This past week I attended the 7th annual ASPO-USA Peak Oil conference in Washington DC. All of the talks were very interesting, and I was happy to see that at least two members of our congress, Congressman Mike Honda (D-CA) and Congressman Roscoe Bartlett (R - MD), are aware of the peak oil challenge we face. For me, the best part of the weekend was the time I spent between talks discussing peak oil investing with a number of people who whose entire investing strategy revolves around peak oil.
I tend to take a lot of notes and when I hear interesting quotes, I write them down verbatim. So here are the top 10 interesting quotes from my note pad:
# 10) "Place a peak oil filter on top of your investment strategy" -Jim Hansen of Ravenna Capital Management
# 9) "No politician wants to admit that we have grown more than this planet can sustain" - William Catton
# 8) "I make my decisions based on information, but I'm unusual" -Chris Martenson on the public narrative problem with peak oil
# 7) "I'm a mac guy" -Robert Hirsch, author of the famous Hirsch Report, during some technical difficulties
# 6) "If they had to run on their own production, it would fall apart"- Robert Rapier describing the EROEI problem of corn ethanol
# 5) "We're in a zero-sum world" -Jeff Rubin
# 4) "Soil is more important than oil"..."the date will come when we stop treating soil like dirt" -Wes Jackson
# 3) "I think the peak oil situation will come very quickly" -Charles Schlumberger, Lead Air Transport Specialist at The World Bank
# 2) "Since oil is a finite resource, the oil industry is a finite industry" -Andy Buckingham, an oil industry wildcatter
# 1) "It is not the strongest of the species that survives, nor the most intelligent, but rather the one most adaptable to change." - Angelina Galiteva quoting Charles Darwin
Last Friday, September 23rd, 2011, I presented this "Peak Oil 101" presentation at Cornell University. We had Dr. Chris Martenson, a renowned peak oil author and Johnson School alumnus, join us by phone to answer questions after the presentation.
Late last week the Obama administration announced that they would be releasing 30 million barrels of oil from the US Strategic Petroleum Reserve as part of a broader US-led release by the International Energy Agency of 60 million barrels of crude oil from member nations. The move was unexpected and unprecedented. This is only the fourth time in history that the Strategic Petroleum Reserve has been tapped. The past three times were in 1991, during Operation Desert Storm, in 1996, when Bill Clinton used the reserve as a political tool to try to reduce the deficit and in 2005, after Hurricane Katrina knocked out 95% of Gulf of Mexico crude production. The official reason given for the release of oil is to offset the lost Lybian oil production resulting from the Arab Spring-sparked civil war there.
Operation Desert Storm - one of four times the US used the Strategic Petroleum Reserve
In actuality, the release is probably designed to provide relief at the pump to American consumers as they enter the busiest part of the summer driving season. With the QE2 stimulus ending on June 30th, the FED has planned to continue keeping interest rates low by using the proceeds from the maturing debt that was purchased during QE1 and QE2 to continue purchasing $25 billion worth of treasuries per month. This continued quantitative easing would likely have an inflationary effect on oil prices, and this release of oil should partially offset this effect, at least for the next two months. An economically-motivated drawdown of the Strategic Petroleum Reserve still has military consequences, leaving the US more vulnerable to supply disruptions, and as the US releases its stockpile of oil, China is rapidly filling its own strategic petroleum reserve.
After OPEC refused to raise production rates, many people expected Saudi Arabia to step in and raise their own production to offset the lost Lybian oil. The fact that they haven't done so raises the specter that they may have in fact reached peak oil and are unable to raise their production rate any further. Part of the problem is that the only additional oil that Saudi Arabia can quickly bring to market is heavy crude. Because it takes many months, many millions of dollars and numerous legal hurdles to upgrade refineries to be able to process heavy crude, heavy crude refining capacity remains tight, meaning the additional Saudi heavy crude capacity is unlikely to offset the lost light sweet crude production from Lybia. This may continue to be a problem well into the future, as upgrading refineries for heavy crude and tar sands can cause their emissions per barrel to triple - making these upgrades difficult to justify politically.
With the world consuming over 86 million barrels of oil per day, the oil release is equivalent to a little more than 16 hours of global oil demand, meaning that the 5% drop in oil prices could be short-lived. In fact, oil markets, which had been trading in backwardation since February, recently went into contango, signalling that supply shortages are just around the corner. As a result, this short-sighted release of oil may present a buying opportunity for people wishing to profit from higher future oil prices.
Some of the more alarmist peak oil writers have put forth the idea that once we reach peak oil, the world's fiat currencies will experience hyperinflation and currency collapse. The general argument made by these authors, is that in the event of a rapid decline in world oil production, economies could suffer and governments may resort to printing money in order to prop up their economies (quantitative easing) or in order to purchase rapidly depleting resources. This money printing could quickly get out of control, leading to hyperinflation and currency collapse.
Hyperinflation has happened a few dozen times before. The most commonly cited cases are in Weimar Germany, which ultimately led to the rise of Adolf Hitler, and the recent 2004-2009 hyperinflation in Zimbabwe, which led to the government printing 100 trillion dollar bills that were so useless that they couldn't even buy a bus ticket. Even in the United States, we experienced hyperinflation with the Continental Currency becoming so completely worthless through money printing that by 1778 the phrase "not worth a continental" entered our lexicon.
A Zimbabwe 100 trillion dollar bill
Personally, I think the risk of peak-oil-induced hyperinflation is relatively low, due to the fact that markets will, for the most part, properly allocate capital into energy alternatives and energy efficiency technologies. Currently, the energy intensity (the amount of energy we use per unit of GDP created) of our world's economy is relatively low. As we move from high net-energy oil (conventional oil with a high EROEI) to lower net-energy oil (tar sands, coal-to-liquids, etc.), the energy intensity of our economies will increase, but this will create an enormous financial incentive to increase our industrial energy efficiency and to develop renewable energy technologies. To put it another way, oil will become more expensive, but we'll find ways to make the same amount of money with less oil, while at the same time, using oil alternatives that will become more and more affordable. The change in world infrastructure may be massive and fraught with political and social pains, but inevitably, the world economy will continue chugging along as it always has.
Nevertheless, I find the topic to be fascinating (I even have a framed Zimbabwean $100 trillion bill on my wall), so let's take a look at various forms of alternative currencies that would theoretically save you from the "dollar apocalypse":
Other Fiat Currencies
There is a saying, that "everything is relative". In the event of a currency collapse in one country, the currencies of other countries will gain relative strength. During the hyperinflation crisis in Zimbabwe, locals began using the US Dollar and South African Rand in lieu of Zimbabwean Dollars. Throughout history, some currencies have always been more stable than others. The Swiss Franc, for example, has held its value extremely well while currencies around the world have fluctuated wildly. Peak oil may cause the dollar to lose value if oil exporting countries lose faith in the dollar and begin to price oil in other currencies, such as Yen or Euros. The world may abandon the US Dollar as a reserve currency and instead begin to use a basket of currencies for international trade. In such a case, other currencies would gain on the dollar's loss. As the world passes the peak of oil production, oil prices may skyrocket, benefiting the currencies of exporting countries, like the Russian Ruble. If Saudi Arabia de-pegged its Riyal from the US Dollar, its value could skyrocket. Fiat currencies from commodity-rich economies, like Australian Dollars, Canadian Dollars, and Norwegian Krone may also benefit in such a scenario.
Holding these currencies in a forex account or through currency ETFs may allow investors to benefit from changes in relative currency values, but using other countries currencies in day-to-day transactions is extremely difficult, as it may be impossible to get physical foreign currency during a crisis, and people may be unwilling to transact in currencies they are unfamiliar with.
