracle does a good job of introducing the key drivers for Asia’s growth. The analysis is clear and generally convincing. Readers familiar with Asia’s story would benefit from more hard data within the text, but the footnotes usually provide a starting point for readers interested in more detail.

Overall: 4.5 / 5.0

The Miracle is a thorough, well-written introduction to the reasons for Asia’s amazing economic growth. Schuman does a remarkable job of bringing to life the people behind the story. His careful analysis shows that there is more to Asia than a generic “Asian development model” of economic growth. The Miracle is essential reading for anyone interested in global business and economics.

Recommendation: Read and Study

If you are interested in learning more about The Miracle or want to see other reviews, check it out on Amazon.com: The Miracle: The Epic Story of Asia's Quest for Wealth

New Feature: Book Reviews

jeffreykramer@econoutlook.com (Jeffrey Kramer) — Mon, 02 Nov 2009 02:26:00 +0000

When I'm not working, doing research or playing with my dogs, I can usually be found reading. Given the number of economic, political, and historical books I read, I have decided to add a new feature to Economic Outlook – book reviews!

Time permitting, each week I will post a video review of a book I have recently read. The reviews will cover a variety of books relevant to economics, investing or management.

To make sure I offer an objective and unbiased opinion, I will only review books I have read in their entirety. Most will be recent releases, but I will also include older books that I read and find particularly informative or lackluster.

My goal is to help readers find quality books which provide adequate value in return for the time it takes to read them. Each review will follow this format:

Target Audience – Who will benefit from reading this book?
Best Feature – What does the book do best? What did I find most interesting?
Worst Feature – What is the book’s key shortcoming?

Next, I will evaluate the book in five categories, ranked on a scale from 0 (worst) to 5 (best):

Quality – Is the book well-researched, balanced and informative?
Applicability – Does the book meet the needs of its target audience?
Writing – Is the book well-written? Does the writing style add to or detract from the value of the book?
Analysis – Is the book’s analysis thought-provoking? Is the approach defensible?
Overall – This is a measure of the overall value of the book, not an average of the other four categories. This reflects my opinion of the value and quality of the book as a whole.

The review will conclude with a recommendation for the book’s target audience:

Read & Study – The book is essential reading. The analysis is so good, it will serve as a reference for its field.
Read – The book is high quality. It is well worth the time to read and consider.
Skim – The book is worth a quick read. However, it lacks enough detail or value to merit careful attention.
Ignore – The book offers too little value to justify the time spent reading it.

Look for the first book review to be posted this Wednesday!

Carry Trades (Part 2): Dollar-Denomination

jeffreykramer@econoutlook.com (Jeffrey Kramer) — Thu, 29 Oct 2009 22:36:00 +0000

In my previous entry, I introduced currency carry trades. This entry will explore their structure in more detail and explain the possible implications for a shift to dollar-denomination.

Important Features of the Carry Trade

The structure of the carry trade raises several key points. First, the success or failure of a carry trade depends upon the market exchange rates at the inception and closing of the trade. If the spot rates are nearly the same or if the original currency depreciates relative to the second, the investor will make money on the carry trade. Conversely, if the currency appreciates, the investor will lose money. In the previous example, the investor was successful with a final spot exchange rate of ¥ 119.45/$. If the exchange rate fell to ¥ 115.00/$ (which it did in September 2003), the trade would have lost money.

Carry trades’ sensitivity to exchange rates raise a second important point. Carry trades help create efficient markets. It is possible to use carry trades to create true riskless arbitrage opportunities. The firm could purchase forward contracts for currencies at the time the trade is created and lock in profits. This happens occasionally, and is called covered interest arbitrage. However, the forward market for currencies anticipates differences in interest rates to properly price the contracts. Therefore, it is difficult to find such arbitrage opportunities.

This suggests an important question about the relationship between the spot rate and forward rates for currency exchange. If two currencies can be invested for different interest rates, why does the future spot price not always reflect this difference? A theory called the International Fisher Effect suggests that foreign exchange rates should shift over time in direct proportion to the nominal interest rates in two countries. In the example, interest rates in Japan were lower than in the US. According to the International Fisher Effect, dollars should buy fewer yen at the end of the trade so that the profit from either strategy is equal. The long-term relationship between the yen and the dollar seen in the chart to the right reflects this reality. The value of the yen rises relative to the dollar at the same rate as the difference in interest rates.

In the short term, this relationship does not always hold. A major cause is the structure of carry trades themselves. When firms initiate carry trades, they borrow and then sell the currency on the spot market to buy the second currency. Gradually, carry trades weaken the currency that is borrowed (in this case the yen.) When the currency weakens, its exchange rate depreciates, helping to offset the gains predicted by the International Fisher Effect. Frequently this results in the currency maintaining a steady exchange rate rather than gaining value versus the second currency in the trade.

Other factors come into play as well. A county might decide that it needs to strengthen the competitiveness of its exports. It would intervene in currency markets to help depreciate the currency. This benefits carry trade participants, because the weakening of the currency helps them repay the initial loan and increase the profit margin of the trade. This happened in Japan and other east-Asian countries as governments sought to build manufacturing capacity and make their products less expensive (and more attractive) abroad.

The scope of the financial forces at play in a carry trade raises a fourth important point. Carry trades are typically carried out by large retail investors. Only institutions like investment banks have the market strength to borrow closer to the interbank rate. The ability to borrow freely at low rates is critical to the success of a carry trade. Carry trades require large sums of money and low transaction costs to be effective. Only major financial firms have this kind of leverage.

Dollar-Denominated Carry Trades

As the previous discussion demonstrates, national interest rate policy is important to the construction of carry trades. The United States’ Federal Reserve has reduced overnight rates to almost zero to increase liquidity in response to the financial crisis of 2007-2009. This has helped fuel carry trades denominated in dollars rather than traditional currencies like the yen.

Institutional investors are taking advantage of low rates to borrow dollars and invest them in a variety of asset classes. The borrowed money needs a home, and many observers believe the money is flowing into equities. Some estimate that the sector is overvalued by ten to twenty percent relative to market fundamentals.

There is some validity to this opinion. Carry trades rely upon weak currencies, and the dollar has certainly depreciated relative to its peers. Equally important is the posture of the Federal Reserve. As long as interest rates remain near zero, the value of the dollar will stay low and help fuel trades. Eventually this posture will change and dollar carry trade positions will need to be unwound to avoid heavy losses as the currency appreciates.

Experts note that unwinding carry trades will pull dollars out of equities to repay their original loans. This will necessitate the correction in equity prices that many observers fear. Measuring the severity of the problem is difficult, because no one is sure how much dollar-denominated money has been generated through carry trades.

The phenomenon reflects a more general concern about monetary policy. The Federal Reserve used low interest rates to stimulate the economy after the collapse of the technology bubble and the September 11 terrorist attacks. This loose monetary policy helped equities, but indirectly fueled the housing bubble. Now, after another collapse, low interest rates may be precipitating another problem. The Federal Reserve faces a classic dilemma: how to stimulate the economy while preventing speculation enabled by low interest rate borrowing. Low rates create bubble environments which feed upon themselves.

Are the consequences of dollar carry trades as severe as the housing bubble? Will they cause (as some experts argue) a further shift away from the dollar as the world’s primary reserve currency? Probably not. The magnitude of overvaluation resulting from carry trades is less severe and intrinsic than speculation during the housing boom. The likely correction should be much more contained. Dollar carry trades will have a relatively short life as the Federal Reserve inevitably tightens monetary policy. Other currencies like the yen will again fall back into favor.

More important than the trade is what it represents. The United States is still in the early stages of recovery. Economic and technical indicators are improving slowly. Better earnings are frequently more a result of cost-cutting than market strength. Investors should be wary of over-zealous equity advancement, and aware of subtle factors like carry trades which may magnify trends.

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Carry Trades (Part 1): Structure

jeffreykramer@econoutlook.com (Jeffrey Kramer) — Thu, 29 Oct 2009 21:28:00 +0000

The financial press has recently focused on a rising phenomenon: the dollar-denominated carry trade. The strategy is referenced in a number of contexts. Depending on the situation, the dollar-denominated carry trade is believed to be…

… a sign of how the value of the dollar has fallen relative to other currencies.

… an unavoidable consequence of historic current account deficits.

… an indication that American financial power is beginning to decline.

… the reason equities may be overpriced.

… a signal for countries to consider other reserve currencies like the Euro.

All of these ideas have merit. Some are accurate and applicable today. Others are more speculative about the future of the dollar and its role in international finance. To understand these distinctions, it is important to know what a carry trade is and why dollar-denomination is an unusual and important signal for global markets.

What is a Carry Trade?

Before exploring the implications of dollar-denomination, it is critical to understand what a carry trade is. Carry trades are derived from the concept of “carrying cost.” Simply put, carrying cost is the amount of money required to hold something in inventory, be it a commodity like oil or a currency like the dollar.

In the case of oil, carrying cost is the amount of money someone must pay to store the oil in a tank until it is sold or refined. The same concept applies to currencies like the Japanese yen or the United States dollar. The carrying cost is the interest paid on a loan to receive the currency.

Currencies have different carrying costs. In practice, this means that some currencies are less expensive to borrow than others. A carry trade tries to exploit the different interest rates (or carrying costs) for two currencies.

In a typical currency carry trade, a firm will borrow a currency loaned at a low interest rate. It will then convert the currency to a higher-yielding currency and invest in an interest-bearing account. At the end of the investment, the firm will convert the second currency back to the original and repay its loan. The firm’s profit is the difference between the interest paid on the high-yielding currency investment and the cost of the loan in the low-yielding currency.

For a few years, consumers created a form of carry trade with introductory credit card rates. Borrowers would sign up for 0% introductory terms lasting up to one year on new cards. Then, the borrower would take a cash advance on the card and invest it in a saving account. He or she could pocket the savings account’s interest and repay the credit card company when the introductory rate expired. This practice became impractical when card companies began to charge origination fees on cash advances, but the concept is remarkably similar to currency carry trades.

