This is a simplified version of the presentation I will be making this Tuesday morning at the ASPO 7 Conference (the full presentation should be posted on that website in a couple of days). I must admit that I have been a bit nonplussed to see that the peak oil community seems to share the oil industry’s dismissal of wind power as irrelevant and useless in the face of the currently energy challenge (maybe I am unfairly judging from a few individuals’ comments, but it’s definitely an existing undercurrent in the community).

So, in reaction, let me put up here a few arguments that suggest that wind could play a major role in solving our current energy woes – not a silver bullet, but rather more than a side show.

First, the “wind is too small to make a difference” argument: well, so was nuclear, until it got big enough. Wind is following the exact same growth trajectory:

Pure Power
EWEA, March 2008 (pdf)

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And, as the image show before, wind power has already been a large part of energy investments for a number of years now, at least in Europe (but the rest of the world is now catching up, with the USA and China booming):

Pure Power
EWEA, March 2008 (pdf)

Over the past 8 years, wind has represented around 40% of new installed capacity (which, it is true, represents a smaller fraction a new production, in MWh, which is probably closer to 25%). In terms of investment amounts, wind has actually been the biggest business for the power generation manufaturers like GE or Siemens, given that a wind MW costs about double what a gas MW costs (prices per MWh are something else, given that you still need to buy the natural gas to burn to generate using a gas turbine…).

Wind will be a core instrument for the EU to fulfill its stated objectives of reducing carbon emissions and improving energy independence.

Penetration, 2005 & 2020
Implication of Large-Scale Wind Power in Northern Europe
Klaus Skytte, Econ Poyry, presentation to EWEC 2008

So it is simply false to say that wind is too small to matter. It is the biggest power generation industry by turnover in Europe, and it is on a fast growing trend that will quickly ensure that it becomes a significant part of the installed generation base. The industry reached the level of 100 GW ofinstalled capacity this year, as well as the threshhold of being able to produce 1 exajoule per year of useful energy. In fact, wind is reaching the stage where nuclear was when it was hit by the 1973 energy shock (which lowered demand and killed new investment) and the 1979 Three Mile Island accident (which turned the public against the industry) and is unlikely to hit the same snags:

Public opinion, despite persistent anti-wind lobbying by the coal or nuke industries and a few well-funded NIMBY associations, is massively behind wind power:

Harris Interactive

More importantly, wind has a major economic quality: the more there is, the lower electricity costs:

The effect of wind power on spot market prices (pdf)
Rune Moesgaard, Poul Erik Morthorst, presentation to EWEC 2008

Under market price setting mechanisms, wind power (which has a zero marginal cost) brings wholesale prices down when it is available, by avoiding the need for more expensive coal-fired or, more usually, gas-fired power plants that would otherwise be required to balance the system.

The effect of wind power on spot market prices (pdf)
Rune Moesgaard , Poul Erik Morthorst, presentation to EWEC 2008

The overall effect (price reduction multiplied by the relevant volume) now brings savings to consumers in Denmark that are equivalent to the gross cost of feed-in tariffs, and significantly higher than the net subsidy, as wholesale prices are now pretty close to, and increasingly often higher than, the feed-in tariffs guaranteed to wind power producers.

The same is already true in Germany, despite its somewhat lower wind penetration than in Denmark (11 (ed: wrongly used the number for Spain) 7% of electricity produced, vs 25%)

Assessment of the impact of renewable electricity generation on the German electricity sector (pdf)
Mario Ragwitz, Frank Sensfuss, Fraunhofer Institute, presentation to EWEC 2008
Note again that the cost noted above for the subsidy is the gross amount of the tariff, not the difference between the tariff and the wholesale price, which would be the correct amount of the subsidy granted to wind power producers

In other words, wind subsidies demonstrably save money for eletricity consumers, ie they are smart regulation.

An another interesting point to note is that wind power costs are now also well understood: industrial-size turbines now have a 15-year track record, and availability has been consistently in the 96-98% range, as shown by this meta study on 14,000 turbines:

Availability Trends Observed at Operating Wind Farms (pdf)
Keir Harman, Andrew Garrad, Garrad Hassan, presentation to EWEC 2008

And while offshore is slightly more expensive today than onshore wind, we’re not about to run out of convenient spots at sea, away from whining onlookers, to continue the development of the industry:

photo by author
Thornton Bank, Belgium, August 2008

More stories about wind, and more discussion of other issues surrounding wind can be found on this page, of which I select a few noteworthy items:

the real cost of electricity
Alternative energies: wind power (an introduction)
My job (financing wind farms)
No technical limitation to wind power penetration (discussing the intermittency issue)
Why wind needs feed-in tariffs (and why it is not the enemy of nuclear)
Fierce price – yes it works! (first offshore wind farm to be financed is completed)
Gore sets goal of 100% carbon-free electricity by 2020 (how it can be done)

The conclusion is simple: wind power deserves to be taken seriously

Despite the first rejection of the Paulson Plan, the effort is ongoing in Washington to push through a plan that is likely to be substantially similar to the first one (as far as I can tell, the only changes will be tax cuts and the inclusion of the renewable energy bill items). Given the overwhelming pressure to “do something”, and despite warnings that we are being rushed for no reason into a terrible plan, it is rather unlikely that the final version of the plan is going to be very satisfactory. In any case, the following will hold true irrespective of the outcome of the Paulson Plan.