Physical gold and silver Commodity currencies, like gold and silver, our some of our oldest forms of currency and are even mentioned in the Bible, with Jesus referring to the Roman silver Denarius coins when he says "Render unto Caesar the things which are Caesar’s". Throughout history, the purchasing power of precious metals has been surprisingly stable. If you had an ounce of gold in 562 BC, during the time of the Babylon Empire, you would've been able to purchase about 350 loaves of bread. Today, the same ounce would buy you about 500 loaves. By comparison, a dollar would buy you twenty Hershey bars in 1954, but today it will only buy you one. Clearly, physical metals are superior to fiat currencies in holding their value.
Unlike foreign currencies, people still have a general idea of how much a gold or silver coin is worth, due to the fact that so many people own gold and silver jewelry. In the case of gold, because it never corrodes, it will remain in completely pristine condition forever. It can be melted, combined and cast an infinite number of times, making it completely untraceable. Gold and silver are relatively scarce and will likely remain so well into the future, due to the energy required to extract them from the ground. Indeed, as peak oil makes energy more and more expensive, and as we move past all of the easily extractable gold, we could reach "peak gold" at some point in the future, and may have even reached it already. Because well-recognized physical metals require absolutely no infrastructure to trade, they can be exchanged in the absence of electricity or even in the absence of government. This advantage of gold was seen only a couple of years ago in Zimbabwe, when people began trading physical gold for food and other goods as the local currency collapsed.
Physical gold and silver, in the form of bars or coins, isn't easily divisible and has a relatively high value per unit, making it difficult to use in small transactions. Instead of buying you a cup of coffee, for example, a silver coin might buy you twenty cups. Coins are also subject to counterfeiting and coin clipping. Verifying the authenticity of a coin may be extremely difficult and may require complex and expensive instruments. Physical metals are also easy to detect and confiscate and can't easily be moved across boarders. Finally, there is the problem with the physical security of precious metals. Because they are so valuable, the risk of theft is high, and people may have to spend significant money simply to keep their physical metals safe. Recent changes to the US tax code are also making it more difficult to transact in physical gold, as starting in 2012, all transactions valued over $600 (which includes most gold transactions) need to be reported on federal 1099 tax forms. With the recent government raid on Liberty Dollars, it's also becoming more and more uncertain if it is legal for US citizens to use gold and silver coins as a currency.
Digital gold currency
Digital gold currencies have attempted to replace some of the shortcomings of physical gold by "digitizing" them. Essentially, a digital gold service holds physical gold in a vault and allows its users to exchange gold amongst themselves online. This solves the problem of divisibility, as digital gold can be divided into tiny fractions of an ounce. It also partially solves the problems of authentication and physical security, as all parties agree to trust a central authority to hold real gold.
While digital gold currencies may make it easier for people to conduct gold-denominated transactions, the risks are numerous. The main drawback to digital gold currencies is that customers must put complete faith in the organization that holds the physical metals. Customers must believe that the organization both holds real gold and that the organization isn't some "fly by night" operation that will take their money and run. Electronic gold companies like "e-gold" have failed to reimburse customers after their accounts were hacked, and both e-gold and "e-bullion" have been shut down by the US government.
BitCoin Bitcoin is the world's first decentralized digital currency. Through the use of cryptography and a peer-to-peerdistributed database, bitcoin allows people to exchange money online in an anonymous manner, similar to how we use cash today (think of it as an anonymous paypal that isn't controlled by anyone). Because the money supply is finite and can't be adjusted by any central authority, bitcoin eliminates most of the problems that are created by the central banks that we have today.
For a good explanation of bitcoin, watch this video:
Because the number of bitcoins are finite, any banks that would use them would be less likely to practice risky forms of fractional reserve banking. Unlike our banks today, if a "bitcoin bank" used the money multiplier effect to leverage up a $1,000 deposit into $10,000 in loans, it would then be at risk of a bank run. Since there's no central bank to eliminate systemic risk through a mechanism like our FDIC, banks would need to use money multipliers that are lower than are currently used in order to limit their risk of a bank run. A bitcoin bank could theoretically use a higher money multiplier and pay an insurance company to insure them against a bank run, but the result may be similar to what we saw when AIG, which insured against defaults of collateralized debt obligations by issuing credit default swaps, went bankrupt, causing a wave of bankruptcies that ended in the Great Recession. In practice, if someone started a "bitcoin bank" it would most likely be a "full reserve bank" that would only allow people to store their money at the bank for a "safekeeping fee" or invest it by allowing the bank to loan it out in return for interest. For deposit accounts, banks would need to compete against each other on the basis of which was the most solvent, rather than which can provide the most gimmicks like "free checking".
By eliminating the central bank, bitcoins also eliminate the "too big to fail" moral hazard problem with banking, whereby if banks do well, bankers are paid large bonuses, and if they fail, they get bailed out by the government and bankers are still paid large bonuses. Such moral hazard, where there are no consequences for failure, cause bankers to take imprudent risks. With bitcoins, since there is no central bank to print money and bail out failed banks, bankers would have to take more measured financial risks by using less leverage, which would make booms and busts smaller and less painful. Without a central bank to control the money supply, inflation and deflation would be determined by the free market.
While bitcoins make hyperinflation impossible, one of the arguments against currencies with a finite money supply, like bitcoin and commodity currencies like gold, is that without continual inflation, the currency could be susceptible to a deflationary spiral whereby people horde the currency as goods and services become cheaper and cheaper. Bitcoin has a built-in algorithm that causes near-term inflation that will gradually taper off into a finite amount of coins that are infinitely divisible. As bitcoins become a finite currency, critics argue that they'll experience a deflationary spiral. Arguments suggesting that currencies with a finite supply can cause a deflationary spiral are generally specious, as deflationary spirals aren't self-sustaining to infinity. As deflation hits an economy, savers will hold out until the correction is at a point where the benefit of spending their savings outweighs the benefits of holding their currency any longer. To put it another way, at some time during a deflationary spiral, there is an inflection point where the yield from investing the deflating money becomes higher than the yield from holding the money any longer. At this point, the correction ends, the economy stabilizes, and everyone continues on their merry way. Because humans have a time preference discount rate that favors consumption in the present over consumption in the future, there will always be a point at which people will want to stop hording a currency and start spending it. There is a good deal of academic research that shows that deflation doesn't cause recessions, and can, in the case of a gold-backed currency, even be good for the economy.
Bitcoins eliminate the problem with currency debasement. Throughout history, governments that have used commodity-based currencies have debased their value by gradually lowering the quantity or quality of the underlying asset. In Roman times, the government debased the silver Denarius coins by reducing their size and lowering the fineness of the silver in them. Beginning in the 1100's, the British Pound was backed by a pound of sterling silver. In 1971, the pound was de-linked from silver and free-floated against other currencies. The British pound that would buy you a full pound of sterling silver in the 1100's will buy you only 0.003 pounds of sterling silver today. Rather than debasing the currency by physically altering the metal, the government debased the currency by simply changing the law. Because bitcoins float freely against all of the world's currencies and because no government law can alter their supply, it is impossible for a government to debase the currency.