An Example of the Carry Trade: The Japanese Yen

The following example will help illustrate how a carry trade works and explain how firms are able to profit from the strategy.

Step 1: Borrow a currency at a low interest rate.

The first step in a currency carry trade is to borrow a currency at a low interest rate. Historically, firms have been able to borrow the Japanese yen at low rates, making it an attractive vehicle for carry trdes.

This chart shows the Japanese interbank lending rate and the United States effective Fed Funds Rate. Both rates represent the cost for banks to make overnight loans to meet reserve requirements. Each also forms the basis for Prime Rates and general lending rates in their respective economies.

Since 1971, the Fed Funds rate has usually been higher than the Japanese interbank lending rate. This signals that it is cheaper to borrow yen than dollars, because the ultimate implied interest rate in Japan is lower.

Step 2: Convert the proceeds of loan to a currency where the funds are invested at a higher rate for a specific term.

The chart above shows that interest rates in the United States are typically higher than Japan. This means that dollar-denominated investments will probably yield higher returns. The firm will convert the borrowed yen into dollars at the spot exchange rate. It will then invest dollars for a specific term.

As the chart to the right shows, interest rates in Japan remained below those in the United States for most of 2002-2003. In the hypothetical trade described below, I will use interest and foreign exchange rates from this time period.

Step 3: At maturity, convert the second currency back to the original and repay the loan.

When the dollar-denominated investment reaches maturity, the firm will convert the dollars back into yen and repay the original loan. Assuming the exchange rate remained constant, the firm will make a profit equal to the difference between the interest paid on the dollar-denominated investment and the cost to finance the loan in yen. (More details on the exchange rate risk will be discussed in a moment.)

Structure of a Carry Trade

This example shows a complete carry trade with actual figures from 2002-2003. In this example, a firm borrows ¥ 10,000,000, converts it to dollars, and invests it at a 4.00% annual return.

At the end of the trade in July 2003, the dollar-denominated investment is converted back to yen at the market exchange rate. The firm makes a profit of ¥ 298,883. The carry trade helped the firm borrow at a low rate and invest the proceeds at a higher rate. Had the firm invested in yen, it would have made only ¥ 50,000. Similarly, if the firm had simply borrowed dollars, it would have made less money because its interest rate would have been much closer to the money-market rate of 4.00%. Because the firm borrows money it does not previously have, it creates profits synthetically.

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News, Information & Opinion at CNBC.com

jeffreykramer@econoutlook.com (Jeffrey Kramer) — Tue, 27 Oct 2009 21:07:00 +0000

The US stock market’s recent rally has raised more questions about the timeline for recovery than it has provided answers. On October 27^th, 2009, CNBC’s website offered an example of the contradictory opinions in play:

At 7:40 am Eastern, the site suggested that some stocks were set to climb in value
At 10 am Eastern, it reported that consumer confidence “skidded unexpectedly” during October
At 10:58 am Eastern, Art Cashin speculated that dollar carry trades could weigh upon markets (similar to Nouriel Roubini’s thoughts yesterday)
At 11 am Eastern, David Rosenberg speculated that the market was overvalued by “at least 20%”
At noon Eastern it noted that the Dow had “clawed higher” after “upbeat” earnings reports
Finally, at 1:23 pm Eastern, CNBC posted five reasons why US retailers may have a more “jolly holiday” this year

CNBC’s stories are characteristic of a financial market feeling its way through a nuanced, difficult recovery period. Leading indicators contradict each other and expert opinions differ.

These contrarian opinions make interesting stories. Readers know what is happing in the moment - they are more curious about the future, and contrary opinions fulfill this need. CNBC documents the good (reasons for retail optimism, traction in the equity market) and the bad (dour equity predictions, dollar carry trade issues), often side by side.

This creates a strange mix of headlines for CNBC’s visitors. Contrarian stories are natural draws, and in a volatile market, there is room for hyperbole on both sides of the bull-bear spectrum. There is also the usual mix of stories which are little more than attention-grabbing lists or speculation.

Today at 1:30 pm Eastern, a visitor to CNBC.com would have seen the following stories stacked one-atop-the-other on the main news board:

Five Reasons US Retailers May Have Jollier Holiday This Year
Stocks are ‘Overvalued At Least 20%,’ Rosenberg Says
Where’s Home-Buyer Tax Credit Headed in Congress?
12-Hair-Raising Money Tales: Readers Share Their Worst
Were Last 18 Months Buffett’s ‘Most Successful’ Ever?
It’s a Bad year to Get Wrecked at the Company Party
Icahn Touts CIT Plan as Protection for Small Bondholders
Porn Flounders, But Adult Novelty business Booms
Why Ford is Beating Chrysler and GM in Car Quality
Ex-A.I.G. Chief is Back, Luring Talent From Rescued Firm

These stories run the gamut of hyperbole. Dire predictions are set alongside good news and attention-grabbing fluff. This chart summarizes all of the stories on the main page and groups them into one of four categories: bull market, bear market, attention-seeking, or news and opinion. If an opinion piece falls into either the bull or bear extreme, it is grouped accordingly.

Not surprisingly, CNBC offers an equal number of stories predicting future bull or bear price changes. Holiday prognostications and improving home prices are set alongside warnings about the dollar carry trade and estimates of overvaluation.

Interestingly, it is the hodge-podge of attention-seeking stories that is more noticeable than the bull-bear dichotomy. These stories offer little hard news content. Their intent is to capture the attention of the reader and provide light commentary. At best, these stories have a tangential connection to major markets.

Readers’ “hair-raising” money stories are juxtaposed with real news on the future of the home buyer tax credit. The travails of the pornography industry receive a larger headline font than August home prices. In fitting Halloween fashion, the site raises the grim specter of Maurice Greenberg returning to “lure talent” from A.I.G..

The site plays to readers’ desire for schadenfreude with lists of “hedge-fund mansions” being sold at discount prices. It also offers insight into “getting wrecked” at company functions. CNBC’s expert advice? Don’t do it in a tight job market. The cutting-edge reporting continues with a list of the best-selling adult DVDs and an analysis of why sex toys are recession-proof.

Some of these stories are entertaining and a few offer real insight buried within frivolous concepts. My complaint involves the placement of these stories alongside other news of greater consequence to investors and financial professionals.

CNBC claims that it is “First in Business Worldwide.” The legitimacy of this claim rests on CNBC’s reporting and information services. CNBC undermines itself when it offers light-hearted stories directly alongside (and sometimes above) valuable, objective financial content. The site’s core market commentary is relegated to the small “Market Buzz” section while fluff stories dominate the main headlines.

I frequently reference CNBC’s news reports because of their timeliness. I even find value in some of the more extreme contrarian opinions it publishes. However, CNBC’s decision to promote superfluous content risks undermining its brand position. As entertainment-value stories receive more prominence, CNBC begins to resemble publications like Newsweek which blend light news with human interest, gossip and entertainment features.

CNBC should assign novelty and entertainment-value articles to a more clearly-defined category. The headlines on the main page should focus on important news and market events. The line between fact and opinion must be unambiguous. The site should better utilize its space to offer readers a clear list of major news stories, market events, expert opinion and entertaining features. CNBC can maintain its reputation for news and information while still being entertaining. More judicious headline management and story placement would accomplish this goal while maintaining the ability for the site to inform and entertain readers.

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Quick Update

jeffreykramer@econoutlook.com (Jeffrey Kramer) — Tue, 27 Oct 2009 00:26:00 +0000

Unfortunately I haven't had a chance to film a new video with my new equipment yet. I have not felt well, but I will definitely have new material as soon as I feel better and can film it comfortably.

New Equipment!

jeffreykramer@econoutlook.com (Jeffrey Kramer) — Fri, 23 Oct 2009 03:47:00 +0000

Today I received several new pieces of video equipment. I hope that these new additions will make the filming of entries easier and of higher quality.

The most important (and coolest!) new tool is a Bluetooth-enabled wireless microphone. I can clip the microphone to my shirt and the sound is broadcast directly in to the camera data feed in 5.1. This should end the constant audio-level problems once and for all.

I also purchased a new light and tripod to help improve the video quality. These aren't the most exciting new additions, but anything that improves the output is worth having.

I will test out all this new gear in my next entry which I will film this Sunday and hopefully have posted by Monday afternoon (pending YouTube's fickle upload capabilities.)

Mortgage-Backed Securities (Part 2): Structure & Failure

jeffreykramer@econoutlook.com (Jeffrey Kramer) — Tue, 13 Oct 2009 23:02:00 +0000

In my last entry, I explained how mortgage lending evolved as housing prices exploded in the United States. Today I will explain how mortgage-backed securities and their derivative instruments are constructed. I will also examine how the collapse of these financial instruments almost toppled the global economy.

Mortgage-Backed Securities

Mortgage-backed securities became a logical home for investors who wanted to capture some of the housing market’s returns. Capital flowed into MBS’s from both foreign and domestic sources. Part of what made mortgage-backed securities attractive was that investors could convert them into a variety of derivative securities called collateralized debt obligations (CDO’s).

CDO’s gave investors the ability to pool diverse bundles of mortgages into different “tranches,” or risk levels. Structured finance professionals could take a single mortgage pool and build a portfolio of derivative securities, each with an appropriate expected return relative to its risk level.

During the bubble, a typical mortgage pool would hold loans of varying quality. A single pool would contain prime, fixed rate loans and the most risky subprime, variable rate offerings. The aggregate level of risk for the entire pool was higher than that of the best prime mortgages. Conversely, customers with adjustable-rate loans and a high likelihood of default were more risky than the pool as a whole.