(Note: This was written for the European Tribune this week-end, ie before the rejection of the plan by Congress, and before the most recent bank bailouts, but its conclusions stand)

• the consequences of the financial crisis are so dire that the lesson here should not be that a bailout is necessary (it is, at this point) – but to acknowledge that the financial sector has the power to hold the rest of the economy to ransom during both good times and bad times and thus that it need to be emasculated so that we never get again to the stage where a bailout is necessary. The lesson is that the financial world cannot behave responsibly, if left to its own devices and thus should not be left to its own devices;
• another is that the main argument to give financial markets a free hand — that they have created so much growth and prosperity — needs to be called for what it is: a lie. Not only the so-called prosperity of the past year was highly unequally shared (see the next point), but it was not even real, as the income and profits of the good years are now dwarfed by the losses of today. Arguments about growth need to be dismissed by a reference to the “full cycle,” i.e. the prosperity of the recent past can only be accepted as real if it wasn’t a capture of the prosperity of today and the near future. If the forthcoming growth and GDP numbers are dismal, this should be seen as a direct proof that the growth of the past was nothing but, and that the policy prescriptions focused on financial profit are abject failures;

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• as the bailout calls for yet another transfer from poor to rich, it is worth noting that even in the good years, the vast majority of the population saw very little of the then much touted prosperity: incomes were stagnant or declining, while benefits declined, and healthcare and energy costs skyrocketed. Thus, current policies seem focused, at all times, on maximizing the income of the few rather than that of the general population;
• the next conclusion is that our political systems are completely geared towards fulfilling that last goal: politicians of all stripes are supporting the bailout despite massive protests by their constituents, just like they supported financial deregulation, labor market “reform,” “free” trade, the tax race to the bottom and other similar policy prescriptions in the past. Politicians are supported in that by a media system that brings to the fore pundits that are fully aligned with these prescriptions, and creates an incestuous class of insiders who, as it were, tend to personally benefit directly from the overall winner-takes-all policies put in place;
• the quasi-unanimous support of the Serious People for the bailout, or at least their inability to point out that the current crisis was the inevitable conclusion of the policy framework pushed by the neolib cabal shows how successful they have been at killing alternative ideas as fringe or absurd or dangerous, and suggests that there still is an ideological vacuum; alternative ideas are not “there” enough to be taken seriously despite the ongoing reality, and I’m not sure they will until the current elites are completely pushed out;
• given that staying in power and doing whatever it takes to achieve that goal is their main competence, I fear that we’re going to be pushed into ever more dangerous brinkmanship, as the Republicans have amply demonstrated in recent days. They will not leave without a fight, even if reality is overwhelmingly against them, and I expect obfuscation, distraction and worse to be used to deny or avoid that reality. Quite frankly, the alternative now, just like in the 30s, is either a full break from the past (a new “New Deal”) or a move towards fascism and war — the latter being our current elites’ only chance of holding onto power.

The question therefore is: will the new President, and the new Congress, be part of the problem or part of the solution? Neither McCain nor Obama have taken the lead in mapping out alternative routes – token adjustments to and/or lukewarm support for the Paulson plan cannot count as leadership. As to Congress, many future members are already in now, and their performance, frankly, is not encouraging. What will it be?

In other words: nothing short of a revolution will do. Can it still be a peaceful, democratic one?

The Financial Times is (rightly) worried:

Banks are not to be trusted. This is not just the view of the public and policymakers, but that of the banks themselves.

And indeed, the most notable thing over the past year has been the general mistrust amongst banks, and their reluctance to lend to one another. This graph shows a direct indicator of the level of defiance between banks:

Via Mish

– Initially posted on European Tribune, where we’ve had many good threads on the financial crisis and the bailout.

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The TED spread can be used as an indicator of credit risk. This is because U.S. T-bills are considered risk free while the LIBOR rate reflects the credit risk of lending to commercial banks. As the TED spread increases, the risk of default (also known as counterparty risk) is considered to be increasing, and investors will have a preference for safe investments.

As the FT notes:

If lenders demand huge spreads for such short periods, they are either tightly constrained in their ability to lend, deeply concerned about the solvency of counterparties, or engaged in predatory behaviour. Whichever of these possibilities is true, credit to the economy will dry up.