Bitcoins could theoretically eliminate a government's ability to hamper free enterprise by confiscating hard money and enacting price controls and rationing measures. In 1933, Franklin Delano Roosevelt ordered the confiscation of all privately-held gold through Executive Order 6102. Since bitcoins are virtual and decentralized, it is impossible for any government authority to confiscate them or freeze people's assets. In the Soviet Union, for example, the government enacted price controls and rationing schemes during periods of goods shortages. These efforts merely distorted the markets and encouraged underground economies to spring up. The ultimate solution to shortages is the free market, because by determining resource allocations based on the proper price of goods, it sends price signals to the market, thereby encouraging investment in production of whatever is in short supply, and helping to bring the market back to equilibrium. With government interference, these price signals are warped and resources may be easily misallocated. If the economy used bitcoins, there would be no way for the government to restrict the underground economy, making price controls and rationing difficult or impossible to enforce.
If a government used bitcoins, rather than its own fiat currency, it would have to operate the way governments did under the gold standard. Instead of printing money to pay for budget deficits, it would have to balance its budget or issue bonds. If the government issued bonds, they would need to have an interest rate that compensated people for the risk of default. Under the previous gold standard, the US government defaulted on gold-backed liberty bonds in the 1930's, leading to difficulties in selling further bonds. The "inflation tax" that we all pay, but rarely notice, would be replaced by traditional taxes. Without the inflation tax, there would be far more transparency in the way that we fund our government, and people would be less likely to allow the government to fund "pork barrel" projects or subsidies that benefit only a select few at the expense of the many. People would be less likely to allow the government to fund wars without a clear idea of how the vast expense of wealth and human life would benefit the citizens back home.
The use of bitcoins by a government could also eliminate the iron triangle problem, as banks wouldn't be able to lobby a central bank to enact a loose monetary policy that would increase their profits and allow them to fund even more lobbying for even looser monetary policy. This system would also eliminate the problem of political influence over central bank money printing. For example, the incumbent political party wouldn't be able to create the appearance of a robust economy right before an election by pushing the central bank to enact loose monetary policy. Politicians would have to get elected based on how their policies created actual economic prosperity, rather than perceived prosperity.
Governments could theoretically attempt to restrict bitcoins by declaring them illegal and prosecuting individual users, but because of the anonymity and decentralized nature of the currency, the government would have to expend enormous resources to find and prosecute people. Short of catching someone in a sting operation, the anonymity of bitcoins, especially if they're run through an open wifi using nested VPNs and an anonymous protocol such as tor, could provide enough plausible deniability to make it impossible to prove guilt beyond a reasonable doubt in a court of law. Since bitcoin is completely decentralized, the only way to shut down bitcoin would be to take down the entire internet. As a result of the governments in Egypt, Libya, Tunisia and Bahrain shutting down their internet connectivity during the recent "Arab Spring" revolts, many smart technologists are looking into ways to make the internet more difficult for a single party to shut down. Distributed infrastructure like the IEEE 802.11s standard for wireless mesh networking, is already being widely adopted throughout the developing world through the One Laptop Per Child program, which supports the standard. These 2 million laptops can create a wireless mesh network where internet traffic can "hop" from laptop-to-laptop until it reaches one that is connected to the internet. In the case of the Egyptian internet shutdown, journalists used satellite phones to connect to the internet and many people used old dialup modems to call international ISPs over land-lines to get back on to the internet. The biggest current flaw to the resilience of the internet is the centralized nature of our domain name system. As we saw recently with the US government's crackdown on internet poker sites, rather than shutting down the companies' servers, the government simply redirected their domain names. Bitcoin has created a solution to this problem of internet centralization through the peer-to-peer domain name system called "namecoin" (to visit this blog over namecoin, simply use a namecoin-supporting DNS and go to http://will.bit/). These domains, which end in ".bit", are completely decentralized and can't be shut down by any government authority. There are other similar P2P DNS projects in the works, such as dot-p2p and MondoNet, but currently only namecoin is operational. In theory, the combination of bitcoin and namecoin would allow an organization like Wikileaks to receive payments from supporters and operate a website which couldn't be shut down by any government. The implications of these combined technologies on government transparency are enormous.
Clearly, bitcoin is a game-changer. It has all of the advantages of traditional "hard money" like gold, all of the advantages of a digital currency and all of the advantages of cash. When compared to fiat currencies, its drawbacks are few, if any. It is a relatively rare occurrence when a new currency comes on to the scene and solves so many problems at once, which is why I and some of my friends here at Cornell are justifiably excited about this new currency. Most of the hypothetical scenarios I previously laid out are simply designed to give a sense for how beneficial the widespread adoption of bitcoins could be. At the very least, it is a superior alternative to the world's fiat currencies for online transactions, and it could be used in the event of hyperinflation or currency collapse.
Finally, I want to discuss local currencies as an alternative for central-government fiat currencies. Local currencies allow people to barter their goods and services within their own communities without the use of national fiat currencies like the US Dollar. There are many examples of local currencies, from Detroit Cheers in Detroit, Michigan to BerkShares in the Berkshires region of Massachusetts. Many cities have set up Local Exchange Trading Systems that allow people to trade their local currencies online. Ithaca Hours, our local currency, is the oldest and largest community currency in America. Each Ithaca Hour is valued at 10 US Dollars or 1 hour of labor and can be exchanged only within Ithaca, New York. The benefits of Ithaca Hours are numerous. They keep wealth circulating within, rather than leaving the community, they encourage people to purchase locally produced goods and services and they provide community entrepreneurs with opportunities to generate wealth. Dozens of other community currencies have sprung up since the creation of Ithaca Hours, and many have followed the Ithaca Hours model. Currently over 500 local businesses accept Ithaca Hours, from our local grocery co-op to our local credit union. Around the world, the Transition Towns Movement, which is bringing people together to prepare their communities for the dual challenges of climate change and peak oil, actively encourages local currencies.
1/8th of an Ithaca Hour
I've recently spearheaded the "Ithaca Hours Revitalization Initiative" here in Ithaca to increase the awareness and adoption of the currency around town. This year is the currency's 20th anniversary and over the next year I and my team will be working with the Ithaca Hours organization to make it easier for Ithacans to use Ithaca Hours. We're currently exploring the idea of digitizing the currency, and we're hoping to incorporate some of the ideas from bitcoin into America's oldest and largest local currency.
Once again, no matter how fascinating I find this topic to be, I personally believe that the chance that peak oil will lead to hyperinflation or a currency collapse is quite low. Rather, I believe that markets will act accordingly to allocate capital into the extraction of ever more scarce resources until these sources of energy become more expensive than their sustainable alternatives. The transition to these sustainable energy sources, however, may not be entirely smooth, and it therefore may be prudent for investors to consider moving some portion of their wealth into dollar alternatives.
Australia, with its vast resource wealth and political stability, is uniquely positioned to benefit from peak oil by exporting energy and raw materials at higher prices to an increasingly energy-starved world. At the same time, its geographic remoteness and depleting oil resources makes it uniquely susceptible to some of the worst consequences of peak oil. Australia is, therefore, a bit of an investment paradox if one is looking to reduce their exposure to peak oil - there are a multitude of investment opportunities, but likewise a multitude of traps.
The good news is that Australia is energy self-sufficient due to its vast reserves of coal and natural gas. Australia is the world's largest coal exporter and the world's 12th largest natural gas exporter. So despite the county's oil peak and rapid decline in oil production, Australia remains a net exporter of total energy. Australia's massive coal reserves could allow the country to benefit enormously from peak oil through coal liquefaction technology. Indeed, a number of Australian companies, such as Hybrid Energy, Monash Energy, Linc Energy and Syngas, are currently working to create fungible crude oil substitutes from coal.
