This month’s publication, Oil’s Ultimate Fate, covers the structural shift as oil consumption continues to migrate from the West to the developing world. As this trend nears completion, oil will finally be ready for its next, major repricing:

Oil’s quiet period has been composed of declining OECD demand, a hardening of the floor of oil prices, increased supplies of high-cost, marginal oil, and the almost silent shift of demand from West to East. Non-OECD economic growth, however, has not quite been strong enough to cause oil prices to breakout to the upside. Indeed, weak OECD economies and oil demand have provided just enough counterweight to keep oil prices from taking off. Oil’s quiet period, therefore, has seen oil trapped in a very tight range, unable to move lower because of marginal costs—and—unable to move higher because of continuing affordability issues in the OECD.

The May issue also includes an analysis of Japan’s worsening energy-balances, as the country’s currency debasement strategy meets up with soaring volumes of imported LNG:

While hedge fund managers focus on Japan’s debt dynamics, they should monitor instead these fragile energy-balance dynamics for the trigger to Japan’s next crisis.

To purchase, please follow the link below:

Oil’s Ultimate Fate: May Issue of TerraJoule.us

–Gregor

Five years into a rough, twenty year energy transition in which the global economy has been deprived of cheap oil, new trading relationships have emerged for the remaining BTU, as fossil fuels from coal to natural gas are consumed and traded with increasingly regularity. The United States for example has seen a massive decline in its own oil demand. In its place, the US has moved to take advantage of domestic natural gas, for which its pays some of the lowest prices in the world. This means the US has been free to export coal, which helps countries like Japan and even Europe to deal with their own rough exposure, to energy transition. Arbing Quads, the April, 2013 issue of TerraJoule.us, quantifies the unfolding story of this global energy transformation, as the next phase of energy transition unfolds. There are winners and losers in this story, some countries and economies will have to suffer through ongoing, structural disadvantages while others will reap windfalls. But most intriguing of all is that natural gas is starting to emerge as a partner of coal, as the oil age continues to recede. Indeed, despite recent story-telling, the oil age has been in steady retreat for over ten years now, and that trend shows no signs of slowing down. Arbing Quads explains who are the price takers, and the price makers, as the world looks set to burn the next tranche of BTU.

TerraJoule.us uses the Ganxy platform, and will publish on the first calendar day of each month.

–Gregor

For a successful technology, reality must take precedence over public relations, for nature cannot be fooled. ~ Richard Feynman

Waiting for Japan’s economy to make a strong recovery has been an ongoing game since 1990. Shall we play that game one more time?

There have been many false dawns in Japan over the past 20 years. Struggling with a combination of crushing debt and deadly demographics, Japan’s economy has stubbornly refused to make progress, despite numerous government efforts that range from currency devaluation to endless public works projects.

None of this was enough, however, to prevent further declines in the country’s fertility rate, for example, which only exacerbated deflationary pressures on the economy. Nor were the collective set of policy measures enough to boot capital flows away from the bond market, as Japan’s savers simply kept on saving.

For the past twenty years, value investors have probed the individual names in the Nikkei for cash rich insurance companies, debt-free manufacturing companies, and for rock-bottom low P/E names, all in the hopes of riding a broader recovery higher. Alas, no sustainable recovery in Japan’s economy or stock market has ever unfolded.

One can only smile at the reaction that more senior, experienced Japan recoverists must now be feeling as they watch a new generation succumb to the excitement of the latest resurrection of Japan’s economy. That the Nikkei is up by 25% in just 90 days has triggered all sorts of congratulatory commentary, even from Nobel Prize winners like Paul Krugman, who also is swept up in the latest round of recovery fever:

Krugman explains that one of the problems with modern central banking is that people believe they’re too credible in their desire to stamp out inflation when it starts to pick up. So in other words, the Central Bank may say it will let growth and inflation run hot for awhile (so that nominal GDP can catch up to trend) but nobody believes that they’ll actually do that. What Japan may be in the process of doing — by having the Bank of Japan take orders from the Ministry of Finance and the new Prime Minister — is solve this problem, by having the bank commit to being irresponsible.

Thankfully, Japan’s latest attempt to recover by aggressive devaluation is almost assured to provide resolution to its generational quagmire. But the outcome will not look anything like recovery.

Instead, Japan has entered the terminal phase of its long, reflationary road.

Culturally, the frustration and exhaustion at the country’s lack of progress has unsurprisingly led to this important juncture. The Japan recoverists are correct that the latest round of monetary policy “is not like the others.” However, the results are likely to provide a real-world test case of the limits of Keynesian policy at a time when the world faces scarce resources.

This final chapter will be spectacular. So in a lurid sort of way, we should be thankful that Japan has now crossed the threshold and is ready to proceed to its denouement.

The Miracle of Post-War Japan & Resource Arbitrage

Students of ecological economics should pay close attention. Japan is about to add itself as a test case.

Ecological Economics is a thesis of elegant simplicity. Simply put, the economy is a subset of the environment – and not, as neoliberal economists would have you believe, the other way around. Economies can “grow” up to the limit of the natural resources which they can extract, or acquire.

In a time of cheap resources, when the cost of inputs is extremely low, the importance of these inputs tends to be ignored. Thus, we can see the most obvious implication of environmental economics is that extraordinary profits can be harvested when the price of resource inputs is low and the purchasing power of consumers in the market place is high.

This is exactly the condition that allowed post-war economies like Japan to reap gigantic capital windfalls during their post-war industrial phase. Additionally, it is also critical to point out that the prices of energy inputs in the post-war era were so cheap that it was not necessary for countries like Japan to own any such resources domestically. Indeed, as it’s well known, Japan is nearly barren of any large deposits of energy resources.

Countries like Sweden, South Korea, and Japan during the 1945-2000 period essentially engaged in a kind of resource arbitrage: sourcing energy inputs from abroad and using them to manufacture high quality goods for export. If the resource-curse explains how countries rich in oil, copper, iron ore, and coal often wind up in a place of stagnation and corruption, bereft of innovation and diversity in their economies, then a country like post-war Japan received a kind of resource-poor blessing. Short of raw materials, Japan’s only choice was to become expert in using raw materials to get rich. And rich, indeed, did Japan become.

But all things must pass. The greatest gains from Japan’s industrial arbitrage were harvested from after the war up to 1990. It would be impossible to exaggerate how much capital the country extracted from the world economy during this time.

It would also have been impossible, given the tidal wave of that capital, for Japan to have avoided the asset bubble, whose bursting, just a decade before the new millennium, would prove so crippling. By the time Japan had hobbled into the year 2000, new low-cost manufacturers like Mexico, China, and other Asian countries had appeared on the scene to essentially imitate Japan’s post-war triumph.

Japan & Ecological Economics

Economies consume natural resource inputs, produce useful services for people, and generate waste. Fed a steady diet of affordable energy, the global economy grew and produced waste for most of the post-war period. Until, of course, the energy shock of high oil prices and the bursting of the credit bubble halted growth, in 2008-2009.

The results were unsurprising, and best articulated by the global output of CO₂ emissions in the chart below:

Global carbon dioxide emissions fell as expected during the crisis of 2008-2009, as global industrial output crashed. Since that time, the world has built GDP on the back of electricity supply – not oil supply – as the transition to natural gas and coal continued and moderate growth resumed.

Japan fits into this picture in a very intriguing way, because of its new call on coal and natural gas in the wake of the Tohoku Earthquake. But here Japan has run into serious problems. Problems which will not ameliorate, but instead will worsen.

Following the Abundance Script

After WWII, Japan followed precisely the kind of thesis laid out in Peter Diamandis’ book Abundance.

In the view of Diamandis, history shows that humans are so amazingly innovative and productive that scarcity of natural resources is no barrier to successful economies. Diamandis argues that history shows that over time many natural resources are substitutable, or expandable in their supply. And that human-created technologies trigger revolutions in resource allocation and availability.

Many of the enormous gains that Diamandis forecasts for the world in the next 20 years were captured by Japan after the war, as it ingeniously imported metals, rubber, silicon, oil, and other resources to make cars, electronics, and other highly engineered equipment. Indeed, Japan no doubt gave the world a number of energy-saving devices as its own economy became a hyper-efficient user of energy in its own right. Japan consumed its own products, as well, and became one of the lowest per capita users of energy while maintaining one of the most powerful industrial complexes in the world.

The fifty years between the war and the new millennium was a time of price stability in global energy prices. Oil averaged, on an adjusted basis, at roughly $15 per barrel. Coal, increasingly rejected by industrial economies, was also cheap. And no other industrial economy took better advantage of these fertile conditions than Japan. Using a population not much bigger than Britain, Japan bulked up to become the third largest economy in the world with extraordinary industrial output. Those TVs, stereos, and of course automobiles, were manufactured using cheap imported coal, and oil.