As someone on European Tribune noted a while ago, banks started looking at their balance sheets last August, suddenly decided they did not like what they saw, and went through the following process: “We’ve been wiser than others, so if our balance sheet stinks like this, we don’t even want to know what those of other banks look like – but we’ll stop lending to them.” Interbank lending froze up then, and has never really recovered – it just gets worse at each new seizure of the markets, and the current situation can only be described as critical.

This one shows what’s happening with euro bank credit risk

Banks are hoarding all the cash they can (avoiding new deals, not renewing facilities that come to an end and would in normal times be extended, and now even trying to find legal – if not necessarily very proper – ways to sneak out of existing commitments), both because they need it for their own basic needs, and because they simply don’t trust the risk represented by other banks.

And given that at any time a bank makes a loan to a customer (at least for big corporate deals), it borrows the same amount of money on the markets, the fact that the interbank market, ie where that borrowing part takes place, is frozen can makes it difficult for banks to continue with the lending.

Those that still have access to liquidity are paying an increasingly high price for it (the above represents the price the best banks have to pay – its even worse for most others). Others have to make do with ultra short central bank liquidity lending, but you cannot run your ordinary lending activities (which rely on 3-month or 6-month funds) on overnight funding at punitive rates.

Thus, credit to the economy is drying up. Corporations often had a good balance sheet, and lines of credit that were available to them at good conditions, but these are either used up or expiring as time goes by. They are no longer renewed, and the pressure is building up for companies to start scrounging for cash.

In the financial world, this is bringing about a grand de-leveraging (ie the infamous tide that supposedly lifted all boats is moving out rather brutally, and we’re seeing, to mix maritime metaphors, who was naked under the water).

• The players that had low risk, low cost funding, high volume investment strategies are stuck as the low cost bit has disappeared; they have to stop their business; some have come to trouble in the process, but this is a liquidity issue and they might be saved by central bank intervention;
• those that had high risk, low cost funding, high(er) returns are quite dead as the high risks happen to have been (really) bad risks. The disappearance of low cost funding is, to a large extent, irrelevant to their situation.

The trouble is that the two cases are often hard to distinguish, because they are engaging in the same behaviour: they are trying to sell assets: in one case, to reduce their (now expensive) borrowing requirements, in the other to raise cash to plug holes in their balance sheet or to get rid of the toxic stuff.

And banks have realised that, in the best case, they belong in the first category (they are highly leveraged, borrowing amounts many times their own capital to lend them again) and, it seems, in many cases they look like members of the second group – and there is no way to know which (and banks often don’t even know in which category they are themselves!). rdf provides a good analogy for what financial products look like these days, and how hard it has become to truly understand what they’re worth, but what is even scarier is that the underlying assets that underpin all the financial bets made about them are turning sour, as the housing markets continue to fall and the economy grinds down to a halt.

So, while banks have frozen in the fear that they no longer understand what they and their colleagues have been doing, their core assets are turning bad and, in a chain reaction, will pollute all the financial bets made on them, ensuring that the banks’ current fears turn to reality.

from an earlier Martin Wolf column

Banks are paralysed because they don’t know how much bad stuff they have. Can it be better when they know that they really have a lot?

Thus the Paulson plan is unlikely to help much if it does not deal with the assets at the bottom of the toxic waste pile: not even the mortgages, but the houses themselves. The only way to do this would be to actually buy the houses, to prop up their prices, but this would cost rather more than $700 billion, and would bankrupt, for real, the government.

Fundamentally, house prices are out of whack with any realistic capacity of people to pay for them, and these must converge again. Apart from falling house prices (and the ensuing collapsing house of cars built on top of it), the only way to do this is to increase incomes – not those of people that own several homes, but rather of those that are trying to own one.

The bottom for houses, and for the banks, & nbsp; which fundamentally ride on them, will be reached when incomes – for the majority, not for the few – catch up with them. Governments should work on that, with simple ideas:

• re-regulate labor markets, in particular with increases in minimum wages, and with actual enforcement of existing rules;
• launch a massive public investment plan in, for instance, public transport infrastructure, housing thermal insulation and renewable energies;
• make banking boring by limiting leverage and eliminating banks that are “too big to fail”;
• and increase marginal tax rates significantly to pay for it all.

Who knows, it might save a few banks – and investors – along the way.

Note: I also made a proposal elsewhere for a National Investment Bank. To those who ask why we write about the banking crisis on TOD: a response is that the good policy answers are surprisingly similar to those for the energy crisis, whereas the easy political answers to the financial crisis are likely to make good energy policy that much harder.

Paulson, Bernanke Tell Lawmakers Urgent Action Needed on Treasury Plan

WASHINGTON — U.S. Treasury Secretary Henry Paulson and Federal Reserve Chairman Ben Bernanke urged swift action on a Treasury Department plan to buy illiquid mortgage-linked securities and avoid severe spillover effects on the economy.

Mr. Paulson cautioned lawmakers against letting the plan get bogged down in a debate over unnecessary additions.