CDO’s allowed the holders of mortgage-backed securities to subdivide the portfolio into tranches and sell derivative products with risk-appropriate pricing. A hypothetical set of CDO’s might include:

Senior Secured (Expected return: 6%)
Mezzanine (Expected return: 10%)
Unsecured (Expected return: 13%)

Investors who purchased CDO’s would receive a return commensurate with the tranche’s risk level. Senior secured had the lowest credit risk (and lowest yield) while unsecured debt had the highest credit risk and highest yield.

From a structural standpoint, CDO’s use a system of payment distribution to create each tranche’s individual risk profile. Senior secured debt is paid first; unsecured debt is paid last. Lower tranches cannot receive their portion of the monthly payment from the MBS until higher tiers receive their full payments. This system of payments creates the credit risk for each tranche. Holders of lower tranches are compensated for the chance they may not receive payment by receiving a higher yield.

This payment schedule and yield distribution creates a unique risk profile for each tranche. Independent agencies assign debt ratings to individual tranches. Therefore, it is possible to create a AAA senior secured offering from even the most lackluster mortgage pool through payment assignment and yield distribution.

The creation of derivative CDO’s increased demand for MBS’s, which in turn fueled more lending. Unfortunately, the structure of CDO’s made them especially vulnerable when the housing bubble burst.

Distribution of Risk and the Failure of CDO’s

The bubble-model of mortgage generation is known as “originate to distribute.” Banks and brokers originated mortgage loans (and captured transaction fees) while distributing risk to investors in MBS’s. These investors distributed CDO’s of varying quality with independent debt ratings and payment schemes. This system created a self-feeding cycle which ultimately imploded and exposed the faulty rating and pricing of MBS’s and CDO’s and cost investors hundreds of billions of dollars.

This system works as long as MBS’s are priced appropriate to their risk level. Unfortunately, the bubble in housing prices coincided with lax lending practices which badly overvalued the underlying MBS’s relative to their risk of default. Poor underwriting standards and a lack of scrutiny for automated lending gave brokers and borrowers ample opportunity for fraud. The lack of oversight also encouraged homeowners to make poor decisions, borrow too much and speculate on prices. Lenders loaned money too freely and did little to examine whether or not borrowers could actually repay their loans.

Once home prices reached a plateau and began to decline, customers defaulted on their payments. Subprime borrowers who had purchased adjustable-rate mortgages were unable to refinance when their rates reset or teaser periods expired. Borrowers who had interest-only loans or put too little money down saw their monthly payments increase far beyond their means to pay. Over-leveraged home owners began to default on payments and enter foreclosure.

As borrowers defaulted, pass-through payments to mortgage-backed securities declined. This caused a domino effect. Mortgage-backed securities lost value as their underlying collateral (homes) became less valuable. Their derivative securities declined as well. In theory, non-payments should have been absorbed by lower tranches with poor debt ratings. However, defaults became so widespread that CDO issuers could not make payments for mezzanine or senior secured tranches either. The CDO market collapsed along with the value of mortgage-backed securities.

Who is to Blame?

There is ample blame to share for the fall of CDO products. First, the value of higher tranches did not reflect the true risk of non-payment. This failure can be attributed to both the writers of the securities and to the underlying mortgage originators who made dangerous loans with little hope of repayment in a down market.

Rating agencies are also at fault. CDO issuers created senior secured offerings from pools of subprime mortgages. A more judicious analysis of the underlying securities should have resulted in lower debt ratings for even the highest tranches. Rating agencies ignored the poor lending practices inherent in the mortgage pools themselves. They also failed to accurately assess the likelihood that the domestic housing market would enter a sustained downturn. Unfortunately for investors, rating agencies ignored a clear conflict of interest. Agencies were paid by investment banks who sold the rated securities. By the time agencies lowered ratings to reflect economic reality, it was far too little, too late.

The investment banks which were instrumental in establishing the market for CDO’s were also complicit in creating the system which collapsed. Executives and investors bought and sold products they did not fully understand. Additionally, compensation for derivative originators and executives was transaction based. Dealers were rewarded for the number of derivative contracts they put together and sold to investors. Bonus payouts were so large that individuals took on too much short-term leverage. Wall Street compensation failed to promote the long-term health of investment banks and global markets.

Lax regulation, government policy, consumer greed, and the Federal Reserve’s interest rate posture are also guilty in helping create a culture which rewarded short-term transactions to the detriment of adequate risk management. All of these topics are explored in depth elsewhere. The G20 summarized the situation succinctly:

During a period of strong global growth, growing capital flows, and prolonged stability earlier this decade, market participants sought higher yields without an adequate appreciation of the risks and failed to exercise proper due diligence. At the same time, weak underwriting standards, unsound risk management practices, increasingly complex and opaque financial products, and consequent excessive leverage combined to create vulnerabilities in the system. Policy-makers, regulators and supervisors, in some advanced countries, did not adequately appreciate and address the risks building up in financial markets, keep pace with financial innovation, or take into account the systemic ramifications of domestic regulatory actions.

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Mortgage-Backed Securities (Part 1): Origins & Changing Practices

jeffreykramer@econoutlook.com (Jeffrey Kramer) — Tue, 13 Oct 2009 22:00:00 +0000

For many people, the financial crisis from 2007-2009 remains difficult to understand. In this entry, I will discuss one part of the meltdown: mortgage-backed securities (MBS's). These instruments (and their derivatives) were at the core of the subprime and liquidity crises.

Mortgage-backed securities helped topple Bear Stearns, and Lehman Brothers. It also prompted the federal government’s massive bailout package. I will explain what a mortgage-backed security is and how it can be used to create derivative products.

It is not my intention to explain the entire subprime crisis or delve into all of the nuances of collateralized debt obligations (CDO’s). This entry will explain how mortgage-backed securities are created and the ways in which they can be abused with improper pricing and risk controls.

Traditional Mortgage Lending

To understand the origin of mortgage-backed securities, it is important to know how the process of mortgage lending has evolved over time.

Traditional mortgage lending was straight-forward. A mortgage represented a stable monthly cash flow. Banks could value (discount) these fixed-income cash flows relative to market interest rates and the risk of early repayment. The bank also weighed the credit-worthiness of the applicant to determine the appropriate interest rate to charge.

This made mortgages a profitable, low-risk activity for banks. The mortgage was a safe investment because the security (the mortgage loan) was collateralized by a tangible object – the buyer’s house. If the buyer defaulted on his or her payments, the bank could sell the house and recoup its initial loan. Banks also required minimum down-payments to further offset the risk of non-payment.

Mortgages represented a long-term commitment between a bank and a home buyer. Profitability depended upon judicious pricing and an accurate assessment of home values in case the buyer defaulted.

This dynamic began to change in the 1990’s. Low interest rates and soaring home values created a new paradigm for lending.

The Rise of Subprime Lending

Increasing home prices and low interest rates created the conditions for subprime lending. The US Census Bureau reports that home ownership increased from 64% of the population in 1994 to 69.2% in 2004. Much of this increase can be directly attributed to banks lending money to subprime mortgage candidates.

As prices increased, so did speculation and investment. Consumers sought exotic loans to spend more money on housing. Some people bought houses at higher multiples to gross annual income; others used second mortgages to fund home improvement projects or make discretionary purchases.

Lenders relaxed credit standards and introduced adjustable-rate mortgages (ARM's). Buyers could purchase homes with little or no money down. Low interest rates fueled lending. As money poured into the housing market, prices rose steadily. Buyers could refinance their ARM’s or lock in gains by selling their property.

Between 1997 and 2006, home prices increased by 124%. This change was directly related to the surge in subprime lending. Growing numbers of subprime borrowers increased the aggregate demand for homes. These consumers (along with prime borrowers) also reduced their annual saving rates to put more money toward housing. As long as there were willing lenders, increasing values and low interest rates, consumers were insulated from the ramifications of being over-leveraged.

This type of lending would not have been possible under the traditional mortgage lending model. The rise of securitization created a new relationship between borrowers, banks, and powerful institutional investors who saw opportunity in the booming housing market.

Mortgage Lending with Securitization

Lending to subprime consumers was limited under the old buyer/bank relationship for two reasons.

First, subprime lending entailed far more risk for banks than prime loans. Banks did not want to seize and sell property. This process introduced price risk if the home lost value. It also deprived the bank of the interest payments which made the mortgage profitable in the first place.

A second problem stems from banks’ ability to lend. Under the old model, banks would lend money and receive payments, typically over thirty years. Home loans required large cash outlays. Banks could issue a fixed volume of loans before exhausting their capital allocation for the level of risk associated with prime mortgages. Subprime lending (even with its increased return) didn’t fit into most banks’ risk portfolios.

The process of securitization changed the way banks viewed mortgage lending and solved both of these problems.

Mortgages represent a series of cash flows. If mortgages are pooled together, they resemble a standard bond. The pooling of mortgages is a kind of securitization: debt instruments (mortgages) are aggregated and a new security is issued to investors.

There are three major companies which buy mortgages for securitization:

The Government National Mortgage Association (Ginnie Mae)
The Federal National Mortgage Association (Fannie Mae)
The Federal Home Loan Mortgage Corporation (Freddie Mac)

When one of these companies (or a private counterpart) purchases a mortgage from a bank, it solves the two hindrances to subprime lending. The bank is able to immediately make a profit on the sale of the mortgage. It also receives the money it needs to lend to another customer. This gives the bank the capital resources to lend to both prime and subprime borrowers.

Companies which buy mortgages from banks pool the mortgages together and sell the pools to willing investors. These investors receive the mortgage-backed security (MBS), which behaves like a bond: The investor receives the pooled monthly mortgage payments (a coupon).

This process creates a cycle by which banks’ resources are continually replenished. The issuer buys the banks’ mortgages and sells the MBS. The issuer can then purchase more mortgages and repeat the cycle as long as there are willing buyers of the MBS.

This process is not accidental. The US government established Ginnie Mae to help banks issue more mortgages. An MBS issued by Ginnie Mae is backed by the “full faith and credit” of the US government. Essentially, the government guarantees the monthly payments to the holder of the MBS. Fannie Mae and Freddie Mac do not receive the same explicit support, but each has privileged access to US Treasury loans.