It is not a coincidence that Japan also seized the nuclear opportunity, starting in the early 1960’s. Yes, coal was still cheap, but Japan’s economic security demanded that a country naked of domestic energy resources look to securing its future. And that is how Japan seized both the miracle and the nightmare of nuclear power.

The Tohoku Surprise

Japan’s hyper-efficient, energy-conserving economy was not completely shielded from the new millenium’s price revolution in oil.

That said, Japan has done an extremely good job of bringing oil down to 40% of its total energy consumption mix. Japan can be still be thought of as a substantial user of oil, but, an even heavier user of electricity sourced from imported LNG, imported coal, and its own nuclear power.

| see: Japan Total Energy Consumption 2010, source EIA Washington:

But the shock of the Feb 2011 Tohoku earthquake peeled back the risk on nuclear power in Japan. The problem, which I outlined in Returning to Simplicity (2012) is that dependency on nuclear power is synonymous with dependency on a tightly-coupled system. And, tightly-coupled systems are not robust. Rather they are fragile, and vulnerable to systemic failure.

Worse, the Tohoku earthquake and tsunami arrived in Japan at the precise moment in the country’s history when debt levels, global demand for automobiles, demographics, slow growth in the OECD, and price levels for energy resources were all conspiring to merge. And not in a way beneficial to Japan.

The Tightening Noose

The nasty reality for Japan is that its cost of inputs are rising at the same time demand for its goods continues to soften.

We must emphasize that Japan is an island, and so major upside surprises in new natural resource discoveries is highly unlikely. Except for its ability to lock in the price of inputs through large hedging programs, it is fully exposed to present and future prices of LNG, coal and other essential commodities. Indeed, Japan is the largest importer of LNG in the world, and global suppliers take advantage of this fact.

In Part II: The 10 Next Predictable Steps to Japan’s Unfolding Disaster we focus on that what’s important to realize here: Japan’s economy is going to fail. And when it does, the outcome will have spectacular implications for many global assets, ranging from real estate, to stock markets, to oil and gold.

There is a progression of increasingly likely events that will happen as Japan’s troubles mount. Investors looking to protect capital will do well to learn and watch for them (as well as those with appetite to find opportunity in crisis)

For all others, this story is important to understand because Japan also serves as a bellwether for the other OECD countries, many of whom face similar macro headwinds of excessive debts and increased global competition for key commodities.

As Japan goes, so very well may we all.

Click here to read Part II of this report (free executive summary; enrollment required for full access).

Recently, in the past three months, a consensus has begun to form that China’s use of coal may have just slipped past the fattest part of its growth curve. That may be true. But as you can seen on the 2010 photograph below, China is not the only “country” in Asia that has seen its demand for electricity advance strongly, since 1992:

It’s understandable for people to be encouraged by recent trends in global coal consumption, mostly in the United States. If China’s rate of coal consumption growth is also about to slow, that too is encouraging. The problem however, is that China would be slowing its rate of growth from a very, very high level of absolute demand. Further, as you gaze across other regions of southeast Asia in the above photos, global coal consumption is less about “country” and more about population. 1.2 billion people in the world are still unserved by electricity. A good portion of them live in India, for example, where you will notice the “advance of nighttime” lights has also been quite strong.

While there is certainly a possibility that Non-OECD countries will adopt more wind and solar—owing to the relative simplicity of those technologies—we need to be sober about current trends. The great trajectory of coal underway the past decade has a number of competitive advantages, especially the phenomenon known as path dependency. This is why I say the great news for clean energy, on a global scale, does eventually arrive. But, not until later in the century. Before then, the world unfortunately is transitioning even harder to fossil fuel energy, of the dirtiest kind.

The quest for cheap energy and cheap labor is a conquering human urge, one that has played out with notable ferocity starting with the Industrial Revolution. The introduction of coal into British manufacturing and the more recent outsourcing of Western manufacturing to Asia have marked key thresholds in this ongoing progression.

But despite the harvesting of additional productivity gains from the more recent revolution in information technology, the suite of macro data suggests that the rate of advancement in physical production has slowed, notably, in the past thirty years.

Seen in this light, the greatest gains to global industrial production were probably enjoyed from the late 18th century (when coal extraction and use began in earnest) into the mid-20th century (when oil reached broad distribution). In contrast, computers, the Internet, and the leveraging of developing world labor might eventually be seen as the finishing touches on this great industrial wave.

The Siren Song of the Robot

Indeed, the world now faces a double constraint to any further revolutionary gains to physical production: resource scarcity and the diminishing supply of the cheapest global labor, as wages in the Non-OECD have most likely seen their low.

That we have reached this juncture probably explains why a new idea has arisen: The advent of robots.

That fleets of more technically-proficient robots becoming ever more encompassing in their role in the economy will trigger the next Industrial Revolution, the one that does indeed deliver extraordinary productivity gains. The Rise of Machine Intelligence, it’s now anticipated, will finally pull GDP back to the higher growth path seen in previous industrial advances.

The past year has been a fertile time to consider this possibility. In March of 2012, Amazon.com bought the warehouse robot company, Kiva Systems. It seems not coincidental that Amazon has also engaged in a new wave of construction, building distribution centers poised to leap into an age of next-level automation. Each one, in its vastness and architecture, seems perfectly set up to reduce the quantity of human labor required to run Amazon’s business. From The New York Times article:

“Amazon has not had great margins,” Jason Helfstein, an analyst at Oppenheimer & Company. “One has to believe they looked at this and thought, ‘Why not just own it and take all the technology in house?’” The acquisition comes as Amazon aggressively adds distribution centers to service its growing consumer base. The company has heavily promoted its Prime service, which provides customers two-day shipping for $79 a year. Last year, Amazon said it planned to add 17 warehouses, bringing its total to 69.

You can see the video of Kiva robots here, acting as automated shelf and inventory movers. Note also the remark from the Oppenheimer analyst, concerning Amazon’s poor margins. (Well, that’s not news). However, it’s a key theme to the pressures fated to drive the rise of machine intelligence (Capitalism demands it).

Accordingly, it’s not surprising that even energy companies like ExxonMobil are thinking about the global shift to automated manufacturing, data centers, and, importantly to Exxon, the rise of electricity (I have been writing continually over the past year about the transition from a world running on liquid BTUs to a world running on power. Please see Rise of the Global PowerGrid, August 2012).

In its just released Annual Energy Outlook, looking ahead to the year 2040, Exxon writes:

One of the emerging drivers of demand globally relates to digital warehouses. The New York Times reports that on a worldwide basis, these data facilities use about 30 billion watts of electricity, roughly equivalent to the output of 30 nuclear power plants. Data centers in the United States are estimated to account for one-quarter to one-third of that load.

2012 was also a year in which military drones finally penetrated public awareness levels, given their widespread use by the military. WIRED magazine has declared that 2012 was the year of the drone in Afghanistan. Indeed, the military drone is increasingly carrying the weight not only of U.S. ground operations globally, but, assuming that the U.S. is in a leadership position now in the field of military drones, we can conclude that unmanned craft are creeping up to become a feature of U.S. foreign policy.

Let’s pause here and consider that in just these two examples. We have one type of robot – the military drone – whose greatest contribution is to radically reduce the amount of resources required to deliver lethal strike capability. And we have the other, whose promise is to displace human labor on the shop floor (or in Amazon’s case, the inventory floor).

The replacement of human labor and its myriad, associated costs is revolutionary. The promise for robots to take energy input costs down a notch, at a time when the price level for energy has gone through a phase shift higher, is compelling. If we assume that the I.T. revolution so far has delivered only small, incremental gains to the production of physical goods, then a robot revolution could finally usher in the changes that critics correctly say has not yet been delivered by a world of bits.

The combination of robots and cheap electricity could well unleash a new phase of profitability for corporations – and, of course, the owners of the means of production. What’s less likely, however, is that any such revolution is sustainable.

Because unlike the Industrial Revolution, which added powerful BTUs in the form of coal to augment human labor, thus creating a tidal wave of profits and increased wages, a robot revolution promises to furnish the world with stuff at the expense of human employment.

Many thinkers currently writing on this subject believe that a labor force deprived even further of purchasing power, yet given greater access to cheap goods, will wind up richer on the whole. I won’t say that’s wrong, but I will say it seems unlikely.