“Unnecessary additions” – things like accountability, transparency, making sure that the crisis does not happen again, and making sure that it solves the underlying problem. But nope, no “bogging down”…

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The message could not be clearer – they are not avoiding the brinkmanship – they are escalating it, in the (not wholly unreasonable, given the recent past) expectation that the Democrats in Congress will fold, out of fear of being blamed for the tumbling stock market prices as the plan is delayed.

So, just for the record, a few arguments:

• the stock market is going down again NOT because the plan is delayed but because, even if the $700 billion gift to the banks is granted, it will still not solve the underlying situation;
• as the plan is currently drafted, giving $700 billion to the banks to relieve them of their bad assets protects the very institutions or people that lost money by taking stupid risks (and having seen it from the inside, believe me, it was truly stupid) without proposing any upside for taxpayers, nor any reform that would at least avoid the same mistakes from happening again;
• in the up leg of the bubble, the problem WAS too much liquidity (which helped take silly risks when these were not properly assessed); today’s problem is massive deleveraging – that deleveraging is NOT caused by lack of liquidity, but by risk aversion (investors no longer want to invest in anything that looks even remotely risky). Throwing more money at that problem will do nothing to solve it. It will create simply a circuit whereby the government creates new Treasuries, hands them over to the FED, which uses them to create more cash, which it trades with the banks for dubious assets; the banks will use the cash to buy Treasuries. It’s a closed circle which helps no one but the banks (and the Fed, see below).
• the real worry is on actual economic activity, which is straining under the twin burdens of asset price depreciation (house prices crashing, leading to lower incomes for people, less construction activity and foreclosures) and the credit crunch (business no longer having access to credit to develop their activity). Given that companies and households are also deleveraging (reducing their debts or increasing their savings), or are about to be forced to do so, the real need is to inject actual revenues, ie wages coming from real activity, in the economy, and NOT debt. What government needs to do is to spur real economic activity – as it were, there are whole sectors begging for it, like investment in public transporation or renewable energy infrastructure.

The plan from the Bushies helps stricly no one beyond providing TEMPORARY relief to banks, which might be enough but does not quite explain their willingness to engage in such brinkmanship.

Which makes the following suggestion, emailed to me by a US central banker friend, all the more intriguing:

Jerome,

I’ve been puzzling why Paulson would propose legislation which is so obviously dictatorial, extra-legal and dangerous, even with the careful orchestration of the Lehman Brothers/Reichstag Fire.

I think I’ve just figured out why they are doing it.

All the Fed’s alphabet soup of emergency liquidity facilities innovated over the past year were structured around repurchase agreements. Toxic waste securities were used as collateral for US Treasuries and dollar credit at 85 percent of face value. But as each facility expires, it has to be rolled over and increased to keep pace with the implosion of credit in the interbank markets. Well over half the balance sheet assets of the Fed have been loaned out in this way, perhaps a critical amount in excess of this estimate. Without recapitalisation, the Fed is at risk of failure in the midst of this crisis. Its Enron-style accounting for the toxic waste makes it very vulnerable to a default by any of the repo counterparties it oversees and limits its ability to enforce any constraints as well.

The Paulson plan will provide a one off opportunity for banks to take their toxic collateral back and sell it at a Paulson-determined price for cash. He issues Treasuries to finance the plan which increases the supply available. He selectively decides winners and losers, of course in making the scheme available and pricing assets, creating arbitrage opportunities and survivor bias in the process.

In the meanwhile, the removal of the toxic waste from the Fed balance sheet and redeposit of Treasuries and cash as the repos unwind gets the Fed off the hook for having hypothecated most of its assets against worthless toxic waste at Enron-styled false valuations.

If I’m right, the Paulson Plan recapitalises the Fed without ever publicly admitting that it was dangerously overextended.

My friend provides this video which says Fed has lent out $600 billion of its $800 billion balance sheet.

http://video.msn.com/video.aspx?mkt=en-US&brand=money&vid=25f132d8-4c5d-…

and concludes a follows:

Real question in my mind is whether the $1 trillion from the Paulson Plan goes to recapitalise the Fed as I suggest, or whether it goes into offshore flight capital before the criminal mafia in Washington and Wall Street flees the jurisdiction.

The theory here is that the Fed has destroyed its balance sheet by taking on increasingly large chunks of non performing assets (the “toxic waste” made from mortgage-backed securities and the like) in exchange for loans of “real” cash to banks that may still end up not repaying them.

It is effectively “broke.” This is not what is supposed to happen to a central bank, which can print money without restriction, so let me explain what this means: it can no longer help the banks in a non-inflationary way. In order to take on more toxic collateral from the banks, it would need to actually print money, which would immediately be visible and would be seen as very inflationary. Instead, by getting government to take on more public debt, the impact is diluted in a much larger pool (public debt, rather than cash).

So this is a desperate gamble by Paulson and Bernanke to avoid the run on the dollar that would be triggered by direct cash creation.