Australia's Gorgon Gas Project off the country's western coast is one of the largest natural gas export terminals in the world. Expected to reach full production this year, the facility will pull natural gas from the North West Shelf and ship it as LNG to Japan, China and India. Another project, the Gladstone LNG project in Queensland, will convert coalbed methane into LNG for export by 2014. With Japan's recent earthquake/tsunami causing a nuclear meltdown at the Fukushima power plant, the role of natural gas in generating electricity will become more and more important as a worldwide public backlash against nuclear power forces existing older reactors into retirement and hampers the construction of future nuclear power plants. Countries like Japan, with few energy resources of their own, will look to countries like Australia to provide them with the energy they need to maintain their modern society. Developing countries like India and China, with their insatiable appetites for energy will also be major customers for these LNG exports.
In addition to its energy exports, Australia is one of the world's most important minerals exporters. It is the world's largest producer of bauxite (used in aluminum production), 2nd largest producer of zinc, 3rd largest producer of gold, 3rd largest producer of iron ore, 3rd largest producer of uranium, 4th largest producer of silver, 5th largest producer of copper, and a world leader in the production of a number of other minerals. Higher oil prices coincide with higher commodities prices in general, and many leaders in the mining industry, such as BHP Billiton and Vale, are predicting minerals prices to remain high. Peak oil could very well lead to "peak minerals", making these resources extremely valuable to Australia in the long run. These exports, however, are highly dependent on world economic growth. If oil prices spike too quickly, the economies of the world could be pushed into a recession, thereby reducing the demand for industrial metals and hurting Australia's mining industry. Since the mining industry is highly cyclical, investment in this sector should be timed properly and hedged through diversification of investment into other sectors. Of particular concern, given that Australia hold's the world's largest uranium reserves. is whether the Japanese nuclear meltdown will hamper uranium exports. Most analysts agree that even with a public backlash forcing retirements of nuclear power plants in developed countries, the increased demand for nuclear power in developing countries, like China, will outweigh this headwind.
Australia has the lowest "physiological density" of any country on earth, with only 43 people per square kilometer of arable land. As peak oil makes energy-intensive agriculture more and more expensive, Australia will benefit enormously from exporting food to the world. Perhaps more importantly, Australia has the most certified organic farmland of any country on earth, with 12 million hectares. This also puts Australia in the enviousness position of having the lowest "organic physiological density" on the planet with only 1.9 people per hectare of organic farmland. Because organic agriculture doesn't require the used of petroleum-derived pesticides and fertilizers, the food energy output per unit of energy input is about double that of our world's current petroleum-intensive agriculture systems. From a food standpoint, Australia is completely "peak oil proof" and will likely play an extremely important global role as the world's struggles to feed nearly 7 billion people with less and less oil available for pesticides and fertilizers.
Global warming will shift much of the productive farmland from the north to the south of Australia over the next half-century. In the short term, the country as a whole will experience more temperate weather, with longer growing seasons for many crops. Water scarcity, however, may dampen much of the benefits gained from these advantageous changes. Droughts and floods already plague Australian farmers. Australia had its wettest spring on record last year, with Queensland and Victoria experiencing major floods. At the same time, however, the southwest experienced severe drought with its driest and hottest year on record. These types of events could potentially get much worse as a result of global warming. Adapting to these changing climate conditions will require tremendous infrastructure costs for the protection from floods and the production and distribution of water. Australia currently gets much of its drinking water for western cities through multi-billion dollar desalination plants. Expanding the use of desalination, especially if it becomes required for crop production, will be extremely energy intensive and increasingly costly in the future.
One factor pushing Australia in the right direction is the environmental awareness of its citizens. When it comes to environmental issues, Australians are the third most knowledgeable group of people (behind Swedes and Japanese) and they are the most likely group to purchase energy-saving appliances for their home for environmental reasons. This environmental awareness likely stems from the 1970's when Australia's unique susceptibility to ozone depletion catapulted environmental issues to the forefront of minds. Countries in the lower latitudes of the southern hemisphere were the first to be threatened by the growing hole in the ozone layer, and countries like Australia, New Zealand, and South Africa, with their citizenry of fair-skinned European descendants, were particularly threatened by the cancer-causing UVB radiation leaking through the ozone hole. Abroad, the Australian government became a leader in the fight against ozone-depleting CFCs, ultimately leading to the ratification of the Montreal Protocol in 1987. At home, the Australian government pushed hard to educate its citizens on the cancer danger of ozone depletion. It's famous "Slip Slop Slap" campaign greatly reduced skin cancer rates by encouraging children to "slip on a shirt, slop on sunscreen, and slap on a hat", and today, almost all schools employ a "no hat, no play" policy for children. This massive environmental awareness campaign focused on ozone depletion likely had spill-over effects, with Australians today being more aware of all environmental issues facing them. With the ozone hole problem, Australians saw an environmental catastrophe looming over them and were able to band together to enact international political change to solve the problem. With global climate change, the country faces a similar challenge today, so it is no wonder that they are keenly aware of the need to push change both at home and abroad in order to solve the problem.
"no hat, no play"
From a peak oil standpoint, this environmental awareness is pushing Australia towards more sustainable sources of energy and reducing the energy intensity of Australia's economy overall. Awareness of peak oil itself is high in Australia. The country did, after all, create the first "peak oil movie" with the 1979 dystopian action film "Mad Max". On a political level the Australian government is one of the few to have released a report officially acknowledging peak oil and analyzing possible mitigation strategies. Even in my own blog stats, I receive a disproportionate amount of page-views from Australia on a population-weighted basis than I do from other developed countries, leading me to believe that Australians, on average, have a higher awareness of peak oil than people from other nations. Culturally, there is also an emblematic tradition of rugged self-reliance in Australia, similar to America's western culture of independence and self-determination. This cultural tradition will help Australia greatly as the world enters a post-peak phase, when sacrifices and difficult decisions need to be made. This public awareness of global climate change and peak oil is slowly pushing Australian politicians to enact energy legislation that promotes more sustainable forms of energy. Australia gets the vast majority of its electricity from coal-fired power plants, making it one of the world's worst greenhouse gas emitters on a per-capita basis. Coal power is slowly being replaced with a number of renewable energy sources through state subsidies.
Similar to the US, Australia has no cap-and-trade carbon scheme but unlike the US, the Australian federal government has enacted a mandatory renewable energy target of 20% renewable electricity by 2020. Individual states have imposed feed-in tariffs and state renewable energy targets, ranging from 15% by 2014 in South Australia to 25% by 2020 in Victoria. Adoption of renewable energy in Australia has increased by 41% over the last 30 years but absolute adoption remains extremely low, with 6.4% of the country's electricity coming from hydroelectric dams, and only 0.7% coming from wind power. Over the next decade, wind and gas adoption will increase significantly to meet these state targets, but coal will still remain the number one source of energy in Australia. The sunny climate across vast parts of Australia makes the country a perfect candidate for solar power, and currently about 7% of households have solar hot water heaters on their roofs. These systems typically have about a 5 year payback period for homeowners and are expected to become more widely used in the coming years. Solar photovoltaic adoption, through both industrial scale projects as well as distributed home generation, will almost certainly increase in the future, especially with the government's favorable subsidies.
Australians are the third least likely group of people to use public transportation (after Americans and Canadians) and along with the French and the Americans, Australians are the third mostly likely to drive their car alone. Australia currently does not have any high speed passenger rail lines and despite many feasibility studies, there are no plans for construction of any lines in the near future. Like the US, Australia has a strong car culture, large sprawling suburbs and vast distances between cities in the west. This all combines to make the country extremely dependent on gasoline for daily life. Peak oil and correspondingly high gasoline prices will require tremendous societal change, as people move to more walkable neighborhoods, drive fewer miles and drive more fuel-efficient vehicles.