Radical Price Shifting

Let’s engage in a thought experiment, a scenario in which robots almost totally disrupt a particular type of consumer good. I’m choosing an example that I think would be most favorable to those who are sanguine about a robot-manufactured world, in which our wealth and free time are enhanced and people “become liberated to engage in other activities.”

Given the daily drudgery of cooking and meal preparation, let’s imagine that a company is able to take high-end cooking ranges, high-end cooking equipment, and high-end refrigerators and freezers, and deliver them to market at discounts up to 50% off current prices. There is already a cultural shift underway to eat home-prepared food. Arming consumers during a time of higher food costs with the very best tools to prepare and store food dovetails nicely with current trends and household cost pressures.

White goods, such as these, are a substantial part of furnishing a home. By radically lowering the price of these high-end tools, the owners of private homes and also apartments are more easily able to buy, prepare, and freeze food, thus freeing up capital  (time) for other pursuits. Taking a look at the manufacturing locale, and input costs, of our hypothetical new company will be instructive.

We’ll call our new whiteware manufacturer Man Who Fell to Earth, Inc. (MWFE).

No Need for China

Western economies burden corporations with complex labor regulations and even more onerous tax liabilities. The decision to place a human being on the payroll in France, Britain, or the United States is not taken lightly, and it represents a huge increase in costs for health care, taxes, and unemployment insurance. A person hired at a salary of $125,000 can imply total costs double that amount. This is why cheap labor in Asia has been such a draw for Western corporations. But now that China has reached the Lewis Turning Point, there is less reason to locate there.

Instead, Man Who Fell to Earth (MWFE) needs to think about shipping costs and energy input costs, because robots run on electricity. As it turns out, the United States has some of the cheapest electricity rates in the OECD. Average U.S. rates are just below 10 cents per KWh, and are stable as well. Even better, industrial and commercial rates are even lower. From the most recent data, via EIA Washington:

Robots need no healthcare and incur no payroll taxes. Indeed, as machines, they would be conveniently depreciated like other capital equipment.

Owing to U.S. hydropower and our cheap natural gas-fired powergrid, it’s no longer clear that a factory making stoves, refrigerators, and cooking equipment with robots would be any cheaper in Asia. Indeed, current data suggests the price of electricity in China is roughly around 7.5 cents (or higher) per KWh.

So, where might be a good locale for MWFE and its factory?

The Columbia River: The Dalles

Within the U.S., the cheapest electricity rates are in the Pacific Northwest. For the very same reasons that Amazon and Google have chosen The Dalles to site data centers, our Man Who Fell to Earth, Inc would find access to rail and river routes would set up the operation well, not only to receive raw materials but to ship to both North American and Pacific Markets.

The Pacific Northwest is also the site of the largest smartgrid demonstration project in the U.S., operated by Battelle Labs and the Department of Energy. Microsoft and Yahoo have also chosen the Columbia River region to build enormous electricity-gulping data centers. Here is a photo of Google’s complex in the Dalles:

A Clutch of Humans

As towns along the Columbia River and elsewhere in the Pacific Northwest have discovered, electricity-seeking data centers employ very few people. Google’s data center cost over a half billion dollars to build, but employs at best 200 people. Facebook’s data center in Prineville, OR employs only 55.

Once the construction phase is over, Man Who Fell to Earth, Inc (MWFE) becomes an operation also employing few human workers.

Mostly, MWFE would engage in consumer marketing and would concern itself with the futures market for finished steel, copper, and other commodities. MWFE strikes long-term shipping agreements with railroad companies and it monitors quality control mostly through remote instrumentation. Its only need for humans is to manage relationships with raw material providers and to liaise with the robot manufacturers for maintenance and upgrades. It’s probably the case that MWFE is robot-staffed by an array of 3-D printers and various free-ranging robots. It’s probably also the case that the initial up-front investment is enormous, but while there are still the usual uncertainties about the economics of the operation itself, the company has taken the volatility of ongoing labor costs down to very low levels.

More and U.S. manufacturers are already making the choice to invest in ‘intelligent machines’ to guide robot production lines. Adam Davidson’s excellent piece on this subject on last year’s Atlantic, Making It in America, charts the course of automation as the U.S. competes against cheap developing-world labor through the use of advanced machines. Of course, this means that the U.S. economy holds some moderate ground in terms of output.

But it also means that demand for human labor collapses further:

Yet the success of American manufacturers has come at a cost. Factories have replaced millions of workers with machines. Even if you know the rough outline of this story, looking at the Bureau of Labor Statistics data is still shocking. A historical chart of U.S. manufacturing employment shows steady growth from the end of the Depression until the early 1980s, when the number of jobs drops a little. Then things stay largely flat until about 1999. After that, the numbers simply collapse. In the 10 years ending in 2009, factories shed workers so fast that they erased almost all the gains of the previous 70 years; roughly one out of every three manufacturing jobs – about 6 million in total – disappeared.

Implications

There is nothing our robot manufacturing company can do to lower the price of steel, copper, rubber, and chemicals. Likewise, it’s beholden as well to the robot and 3-D machine manufacturers. It still has to negotiate with transport companies, who themselves, in the case of the railroads, enjoy monopoly pricing. But MWFE has escaped the high cost of maintaining a human workforce and is passing on those savings to consumers.

But what happens to the economy should this trend broaden?

During the past 30 years, Americans have been treated to a flood of cheap goods and outright deflation in most foreign manufactured items. Did this make us wealthier? Because that is the standard position of many economists.

The developed world has learned over the past decade that a steady supply of cheaper, foreign-made goods does not guarantee prosperity. What impact will (perhaps only moderately) cheaper goods have if coupled with reduced employment as human labor is displaced by machines? If we are unable to find a higher use for the displaced human labor, we are actually worse off.

In Part II: Why the Robot Age May Create a Massive Deflationary Bust, we take a look at why the end of cheap energy will drive the economics of machine intelligence, as global capitalism desperately seeks its next revolution.

The efficiencies promised by robots and other intelligent machines are real and will play a critical role in our industrial future. But their hidden risks to society are high and must be addressed early on in order to enter into the ‘robot age’ without triggering radical levels of inequality.

For if we don’t, we may well find that the solution is worse than the problem we’ve designed it for.

Click here to read Part II of this report (free executive summary; enrollment required for full access).

 It was the best of times, it was the worst of times for the American public over the past month, as it was treated to two high-profile, but deeply conflicting, economic forecasts.

Despite declaring in 2008 that the age of cheap oil was over, the International Energy Agency (IEA) surprisingly announced last week that the United States would become the largest oil producer in the world by 2020. Hooray! This superlative declaration titillated U.S. media organizations, who understand quite well that Americans love to secure a #1 ranking in just about any category (save for prison incarceration, divorce rates, and obesity). As I explained to the Keiser Report, however, the IEA has done little more than produce an attention grabbing headline here. Simply ranking the ‘top oil producer’ in 2020 may mean much less than the public currently understands.

This announcement has since led to the magical thinking that we can somehow take ownership of this future “extra oil” not 8 years from now, but rather…. today. In other words, the additional 3 mbpd (million barrels per day) of crude oil and the 1 mbpd of NGL (natural gas liquids) that the IEA forecasts for 2020 have suddenly been booked into the “readily-available” column and are already being factored into U.S. growth projections. That is premature, to say the very least.

In contrast to the IEA’s report was the grim outlook recently offered up by legendary investor Jeremy Grantham, of GMO in Boston. Mr. Grantham has been increasingly sounding the alarm on a future of significantly lower growth rates for some years now. It is rather obvious, as well, that Grantham has been methodically making his way through the reading list of resource scarcity scholarship over the past five years, taking in the views of everyone from Joseph Tainter to Jared Diamond. Combined with the available data, Mr. Grantham has come up with the rather unsurprising conclusion that the rate of future growth is set to be much lower than most anticipate. In Grantham’s view, there will be no return to normal growth as was enjoyed in the U.S. in the post-war period (after 1945).

Reactions to Grantham were predictable. Has he lost his mind? And of course: Grantham goes Malthusian was another common refrain. Many of the media outlets covering Grantham’s letter, On the Road to Zero Growth (link to PDF here; free registration required at GMO website), also engaged in predictable reductio ad absurdum, claiming incorrectly that he was calling for the end of the world. Indeed, no such call by Grantham was made.

It leaves the rational observer wondering: why is the media so breathless in its exulatation of any optimistic forecast, no matter how poorly supported? And why does it villify those who attempt to argue the other side?

Where has our objectivity gone?

Grantham’s Actual Message

It’s clear that very few understood what Grantham was really saying.