Obviously, as the market shows (with the euro up by 6 cents since the plan was announced Thursday night, and gold and oil similarly massively up), worries about inflation have not quite been killed, but they have been kept to a manageable scale.

At this point, of course, the goal is to avoid a bigger crash before the election.

Talks Continue in Effort to Rescue Lehman

The fate of Lehman Brothers, the beleaguered investment bank, hung in the balance on Sunday as Federal Reserve officials and the leaders of major financial institutions continued to gather in emergency meetings trying to complete a plan to rescue the stricken bank.

The talks took on even greater urgency on Sunday as government officials push for a deal to be completed before the markets open.

After weeks of agony, Lehman’s fate appeared sealed by the end of last week, as its stock market value dropped 74% in a few days, after having lost more than 80% since the beginning of the year. That the Fed and Treasury have called an emergency meeting over the week-end ensures that things are over for the bank and it will either be bought over the week-end (with someone taking over its liabilities) or go bankrupt.
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And the very reason the government took action over the week-end is also the one that ensures that it will not go bankrupt: it is considered too big to fall. As the WSJ notes:

A disorderly unwind of Lehman’s derivatives trades is only one worry. Another worry is that if Lehman collapses, its distressed assets — such as commercial real estate — could suddenly hit Wall Street for sale, forcing prices even lower and potentially forcing other dealers to mark down once again the value of their own holdings.

With both Merrill Lynch and AIG seen as extremely weak (both lost more than 30% of their market value on Friday alone), a liquidation of Lehman could bring them, and others, down, in a collapsing house of cards.

The reason is that in a liquidation, all the liabilities become immediately due, whereas the assets need to be sold to willing buyers. So the “loss” in such a collapse is not, as it would be in normal times, the difference between the liabilities and the assets, it is the difference between the liabilities and what money can be realised fast with the assets. It’s the difference between the value for you of a mobile phone, and its value for a junkie that needs to raise cash quick to get its cash.

In normal times, or for non-financial companies, such a loss could be tolerated, but in today’s context, this would have a number of nasty consequences:

• other banks that deal with Lehman would suddenly lose the counterparty to these transactions: whether Lehman had committed to take a risk, or to make a payment, that commitment is suddenly in doubt, and if these transactions were a hedge for another transaction, that other transaction suddenly becomes something different. In each individual case, the risk may not be that big, but the problem is that Lehman is a big player in some markets that have become staggeringly large, like CDS (credit default swaps), which banks use to move risk arond, and which reach into tens of trillions of dollars (yes, trillions with a t). These markets are zero-sum games, but if ou suddenly remove one link in the chain, it can unravel all interlinked transactions. In a calm market, such ripples might be tolerated, but at times when banks are weakened, hoard cash and don’t trust one another, it could be absolute chaos if all scramble to protect themselves in an uncoordinated way;

• even more worrisome for banks would be a firesale of Lehman assets. Banks are forced by accounting rules (which they pushed for when times were good and these rules favored them) to “mark to market”, ie to value the assets they have on their books as the markets values them. For simple stocks, this is a no-brainer, but for more complex financial instruments that are not usually traded on public markets, this means valuing them by using the price comparable products fetched in recent transactions. If Lehman sold its financial assets at distressed prices, this would force many other banks to mark similar assets on their books at such prices, causing more losses to appear: these would be paper losses, to be sure, but the impact on accounts would be real and would certainly trigger regulatory requirements to raise more capital to plug the holes – at the very time when banks are struggling to shore up their balance sheets already.

In other words, a Lehman collapse could cause chaos in the markets, and bring other banks down.

So far, the solution pushed by the Treasury is not unreasonable, as the NYT describes it (link above):

The leading proposal would divide Lehman into two entities, a “good bank” and a “bad bank.” Barclays of Britain would buy the parts of Lehman that have been performing well, while a group of 10 to 15 Wall Street companies would agree to absorb losses from the bank’s troubled assets, according to two people briefed on the proposal. Taxpayer money would not be included in such a deal, they said.

Under that plan, the Wall Street banks would agree to provide up to $30 billion of support to absorb the losses of the bad bank. That is roughly the same amount of money that the government agreed to commit to support JPMorgan Chase’s emergency takeover of Bear Stearns in March.

The assets of the bad bank would be sold over time as the market for mortgage-related assets recovers and buyers emerge. If the assets appreciate, the bank consortium would share in the profits. But they would also be responsible for any losses.

Saving Lehman would avoid massive problems for Wall St’s other banks, and thus it would be appropriate to get them to contribute the (much smaller) amounts that would allow for an orderly closing down of Lehman.

The problem is, of course, that each has an incentive to put up as little money as possible, as long as others put something. And none want to help the buyer of the good bits to get a good deal at their expense. But of course, no buyer has any reason to do any deal and put any money on the table unless it makes sense for it to do so.

A classic “freerider” problem, which can only be solved if there is an outside force to coordinate contributions and, if necessary, impose them. This is the function that the Treasury and the Fed can play.