Many purchasers of MBS’s have assumed that Fannie Mae and Freddie Mac are actually guaranteed by the government. In practice, the government has shown that it is unwilling to allow either of these institutions to fail. All three have the de facto support of the federal government and US Treasury. This makes MBS’s especially attractive to investors, since the security’s coupon payments are essentially guaranteed. The same guarantee does not apply to private issuers of mortgage-backed securities.

From the consumer side, the shift to securitization was hardly noticeable. Home buyers would still receive a mortgage and make monthly payments to a loan servicer. The servicer would forward the monthly payments to the issuer of the mortgage-backed security, who would in turn make payments to MBS investors.

The most noticeable change for consumers was the rise of mortgage brokers and the “originate to distribute” model of loan generation. Once investors began to purchase MBS’s, banks were able to lend to more customers. Mortgage brokers emerged to help match borrowers with banks willing to lend.

Brokers earned a commission on each loan he or she generated. This created a unique alignment of incentives which pushed both banks and mortgage brokers into the subprime market. Both parties made more money as mortgage generation increased. Banks were able to lay-off risk to the issuers of MBS's, and mortgage brokers realized that sub-prime borrowers represented a vast, untapped market. The incentive structure became predicated upon origination and transaction volume rather than on proper risk control.

Rising home prices further fueled lending. The system created a classic bubble which fed upon itself as prices rose and lenders looked further down market with more exotic and risky products like interest-only loans and introductory teaser rates.

In my next entry, I will discuss the structure of MBS's and CDO's. I will also explore how the failure of these securities contributed to our economic crisis and nearly toppled the global economy.

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CDO Analysis

jeffreykramer@econoutlook.com (Jeffrey Kramer) — Mon, 12 Oct 2009 15:34:00 +0000

This is a quick update to let everyone know that I have almost completed the CDO analysis promised at the end of my last entry.

As I began to write about mortgage-backed securities, I realized that there is already a large base of material written about the topic. Rather than rehash what has already been said elsewhere, I have decided to focus on one particular aspect of CDO's which made them particularly vulnerable.

In my next entry, I will explain how sub-prime mortgages were packaged to create highly-scored debt products. The construction of these products is a nuanced process which I will explore in more detail.

Check back on Wednesday for the full update - both video and text!

Cheap Energy: A Challenge for Michael Lynch

jeffreykramer@econoutlook.com (Jeffrey Kramer) — Sun, 27 Sep 2009 23:00:00 +0000

It seems that major news outlets are paying more attention to the concept of peak oil. Unfortunately, the quality of the analysis in many of the articles limits their value. The trend began with Ruchir Sharma’s ill-informed piece in April’s international edition of Newsweek. More recently, observers have scrutinized oil discoveries and price movements. The latest example comes from the New York Times. On August 24, the Times published Michael Lynch’s op-ed article titled “’Peak Oil’ is a Waste of Energy.”

Mr. Lynch wastes no time asserting his thesis:

A careful examination of the facts shows that most arguments about peak oil are based on anecdotal information, vague references and ignorance of how the oil industry goes about finding fields and extracting petroleum…

…A related argument — that the “easy oil” is gone and that extraction can only become more difficult and cost-ineffective — should be recognized as vague and irrelevant.

In the article, Mr. Lynch criticizes three facets of the peak oil debate:

The rate of new discoveries which replenish oil physically produced each year.
The risk of political instability to existing supply chains.
The percentage of oil we have already extracted as a fraction of all the oil in the ground.

Mr. Lynch employs a variety of rhetorical techniques and historical comparisons to justify his position. Rather than refute each argument individually, I would refer interested readers to my lengthy series on oil depletion. These articles address Mr. Lynch’s points and provide hard data (not “vague references”) to support the counter-position.

I am more interested in Mr. Lynch’s assertion that oil prices are likely to stabilize near $30 per barrel:

Oil remains abundant, and the price will likely come down closer to the historical level of $30 a barrel as new supplies come forward in the deep waters off West Africa and Latin America, in East Africa, and perhaps in the Bakken oil shale fields of Montan and North Dakota.

My view on oil prices is well-documented. I believe that prices will rise as economic conditions improve, demand grows and production plateaus.

Given our opposing viewpoints, I have a challenge for Mr. Lynch similar to one offered by an Oil Drum contributor. Since he claims that peak oil advocates are deliberately “vague” and “anecdotal,” I would like to give him a chance to make a concrete transaction.

If Mr. Lynch believes that oil prices will be near $30 per barrel in the next few years, he should be willing to sell call options with a strike price of $30 per barrel for some premium. The options would be non-transferable, European-style, and have staggered expiration dates through the year.

If Mr. Lynch isn’t comfortable selling calls, he could also buy puts. The same concept would apply: Mr. Lynch would buy puts with a strike price above $30 per barrel for a predetermined premium. The same conditions would apply. (There are other details to option contracts, but these are the most important facts necessary for the foundation of an agreement.)

To make the challenge fair my company, Kramer Strategic Services, will enter into either transaction. I will buy as many calls as Mr. Lynch wants to sell, or I will sell him as many puts as he wants to buy. We will set an agreed-upon timeframe to remove normal market vacillations and seasonality. The key is whether or not we can agree on option premium.

My question for Mr. Lynch is simple: What premium would you charge for the call option? The answer will reveal how confident you are that peak oil analysis is imprecise and anecdotal.

If Mr. Lynch is confident that prices will remain low, he will charge a lower premium for the call option. The premium compensates the seller of the option for the probability that the option will expire in the money. What might Mr. Lynch charge? Ten dollars? Twenty? Something higher? If oil prices are higher than $30, I will exercise the option and Mr. Lynch will lose the difference in the real price and the strike price minus the premium. The option premium gives Mr. Lynch some price flexibility. If the option expires out of the money, he earns the entire premium.

The same logic applies for puts. We could agree on a predetermined strike price above $30 and I would sell puts to Mr. Lynch for some premium. If prices are below the strike price at expiration, Mr. Lynch can then exercise the option and make the difference minus the premium he paid. If prices are low, he will make money; if they are high, he loses the premium he paid and the options expire worthless.

Ultimately, these option transactions depend upon the premiums Mr. Lynch would charge or pay. The premiums depend upon how confident Mr. Lynch is in his own predictions about the future of oil prices. Since Mr. Lynch accuses peak oil analysts of imprecision, I challenge him to take a firm financial stake. What premiums would you accept? The answer will reveal Mr. Lynch’s confidence in his own convictions.

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Relocation Complete

jeffreykramer@econoutlook.com (Jeffrey Kramer) — Fri, 25 Sep 2009 16:51:00 +0000

I have completed another relocation, so expect new entries this weekend detailing my challenge to Michael Lynch and an explanation of both how and why mortgage backed securities proved to be fragile financial instruments.

The story of CDO's is a classic example of how financial products can be misused or misunderstood, to disastrous results. Since so much has been written on this topic in the past year, I will focus on the mechanics behind sub-prime CDO's and explain the subtle but critical relationship between Fannie Mae and the Federal government. Check back Sunday!

Conclusion of the Depletion Series

jeffreykramer@econoutlook.com (Jeffrey Kramer) — Tue, 01 Sep 2009 23:06:00 +0000

The final video for the depletion series was successfully uploaded this morning. All of the entries are posted in their entirety. I am pleased with the results of this analysis, and I hope everyone finds the results as interesting as I found the research.

Here is a list of all 13 entries with the appropriate links:

Part 1: Why Depletion Matters

Part 2: Hubbert Linearization

Part 3: Linearization Applied to the US

Part 4: Production Shifts

Part 5: Relative Production

Part 6: Review and Sources

Part 7: Country Production

Part 8: Depletion in Norway & the UK

Part 9: Depletion in Mexico, China & Canada

Part 10: Depletion in Russia, Nigeria & Saudi Arabia

Part 11: Ghawar & Global Depletion

Part 12: Implications of Depletion

Part 13: A Visual Summary of Global Depletion

I would also like to thank the various people and websites which provided me with data and help in the model building process. I cover this in Part 6, but they merit repeating. The Oil Drum, Dr. Sam Foucher, Dr. Kenneth Deffeyes, and Matthew Simmons have all been a tremendous help and inspiration. I would encourage everyone to review their work if what you find here interests you. Additionally, any errors or omissions in the use of this data are wholly my own.

My next project is a special reply to Michael Lynch, whose op-ed piece in the New York Times is almost as bad as Ruchir Sharma's embarrassment in Newsweek. The refutation to most of his arguments can be found in this depletion analysis, but I will address a few in particular in my next entry. I also have a unique offer for Mr. Lynch - check back later this week to see what it is.

Also, several people have asked me to explain the sub-prime and CDO problem in a way that a non-specialist can understand it. I am going to write up a short primer on the subject that explains debt tranches, packaging securities, and why it all fell apart. Until then, enjoy the depletion series!

Oil Depletion (Part 13): A Visual Summary of Global Production

jeffreykramer@econoutlook.com (Jeffrey Kramer) — Mon, 31 Aug 2009 21:00:00 +0000

Where We Stand Today

Linearization analysis has shown that the world’s oil producers vary in terms of quality and their levels of depletion. This chart is my attempt to summarize the information I have presented in a way that is intuitive and easy to understand.

The chart works like this:

The vertical axis displays each country’s annual production in 2007 in billions of barrels of oil per year.
The horizontal axis shows the depletion level of the country’s oil supplies based on cumulative production through 2007 and the best URR estimate from linearization or expert opinion.
The size of the bubble represents the quantity of oil the country has left to produce, regardless of depletion levels.

This construction divides the graph into four distinct quadrants:

Lower left: Lower depletion, lower production
Upper left: Lower depletion, higher production
Upper right: Higher production, higher depletion
Lower right: Lower production, higher depletion.