Moreover, many were mistaken that Grantham has adopted an ethos of negativity or that he has become ideological in his views. Quite the contrary. He is working with the same data observed by many hedge funds, international organizations, and academic research that shows that, as we entered the past decade, the extraction and production rates of many critical resources began to slow – and slow significantly.

Just to kick off this discussion, let’s start with the master commodity, oil:

In the ten years leading up to 2004, global crude oil supply grew at a compound annual growth rate (CAGR) of 1.71%. This rate of supply growth started during the strong economic phase during the 1990s, and only strengthened after the recession of 2000-2002 when countries like Russia came online with fresh oil supply.

However, in the years since 2004, the rate (CAGR) of supply growth has dropped sharply to just 0.53%. This deceleration in the extraction rate — which is also seen in many other resources, such as copper — is the secular change that has drawn Grantham’s attention. This is empiricism, not ideology.

When We Needed the Resources Most

Just when the world needed oil and copper the most — as China’s and India’s industrialization kicked into high gear — world supply growth flattened. Hence, the upward price revolution in commodities. What Grantham is saying – observing, really – is: the price revolution in critical resources will not be reversed. Accordingly, economy-wide input costs are now structurally higher, which will lead to structurally lower growth. I mean, really; it’s not that complicated.

Remember, Grantham has been trying in vain to explain his developing position to fellow money managers for over four years now. As I wrote in 2009 and also in 2011, few have been paying attention. From my post last year, Jeremy Has Spoken (But Rest Assured, Pro-Money Management Isn’t Listening):

Jeremy Grantham endeared himself to resource depletionists once again this week, as the longtime manager at asset giant GMO confronted the issue of limits, in a finite world. | see: Time to Wake Up: Days of Abundant Resources and Falling Prices Are Over Forever.

I wrote about Grantham’s original revelations in late 2009, when he first disclosed to the public his views on resource depletion, and in particular peak oil. Like the rest of us who’ve attempted to explain the trailing, cultural normalcy bias that’s been built up over the past 100 years, however, Jeremy’s discovered that having spoken—even from the mantle of GMO—doesn’t mean asset management professionals will pay attention. From my 2009 post: Peak Oil and Professional Money Management:

I was unsurprised to read Jeremy Grantham’s passing lament in his latest Quarterly Letter, that, his previous remarks on resource depletion went almost completely unnoticed, as though his words “had disappeared down a black hole.”

An excellent way to better understand Grantham’s perspective is to simply read what he’s been reading. For example, it’s clear that Grantham has integrated into his own work the ideas of Joseph Tainter, author of The Collapse of Complex Societies. Tainter’s ongoing study of collapse and complexity is historical and well-researched. When Grantham writes, “If resources increase their costs at 9% a year, the U.S. will reach a point where all of the growth generated by the economy is used up in simply obtaining enough resources to run the system,” he is keying on a signature theme of Tainter’s: as economies mature and become more complex, the natural resources which were originally used to build and grow the economy then have to be used just to maintain it.

If one adds to this phenomenon the extra pressure that comes when natural resources become more expensive to obtain, then there are even fewer inputs available to fund new growth.

This is hardly a revolutionary idea. Companies, states, and countries typically kick off from inception with high rates of growth, and then as they mature, their growth rate slows. Geoffrey West of the Santa Fe Institute has modeled this phenomenon quite well in his work. (So no, Jeremy Grantham has not lost his mind. He is, instead, in full possession of it.)

One of the more important insights that can be derived from West’s work, is that growth can continue for a short while even as systems mature through the process of harvesting efficiencies. In other words, systems – such as cities – can continue robust growth after their initial growth phase by turning to economies of scale and other technological improvements. But this phase of a system’s growth tends to be terminal.

And it’s very likely the phase that the U.S. has now entered.

The Growth Problem is Not Limited to Energy and other Natural Resources

When observers first hear of these ideas, there is a knee-jerk impulse to reject or even attack such views simply because many are not acquainted with the scholarship. But Grantham identifies other trends in a maturing United States economy that should have been more easily recognized.

For example, birth rates in the United States – which have been gently trending downwards for some decades – have undergone a more pronounced decline since 2008. As a result, last year, U.S. birth rates fell to their lowest ever recorded. It’s hardly a surprise that the greatest economic shock and decline since WW2 would produce a sharp response in U.S. birth rates. But the surprise is that observers in the financial sector, who regard themselves as numerate and data-oriented, would be ignorant of such trends and offer up “bafflement” as to why Grantham was calling for a secular phase of below-trend U.S. growth.

I think the pushback against Grantham, who is really just aggregating the scholarship of other writers, now appears because the tangible experience of “slow growth” is now coming more clearly into view and can be quantified. Therefore the attempts to push back against these views as either doomerish or ideological are not sticking, in part because the OECD has now very clearly trended towards a much lower growth rate, with little prospect of change.

So, let’s look at Grantham’s numbers. As a result of the various factors discussed here, the rate of US growth is now forecast to run at barely 1.00% until 2030.

Let me make what I think are the two most important points about such a forecast:

1. Systemically, 1.00% growth over the next 18 years in contrast to 2.00%-3.00% growth over the same period represents a profound and huge challenge to every institution – from our government’s future liabilities and payments, to private pension funds, workers, infrastructure, and our wealth.
2. When the rate of oil supply growth is similarly reduced from 1.00%-2.00% per year to 0.50% per year and is accompanied by comparable reductions in the supply of other resources, this, too, has a profound effect on growth, unless it can be reversed rather quickly (which seems unlikely)

Ignoring Grantham and Basking in Energy Abundance

The public does not wish to focus on Grantham’s message, but would instead prefer to rely on the IEA’s recent forecast for oil supply growth in the U.S. As I have acknowledged in previous essays, while we remain in the domain of Peak Oil, we are not in the domain of Peak BTUs. The world still has plenty of coal and natural gas to burn, as has been proven over the past four years. We are not facing Peak Energy (yet). But we do face a growing liquid fuels crisis.

In Part II, Dissecting the Energy Boom Story, we will review the latest data showing a slight rise in global oil production – the first in nearly eight years. We will critically asses the IEA forecast for U.S. oil production by 2020 and discern whether this changes the Peak Oil story. Moreover, it is also time to make an oil price forecast for 2013, given the probable economic forecast for next year.

Click here to read Part II of this report (free executive summary; enrollment required for full access).

Flood myths are common to human culture. Swollen rivers, tidal storms, and tsunamis make their appearance frequently in literature. But Hurricane Sandy, which has drawn newly etched high-water marks on the buildings of lower Manhattan (and Brooklyn), has shifted the discussion from storytelling to reality.

Volatility in climate has drawn the attention of policy makers for a decade. But as so often is the case, a dramatic event like superstorm Sandy – the largest storm to hit New York since the colonial era – has punctured the psyche of the densely populated East Coast, including the New York-Washington, DC axis where U.S. policy is made.

Not surprisingly, in the weeks since the historical hurricane made landfall, new attention is being paid to the mounting costs that coastal world megacities may face.

Intriguingly, however, this new conversation about climate, energy policy, and America’s reliance on fossil fuels comes after a five-year period in which the U.S. has dramatically lowered its consumption of oil and seen an equally dramatic upturn in the growth of renewable energy. America’s production of CO₂ in the first quarter of 2012 fell to twenty-year lows. The country is using less coal, increasing its use of natural gas, and (like the rest of the OECD) is seeing its transportation demand migrate from cars and trucks to rail. While Europe is often cited as being at the forefront of renewable power, the U.S. has also started to produce very strong growth rates for wind and solar power:

The combination of declining oil use and a greater reliance on the global powergrid is going to shape energy and climate policy. Especially at a time when the concerns of climate change – or, rather, rising seas and the greenhouse dangers of fossil fuel dependency – are being increasingly raised. This will make for a rather muddled and complex array of diverging policy initiatives.

Moreover, as the oil-based economy (which was harder to meter) gives way to the electricity-based economy, policy makers will find there are more levers to shape energy demand in their economies. The Oil Age was a more natural fit for free-spirited individualism. The Electricity Age will see an era more comprehensively dominated by policy, as the powergrid becomes the mechanism for governments to shape the future of energy demand.

Rebounding to the Grid

The oil age went into decline roughly ten years ago.

Oil’s share of total global energy demand, which had been on the rise since the 1930s, peaked in the mid-1970s but held steady for over twenty years until the new millennium. But starting early last decade, through a combination of oil’s repricing and the industrialization in the Non-OECD, oil’s market share in the global energy mix retreated.

This decline of oil in the global economy explains perfectly why the weak rebound since the 2008 financial crisis has grown along the contours of the powergrid. It’s not just the United States. In Japan, and especially in Europe, oil use has continued to decline right through “the recovery,” as increasing numbers of car drivers are taken off the road, as jet travel declines, and as trucking has given way to higher deployment of freight rail.