But – they are themselves against the wall: if no solution is found before the markets open on Monday (and that’s only a few hours away in Asia now), then there is a good chance of a total financial meltdown, something that the Treasury is desperate to avoid.

Thus it is likely that the Wall St banks are holding their own commitments to the last minute to push for public money to help make the deal. Given the precedents that have been set first with Bear Stearns in March, and only last week with Freddie Mac and Fannie Mae, it is not surprising that they expect the same to happen again.

So my bet is that we’ll see another bailout of Wall Street and the financial investors it serves, with large amounts of public cash committed in a way that looks painless today (ie, no money upfront, but large liabilities into the future, likely to cost hapless taxpayers billions later–after the election).

Has this administration ever behaved otherwise? The mores and havemores have created massive problems, but they are “the base”, and they cannot be let down.

They gorged in the good times, and they are letting taxpayers deal with the hangover. A sweet deal if you can get it (all you need is a few billions).

The bailout of Freddie and Fannie has just been announced by Hank Paulson, with supporting words from Bernanke. What’s interesting in what’s proposed, as usual, is what’s unsaid. This would seem to be an incredibly ambitious gambit: a nationalisation, an attempted bailout of ALL the banks, and an open-ended commitment of taxpayer money to save the financial world.
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Treasury Lays Out Fan-Fred Plan

WASHINGTON — U.S. federal regulators outlined their bailout for Fannie Mae and Freddie Mac Sunday morning, including a takeover of the firms by their regulator and a Treasury Department purchase of the firms’ senior preferred stock.

The plan, outlined jointly by the Treasury Department and Federal Housing Finance Agency, also includes a plan for the Treasury to purchase mortgage-backed securities from the firms in the open market, and a lending facility through the Treasury from its general fund held at the Federal Reserve Bank of New York.

The Treasury said its senior preferred stock purchase agreement includes and upfront $1 billion issuance of senior preferred stock with a 10% coupon from each GSE, quarterly dividend payments, warrants representing an ownership stake of 79.9% in each firm going forward, and a quarterly fee starting in 2010.

That’s the nationalisation bit: it’s a slow motion version: there’s a small upfront commitment of funds ($1 billion is small change for these companies: even if it represents roughly 10% of their combined market value today, it’s less than 1% of their announced equity), but the main part if the warrants, which are rights to buy shares exercisable in the future. This is consistent with the announcement that public funds would be injected over time, as needs arise. But no amounts are given there yet.

What seems apparent is that this is good news for the other owners of preferred shares, which are regional US banks and a lot of foreign governments (which used these shares as a proxy for US Treasuries, with somewhat better remuneration) – they are not going to be wiped out. The preferred shares not being wiped out allows to avoid bankruptcy risk for the banks owning them, and to avoid pissing off a lot of foreign creditors, so it’s a reasonable thing to do.

The FHFA, which regulates the two government-sponsored enterprises, will act as conservator of the two firms, taking control of the companies’ day-to-day operations. The agency said in a release that there is “no exact time frame” for when the conservatorship may end, and that the powers of the firms’ stockholders will be suspended until the conservatorship is terminated.

As expected, as the government takes over, the normal shareholders are wiped out, something that will allow the Bush administration to claim that they are being tough and not bailing out investors, but we’ll see that this claim is fundamentally false.

This whole side of the package will allow the government to claim that the bailout has a minimal cost: $1 billion only for now, a highly disingenuous claim (the warrants will most likely need to be exercised – but only next year, and there is the rest…)

The plan, outlined jointly by the Treasury Department and Federal Housing Finance Agency, also includes a plan for the Treasury to purchase mortgage-backed securities from the firms in the open market, and a lending facility through the Treasury from its general fund held at the Federal Reserve Bank of New York.

This is huge. This is the federal government taking over the “toxic waste” in a way that will have an impact not just on Freddie and Fannie, but on the whole market. By “buying” mortgage-backed securities instrad of taking them as collateral, the Treasury does two things at the same time:

• it takes off the assets and liabilities off the balance sheet of the two companies in a definitive way (rather than temporarily) and assumes, for sure, the associated risk;
• it sets a price on these securities. This has been the biggest problem to solve the credit crisis: nobody has been willing to set a price on these assets, because of the uncertainty on the real value of the underlying assets (or because everybody could see that they were falling by the day). By setting such a price, the government creates a highly significant precedent – and, in all likelihood, provides a floor to these prices, ie an implicit commitment (or at least the expectation of a commitment) to buy more such securities.

In doing this, the government is boldly trying to call the end of the financial crisis, set a total price to it, and agree to pay the difference if the cost is higher in the end. This, to me, looks like a full governmental guarantee to the whole banking sector. Of course, a lot will depend on where the price is set to purchase these mortgage-backed assets, but this is still a take-over of the toxic waste by taxpayers, at aprice that may or may not (and, frankly, is highly unlikely to) be right.