The vast physical distances separating Australia from other developed world economies (besides New Zealand) creates an "economic remoteness" that could potentially be greatly exacerbated by the onset of peak oil. Because sea shipments require a lot of oil, as the price goes up, Australia could become less economically competitive against other nations for the trade of certain goods. Australia's biggest trading partner is China, followed by Japan and the United States. Shipping from Melbourne, the busiest shipping port in Australia, to Shanghai, the busiest shipping port in China takes 15 days to complete the 5,131 nautical mile journey. For comparison, Norway's largest trading partner is the United Kingdom. Shipping from Stavanger to Aberdeen requires a distance of only 274 nautical miles.
One way to look at this difference in "economic remoteness" is to compare the difference in shipping costs for the two countries at different oil prices. Research from CIBC shows that to ship a 40 foot container the 5,724 nautical miles from Los Angeles to Shanghai, China, costs about $8,000 ($1.40 per mile) with oil at about $130 per barrel. A regression analysis of the CIBC data shows that the predictive equation they use for calculating shipping cost per mile in relation to oil prices (with a statistically-significant p-value of 0.026 and a r-square of 0.95) is: Shipping Cost Per Nautical Mile = 0.185 + 0.011 * Oil Price. With oil at $100 per barrel, the cost for a Norwegian company to ship a 40-foot shipping container of lingonberry jam from Norway to the UK would be about $350. The cost for an Austrailian company to ship a 40-foot shipping container of vegemite from Austrailia to China would be about $6,600. With oil at $200 per barrel, shipping the lingonberry jam would only cost $650 while shipping the vegemite would cost $12,200. The average shipping container holds about $300,000 worth of goods (with a $100,000 standard deviation). With profit margins of less than 2% in the food industry, the $6,000 profit for the Australian company shipping vegemite to China quickly disappears as oil prices rise, while the Norwegian company will continue shipping lingonberry jam to the UK at a profit.
The susceptibility of long-distance sea shipping trade to volatile oil prices is perhaps more important than the absolute costs of shipping. According to a United Nations report on international trade, the price elasticity of inter-modal freight rates to oil prices ranges between 0.19 and 0.36. This range is relativity inelastic, and it means that as oil prices fluctuate wildly as we enter the bumpy plateau of peak oil, companies in Australia that are heavily dependent on international sea shipments may experience significant economic pain.
In recent decades, the "graduation" of some Southeast Asian countries, like China, Singapore and Taiwan from "developing" to "developed" has created more trade partners in the region. As the southeast Asian "tiger" economies continue to grow into a larger portion of the world's GDP, Australia's average economic distance will fall, while economic remoteness on relative terms will increase for European and western-hemisphere countries. This should help Australia stay economically competitive for many exports.
Australia's vast mineral wealth could also help it overcome its economic remoteness. The United States overcame the physical remoteness from its European trading partners in the 1700's by exploiting its vast natural resource wealth and exporting raw materials to these advanced economies. Despite the cost of shipping, mineral exports will likely continue to remain competitive even in a post-peak enviornment.
The economic isolation from other trading partners may also make Australia one of the first countries to experience "localisation" of the kind Jeff Rubin describes in his book "Why Your World Is About to Get a Whole Lot Smaller". The most remote cities in the central and western part of the country may be forced to become more economically self reliant, producing more goods locally. As a whole, the country will become more reliant on the export of services and less reliant on the export of manufactured goods, much as many economists are encouraging America to do now.
As peak oil pushes up the cost of aviation fuel, air travel will likely become more and more expensive in the future. Due to the vast distances required to travel to Australia, the country's tourism sector may be particularly hard-hit by peak oil. Tourism currently represents 11% of exports and 4.2% of Australia's GDP, but it employs 5.7% of of the country's workforce. The government realizes the importance of the tourism sector to its GDP and spends a lot of money trying to entice more international travelers to come visit. Just last year, the government's tourism agency spent $3 million to get American talk show host Oprah Winfrey to promote American tourism to Australia. International visitors, however, only contribute 23% of the country's tourism revenue, with the remaining 77% coming from Australian residents. Just as "localization" will make communities more economically self-reliant, peak oil will likely make Australian's tourism industry more dependent on this large domestic revenue source, possibly at the expense of the country's major airlines like Quantas and Virgin Blue.
High oil prices will also increase the cost of air-fright transportation for some internationally-sourced "just in time" perishable goods like flowers and sushi, which currently make up 80% of air freight shipments. Such internationally-sourced time-dependent consumer products, both coming from and going to Australia, will become prohibitively expensive for all but the wealthiest people in the world, and will be gradually replaced with more locally sourced items.
Jet fuel sourced from biofuels, derived from feedstocks like camelina oil or algae, will enter the market as oil prices get prohibitively high for the aviation market to stomach. Australia, with its vast agricultural resources that I described above, will be extremely well positioned to profit from this transition. Movement towards aviation biofuels will also mitigate some of these pains, especially as improved crop technology, like better genetically-modified biofuel feedstocks increase the energy returned from energy invested, making them more cost-competitive against increasingly expensive oil.
Economic Energy Intensity
Australia's economy has a rather high energy intensity of 0.18 kilograms of oil equivalent per $5USD of GDP created in constant purchasing power parity terms. This energy intensity is slightly better than the world average but lags behind the developed world's (OECD) energy intensity of 0.15 koe/$05p. This is largely due to the energy intensive nature of some of Australia's largest economic sectors like mining and energy, as well as the energy-intensive nature of importing and exporting goods over the vast distances require to reach Australia. The positive news is that Australia's economy has been becoming more and more energy efficient over the last 20 years and may still be able to make vast efficiency improvements, given the correct business enviornment.
Australia's Economic Energy Intensity
Relative to many of the world's energy exporters, Australia has an extremely stable government, stable currency and stable civil society. The Economist Intelligence Unit ranks Australia in the top category for democracy. Transparency International ranks the country in the top category of least corrupt regimes on earth. With a Gini index of 30.5, Australia ranks better than the European Union in terms of income equality, which has been show to be statistically correlated to social cohesion. The government has extremely low debt relative to the country's GDP with the national debt representing only 22.4% of GDP. The banking sector is very tightly regulated, far more so than in places like the United States, and as a result, Australia was able to largely avoid the late 2000's financial crisis. The Australian dollar is the 5th most traded currency in the world and is often included in discussions about a future currency basket that could replace the US Dollar as the world's reserve currency.
Peak Oil Proof Portfolio: EWA
In the Peak Oil Proof Portfolio, I suggest investing in Australia through the iShares MSCI Australia Index Fund (EWA). This ETF is a broad-market fund holding equity in companies across all of Austrailia's economic sectors. The top 10 holdings of the fund are:
Major producer of offshore oil and gas in Australia
Oil exploration and production worldwide including in the US Gulf of Mexico
Since the EWA ETF is holds the market as a whole, it is not a targeted way of investing in only Australian companies that are likely to benefit from peak oil. Some companies that could benefit from increasing energy prices are:
This list of companies is just a starting point, investors need to do their due diligence. Ideally, investing in these companies would be timed to coincide with favorable market conditions. The bumpy plateau of peak oil may mean that oil prices will fluctuate wildly and that oil price spikes will create significant demand destruction followed by market corrections. Oil is currently trading at over $120 per barrel, the highest it's been since the last oil price spike sent us into the worst recession since the great depression. It may be prudent to hold off on equity investments at this point, as high oil prices may put a wrench in the current economic recovery.