However, this opens up a number of new constraints as well as new opportunities, because while there is high growth in solar and wind power, the growth of global electricity is largely driven by coal. That means awareness of coal’s role is going to widen among populations, and governments are going to be drawn into action over coal.

Carbon Taxes, Renewable Portfolio Standards, and Feed-In Tariffs

Global coal markets have recently sputtered in the face of slower growth in China as well as the rise of natural gas in the United States, which has dislocated consumption of its own coal. If glanced at quickly, this looks like an interruption in the supertrend. Alas, no such interruption is taking place.

Instead, the coal which Americans are no longer consuming is being exported to the rest of the world. Even Europe is taking greater volumes of U.S. coal, which in 2012 is on pace to see the highest level of exports in U.S. history.

But a more important phenomenon to understand regarding global energy consumption is that much of the upswing in Asian coal demand over the past decade, especially in China, is really just an offshoring of OECD manufacturing capacity. In other words, an increasing proportion of goods purchased by Westerners since the year 2000 is the result of goods made in Asia. And these goods are made in factories powered by coal-fired electricity generation. Clothing, appliances, electronic devices – yes, iPhones, too – are made in facilities powered by coal.

This is why, as policy is increasingly driven either by concerns about climate, increased distaste for dependency on fossil fuels, or both, the clamor for carbon taxation is going to grow.

In a recent essay, Forget Kyoto: Putting a Tax on Carbon Consumption, the author takes note of the emerging emphasis on the global trade of energy use:

China’s phenomenal economic growth has been based on exports, notably of energy-intensive goods, from steel and petrochemicals to a host of manufactured products. These have been bought largely by the U.S. and Europe, which together account for nearly 50 percent of world GDP. It is carbon consumption that measures the carbon footprint and hence responsibility, not the carbon production in particular geographical areas. Yet remarkably the Kyoto framework does not take consumption into account. Instead it focuses on carbon production, and mostly in Europe, where deindustrialization and the collapse of the former Soviet Union make compliance with the targets easy.

Politically speaking, carbon taxation has been a very tough sell, especially in the United States. Interestingly, there have been trial balloons since the election that the Obama Administration may even tie together (or try to tie together) new carbon taxes as a way to lower the U.S. budget deficit. That, too, is unlikely to have much political appeal, though it does signify the shift coming in the wake of Hurricane Sandy and this summer’s extraordinary drought.

However, there are interesting divergences about the effectiveness of carbon taxation among those who work in the areas of energy and climate policy.

Chris Nelder, writing in Smart Planet, Why America Needs a Feed-in-Tariff, makes the case that a carbon tax policy will not necessarily spur construction of renewable energy. Essentially, if getting renewable energy infrastructure built is the ultimate goal shared by both climate policy and energy policy, then why not pursue a national FiT (feed-in tariff), of the kind deployed in Europe?

Given the obvious success of FiTs as a policy tool in Europe, one must wonder why the U.S. has not embraced them. Germany already tried all the incentives that we’re using in the U.S., such as aspirational targets like renewable portfolio standards (RPS), rebates, and low-interest loans, and eventually turned to FiTs because they proved to be far more effective, simple, low-cost, and efficient.

But while it’s true that growth of wind and solar power is already growing at a very strong rate in the U.S. (as discussed previously), it’s not clear this will continue at the same rate.

California’s RPS (renewable portfolio standard) has triggered the construction of a great deal of new utility-grade solar power. However, this is small in comparison to California’s overall energy challenge, as it sees its own dependency on out-of-state power supply continue to expand. As I have addressed previously, California’s energy production from all sources is at 50-year lows. This comes at a time when, just as in the rest of the country and the world, transportation demand is switching over from cars and trucks to the grid as light rail is built out in its cities.

New Energy, Climate, and Urban Infrastructure

(image: Thames Flood Barrier, Greater London, UK)

Western cities are aging, and the forecast for rising sea levels may hold true regardless of any climate policy. In a recent post, Roger Pielke Jr notes that mitigation of rising sea levels through aggressive CO₂ reduction may not change the current trajectory all that much:

One of the more reasonable discussion points to emerge from efforts to link Hurricane Sandy to the need to reduce carbon dioxide emissions focuses on the role that future sea level rise will have on making storm impacts worse. Logically, it would seem that if we can “halt the rise of the seas” then this would reduce future impacts from extreme events like Sandy. The science of sea level rise, however, tells us that our ability to halt the rise of the seas is extremely limited, even under an (unrealistically) aggressive scenario of emissions reduction.

If cities like New York are compelled instead to construct tidal barriers, and other coastal cities in the U.S. follow, then changes in global energy consumption and in the public’s perception of climate issues may see governments drawn in more closely than ever before to such policy making.

After all, the construction costs for mitigation through infrastructure will come through state and federal partnership. Indeed, the discussion about tidal barriers for New York has already begun. Given the extent of recent flooding, this is no surprise. And subsequent storms will only push such initiatives along further.

The New Policy Era

The decline of oil’s share in the global economy marks the end of a kind of free-ranging era in which individual discretion over energy use reached spectacular heights. Cheap oil gave rise to cities such as Los Angeles, where the freedom to drive all distances was a luxury enjoyed by most people. It’s not surprising that the cultural adjustment to a new era, where individual choice in energy use will be redefined, is proving cantankerous.

Moreover, as new oil supplies emerge from domestic American sources, the dream of resurrecting this cheap oil era will no doubt come back around several more times. But none of these new resource plays will change the trajectory of global oil supply much, nor will they lower the price of oil. So far, new oil supply mostly offsets declines elsewhere – but at substantially higher marginal cost. This should now be clear.

In Part II: Investing Strategies for the New Energy Era, we take a look at some of the risks but also opportunities that will present themselves to investors, as the global powergrid rises and comes under heavier scrutiny from government regulation.

While renewable energy is growing almost exponentially, coal still remains the global anchor for many of the most important electricity networks, especially in the developing world. The inevitable switch to the powergrid will draw two competing forces: 1) massive new investment, with many losers and winners, and 2) the attention of governments who will see the grid as a way to implement climate policy and to raise revenue.

Click here to read Part II of this report (free executive summary; enrollment required for full access)

Given emerging data in 2012, it’s becoming increasingly clear that the post-war automobile era in the United States is now in well-articulated decline. Accordingly, it makes sense to note the beginning of a long-term supertrend that is just getting started: the resurrection of America’s rail system.

At Seattle’s historic King Street Station (a classic example of early 20th Century railroad architecture), a nasty looking dropped-tile ceiling – which hung above travellers for decades – was removed late last year to reveal ornate plasterwork as the building undergoes extensive renovation. These cosmetic (and structural) alterations are part of a wide-ranging upgrade to the entire Cascades passenger rail service that runs from Vancouver, British Columbia, to Eugene, Oregon.

In Tacoma, for example, a new station will either be built or renovated, and part of the Cascades line will be re-routed from its current shoreline path more directly through that city. Elsewhere, bridges are being rebuilt, track is being upgraded, and other infrastructure improvements are underway as part of the $500 million program to resurrect more efficient, faster inter-city rail in the 466-mile Amtrak route through this part of the Pacific Northwest.

These changes will not bring European-style high-speed rail to the United States. Indeed, in many similar projects across the country, top speeds of 125 mph will characterize new system capability, rather than the average speed actually maintained from city to city. However, the incremental improvements now underway will become the platform for the next phase of investment, as Americans are increasingly persuaded to limit their car ownership and make rail transport part of their lives once again.

What America Lost

Up until World War II, rail transport of all kinds – intercity, light rail, and commuter rail – dominated transportation in America. Los Angeles had the largest light-rail system in the entire world, connecting the San Fernando Valley to Long Beach, and San Bernardino County to central L.A. and the northern reaches of Orange County. As the old saying goes, however, the car killed America. And the following 40 years from 1945-1985 saw a relentless decline of all forms of rail in the United States.

To get a sense of what the country lost as it eagerly built out a vast highway infrastructure and foolishly stopped investing in rail, let’s look at two historical maps showing a veritable collapse of passenger route miles over just a ten year period. The first map shows that in 1962 intercity passenger rail network still covered 88,710 route miles.

Just ten years later, however, with intrusive highways bisecting American cities and ruining the integrity of their downtowns, the number of passenger route miles had collapsed by over 75%(!), to just 19,366 miles.