This method yields a visual representation of production, depletion and the amount of oil each country has remaining. Countries in the lower left quadrant are less depleted but produce at lower rates than their peers. The upper left quadrant houses the world’s most important producers – those which are relatively less depleted and produce at the highest annual rates. Countries in the lower right portion are lower producers that are also in more advanced stages of depletion. Note that the depletion is relative; only a handful of countries appear to have produced less than half of their oil, and the most critical states are near their estimated peaks.

The graph adds a dimension to the depletion/production relationship by displaying the total oil a producer has left. For example, Mexico is less depleted than some of its peers like the UAE and Kuwait. However, both of these countries’ remaining reserves are of similar size to Mexico. The graph also highlights the dominance of Saudi Arabia and Russia – they are the largest producers and have by far the most oil left to produce. Finally, the amount of oil remaining helps put the declines of producers like the United States, Norway and the United Kingdom into perspective. All are in advanced stages of decline, but the United States has more oil left, even at this stage in its production cycle.

What the Information Means

The graph’s visual representations can be grouped into four general classes of producers.

Emerging Producers

The bottom left corner of the graph represents areas which are less depleted but still lower producing than giants like Saudi Arabia and Russia. The label of “emerging” does not mean that I expect the countries to grow their production levels significantly. However, some growth is possible in China, Nigeria and especially Canada as URR levels increase when non-traditional projects become more viable. Other countries like Iran have experienced political upheaval which has lowered production relative to theoretical capacity. In the future, these countries might be able to grow production in the short term, although long-term gains are far more unlikely.

The main reason these countries are “emerging” producers is that their current depletion status allows them to produce near their current levels for a longer period of time than more depleted nations. As these countries mature, they will shift to the right side of the graph, becoming the second type of producer:

The Stable and Mature Producers

These countries have similar production figures to “emerging” nations but are in more advanced stages of depletion. This makes it less likely that these producers will be able to increase their capacity. Countries like the UAE and Kuwait fall into this category. As these countries age and produce more of their URR, they will gradually shift further to the right on this graph and become the third type of producer.

Declining Importance

Countries in the lower right quadrant produce less annually and are far more depleted than stable or emerging producers. The group includes countries like the United Kingdom and Norway, which have acknowledged that their productive life-cycles will dwindle within twenty years. The United States is also included; it is the most depleted country in percentage terms. Interestingly, the United States still has far more oil left to produce, even at this most advanced stage. This demonstrates the value in this graphical approach: countries at the same level of depletion may have vastly different futures.

Two countries in this group which are more difficult to quantify are Iraq and Venezuela. The political climate and production history in each country makes estimation difficult. The position of these countries might change if more stable production allows for better estimation of reserves. This leaves one class of producer left, the world’s most critical suppliers.

Critical Global Suppliers

Predictably, this category of producer includes only Saudi Arabia and Russia. Both nations possess the largest oil reserves in the world and produce at the highest rates. For this reason, each country is essential to the global supply and demand balance for oil.

The productive capacity of both Russia and Saudi Arabia has been discussed at length in other parts of this article. However, this graph presents one piece of new information: The Ghawar field, Saudi Arabia’s most important, appears to be more depleted than Saudi Arabia as a whole. The graph also shows Ghawar’s importance visually – its remaining oil is a large part of Saudi Arabia’s overall reserves.

The most important question for these super-large producers is how they will move within the graph as time passes. Optimistic planners assume that both will continue to increase production as demand rises. As we have seen, this is unlikely to occur barring new discoveries or unforeseen technological advances. A more likely trajectory is for each country to gradually shift down and to the right as each becomes more depleted.

There is a historical precedent for this pattern. The United States once possessed similar resources to both Saudi Arabia and Russia (approximately 230 billion barrels of URR.) Today, the country is still an important producer, but its annual production falls far short of its peak capacity in the 1970’s.

It is not unreasonable to expect Russia and Saudi Arabia to follow the same pattern as annual production and depletion take their toll. The major question is the time horizon. How long can Russia and Saudi Arabia maintain their current production? What happens to long-term viability if production is increased in the short term? These questions should be central to any discussion of future energy planning.

They are also fo critical importance to global economic development. Recovery is predicated on growth. Growth necessarily increases consumption, especially in emerging markets like China. Since high oil prices are a drag on economic expansion, planners and policy makers must begin building sustainable solutions now. These graphs demonstrate the potential peril of waiting until production figures begin to fall.

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Oil Depletion (Part 12): Implications of Depletion

jeffreykramer@econoutlook.com (Jeffrey Kramer) — Mon, 31 Aug 2009 20:00:00 +0000

What Does This Mean?

The high and more optimistic scenarios increased the world’s URR by 10% and 20% respectively. The feasibility of these two scenarios is difficult to assess, but such large increases assume new discoveries, better technologies, or higher prices which encourage new projects.

The first two options, new discoveries and better technologies, are unlikely to fulfill the entire gap between the current projection and the more optimistic scenario. Since the 1960’s, few new, large oil fields have been discovered on the scale of the North Sea. Few parts of the world remain unexplored for oil, and experts agree that the vast majority of the prime sites have already been exploited.

New technology is unlikely to substantially improve URR, either. The world’s best producers already employ the most advanced technology (Saudi Arabia, Canada, etc.) and others like China are catching up.

Ultimately, any major increase in URR must come from a wholly-unexpected new discovery or from new projects in non-traditional production like tar sands. The fact that these options are being discussed and implemented today is a testament to the growth in demand for oil products and the realization that traditional supplies will be unable to meet demand. The economic logic is simple – producers wouldn’t pay the increased costs to extract and refine tar sands if cheaper alternatives were available in the form of traditional drilling. Costs don’t end with extraction, either. Heavy oil with sulfur costs more to transport, refine, and deliver to consumers.

It is important to note that even a 20% increase in the world’s URR only delays peak production for another fifteen years. Further increases are not out of the question, but they will necessarily entail further exploitation of non-traditional resources and constant investment to improve or increase infrastructure to maintain declining traditional reserves.

These facts generate the single most important conclusion of this analysis: the world’s inexpensive oil resources are fully exploited and future growth will come from non-traditional sources made economical by higher prices.

This concept is critical to the global economy. Can the world maintain strong economic growth when petroleum expenditures constitute a larger and larger part of a country’s available resources? It is my hope that this analysis will spark further discussion on these types of issues.

Oil is the lifeblood of the global economy and growth is predicated on cheap, abundant energy. When energy is no longer expensive, important questions emerge:

How much is a society willing to pay to maintain its traditional habits (commuting, disdain for public transit)?
Non-traditional oils have environmental side-effects. Are we willing to accept more pollution in exchange for increased oil supplies?
Which alternative energy sources should we pursue to help ease our reliance on oil?
What will our military posture be toward oil producers who ideologically differ from our views?
Are we willing to make changes and sacrifices today to improve our energy situation tomorrow?

Linearization analysis is a powerful tool which gives insight into the urgency of these questions. The public deserves to know the possibilities so that officials will make informed decisions. It is with this hope that I will present two final illustrations which help to summarize the position of the world’s major oil producers in a simple and easy-to-understand way.

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Oil Depletion (Part 11): Ghawar & Global Depletion

jeffreykramer@econoutlook.com (Jeffrey Kramer) — Mon, 31 Aug 2009 19:00:00 +0000

Saudi Arabia’s Most Important Field: Ghawar

As stated above, Saudi Arabia’s oil reserves are concentrated in a small number of key fields. One field is the massive Ghawar, easily the most important oil-producing formation in the world.

Ghawar’s size is made all the more impressive by its structural qualities. The flow rate of oil is governed by the porosity and permeability of the rock which houses it. Ghawar’s structure is a rare blend of the two which Matthew Simmons calls “Super-K”. (In oilfield geology, K is the symbol for permeability.) Thus, Super-K means that Ghawar has a rare level of permeability which makes it ideal for oil to flow to the wellhead. For a great overview of these scientific concepts, check out Dr. Kenneth Deffeyes’s book Beyond Oil: The View from Hubbert’s Peak.

Contrary to popular myth, oil does not simply explode from the ground through wells. Sometimes this happens when high-pressure wells are first set. However, it is far more common for wells to pass through a cycle of pressure from high to low. Oil flows through new wells more freely because of the natural upward pressure on the liquid. As wells mature, engineers must manage the pressure by pumping natural gas or water into the wells. This forces oil upward and maintains flow. As more water is pumped into a well, more is found mixed with the extracted oil (the “water-cut.”) High water-cuts imply that a field is running out of natural pressure and becoming more depleted. Ghawar is a rare example of an oilfield with extraordinary natural pressure, although there are some signs that more water is now necessary to help maintain pressure levels.

A final factor which separates Ghawar from other oilfields is the quality of oil it produces. Ghawar’s oil is especially light and sweet, making it easy to refine. Remember, heavy oil or oil with high sulfur content is more expensive to refine into transportation fuel. Ghawar’s oil is largely free of these contaminants, decreasing the total cost to extract the oil and refine it into useable fuels.

In summary, Ghawar is the world’s most remarkable oilfield from both a scientific and productive perspective. Its combined qualities make it the least-expensive, highest-quality oil extraction zone in the world. Factoring in its sheer size (estimated at well over 100 billion barrels), Ghawar serves as a proxy for the world’s supply of cheap, abundant energy. As Matthew Simmons suggests, Ghawar’s peak production probably signals the world’s peak as well.

Modeling the depletion of Ghawar is even more difficult than estimating Saudi Arabia’s overall numbers. Ghawar’s production history is difficult to put together and there are frequent interruptions which cloud the URR.

Part of the problem comes from a beneficial practice. Since Saudi Arabia is a swing producer, there are times when it must produce more oil than is healthy for the long-term viability of an oil field. When demand abates, Saudi Aramco will skillfully “rest” the production of in a field which has seen intense extraction. This helps prevent long-term damage to the fields’ reserves. However, the process of resting makes it more difficult to calculate a field’s full productive capacity.