The 2011 Oil Shock
Special thanks to Dan Miethke in Australia for corresponding with me on this post.
There is some concern right now that because of the potential imminent collapse of the Libyan government, the country may have to temporarily shut down oil production. This would be a major issue, because Libya is currently the world's 11th largest oil exporter.
To get right to the punchline, if Libya were to shut down all of their oil production, the price of oil could spike to $142 per barrel. There's a 20% chance it will happen, and if it does, the US economy could loose $335 Billion in GDP.
Using the short run price elasticity of demand, it is possible to calculate the impact of the secession of Libyan oil production on world oil prices. There are a number of estimates of the short run price elasticity of demand for crude oil from a number of leading journals. They range from -0.034 to -0.05 to -0.077. Based on this range, -0.05 should be a good enough estimate for the purposes of this post. As I stated in my video two weeks ago, there are reasons to believe that the short-run elasticities of both supply and demand are far more inelastic than most economists believe, but for simplicities sake, -0.05 is an adequate estimate. Assuming the adjustment to the supply and demand curves will come entirely from the demand side, we can use the following equation to estimate the change in price: Short Run Elasticity of Demand = % change in quantity supplied / % change in price. I believe this is a fair assumption, given the fact that recent Wikileaks releases, which I discuss in another post, have shown us that the available spare production capacity of Saudi Arabia may be grossly overstated, resulting in a far smaller cushion of spare oil capacity available to reduce the effect of a shock like this. Any price improvement from slack taken up by spare production capacity may be lost in the trading frenzy that would follow an event like this.
% Change in World Oil Production if Libyan crude production is halted = ((84,388,895-1,789,155)-84,388,895)/84,388,895 = -2.12%
-.05 = -2.12%/ % change in price
% change in price = -2.12%/-.05
% change in price = 42.4% increase Brent crude price before Libyan unrest = $100 / bbl
Brent crude price if Libyan crude production is halted = 100*1.424 = $142/bbl
If all of Libya's crude oil production was taken offline, we could see the price of oil spike to $142 per barrel.
The actual Brent crude price today was $108 / bbl - an increase of $8 since last week, when the Libyan collapse started. This means that the increase in the oil price as a percent of the $42 increase potential is 8 / 42 = 0.19047619. So the $8 increase in oil price since the Libyan collapse began is signaling that the market believes that there's about a 20% chance that Libya will halt all oil production.
If the price of oil gets much higher, we will be running dangerously close to the point where demand destruction will cause the world economy to sink back into a recession. This paper uses the short run oil price elasticity of GDP to find that for every 1% increase in the price of oil, the US economy looses .05% of its GDP. To put it another way, with a $14.5 Trillion economy and with oil at $100/bbl, for every $1 increase in the price of oil, our economy looses $7.3 Billion of GDP. With today's $5 oil price increase, the United States lost $36 Billion in GDP. If Libya's crude oil production is taken offline, and the oil price spikes to $142/bbl, the US economy would loose $335 Billion in GDP - a 2.3% decline that would push the US economy back into a recession.
Last week, Wikileaks released four diplomatic cables which had been sent from the US embassy and consulates in Saudi Arabia to the U.S. Department of State. The main headline from these cables was the fact that the US government privately believes that Saudi Arabia may be overstating their oil reserves by 40%.
Coincidentally, the night before the leak I posted a video in which I discussed a few of the reasons why most experts believe that Saudi Arabia and other OPEC members are overstating their reserves and I discussed that the main implication of this is in the short run, we're likely to see an oil price spike within the next two years.
Today, I'd like to put the leaked cables into context with an analysis of the issues discussed in the cables and the possible repercussions of those issues.
The first cable was sent to the US Department of Energy via the US State Department on December 10th, 2007 by Consul General John Kincannon with the subject line "FORMER ARAMCO INSIDER SPECULATES SAUDIS WILL MISS 12.5 MBD IN 2009". Consul General Kincannon is headquartered out of Dhahran, Saudi Arabia - a city of only 11,000 people on the Persian Gulf coast of Saudi Arabia. What's important about Dhahran is that for the past 78 years, it's been the home of the headquarters for Saudi Aramco - the largest oil company in the world. The consulate in Dhahran is one of the most important posts of any US diplomat, as the information brought back from their relationships at Saudi Aramco have wide-reaching implications for the military and economic security of the United States.
Consul General John Kincannon
In the leaked cable, Consul General Kincannon describes a meeting he and the consulate's economic officer had with Dr. Sadad al-Husseini on November 20th, 2007. Dr. al-Husseini served as the Executive Vice President for Exploration and Production at Saudi Aramco from 1992 to 2004 and was a member of the Saudi Aramco board of directors from 1996 to 2004. In these positions, he had complete access to all of the information on all of Saudi Arabia's oil fields. He had complete data from each oil field, including the field's total size, the amount of oil which has been extracted, the amount of oil left, and, most importantly, what the peak production capacity of each field is from an economic and geophysical perspective. During the meeting, Dr. al-Husseini told the consulate general that Saudi Arabia "has oversold its ability to increase production and will be unable to reach the stated goal of 12.5 million b/d of sustainable capacity". Additionally, he stated that "sustaining 12 million b/d output will only be possible for a limited period of time, and even then, only with a massive investment program." He stated that "new oil discoveries are insufficient relative to the decline of the super-fields, such as Ghawar, that have long been the lynchpin of the global market." He goes on to say that "once 50 percent depletion of original proven reserves has been reached...a slow but steady output decline will ensue and no amount of effort will be able to stop it."
Essentially, Dr. al-Husseini told the US that Saudi Arabia's oil production would peak at 12 million barrels per day and would decline thereafter.
Dr. Sadad al-Husseini
He further stated that "approximately 116 billion barrels of oil have been produced by Saudi Arabia, meaning only 64 billion barrels remain before reaching this crucial point of inflection. At 12 million b/d production, this inflection point will arrive in 14 years."
Given that the meeting was held in 2007, 14 years from the date of the meeting puts the peak year in 2021. If Dr. al-Husseini is correct, we will see a Saudi peak within the next 10 years.
What most of the news media missed in the analysis of this leaked cable is that Sadad al-Husseini has been publicly warning people about the Saudi peak for a number of years. In 2004, three years before this meeting took place, al-Husseini did an interview for UK's Channel 4, in which he gave the same warnings about rising oil prices and a future Saudi peak. After his Channel 4 interview, al-Husseini did interviews for the New York Times and the Energy Bulletin in 2005, for writer David Strahan in 2007 and for CNBC in 2008. In 2008 he also met with influential investors like George Soros and T. Boone Pickens in an effort to further raise awareness of the issue. So it certainly wasn't private knowledge that Sadad al-Husseini believed that Saudi Arabia was overstating their reserves. What is important about the leaked cable, therefore, is not the fact that Sadad al-Husseini is predicting a Saudi peak in the next 10 years, but that the US government is privately acknowledging it while publicly saying nothing about peak oil.
The cable brings up the point that one of the factors limiting the addition of new oil production capacity is the lack of skilled workers in the oil industry. Because the price of oil collapsed in the early 1980's and remained low for nearly two decades, thousands of experienced workers were laid off and thousands more who would've entered the industry went on to work in other industries. As a vast amount of the workers who remained in the industry through this bear market are now beginning to retire, they are taking their years of industry knowledge with them and further exacerbating the skilled labor problem. This factor has been discussed recently, as the lack of skilled workers may have contributed to last summer's gulf of mexico oil spill. From the peak oil perspective, the lack of skilled workers is making it harder to bring more oil production online, which could make it difficult to slow the decline once we've reached peak oil.