Laughing at Amtrak

Most people born after World War II have regarded Amtrak as a kind of joke, with its routine dysfunction and massive annual operating losses. The economics of national rail transport, however, deem that your railway system will only be as efficient as the proper mix of investment and operational fitness allows. If you starve your railways of upgrades, make them share tracks with freight rail, and divert national infrastructure spending to other modes of transport, the results will be quite predictable.

One of the great misunderstandings of public rail transport is the mistaken belief that it should run at an operating profit. Not so. The purpose of commuter rail, light-rail, or intercity rail is to harvest economy-wide efficiencies and to ensure that wasteful expenditures spent collectively on transportation can be directed elsewhere. These “savings” were not an issue and were harder to determine during the cheap oil era, when much of the national highway system was built during the era of $14/bbl oil. Now, however, the impact on household budgets and monthly cash flow from much higher oil prices is pushing U.S. transportation demand rather dramatically away from roads and highways – and instead to rail.

In Los Angeles, for example, where the aggressive Measure R has been restoring L.A.’s lost light-rail system, annual ridership has made extraordinary gains. A recent piece from LA Observed reports that “[a]verage weekday ridership on Metro’s rail lines in September soared to 357,096, up nearly 12 percent over the same time last year and 16 percent over 2010.” Similar restorations of commuter rail in cities like Boston and improvements in either infrastructure or rolling stock in the NY Metro region have emerged in the past decade. Indeed, some U.S. regions took the signal of oil’s price revolution early and began work on local rail systems long before federal spending began to shift, ever so slightly, to rail transport.

Meanwhile, on the national level, Amtrak just announced that ridership hit an all-time high and has climbed nearly 50% in the past decade. From its October 2012 press release:

Amtrak carried more than 31.2 million passengers in Fiscal Year 2012 ending September 30, marking the highest annual ridership total since America’s Railroad started operations in 1971 and the ninth ridership record during the last ten years. A year-over-year comparison of FY 2012 to FY 2011 shows ridership grew 3.5 percent to a new record of 31,240,565 passengers and ticket revenue jumped 6.8 percent to a best ever $2.02 billion. In addition, Amtrak system-wide on-time performance increased to 83 percent, up from 78.1 percent and its highest level in 12 years. During FY 2012, ridership on the Northeast Corridor is up 4.8 percent to a record 11.4 million, state-supported and other short distance routes is up 2.1 percent to a record 15.1 million and long-distance services is up 4.7 percent to their best showing in 19 years at 4.7 million. Also, FY 2012 produced other ridership achievements including new records for 25 of 44 Amtrak services, and 12 consecutive monthly records with July being the single best month in the history of Amtrak.  Since FY 2000, Amtrak ridership is up 49 percent.

Rationalizing the Rail System

Many will decry the fact that Amtrak and the United States as a whole are still not in a position to offer European- or Asian-style high-speed-rail, where sustained traveling speeds routinely average above 150 mph. However, five to six decades of neglect necessitate that the U.S. undertake its resurrection of rail in phases. Two of the many projects around the country (The Vermonter & The Cascade Line) demonstrate exactly the type of initial heavy-lifting that must be done, in which fundamental changes are made in route selection and in the separation of tracks between freight and passenger rail.

The Vermonter: New York City to Burlington

Three states, Vermont, Massachusetts, and Connecticut, are currently in partnership with Amtrak to upgrade tracks, bridges, and stations along the route between Burlington and New York City. The state of Vermont has just completed its part by upgrading track with new, very long, continuously-welded rail, which will increase speeds. Work in Connecticut and Massachusetts is now underway, but one of the more significant transformations occurs in the switching of 60 miles of track from Palmer and Amherst back to the other side of the Connecticut River. This is actually a restoration of the original route between Vermont and New York, and means that trains from Springfield, MA will now travel north to Holyoke, Northampton, and then Greenfield before joining up again with the current route through Brattleboro in southern Vermont. Below is one of the new train stations, located in Greenfield, Massachusetts.

In bringing The Vermonter back to the west side of the Connecticut River, Amtrak is rationalizing the route in several ways, but most importantly it is reducing the passenger train’s exposure to freight traffic. Shared tracks, in which passenger service and freight traffic run on the same routes, is actually an enormous problem in the United States and accounts for a tremendous amount of the dysfunction that many users of Amtrak services experience. The biggest change in the Vermont-New York City trip, therefore, will come via on-time reliability as the transfer away from Palmer, MA will greatly reduce overlap with freight rail. Completion of this project is currently set for 2014.

The Cascades Line

The twin ports of Vancouver, Washington and Portland, Oregon – straddling each side of the Columbia River – have seen very strong growth the past few years as increasing volumes of lumber, potash, and wheat are shipped to Asia. Accordingly, on the north side of the river at the Port of Vancouver (Washington), a large freight rail project has been underway to help increase loadings.

But one of the little-noticed initiatives is the construction of new track to alleviate congestion for passenger trains as they head out of Portland toward Seattle. Finally, these trains will be able to steer clear of freight traffic at the Vancouver, Washington side of the river.

As usual, these are not the types of splashy, high-profile infrastructure improvements that garner headlines. But the Portland to Seattle route typically has had very poor on-time reliability, which invariably reduces ridership. As mentioned in the start of this essay, Cascades Line improvements are quite wide-ranging, with the Federal Government having awarded over $800 million to multiple projects. The upgrades will continue for several years, with noticeable differences in on-time reliability already in force.

Aiming for the Virtuous Circle: Reliability and Ridership

Amtrak’s 50% increase in ridership the past decade certainly began as a result of rising oil prices, and not because of any notable service improvements. However in the latter part of the decade and especially in the past 3-4 years, Amtrak (and other rail networks) have started to deliver substantial improvements to riders as the upgrade cycle gains momentum.

Deep skepticism has greeted just about every major rail project in the country over the past twenty years. But a virtuous circle, in which riders are persuaded to reduce car-miles driven, has started to unfold as heavier demand comes online for rail services. This has been especially true in cities such as Los Angeles which started its light-rail project twenty years ago, greeted initially greeted by a fearful public. Now however, L.A. is laying track down along many of the same routes from its pre-war light-rail system. It is finally becoming possible to live in Los Angeles without a car.

Continuing the Virtuous Circle

Various trends are already coming together that will support the resurrection of rail and possibly strengthen it as we move out towards 2025. In Part II, Reducing Your Exposure to Oil, we explore ways to take part in the U.S. rail renaissance. I also offer a personal example of how much savings my own household has captured by moving to a city that is served by extensive rail transport. Finally, I give a brief update on energy transition, as the developed world continues to move away from high-priced oil and pursues economic development along the contours of the powergrid.

Click here to read Part II of this report (free executive summary; paid enrollment required for full access).

The Federal Reserve is probably not ready to take the aggressive plunge into Nominal GDP Targeting, but it likely will.

Such a policy, which received wider attention during Ben Bernanke’s Congressional questioning last year and was also highlighted this year in a paper delivered at the Jackson Hole conference (Woodford, opens to PDF), has not caught any visible traction with Washington policy makers possibly because it’s seen as either too radical, or simply too new.

However, after four years of broad reflationary policy (and another year to come) failing to meaningfully spur U.S. employment growth, the Fed may be willing to try such measures by late next year, 2013.

Indeed, given the Fed’s recent announcement of open-ended quantitative easing (QE), one can already anticipate the incremental move towards Nominal Gross Domestic Product (NGDP) Targeting, which has as its central belief that an aggressive and open-ended promise to pursue growth at the expense of inflation is the booster required to push a structurally broken economy back to normal trend. Moreover, in contrast to Bernanke’s swift rejection last year of NGDP on a conceptual basis, Bernanke discussed the idea in friendlier terms during his post-Federal Open Market Committee (FOMC) news conference.

What’s ‘exciting’ about the emergence of NGDP Targeting into mainstream economic thinking is that, once implemented, it will provide a real-world test of reflationary policy’s final effort to combat the forces that have led to the end of strong, economic growth. The appearance of the Woodford paper (link above) further highlights the reality that endless amounts of cheap capital will be provided to restart economies, now that we are in energy transition, with the world having lost its cheap oil. The battle between credit and natural resources will be renewed.

What will be the effect on global natural resource extraction in an era of NGDP Targeting?

Simple.  All of the remaining fossil-fuel BTUs will be extracted on an accelerated basis, and governments will race to provide the capital to do so.

The Post-Abundance Era

It makes sense that just as the era of abundance is coming to an end – an era which dominated developed world economies over the past 250 years – an enthusiastic, vestigial embrace of Abundance would pour forth from culture. Books such as Abundance: The Future is Better Than You Think and also The Coming Prosperity have appeared in a flourish, all in the past year.