Ultimately, the results of linearization for Ghawar are similar to those of Saudi Arabia as a whole. They are too imprecise for specific predictions or decision making. However, they are directionally useful – it appears that Saudi Arabia is at or near its peak productive capacity and that half of its reserves have been extracted.

Because of Saudi Arabia’s technology, it is possible that more discoveries may be made, although recent efforts have been unsuccessful. It is also possible that more oil may be recovered than initial estimates indicate. However, the purpose of linearization is to provide context, and Saudi Arabia is a special case because of its perception around the world.

Many leaders, industry analysts and economic planners believe that Saudi Arabia possesses nearly-infinite oil reserves and that production can increase to whatever levels the global economy requires. This is simply not the case. The story of the development of Saudi Arabia’s oil is a technological and human marvel. This does not change the fundamental idea that there is a finite quantity of oil which Saudi Arabia can produce over a sustained period of time. Global plans which assume that Saudi Arabia can increase its production by twenty to thirty million barrels per day ignore the reality that technology, no matter how sophisticated, cannot overcome physical restraints.

Given the information gleaned from these individual country analyses, it is time to look the world’s production in aggregate and determine when we may face global peak production.

Global Production Peaks

The process to create a linearization model for global oil production is similar to that for an individual country. In this case, total global production is tallied, and the same calculations are made.

This analysis presents an initial estimate of URR at 2,129 billion barrels of oil. At the end of 2007, the world had produced 1,070 billion barrels, almost exactly 50% of the total.

The actual production numbers closely follow these results. Global production reached a high of 26.96 billion barrels annually in 2005. This appears to correspond to the logistic peak near the same date. However, global production data feature the same problems found in many OPEC producers’ data. Production is higher than expected in the late 1970’s and reached a temporary peak at the height of the 1980 oil glut. Afterwards, production declined but quickly rebounded after 1983.

This aberration in the data means that the calculated URR may be too low. Also, the model predicts that oil is near peak capacity today. If this is true, growing demand and static production will increase oil prices, making new projects (like Canada’s bitumen) economically viable. High prices make more difficult production projects possible and increase the world’s URR.

The second model shown here demonstrates the cumulative effects if these factors increase the world’s URR. More optimistic projections push the logistic peak to later dates. In the high scenario (2,342 billion barrels of URR) 50% of the world’s oil will be produced in 2010. In the most optimistic scenario (2,555 billion barrels of URR) the peak occurs in 2020.

Higher URR’s also increase the world’s annual peak production levels. In the high scenario, the world will produce 28.27 billion barrels of oil in 2010. In the more optimistic scenario, production climbs to 30.85 billion barrels annually in 2020. The original scenario predicted a peak of 25.71 in 2007.

These annual volumes represent increasing daily oil consumption. In the base case, the model predicts that the world will consume 70.43 million barrels of oil per day. In the higher scenario, the world produces and consumes 7.02 million more barrels per day, and in the most optimistic case, global supply increases by 14.07 million barrels per day to 84.50 million in 2020.

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Oil Depletion (Part 10): Depletion in Russia, Nigeria & Saudi Arabia

jeffreykramer@econoutlook.com (Jeffrey Kramer) — Mon, 31 Aug 2009 14:05:00 +0000

Depletion in Russia, Nigeria & Saudi Arabia

I have also chosen not to create a specific model for Russia. It possesses some non-traditional oil resources, but not in as large a quantity as Canada. However, Russia’s production history is too disjointed to create an effective model.

Russia was the world’s largest producer until the 1980’s when output dramatically dropped. The subsequent turnaround placed Russia beside Saudi Arabia as the world’s largest producers. Russia is vital to the world’s oil markets. Unfortunately, the history is too scattered to build a reliable model. The situation is discussed extensively at the Oil Drum, and I will use an estimate of 250 billion barrels of URR in my final calculations.

For similar reasons, I will not present linearization models for Iran, Iraq or Kuwait. The countries’ production histories are too haphazard for meaningful analysis on an individual level. The countries have models similar to Venezuela’s (shown to the left). Production figures are not steady and the resulting logistic curve is not reliable for decision making. Production declined in the 2000’s – is this the result of depletion or political action? The answer is ambiguous and the logistic curve is not reliable for decision making.

Nigeria

Many OPEC nations show capricious production patterns resulting from political turmoil or price fluctuations. Nigeria is one example. However, the country’s production has stabilized over the past twenty-five years. Its estimated URR is now more reliable and the resulting logistic model is useful for directional observation.

Nigeria boasts impressive reserves, by far the highest of any African nation. However, its production history hints that future gains may be more difficult to achieve. The model predicts that Nigeria will reach its logistic peak (50% of its URR extracted) sometime near 2010. This isn’t a firm prediction – there are many factors which could delay a peak. Political tension might reduce output or new discoveries may be made. However, it is reasonable to suspect that if the status-quo remains, Nigeria may soon near its peak capacity.

This is a prime example of directional thinking – “Nigeria may be near its peak.” It would be unwise to use the model to predict specific declines in the next few years. Production and URR estimates are too imprecise. However, the overall theme of the model is valid for analysts in Nigeria and elsewhere. Understanding the realities of production is especially important in nations like Nigeria where oil revenues are a central component of state budgets and fund substantial public welfare programs.

The United Arab Emirates

The UAE is another example of a country for which linearization offers directional insight rather than specific predictions. The UAE suffers from the same “flaws” in its production data which plague other OPEC producers who saw their oil output drop precipitously after petroleum prices collapsed during the 1980’s oil glut.

This decline has complicated the estimation of the UAE’s URR. The model shown here assumes that the country has 40.9 billion barrels of URR. On the positive side, the UAE boasts modern technology and a stable political environment which facilitate efficient production. However, the oil glut caused significant gaps in production for many years. Today, the UAE appears to produce above its productive capacity.

It is possible that the UAE is actually above capacity and will quickly decline. However, it is equally likely that the model underestimates the oil remaining in the ground. If this is the case, the peak in production would be both higher (in terms of annual output) and farther in the future.

Linearization and depletion analysis are critical for countries like the UAE which rely on petroleum as a fundamental part their economies. The UAE has an impressive history of creative thinking and openness to different ideas and cultures which has turned the country into a stable business hub for the Middle East. However, oil production still underpins budgeting and planning. The UAE should carefully consider depletion scenarios as it continues to serve a dual-role as producer and commerce center.

The World’s Most Important Producer: Saudi Arabia

As previously discussed, Saudi Arabia is the world’s most important oil producing nation because of its status as the world’s only swing producer. Whenever demand has spiked, Saudi Arabia has been able to step in and fill the void, helping to control prices and provide stability in the market.

Because of its unique status, any study of the world’s oil resources must include a thorough examination of the situation in Saudi Arabia. Unfortunately, Saudi Arabian production is complicated by many factors.

First, Saudi Arabia (and its state petroleum company Saudi Aramco) regard oil reserves and production data as sensitive state secrets. This makes it difficult to find credible data on the country’s production, and for specific fields like Ghawar. While Saudi Arabia’s position regarding its reserves and production numbers creates difficulty for analysts, it is a common posture for many oil producers. Ideally, all reserves and production figures would be known publicly to help facilitate planning. However, Saudi Arabia’s position is understandable from a competitive standpoint, especially given its strategic position. Transparency is only equitable if all global producers take part. It is unfair to single-out Saudi Arabia alone for guarding this information.

A second problem with constructing a linearization analysis for Saudi Arabia rests with its production history. On the positive side, Saudi Arabia is the unquestioned world leader in oilfield exploration and extraction technology. The sheer scale of Saudi Arabia’s oil operations are a testament to the engineering skill and technical acumen possessed by Saudi Aramco’s professionals. [For an example of this skill, check out this video on the construction of the Shaybah field’s infrastructure.]

To help put Saudi Arabia’s technical capacity into perspective, more than half of its oil is found in just eight major oilfields. (Note: Many of these fields are subdivided into smaller production areas.) This density of production is in direct contrast to a country like the United States which employed a high of 4,530 rigs in 1981.

Saudi Arabia’s technology is important to consider for linearization. Whereas other countries might produce at less than their theoretical capacity (and thus lower the estimated URR) Saudi Arabia has the best extraction technology in the world.

If the technology story were the only factor affecting production data, Saudi Arabia’s figures would be more reliable than they are in reality. Saudi Arabia has shown the same production patterns as other OPEC members, punctuated by a sharp decline after the oil glut in 1980. An additional problem is that even though Saudi Arabia has the best extraction technology, it does not always produce oil at full capacity. Because it is a swing producer, Saudi Arabia does not always generate as much oil as it can. This means that URR estimates may under-represent the oil in place.

Results of Linearization for Saudi Arabia

Despite these major shortcomings, Saudi Arabia is too important to not attempt a linearization model. The main caveat is that the implicit assumptions behind the model (steady, full production) are less reliable. Therefore, the analysis should be used for directional purposes only.

According to the model, Saudi Arabia has produced almost exactly half of its estimated 216 billion barrels of oil. In absolute terms, Saudi Arabia’s production peaked at the height of the oil glut in 1980. However, global demand has brought production levels back to over 90% of its peak.

The logistic model estimates that Saudi Arabia is currently at its logistic peak. The question remains – is the URR estimate accurate? One way to help answer this question to examine one of Saudi Arabia’s most important oil fields: Ghawar.

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Oil Depletion (Part 9): Depletion in Mexico, China & Canada

jeffreykramer@econoutlook.com (Jeffrey Kramer) — Mon, 31 Aug 2009 12:55:00 +0000

Historical Production and New Frontiers: Mexico, China, Canada and Russia

Mexico, China, Canada and Russia rapidly achieved global prominence as oil production in the United States began to decline. Because of their geographic proximity to the United States, Mexico and Canada have a built-in market for their petroleum. In China, economic growth spurred domestic exploration to reduce foreign dependency. Domestic supplies also reduce exposure to price fluctuations.