The cable also discusses the oil price increases in 2007, saying "considering the rapidly growing global demand for energy - led by China, India and internal growth in oil-exporting countries - and in light of the above mentioned constraints on expanding current capacity, al-Husseini believes that the recent oil price increases are not market distortions but instead reflect the underlying reality that demand has met supply". In my video that I put up the night before Wikileaks released this cable, I go into much more depth on this issue. The main conclusion that I reach is that our world's oil supply is beginning to reach a wall and at the same time the world's demand for oil is growing rapidly and becoming far more inelastic. These factors will combine to cause a price spike in the short run and higher oil prices in the long run.
With respect to the motives for Saudi Arabia to overstate their reserves, the cable states that "al-Husseini believes that Saudi officials overstate capabilities in the interest of spurring foreign investment". This is part of the motivation, but it is not the whole picture. The reasons for overstating reserves are both economic and political.
On the economic side, because Saudi Arabia is part of the OPEC cartel they have a huge economic incentive to overstate their reserves. In game theory, this is the classic “prisoner’s dilemma” situation. Each member of the cartel is allowed to produce oil based on the amount of reserves they claim to have. Since the actual exploration and production data that proves these reserve numbers are state secrets, there are no repercussions for lying about them, since it is impossible for the other cartel members to force you to prove them. By overstating their reserves, Saudi Arabia is able to make more profit by producing more oil while the cartel keeps the market price high.
The other economic incentive is one which Sadad al-Husseini brings up - that by overstating reserves, Saudi Arabia is making the economic future of their country look brighter than it really is, thereby encouraging more foreign investment in their country.
In addition to the economic incentive to lie about their oil reserves, Saudi Arabia has huge political incentives to do so as well. They may wish to overstate their oil reserves in order to make themselves seem more important than they really are to international economic and military partners. Countries like the United States are heavily dependent on foreign oil and are therefore most likely to make economic and military alliances with countries that can supply them with oil well into the future. Saudi Arabia is in a very unstable area of the world, surrounded by hostile neighbors like Iran and Yemen, so the incentive to overstate reserves in order to secure these international military partnerships is enormous.
Politically, it may actually be more important for the Saudi government to overstate reserves in order to quell political turmoil within their own country. Oil is the number one source of current and future wealth production in Saudi Arabia and by overstating their reserves, Saudi Arabia makes the future look brighter for their citizens. If the citizens suddenly realized (as they may be realizing right now) that the future that's been promised to them by the royal family won't be there, the population may become restless and overthrow the dictatorship.
As we are seeing right now with governments in Tunisia and Egypt being overthrown, the dictators in these Middle Eastern countries often have a tenuous hold on political power.
Saudi Arabia is currently experiencing a birth explosion, with the population doubling within the last 20 years to over 25 million people today. This huge youth bulge means that the median age in Saudi Arabia is only 24.9 years old. More than half the population is under the age of 20. At the same time, the sex ratio in Saudi Arabia is skewed worse than almost any other country on earth, with 1.29 men for every woman between the ages of 15 and 64. Since the wealthiest men often take more than one wife and it is illegal for men to meet women unless they're accompanied by a chaperone, it can safely be assumed that there are a lot of frustrated young men in Saudi Arabia. The unemployment rate is high for everyone in Saudi Arabia, but it is particularly bad for the youth. The unemployment rate for males between the ages of 20 and 24 is nearly 50%.
Saudi Arabia is the world's largest oil producer but the vast majority of the oil wealth only makes it into the hands of the royal family. It's estimated that there are more than 10,000 princes in Saudi Arabia. The average Saudi sees these princes driving around in Ferraris and living in lavish mansions, but yet 40% of the population lives below the poverty line. By almost all measures, Saudi Arabia has some of the worst income inequality of any country on earth.
Worse still, it was revealed in another leaked cable that, in one of the most religiously conservative countries on the planet, where the punishment for drinking liquor is public lashing, the princes routinely throw outlandish parties with liquor, prostitutes and drugs. Over the past decade, as the internet and satellite television have begun to permeate the country, more and more average citizens are getting a true picture of those in charge.
Saudi Arabia is home to the two holiest sites in Islam - Mecca and Medina. Ever since the 1979 seizure of the Grand Mosque in Mecca by Islamist radicals, the islamic religious leaders in Saudi Arabia have had tremendous political power in areas of social policy. Since 1979, they've set up a madrasah-style education system around Saudi Arabia which teaches these impressionable youth a fundamentalist form of Wahhabi Islam.
So when you combine all of the factors I've described above, Saudi Arabia has a lot of frustrated, unmarried, religiously fundamentalist, unemployed young men, who see most of the oil revenue going to a select few royalty that seem to flaunt all of the religious rules which they diligently follow. It certainly sounds like a recipe for a revolution if you ask me.
Clearly, this social unrest puts another pressure on the government to overstate their reserves in order to paint a rosy picture for the proletariat of a brighter future ahead. If the general public begins to realize that the country's oil wealth won't be growing in the future at the rate it has been growing thusfar, the youth may choose to overthrow the government in order to spread the wealth around while it still remains.
The second cable was sent to the US Department of Energy via the US State Department on May 7th, 2008 by the Riyadh Deputy Chief of Mission (chargé d’affaires) Michael Gfoeller with the subject line "PRINCE ABDULAZIZ ON ENERGY MARKETS, OPEC LAWSUITS". In the cable, Mr. Gfoeller describes a meeting he and the Energy Attaché had on May 6th, 2008 with the Assistant Minister of Petroleum Prince Abdulaziz bin Salman bin Abdulaziz Al-Saud. In the meeting, the Prince told the US deputy chief that he was "extremely worried about demand destruction in the U.S." He said "We are extremely worried about demand destruction, like in the early 1980s. Aramco is trying to sell more, but frankly there are no buyers. We are discounting crudes, now we're at a $10 differential between West Texas Intermediate (WTI) and Dubai Light, sometimes as much as a $12-$13 differential. Our buyers still bought less in April than they did in March." To put the meeting in context, on May 6th, 2008 the WTI oil price had just broken $120 per barrel for the first time in history. Exactly 60 days from this meeting, the oil price would spike up to $147 per barrel, causing extreme demand destruction and triggering the worst recession since the great depression. Over the next 5 months, the price would fall from $147 per barrel to just $30 per barrel.
In my video that I put up the night before Wikileaks released this cable, I explain this demand destruction in more depth. There are two types of demand destruction. The primary demand destruction occurs as the price of gasoline at the pump rises and people and companies begin to curtail their gasoline consumption. The second, and more economically damaging, demand destruction occurs because oil is used as an input in almost everything we consume in our modern lives. As the price of oil goes up, the price of all other goods goes up. Because wages don’t increase along with the price of goods, consumers have to spend more of their income on the necessities in life such as the gasoline needed to drive to work or the food on their dinner table. This leaves the average consumer with less discretionary income to spend on other consumer goods. When you aggregate this across the whole society, the demand for all goods goes down – thereby further decreasing the demand for oil but also causing the economy to tip into a recession. This is exactly what we saw occur less than a year after this cable was sent.
The third cable was sent to the US Department of Energy via the US State Department on June 3rd, 2008 by the Riyadh Deputy Chief of Mission (chargé d’affaires) Michael Gfoeller with the subject line "PRINCE ABDULAZIZ ON ENERGY MARKETS, OPEC LAWSUITS".