Is it not telling that this outpouring has occurred just as it has become crystal clear that prices of resources were not – even in the post-2008 era – returning to levels of the prior decade?

It is either lurid or tragic that assertions of abundance would flower after energy prices endured a price revolution, agriculture prices did the same, and purchasing power and incomes in the developed world entered decline. The repricing of the planet is a super-trend that has endured for more than 10 years now, and it has wreaked havoc on just about every asset class from stocks to housing. While observers currently cheer stabilization in such prices, it’s worth noting that the S&P 500 first reached current levels more than 12 years ago. Therefore, each unit of the stock market buys less of everything. So much for abundance.

It is additionally rather galling to be harangued by Abundance Theorists at a time when OECD economies have essentially failed, both in their financial systems and their ability to produce jobs, and are instead now producers of poverty. As purchasing power declines in the West against energy and food, what can Abundance Theorists possibly be thinking? It is not as if the industrial revolution in the Non-OECD is producing higher quality lives either, as countries like China convert themselves into waste dumps of coal-fired and chemical pollution, and India sees pluralities of its population continue to go without electricity or a reliable water supply.

Abundance would mean that globally, energy is so plentiful that it would be too cheap to meter. On the contrary, global energy prices – and in particular, food prices (which are strongly linked to energy prices) – have completely broken out of long-term trend lines to the upside.

There is no better measure of the aggregate loss of purchasing power against resources than the advance that poverty has made in the past 10 years, especially in the United States. While it’s true that various policy choices have exacerbated income inequality in the West for over thirty years, such explanations were more satisfying from 1975-2000, during a long period of efficiency gains in the economy. As it happens, the U.S. Census Bureau has just released fresh data on U.S. poverty, and while not a surprise, it does not make for pleasant reading. U.S. poverty is at its highest levels since 1993, but the current level — 15% — is very near the highs of the last 40 years:

Number in Poverty and Poverty Rate: 1959-2011

(Source – The U.S. Census Bureau)

Some observers have commented that the U.S. poverty rate is actually “not as bad as it seems” because of food stamps, various state and federal assistance programs, unemployment insurance, and other financial aid that the government now provides to the poor. These are collectively known as “transfer payments.” However, the income bracket requirements to be placed in the poverty category have such a low ceiling that it seems likely that U.S. poverty remains undercounted. From recent news coverage of the poverty figures at the San Jose Mercury News:

Although the poverty rate didn’t rise, the median household income for all Americans declined 1.5 percent to $50,100 in 2011. That was an 8.1 percent decline from 2007, before the recession began, and 8.9 percent lower than the 1999 peak. To be classified as poor in 2011, a family of two adults and two children would have had to make less than $22,811. Some economists had predicted Wednesday’s annual report would show the poverty rate hitting its highest level since 1965, when President Lyndon Johnson announced his war on poverty. The fact that the numbers instead leveled off after three consecutive years of increase was a relief to some. Still, the persistent poverty is troubling: the 15 percent poverty rate ties with 2010 as the highest since 1993 and one of the highest since the government began measuring poverty.

(Source)

There is a certain unreality to a measurement that deems a family of four with an income above $22,811 to not be in poverty. How, exactly, could one live as a family of four in these United States with an income of $24,000 or even $26,000 and not be in poverty? For such a household, energy and food prices alone would dictate either a very poor diet, or the need for government assistance in utility and transport costs, or both. Indeed, a new unreality in our accounting now marks many areas of economic life in the U.S. in the post-Abundance era.

Unreality in Energy Costs: The Ethanol Example

Analysts have pointed out for years that a significant portion of the military budget is devoted to the safety of global oil supply, and thus each barrel of oil has “external” costs that the user does not pay at the pump, but instead pays as a taxpayer. This is undoubtedly true.

So what policy has the U.S. pursued in an era when military costs and the price of oil are even more onerous? The policy of mandated ethanol.

Mandated ethanol in the U.S. has done nothing to lower gasoline prices (which are, of course, driven entirely by oil prices) regardless of ethanol content. Moreover, the energy content of all organic material, in this case corn, is so low that by the time the process of converting corn to a liquid is complete, so many other energy inputs have been required that the net energy pick-up is incredibly small. In order to escape the reality of structurally higher oil prices, the U.S. has diverted enormous capital and other resources to a program that is largely symbolic. But billions in tax credits have been devoted to grow and support an industry that could simply not make it without such support, primarily for two reasons: one, because the low energy content of corn does not provide enough profit to pay all entities in the production chain; and two, because ethanol makers are essentially refiners and do not ultimately control the cost of their feedstock (corn).

Ethanol policy has been underway since 2006, when the price of oil had started its price revolution. And aggressive reflationary policy in the US has actually been underway for 12 years, not just the past four years, when the near-zero interest rate policy was first employed (1.00% interest rates). These two policies are an example of how institutions and economies will grapple with both the loss of cheap energy and the tremors such a loss sends out through an economy. Trying to battle, hold back, and generally thwart secular changes in prices and carrying capacity with patchwork solutions not only is destined to fail, but brings with it myriad other consequences.

For example, because the economy was already experiencing energy limits in the early part of last decade, instead of spurring organic growth, reflationary policy simply distributed into the fixed assets of housing. That was confirmation that other barriers to growth were already becoming embedded.

Reflationary policy produced a greater quantity of resources, nor cheaper resources.

Similarly, in ethanol policy, instead of reconfiguring transportation systems or investing in rail, the U.S. foolishly wasted billions trying to produce more liquids when the real problem was the quickly escalating cost of oil supply. As we now understand, agricultural production is not free, but instead tied very much to fossil fuel costs. So the dream of escaping from high oil prices by running large-scale food-to-fuel programs is destined to fail.

No Carbon or Green Solutions at Sufficient Scale Coming

But if you think these measures are desperate, we have only just begun to push energy and financial systems beyond their capability.

The launch of QE3 (and similar measures by the European central bank (ECB) in Europe) is like the crack! of a starting-gun to human psychology that carries the following, urgent message: Hey, humans – go get those resources quickly, before someone else does! Indeed, the most powerful lever for monetary policy remains our capacity for social competition. The open-ended promise to pursue a faster rate of growth at the expense of inflation, mal-investment, bubbles, and the environment places a new and fast pressure on human economies to perform.

Those who are concerned about the environment and climate change should also read the onset of QE3 and the inevitability of NGDP Targeting as the start of the next big leg of resource extraction. And, accordingly, of CO₂ production.

While the dream of a green energy transition persists, however, no such transition from fossil fuels to renewable energy is taking place at sufficient scale or speed to effectively shift human economies to new energy architectures. We already have sufficient and clear data in our possession to know with some degree of certainty how energy transition is currently proceeding. In short, while wind and solar resources are growing at near-exponential rates, they remain such a small portion of the global energy mix that even in the best case scenario just 15% of the global powergrid will be free of fossil fuels roughly 20 years from now.

Displacing that much of the powergrid with renewables will indeed be an achievement, but unfortunately, the recoverable reserves of natural gas and especially coal are sufficient to fund incremental growth for at least another 20 years. Even if we project a mostly flat global economy for the next two decades, the energy-funding requirements to run a flat global economy will still necessitate that we extract enormous volumes of fossil fuels each year. And that is precisely what will happen as long as aggressive reflationary policy is pursued.

Accordingly, any global effort to place carbon taxes on economies or to agree to other climate treaties will largely be token and symbolic. In Part II: What Happens Once We’ve Burned All the Resources?, we take a look at the remaining reserves of natural gas and coal, and roughly model the composition of energy inputs to the global powergrid as economies transition increasingly away from oil. Also, now that it’s clear that this reflationary policy will carry on for years and years to come, we explore at a rough calendar as new programs roll out in Japan, the EU, and the U.S. Those who predicted Infinite QE have now been proven correct.

Click here to read Part II of this report (free executive summary; paid enrollment required for full access).

Now that oil’s price revolution – a process that took ten years to complete – is self-evident, it is possible once again to start anew and ask: When will the next re-pricing phase begin?

Most of the structural changes that carried oil from the old equilibrium price of $25 to the new equilibrium price of $100 (average of Brent and WTIC) unfolded in the 2002-2008 period. During that time, both the difficult realities of geology and a paradigm shift in awareness worked their way into the market, as a new tranche of oil resources, entirely different in cost and structure than the old oil resources, came online. The mismatch between the old price and the emergent price was resolved incrementally at first, and finally by a super-spike in 2008.

However, once the dust settled on the ensuing global recession and financial crisis, oil then found its way to its new range between $90 and $110. Here, supply from a new set of resources and the continuance of less-elastic demand from the developing world have created moderate price stability. Prices above $90 are enough to bring on new supply, thus keeping production levels slightly flat. And yet those same prices roughly balance the continued decline of oil consumption in the OECD, which offsets the continued advance of consumption in the non-OECD.