Finally, exploration and development in Russia transformed the country into one of the most important energy producers in the world. For most of the 1980’s Russia’s output surpassed even Saudi Arabia. After a substantial decline in productivity, Russia once again experienced production growth after 1998. Today, the country’s output rivals Saudi Arabia (although most observers believe Russia is producing at maximum capacity whereas Saudi Arabia is not.)

Each of these countries is critical to global oil production, but their individual depletion models vary in terms of reliability.

Mexico

Mexico’s model appears to produce the most accurate URR estimate (66.3 billion barrels) of the four countries. Notably, Mexico appears to be near its peak productive capacity right now. The model predicts that Mexico has produced 50% of its URR.

Mexico’s model show how accurate URR estimates allow more precise estimation. Mexico’s actual production dropped slightly after 2004. Similar producers like China, Canada and Russia did not show declines. This suggests several possible explanations:

The drop in production is simply data noise.
The reduction is a temporary market event.
Mexico is near its peak productive capacity and future declines are possible.

Without depletion estimates, an observer might assume that one of the first two scenarios explains Mexico’s decrease. However, the linearization model suggests that other forces may be in play. Given Mexico’s position in its production cycle (near the peak) it is possible that the country will see flat production or further declines in the future as reserves are depleted. Depletion analysis and linearization support this hypothesis.

Of course, it is possible that the drop in production is a temporary aberration. Even the best linearization model is not perfect and new discoveries or economic shifts can change the critical URR estimate. However, linearization provides an additional context within which to view production. Barring significant changes, Mexico is likely near its productive peak. Planners and analysts should scrutinize claims that production can rapidly expand or that a return to 2004 levels are a foregone conclusion.

China

China’s depletion picture differs significantly from Mexico’s. According to the model, China is producing above its expected peak capacity. This reflects the country’s surging demand for energy and rapid modernization. However, it also affects the accuracy of the URR estimate upon which the model is built.

Slow growth in production from 1950 to 1970 has skewed the value of the URR downward (currently estimated at 71.0 billion barrels.) The logistic peak is also reduced. China’s drilling and exploration technology has improved exponentially from its early productive years. China’s leaders, aware of the country’s growing demand for energy, have increased exploration (leading to new discoveries of reserves) and have implemented progressively more advanced extraction tools.

All of these factors indicate that China’s original URR estimate is probably too low. This chart shows two additional URR scenarios. The increase in URR delays the timing of peak production and improves capacity. In the most optimistic scenario, the peak occurs almost a decade later than in the original estimates.

It should be noted that these changes to the URR are arbitrary increases of 20% and 40%. The rationale for making these estimates is that China is improving its reserves and extracting more oil now than when production first began. They are not concrete. Again, linearization provides context and must be viewed as one part of a country’s complete petroleum picture. In this case, China is likely to enjoy growing production for a number of years. However, linearization also provides a warning that even impressive gains in reserves (represented by increasing the URR by 40%) may only delay peak production by fifteen to twenty years. This should be taken into consideration as the country tries to improve its holdings of non-domestic oil reserves.

Canada and Russia

Canada and Russia demonstrate the difficulty in linearization analysis when URR estimates are imprecise or production histories are inconsistent.

Canada has shown stable production as it became the United State’s main oil supplier. However, it is not a good candidate for linearization. The reason is that Canada’s estimated URR is hotly debated. Right now, the country produces primarily traditional oil through standard extraction. The future may be different – the country is host to vast non-traditional reserves like oil sands. For example, the Athabasca oil sands hold almost 1.7 trillion barrels of bitumen.

Obviously, 1.7 trillion barrels of oil radically alters Canada’s depletion picture. However, the issue is far more complicated. The 1.7 billion barrels of bitumen are vastly more difficult to extract and refine into crude oil using today’s technology. The main differences include (but are not limited to):

Non-traditional reserves are more expensive to extract.
The refining process is more difficult, more expensive and less efficient.
The extracted oil is typically heavier and frequently not sweet.
Extraction requires exponentially greater amounts of net energy.

Oil from bitumen is costly to extract and consumes more energy than traditional drilling. The refined product is currently of lower quality than traditional Arab crude. Despite these drawbacks, if oil prices reach certain thresholds, it is economically viable to “mine” bitumen oil and take the product to market. Ignoring concerns about net energy expenditures, the oil is “real” in a physical sense. Should it be included in calculations of URR? If so, what is the yield rate of bitumen into useable oil?

Unfortunately there is no single answer. Since non-traditional oils are extremely price-sensitive, it is difficult to build them into accurate linearization models. However, it is equally unrealistic to ignore them. I have chosen not to create a specific model for Canada because the production and URR estimates are too sensitive to the non-traditional oil issue. This is an example of a country where more research needs to be done before conclusions are drawn.

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Oil Depletion (Part 8): Depletion in Norway & the UK

jeffreykramer@econoutlook.com (Jeffrey Kramer) — Mon, 31 Aug 2009 01:00:00 +0000

Linearization Applied: Norway and the UK

The countries described above illustrate the complexity of the global petroleum market. Producing nations range from liberal democracies to authoritarian regimes. Each country offers a different combination of productive capacity and depletion levels. Linearization analysis (where applicable) is one tool which can be used to evaluate each country’s unique position. An examination of the individual linearization results for each of these countries demonstrates both the efficacy and limitations of linearization. It also provides the necessary context to achieve our ultimate goal – understanding how soon global oil supplies may peak.

When Linearization Works Best: Norway

The depletion of Norway’s oil resources offers a textbook set of conditions which are conducive to linearization analysis:

The production history is stable, without major interruptions.
The country employs efficient extraction technology.
The production history is lengthy enough to establish a linear relationship (constant slope) between P/Q and Q. (Check out Part 2 for a refresher of these terms.)
The model presents a believable URR number and annual production matches the model’s estimates.

The viability of linearization depends upon an accurate estimate for the URR (ultimate recoverable resource.) This estimate comes from the slope of PQ/Q. The accuracy of PQ/Q depends on the stability of the production history, since all of the information for the model originates from annual production date.

For linearization, “accurate” production means consistent output. When war or political manipulation hinder production, the true productive capacity of the country is hidden behind artificially low production numbers. Similarly, if a country is using outdated extraction technology, it will not produce up to its full capacity. This lowers production numbers relative to the amount of oil in the ground and complicates model building.

Norway’s oil production meets all of these criteria. Norway’s domestic and North Sea production grew rapidly until the late 1990’s. The country employs state-of-the-art extraction technology and has avoided disruptions. These factors yield a more credible linearization model. Historical production numbers closely follow the model’s predictions.

The model reveals a URR of 27.4 billion barrels, and a logistic production peak in 2001 at 1.18 billion barrels annually. The actual peak occurred in this same time period at almost identical levels. The country now appears to be in irrevocable decline, having consumed 77% (21.2 billion barrels) of its total oil in place. It will likely produce only half of its peak volume in 2010, and one-sixth of its peak in 2020. This decline is striking: In less than twenty years, Norway will have exhausted over 96% of its URR and be a marginal global producer of less than 0.20 billion barrels annually.

Norway’s Neighbor: The United Kingdom

Norway and the United Kingdom appear to share a common history of oil production stemming from the remarkable North Sea discoveries in the 1970’s. However, Norway is a better candidate for linearization than the United Kingdom. The reason for this discrepancy is Britain’s more volatile production history.

In the ten years after 1986, British production declined to two-thirds of its peak capacity. The disastrous Piper Alpha explosion and fire killed 167 people, hampered production, and convinced the British government to implement new safety standards. Once these changes took hold, production quickly rebounded. The cumulative effect of these events led to a decrease in production from 1986 to 1989 and a rapid recovery from 1990-1994.

The production decrease after Piper Alpha complicates the process of linearization. Under “normal” conditions, the United Kingdom could have produced far more oil from 1986-1989. This “missing” production affects the calculation of URR because the slope of PQ/Q is less credible.

Although British production figures make for imperfect data, it is still possible to create a linearization model and draw some general conclusions. Production peaked at around 1.00 billion barrels annually in 1999. This is later than the logistic prediction because of production decreases in the late 1980’s. Interestingly, the decline from the peak has followed the logistic estimate more closely. British officials believe that production will fall to one-third of peak levels in 2020. The logistic estimate is more pessimistic – it estimates the U.K will produce only 0.21 billion barrels in 2020.

The specificity of a linearization model’s predictions correlate to the quality of its production figure inputs. Countries like Norway and the United States have almost perfect production data. Their models will generate directional insight (“Norway is well beyond its peak production”) and can be used for rough production estimates in the future (“The United States will likely produce about 1.48 billion barrels of oil in 2010.”) Note that production estimates are still subject to change. New discoveries, improving technology, and changing economic conditions can cause URR numbers to increase as the economic viability of oil extraction projects change. All of these factors should be included with any linearization analysis to justify more specific production estimates.

The United Kingdom is an example of a country for which directional predictions are most appropriate. The model shows that the country’s production is likely in terminal decline. However, it would be risky to make specific production estimates because the historical production data is less robust. Even with imperfect production data, the model still makes a compelling case that the country is well beyond its peak production, and official statements echo this idea.

The quality of the production numbers that build linearization models will be an important theme for many of the forthcoming countries.

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Oil Depletion (Part 7): Country Production

jeffreykramer@econoutlook.com (Jeffrey Kramer) — Sun, 30 Aug 2009 19:10:00 +0000

Understanding Depletion: Production by Country

Before looking at aggregate global oil production, it is helpful to examine individual countries to look for patterns or anomalies. Production histories help determine which countries are good candidates for linearization.

Norway and the United Kingdom

The first two countries of interest are the United Kingdom and Norway. Both countries are anomalous because they discovered oil later than other major producers. In the early 1970’s, exploration revealed petroleum in the North Sea. Most experts agreed that the area was an unlikely place to find hydrocarbon reserves.