But it’s even worse than that: by providing an additional lending facility on top of that, the government is saying: we’re putting our money (well, yours) where our mouth is – providing further liquidity to the companies and, I presume, expecting them, once the toxic waste has been cleared from their books (which can happen now that there is a floor price), to lend to the mortgage markets again.

It’s the usual solution of the Greenspan bubble: as soon as one bursts, we blow another one to cover it up and keep the party going a little longer.

Of course, the goal here is simply to create a boost that lasts until November, and given the kind of weapons used, it’s likely to succeed in that short term goal. Saving the US economy is another thing, given that its fundamental problem is spending beyond incomes – more debt does not cure that, rather the opposite. The twin movements of growing spending and stagnant incomes have to be brought back together. Boosting spending via debt cannot work this time; incomes have to be raised – and for the right people.

This plan is not about this, it’s about bailing out the financiers that played and lost with other people’s money, and give them a chance to try again. Par for the course, of course.

Prime Minister Gordon Brown, is trying to reassert his authority on the cheap, by publishing an anti-Russian diatribe in today’s Guardian (a left-leaning newspaper). It’s an impressive exercise in weasel words and tough-sounding emptiness.

Before I take you through it in detail below the fold, let me note again that this sets the tone for public discourse on the topic. Newspapers, even if they have different information on the underlying conflict, have to report the aggressive declarations by Brown and others, and cannot fail to paint that as increased tension with Russia. As Russia responds (and it often does in rather unsubtle ways), reality follows discourse, further inflames it, and the whole process takes a life of its own. Pundits, even well intentioned ones, can then go on to pontificate about evil Russia and a small number of concepts, such as the “energy weapon”, enter public lore and become “acquired concepts” (I’m tempted to write “acquired conceits“) even when the facts on the ground are rather different.

But by then, the Mission has been Accomplished: the discussion is no longer about our failing energy policies (or rather, the lack thereof), or about our leaders’ incompetence, but about the Enemy which wants to hurt us and against which We Must Stand Firm (Behind our Beloved and Fearless Leaders).

I understand our leaders trying this: after all, this is all they have to run on. But why, oh why, does our media have to fall for it hook, line and sinker?

[break]

This is how we will stand up to Russia’s naked aggression
As European leaders meet, the Prime Minister says security is linked to the politics of energy

“We will stand up” to “Russia’s naked aggression” – the stage is set. Once you’ve read the title, you know how it’s going to be, there’s really no need to go beyond. We are going to be provided with an enemy, and fearless leaders to fight it. And we know that this is what goes on TV – you get the headline and the subheader as “comment” by the talking heads. Evil Russia is stealing our energy and making us pay dearly for it and We Will Not Tolerate It.

Twenty years ago, as the Berlin Wall fell, people assumed the end of hostility between East and West, and a new world order founded on common values. As part of this, 10 Eastern European states joined Nato and intensified co-operation with Europe and more wanted to follow. But Russia’s hostile action towards Georgia suggests that they are unreconciled to this new reality. Their aggression raises two urgent questions for us: how best to stabilise Georgia now, and how to make it clear to Russia that its unilateral approach is dangerous and unacceptable. War in Georgia also poses a serious longer term issue – how can we best create a rules-based international system that protects our collective security and safeguards our shared values?

Sigh… Where to begin? This is history rewriting on a grand scale…

• our “common values” are embedded, if anywhere, in the Council of Europe, of which 47 countries are members, including (to quite a bit of debate in the 90s, as the wars in Chechnya raged on) Russia. NATO does not represent “common values”, it is a military organisation created to defend its members against the Warsaw Pact, as run from Moscow. Its explicit – and still sole, despite desperate efforts to change that – raison d’être is to prepare for war with Russia. Making that organisation, rather than the Council of Europe or, more prosaically, the European Union, the embodiment of our values, speaks volumes – as does Brown’s failure to even mention the EU in that paragraph…
• bam, out of the blue, Russia decided to attack poor weak Georgia. No mention of how this conflict originated in the short term (a Georgian attack), no discussion of the complex past history of South Ossetia (whether you look at the last 15 years or the past 2 centuries) – and no reference whatsoever to our policies towards Russia (bringing NATO to Russia’s borders, cancelling the ABM treaty, ignoring them on Kosovo, just to note recent events). Nope. We’re the good guys, they are the bad guys. It is so because we say so, we, the good guys.
• as to creating a “rules-based international system” – how about, you know, us actually following the rules that already apply to us under the existing international system? Like not invading countries on a whim? Not deciding on our own which separatist provinces deserve independence from the countries they are a part of and which don’t? Not threatening attack on various others because they do things we don’t like? It is legitimate for organisations that focus on international rights or human rights and criticize our own failings to criticize Russia for its patchy record; it is quite another thing to hear the same from governments that engage in the exact same behavior they criticize at this very moment!