If oil prices can’t fall that much because of the cost of marginal supply and overall flat global production, and if oil prices can’t rise that much because of restrained Western economies, what set of factors will take the oil price outside of its current envelope?

Those who still don’t understand the past ten years cling to the antiquated view that prices will eventually return sustainably to levels of 2002 in due course. They believe that a great volume of new global oil production will start to appear and prices will be driven back to the cheap levels of last decade. Many who take this view also believe that market manipulation and inflation largely account for the high price of oil and that once reflationary programs like quantitative easing (QE) come to end, the price of oil will lose its speculative bid.

To be sure, the prospect for significantly higher prices in the near term remains dim. The automobile-highway complex is in full retreat in the West, and the developing world is largely funding its next leg of growth not through oil but via natural gas and coal. Short of war, an oil spike of the kind seen in 2007-2008 will not occur until global growth resumes.

That said, the factors contributing to oil’s present stability are worth considering as the foundation for any crash lower – or spike higher – in the year ahead.

Oil’s Current Price Envelope

Autumn is typically a time for financial market crashes. Should the Federal Reserve or the European Central Bank (ECB) waver from their implied promise of more QE, there is not enough organic demand in the global economy to maintain even the current stall speed of international trade and industrial growth. Any return to austerity or move away from reflationary policy would quickly sink asset prices. And that would quickly flow through to demand for oil.

However, QE does not in itself raise oil prices. If the global economy were “normal,” then QE would certainly flow through more directly to oil prices. (If the global economy were truly normal, there would be no QE). But the global economy, and especially Western economies, exited normal four years ago. During the present phase, therefore, QE is largely a psychological inducement and has few, if any, structural implications. QE functions more as a behavioral trigger, preventing economies from falling below their current level of stagnation. Accordingly, QE does not increase the price of oil during a time of debt deflation. Rather, QE simply maintains the global economy at the drip-feed level, thus allowing the OECD and non-OECD to continue their respective decline and advance. The result is a kind of stasis between oil supply and oil demand.

Unsurprisingly, the price of oil has been stable and has oscillated around $90 for nearly two years. A technical analyst might call this a consolidation of previous re-pricing phase, and fundamentally speaking, this is probably accurate. Recently, Ambrose Evans-Pritchard of the Telegraph newspaper marveled that oil prices could be “so high” during such difficult economic conditions:

Goldman Sachs said the (oil) industry is chronically incapable of meeting global needs. “It is only a matter of time before inventories and OPEC spare capacity become effectively exhausted, requiring higher oil prices to restrain demand,” said its oil guru David Greely. This is a remarkable state of affairs given the world economy is close to a double-dip slump right now, the latest relapse in our contained global depression…Britain, the eurozone, and parts of Eastern Europe are in outright recession. China has “hard-landed”, the result of a monetary shock and real M1 contraction last winter. The HSBC manufacturing index fell deeper into contraction in July…So we face a world where Brent crude trades at over $100 even in recession.

(Source)

Yes, the price influences on oil that exert upward pressure are mostly balanced by the array of factors exerting downward pressure. But this is all taking place at the new, higher price level for oil. Let’s take two of these factors, just to start. First, OPEC spare capacity, from EIA Washington:

It is axiomatic that if OPEC increases production, then its spare capacity will fall. And that is exactly the trend that’s been unfolding since 2009, when a weak economic recovery began. While total OPEC production has remained largely within a range of 31-33 mbpd (million barrels per day) for years now, spare production capacity in OPEC has fallen for a third straight year and remains below the five-year average in 2012.

Oil markets always have (and always will) firm up prices when spare capacity falls because reductions in spare capacity simply make overall conditions ‘tighter.’ While I disagree with the Goldman analyst cited above that inventories or capacity will cause an imminent higher price squeeze, it’s absolutely the case that the lack of robust spare capacity in OPEC is supportive of price. Briefly, let’s take a look at OPEC production:

The increase in OPEC production since early 2011 has a paradoxical effect: Yes, more oil comes to market, but spare capacity is reduced by an equal amount. Meanwhile, there is no spare production capacity among non-OPEC producers.

Global oil markets are therefore efficient price discounting mechanisms: OPEC spare capacity, whether being utilized or held in reserve, is, at most times, priced in. (The singular wild-card to OPEC spare capacity is now Iraq, which I will address in Part II).

The Other Half of Global Supply: Non-OPEC

The incremental, post-2009 increases in OPEC production (coming from a low near 30 mbpd) along with the ability of non-OPEC to either maintain or slightly increase production – especially from the U.S. – has likely served to keep prices from running away to the upside. Again, these increased volumes of oil from both OPEC and non-OPEC are not enough to meaningfully lower prices. Rather, in a world where emerging-market demand growth balances developed-market consumption decline(s), these incremental additions to global supply are merely enough to restrain prices.

Let’s take a look at non-OPEC production:

The near-mania over the recovery in U.S. oil production continues to run at very high emotional levels, but as we can see, average non-OPEC production in the three years of 2010, 2011, and 2012, (at roughly 42.5 mbpd) is just one percent above the average high of 2004. The fact remains that non-OPEC oil production is composed of very uneven results from various producers. Many of these have long offered the promise of increased volumes but have turned out to be a disappointment. Brazil is a case in point, where oil production is stagnant and not growing. Meanwhile, Canada remains at least 4-5 years behind projected growth rates from last decade, and other non-OPEC producers continue to suffer declines in places such as Mexico and the North Sea.

Marginal Price Realities

The oil market now understands that should prices fall below $90, it starts to make sense for large integrated oil companies to simply buy oil on the open market for refining rather than spending the capital to develop the oil from the ground. The cruel math of the marginal barrel now means that prices must stay above the $90 mark to encourage investment in new supply.

Furthermore, the rate at which this new supply comes to market remains ploddingly slow. Recent forecasts, such as Leonardo Maugeri’s wildly cornucopian report, completely overstate the rate at which new supply will come to market and the rate at which existing supply is in decline.

More broadly, the public still seems not to understand that many of the giant, integrated oil companies are now mostly price-takers of oil, not price-makers of oil. ExxonMobil, Shell, and ConocoPhillips have increasingly become natural-gas-focused companies as they lost their ability to replace their own oil production with new supply over the last decade. The new oil resources which come on-stream now are made possible by the small and mid-sized oil companies, which are more nimble and more suited to the tight, narrow boundaries that define the next tranche of oil supply. Global oil supply was once composed of giant companies extracting huge volumes from singularly giant fields. Now the landscape has fractured into a million little pieces, with specialists far and wide digging up expensive, hard-to-extract oil.

OECD Inventories

When new supply comes online at very slow rate against existing declines, one of the sources upon which the market can draw is inventory.

Based on the number of days’ supply, total OECD inventories are back down near their lowest levels of the past four years at 57 days’ supply. Readers will recall that the IEA Paris cited these inventories when the Libyan conflict broke out last year, as a reserve of oil that would be sufficient to calm oil markets. Not so. Oil markets were not pacified at all by inventories, which have been in a downtrend for over two years:

For over a year, inventory levels have been below the trailing five-year average. Per the most recent Oil Market Report from the IEA, inventories fell again, counter-seasonally.

Frankly, it is not so much that OECD inventories are at critically low levels, or that inventories are falling rapidly. Rather, the point is that inventories are not building. Indeed, on an absolute basis, OECD inventories at 2,683 mb (million barrels) revisits similar levels from 4-6 years ago (2006-2008). This is yet another reason why stagnating economic growth in the West has not exerted much downward pressure on global oil prices.

Energy Transition and the Next Set of Risks to Oil Prices

Global growth, scarce though it may be, is no longer being funded by oil. OECD economies have rebounded weakly since 2008, and have used natural gas, coal, and renewables like wind and solar rather than oil to build back broken portions of their economies. Meanwhile, in the non-OECD, where oil demand is still growing, the consumption of oil is completely dwarfed by coal consumption. There is no question that energy transition is underway and has been already for at least five years. In my last report, I suggested that one possible pathway for oil was to be finally set free to achieve significantly higher prices as the construction fuel for a world in transition.

In Part II: The March to $200+ Oil, we take a look at the various factors (and the relative influence of each) that are combatting to push oil outside its current price range: lower, as a result of renewed deflation and financial crises, and also higher, as a result of a near-term growth spurt brought on by renewed reflationary operations.

Click here to read Part II of this report (free executive summary; paid enrollment required for full access).