As the production graphs show, both the UK and Norway rapidly developed their oil resources. Both countries encouraged quick deployment of advanced extraction technology. This policy had two consequences. Both nations became important global suppliers. However, the rapid extraction also depleted the resource base more quickly.

Today, both Norway and the United Kingdom appear to have reached their peak production levels in the late 1990’s. Barring new discoveries, both countries’ production levels will continue to decline as the fields age.

Mexico, China & Canada

While Norway and the United Kingdom have passed their peak productive capacities, these three countries have more optimistic futures. All three countries expanded rapidly in the early 1970’s and are important global producers today.

Mexico has a long history of oil production dating from just after World War Two. Growing demand and improved technology created astounding gains in production; the country quintupled its output in less than a decade (1973-1982). Production grew another twenty percent over the next twenty years before small declines after 2004. This presents an important question (and demonstrates the utility of linearization): Is the recent decline in Mexican production an anomaly or a sign that the country’s production has reached its peak? I will explore these questions in the next section.

Much like Mexico, China has a long history of production which grew exponentially in the 1970’s as the country became more integrated with the global economy. China’s case is unique because it has shown (almost) continuous growth since 1968. China is expected to be a leading consumer of petroleum as its economy continues to expand. Therefore, securing stable domestic supplies is an important goal for China’s leaders. Linearization will help determine China’s potential as an oil producer. The country will also demonstrate some of the model’s limitations.

Canada is another country which has shown a growth trend after reaching a temporary peak in 1973. Canada’s supply capacity is especially important for the United States. The U.S. imports more oil from Canada than any other county (including Saudi Arabia.) Canada also presents unique challenges for linearization. The country has vast non-traditional reserves like oil sands. These projects are less economical than traditional drilling. However, as the price of oil increases they become more viable. Is it possible to account for these reserves in the critical URR estimates for linearization?

Russia

The story of Russian oil production is difficult to decipher but critical to global demand. Until the late 1980’s, Russia was the world’s largest producer in both real and relative terms. Then, from 1988 to 1995, Russia’s production fell to less than half of its former peak value.

This decline was not permanent; production has increased every year since 1998 and now equals two-thirds of its peak value. Russian oil companies have faced many challenges including waves of privatization and nationalization. The country proves almost impossible to model using linearization because of the uncertainty surrounding its reserves and URR.

It is unfortunate that little is known about Russia’s oil reserves and depletion levels. With the exception of Saudi Arabia, no other country is more important to the world’s energy supplies. My final section will offer a visual representation of Russia’s importance relative to its peers.

Nigeria, United Arab Emirates & Venezuela

These three major OPEC producers each present interesting production patterns. The United Arab Emirates is the most stable producer of the three and has parlayed its energy resources into the creation of a thriving financial and cultural center in the Middle East. The country is uniquely situated to become a financial hub for the region. However, petroleum exports are expected to play a key role in the continued development of the country for years to come. Understanding the depletion of the UAE’s oil fields is critical for internal planners and international leaders. If the region is deteriorating more rapidly, the state will need to find new revenue streams more quickly then originally anticipated. There is also a market component to this development - like any oil producer, the country must deal with fluctuating prices. Managing changing conditions is challenging in the best economic climate. However, the uncertainty in today's market makes the UAE's decisions more important.

Nigeria produces almost the same amount of oil as the United Arab Emirates but in a more politically divisive climate. The country lives with the threat of militant attacks and questionable elections. It is tempting to stereotype Nigeria as a violent, unstable area. This characterization is an over-simplification. Nigeria is the eighth most populous country in the world with an enviable economic growth rate and rich cultural history. Leaders and policy-makers both within and outside Nigeria must understand its energy resources to create successful public policy.

Venezuela has one of the longest histories of oil production in the world. However, the political climate in the country has spawned volatile production figures. Linearization is impossible because of the uncertain URR and capricious drilling and extraction. Venezuela’s troubled history is well-documented elsewhere.

Iran, Iraq and Kuwait

Most people associate Middle Eastern oil production with OPEC members Iran, Iraq, Kuwait and Saudi Arabia. (The region houses many other important producers like Yemen and Qatar.)

Iran was one of the world’s most important producers in the early 1970’s. However, revolution and political tension have dampened production since 1978. Despite political turmoil and horrific wars with Iraq, the country has managed to grow production each year since 1981 and remains an important global supplier. Unfortunately, its scattered production history makes the country’s linearization analysis a poor basis for comparison and decision making. The same issue occurs in both Iraq and Kuwait. Wars have disrupted production for both of these producers and linearization is less accurate.

Saudi Arabia

Saudi Arabia’s reputation as the world’s most important oil producer is well-deserved. For many years, Saudi Arabia has served as the world’s swing producer. This means that Saudi Arabia has spare capacity which can meet demand increases in the short term. Other countries lack either the capacity to produce more oil or the political conditions to permit it.

In the past, Saudi Arabia has been the one producer which has been able to bring extra supply into the market to stabilize prices and calm fears of demand imbalance. Saudi Arabia’s status as a swing producer means that its ability to increase production in the medium to long-term is vital to global economic growth projections.

Saudi Arabia’s singular importance demands scrutiny. This is especially true for the crown-jewel of Saudi Arabian production: the magnificent Ghawar field. Ghawar (الغوار) is unique for its size and characteristics. The quality of oil and ease of extraction is unmatched. Many experts believe that once the Ghawar field has reached its peak productive capacity, the rest of the world has also reached its peak. Unfortunately, it is difficult to find credible information about Ghawar.

In the next section, I will examine Saudi Arabia’s production as a whole and the Ghawar field in particular. The results will show the probability that Saudi Arabia can maintain its status as a swing producer. It will also reveal whether or not common growth scenarios are feasible for Saudi Arabian production.

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Oil Depletion (Part 6): Review and Sources

jeffreykramer@econoutlook.com (Jeffrey Kramer) — Sun, 30 Aug 2009 16:45:00 +0000

Oil Depletion: What We Have Learned

In my previous entries on oil depletion I discussed several important petroleum trends. These trends form the basis for my next project. I will explain how oil producers are evolving over time. I will also offer several possible scenarios for future production levels.

These facts support the upcoming analysis:

The United States was the world’s leading oil producer for several decades before declining after 1970.
At the time, most oil experts rejected the idea that US fields would be depleted that early.
M. King Hubbert accurately predicted the decline and created mathematical models for oil depletion which are still applicable today.

Hubbert linearization is a good approximation for the famous Hubbert Curve of oil depletion. The technique, borrowed from population biology, plots the derivative of a logistic function to approximate annual oil production. The area under the curve represents the total recoverable oil (URR, or ultimate recoverable resource) in a country. The logistic peak represents the year in which annual production is at its maximum and half of the total oil (URR) has been extracted. A good summary of the mechanics of behind the model can be found here.

I demonstrated the applicability of the Hubbert linearization technique to oil production in the United States. It was a good approximation for when domestic production peaked and for output levels in the following years.

The decline of US production coincided with rapid global economic expansion. As the demand for oil grew both in the United States and abroad, several new oil producers emerged:

Discoveries in the North Sea made the United Kingdom and Norway important oil producers.
Growing economies prompted countries to develop existing oil reserves in places like Mexico, Canada, China and Venezuela.
OPEC nations like the United Arab Emirates, Kuwait, Iraq, Iran and Nigeria expanded production but suffered from low prices in the early 1980’s. Production was curbed but rebounded by the late 1990s.
Russia and Saudi Arabia emerged as the world’s most important suppliers of oil.

Relative production helps put these changes into perspective. Declines in the United States’ production allowed a plurality of countries to emerge as important producers for their domestic markets and for export. Some producers like Kuwait produced a lower proportion of the world’s oil while other countries like Nigeria increased their share. Russia’s dominance reached its peak in the mid-1980’s and declined. However, it still provides the second-highest percentage of the world’s oil supply. Finally, Saudi Arabia emerged as the most important oil producing nation in the world. Saudi Arabia proved that it was the only producer with spare capacity at several critical supply shortages and positioned itself as the last swing producer to help meet demand increases.

Oil Depletion Outside the United States

These facts demonstrate how several countries have risen to global prominence in oil production. As demand has grown, oil producers have invested in the latest technology and most efficient exploration and drilling techniques to keep pace. Supply and demand equilibrium relies on a complex global network comprised of these producers and their associated refineries, pipelines and shipping systems.

Economic recovery is expected to further increase demand for oil. Whether or not the world’s suppliers can match this increase depends upon many factors, but one of the most important is the depletion level of global oil reserves.

The United States demonstrated how a country can quickly swing from growth to decline. If other major producers are nearing similar peaks in production, the ability to meet global demand comes into question. If demand begins to outpace supply, prices may increase or economic growth may slow. Understanding depletion around the world is critical to almost any growth scenario.

To facilitate this examination, I will apply Hubbert linearization to some of the world’s major oil producers. This analysis will reveal which of the world’s producers may be nearing the decline phase and which have room to grow. I will also discuss the limitations of linearization and some of its key faults, especially when applied to countries with discontinuous production histories. Finally, I will apply linearization to the world as a whole and offer possible scenarios for the future. This will include a unique way to view the world’s major oil producers and quickly understand their relative importance now and in the future.

A Note on Sources

All of the data used in this analysis comes from the EIA and the BP Statistical Review of World Energy through 2007. In some cases, I have made minor extrapolations for data prior to 1960. The amount of extrapolation is almost insignificant when calculating URR, but I wanted the dataset to be as complete as possible.

Venezuela has a long history of oil production, and I used this source to help understand the years before 1960. I used Matthew Simmons’ Twilight in the Desert to supplement Saudi Arabia’s data in its early years. Data on the Ghawar field comes from an excellent article on The Oil Drum.

The Oil Drum features several informative articles on linearization. I give them the highest recommendation, especially the work of Dr. Sam Foucher. These discussions prompted my analysis and helped me build my models.

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