In the cable, Mr. Gfoeller summarizes the analysis of Brad Bourland, the Chief Economist of Saudi-based Jadwa Investments, explaining that "while crude has increased by nearly 6 times in the last four years, gasoline prices in the U.S. have at most tripled. While consumers complain vociferously about rising pump prices, nonetheless they are not absorbing the full brunt of rising input prices. The refining sector is absorbing the growing pricing differentials between crude and finished products, leading to plummeting refining utilization rates in the U.S.".
As oil prices spike, refineries find it difficult to send the full cost increase on to their customers, leading to a narrower differential between the crude oil price and the refined product price (this is known as the "crack spread"). Oil refineries that are not vertically integrated with oil producers get "squeezed out", which lowers overall refinery utilization, leading to a reduction in available refined fuels like gasoline and diesel, which pushes prices for these products up even further.
This is just one more factor which can accelerate an oil price spike. Since the last recession began and the oil price fell, many of the remaining independent oil refineries like Big West and Flying J have gone bankrupt and have closed down. On top of these factors, at the end of 2010, the EPA announced it would begin regulating greenhouse gas emissions from refineries within the next two years. If these new regulations aren't shot down in congress, it would be just another headwind against independent refineries. Because of the closure of these independent refineries, the available refining capacity in the US has been getting tighter since the last oil price spike. This means that as oil prices spike again, the increase costs will be passed on to the consumer more quickly - potentially accelerating the speed of the spike and the speed of the demand destruction crash which will follow it.
Mr. Gfoeller further states that "widespread petrol subsidies in China, India, and the Middle East ensure price feedback mechanisms are broken; they therefore predict crude demand will continue to rise there. Governments are abandoning plans to roll back petrol subsidies in the face of escalating food inflation...Essentially there is no price signaling, "go slow" sign in the form of higher prices for consumers as crude rises...we will continue to see unrestrained demand growth, especially in the Middle East and China." Gfoeller goes on to say that "Bourland was not optimistic about prospects for encouraging greater price elasticity in the world energy markets. Inflation, particularly food inflation, recently has become a front-burner issue for many nations. Pressed consumers in many nations have recently found themselves on a knife's edge regarding food security, and are not likely to peacefully accept the rolling back of petrol subsidies which have become effectively institutionalized. Bourland also cautioned that Saudi Arabia's domestic consumption of crude continues to grow by about 100,000 bpd annually, ensuring a tight global market for the foreseeable future."
This cable again relays the warning about the factors affecting the inelasticity of of demand that I discussed in my video last week. Another important point which is brought up is the increasing amount of export cannibalization from the rapidly rising oil demand within Saudi Arabia. The population of Saudi Arabia has exploded over the past two decades, and because energy is heavily subsidized within the country, the demand growth for oil within the country continues to grow year-over-year. The best way to think about export cannibalization in oil exporting nations is through the "Export Land Model", developed by Dallas geologist Jeffrey Brown. Essentially the model predicts that as a country's oil production peaks and begins to decline, the internal demand for the nation's oil continues to rise, cannibalizing exports and accelerating the decline in oil production. Currently, about 40% of the production increases every year in Saudi Arabia are offset by increased oil demand within the country itself. In the years ahead, this will continue to grow until Saudi Arabia is no longer a net exporter of oil. We have seen this happen in every single oil exporting nation from the United States to Egypt.
This third leaked cable again reiterates the United States' concern over Saudi Arabia's peak production with Mr. Gfoeller stating that "it appears unlikely Saudi Aramco could muster the million or more barrels which appear to be needed to make a dent in the normally upwards price trajectory. Saudi Aramco's ability to sustain such a production increase for a year or more raises serious questions. A series of major project delays and accidents XXXXXXXXXXXX over the last couple of years is evidence that Saudi Aramco is having to run harder to stay in place - to replace the decline in existing production. Additional production would likely come from increasingly heavy crude which the world lacks sufficient capacity to easily refine. The Saudis appear dis-inclined to discount its heavy crude sufficiently, so the market is dis-inclined to purchase it."
Ironically, after laying out a seven page case for Saudi peak oil, Mr. Gfoeller ends his cable by clarifying that he is "far from embracing doomsday "Peak Oil" theorists". It's fascinating to see that while it's publicly taboo for US government officials to discuss peak oil, it seems to be privately discouraged as well.
The fourth cable was sent to the office of the Coordinator for International Energy Affairs at the US State Department on November 11th, 2009 by the US Embassy in Riyadh with the subject line "SCENESETTER FOR VISIT OF DOE DEPUTY SECRETARY PONEMAN TO SAUDI ARABIA". In the cable, the embassy discusses a few of the efforts made to increase the Saudi oil production capacity, including "projects to bring non-conventional oil on line to meet the evolving needs of the international market and expand reserves, such as Saudi Arabian Chevron's project in the Partioned Neutral Zone with Kuwait to steam flood heavy oil in limestone cavities".
Enhanced oil recovery methods like steam injection are incredibly capital intensive and require tremendous amounts of energy to operate. These enhanced oil recovery methods have a much lower energy return on energy invested (EROEI) than traditional oil drilling, and are usually only undertaken on light crude fields once the field has peaked an on heavy crude fields once all of the "easy oil" is gone.
The embassy goes on to explain that Saudi Arabia's "electricity demand is growing at 8-10% per year". The tremendous recent increase in electricity demand and discusses a number of efforts which Saudi Arabia is undertaking from renewable energy to nuclear energy. The embassy states that "Saudi Arabia is actively considering the development of a civilian nuclear program, which a number of analysts believe is the only possibility the Kingdom has to generate sufficient electricity to meet projected demand from economic and population growth and increasing affluence without wastefully burning large quantities of fuel oil."
Politically, it might be difficult to set up nuclear reactors in a country which produced 15 of the 19 September 11th hijackers. There could obviously be a lot of international political push-back to a Saudi Arabian nuclear program, given the fact that the country is a hotbed for Islamist extremists who are keen on overthrowing the dictatorship. The cable notes that "in May 2008, the Secretary of State and the Saudi Interior Minister signed an agreement creating the Office of Program Management - Ministry of Interior (OPM-MOI). OPM-MOI is a State-led interagency effort to assist the Saudi MOI with protection of critical infrastructure, including Aramco's petroleum production and transport facilities, which were the subject of a terrorist attack on the Abqaiq production facilities in Dhahran in 2004." Clearly the US government is extremely worried about terrorists attacking key infrastructure targets in Saudi Arabia. Given this level of concern about terrorist attacks on traditional energy infrastructure, constructing and protecting nuclear infrastructure may be logistically risky and politically impossible. If the embassy is correct that without nuclear power, Saudi Arabia will only be able to meet the domestic electricity demand by burning more and more oil, it would fit well with the export cannibalization model I described earlier.
To summarize, these four leaked cables are significant not because of the information they contain, but because they reveal that the US government is extremely worried about a peak in Saudi Arabian oil production. Nearly 1/4 of the world's oil exports come from Saudi Arabia, and when the country reaches peak oil, it's almost guaranteed that the rest of the world has reached a peak as well. These cables reveal that Saudi Arabian peak oil could occur much sooner than most people anticipate. The main factors which are accelerating the approach of this peak are:
Overstated Saudi reserve estimates due to economic and political pressures
Large decline rates in most Saudi fields
Difficulty in adding additional production capacity to offset these declines
Export cannibalization from rising internal oil demand
Because of the rising, inelastic oil demand from the developing world, the approach of a Saudi peak will likely be met with a series of oil price spikes followed by demand-destruction-induced recessions. This process is known as the "Bumpy Plateau"; if you're interested in reading more, please see my post Profit from Peak Oil's Bumpy Plateau.