At tomorrow’s European summit in Brussels we will first unite to alleviate the suffering of the 100,000 Georgian civilians left without homes. The UK has already pledged £2m, and I will urge partners to meet not only Georgia’s immediate needs but its long-term reconstruction and development needs. We will deploy peace monitors to better judge violations of the ceasefire, appoint a senior figure to drive the humanitarian and political effort, and support the Nato Georgia Commission, with a Nato team sent to Georgia.

Ooooh. 2 million pounds?! How amazingly generous. That’s sure going to help. But never mind, let’s create more “Nato Georgia” thingies that take a life of their own, can be ignored if needed (hey, you don’t actually want us to fight against Russia’s army, do you?), but help create the perception in the meantime that we’re standing by our proud new ally against the evil invaders. Let’s keep NATO on the forefront, and sneakily suggest that the EU is doing NATO’s bidding (note that the EU is still not mentioned: a “European summit” is nicely ambiguous in that respect).

Georgia has felt the consequences of the conflict. It is important that the summit also demonstrates to Russia that its actions have real consequences.

Hmmm… I look forward to such a demonstration…

No one wants a new Cold War or the encirclement of Russia.

Let’s deny the obvious. I find it particularly noteworthy that Brown feels ready to acknowledge the “encirclement of Russia”: that means that this (i) is the reality and (ii) that it will be pushed further. It’s denied, so those that say it’s happening can now be dismissed as lackeys of Russia, unserious, cowards or any combination thereof as said encirclement proceeds further (or attempts to anyway).

But when I spoke to President Medvedev yesterday, I told him to expect a determined European response. As David Miliband has said, there can be no return to ‘business as usual’ unless and until Russia commits fully to Georgia’s territorial integrity and withdraws to its previous positions.

Ooooh. He talked to Medvedev! (not to Putin?) In a stern tone! To tell him to do something he is clearly not doing (having recognized South Ossetia’s independence) or … or else! The “demonstration” stepping up… to the naive public at home.

Russia has emerged as a significant economic power, with its trade increasing fourfold. It has done so by reaping the benefits of a stable global order based on agreements that make trade and investment both possible and profitable, bringing greater stability and certainty to international relations.

Yes, Russia’s rising prosperity is clearly due to agreements that make trade profitable (codewords for the WTO. As we know, trade is always profitable and must be expanded) but to which it is not yet a party. It has nothing to do with the higher prices for its main exports (oil, gas and metals) or with the relative stability imposed by Putin and his KGB cronies in lieu of the chaos of the Yelstsin years. No, anything good that happens to Russia has to be claimed by the West’s neoliberal policies. Not only we’re the good guys (ie everything we do is good by definition), but everything that’s good anywhere can and should be credited to us to. Others are, well, othery and cannot, also by definition, do any good. Life can be so simple.

Equally, when Russia fights secessionist movements in Chechnya or Dagestan, it expects others to respect its territorial integrity and not to recognise declarations of independence.

Hmmm…. Let’s not mention the fact that we didn’t really care about Chechnya back then, because we still had access to Russia’s oil&gas resources then (“we” being the Western oil majors, of course). In fact, I distinctly remember that in 1999-2001, in the early years of Putin’s presidency, the UK and US had rather friendly relationships with Russia, whereas France was in a really tense one as its government (well, what do you expect from 35-hour-promoting socialists) and media were rather vocal about Chechnya – an attitude that was mostly criticised by the Anglos as needlessly disturbing business.

So when Russia has a grievance over an issue such as South Ossetia, it should act multilaterally by consent rather than unilaterally by force. I believe Russia faces a choice about the nature of its responsibilities as a leading and respected member of the international community. My message to Russia is simple: if you want to be welcome at the top table of organisations such as the G8, OECD and WTO, you must accept that with rights come responsibilities. We want Russia to be a good partner in the G8 and other organisations, but it cannot pick and choose which rules to adhere to.

Ack. Again, where to start? Bullet points ahoy: here we go again!

• “it should act multilaterally by consent rather than unilaterally by force,” says the head of the government of one of the countries that invaded Iraq despite being told in no uncertain that the invasion was not approved by the UN Security council? Who the fuck does he think he is kidding? (Sad answer: a lot of people, including most of our pundit class);
• more to the specific point, Russia actually went to the Security Council on 8 August to ask for international intervention, as Georgian troops were attacking South Ossetian with heavy artillery. They followed the existing diplomatic procedures, but their claims were ignored or rejected.
• Russia is a member of the G8, an increasingly pointless body, is not a member of the OECD (described by the Economist as a “think tank”), nor one of the WTO (its membership having been blocked for years by the USA for reasons totally unrelated to the current crisis). What’s the value of these carrots, exactly, after years of dangling them in front of the Kremlin’s eyes and denying them, or emptying them of their substance?
• “it cannot pick and choose which rules to adhere to” – nope, that’s only a prerogative of the Good Guys. (I mean, that’s the only way to make sense of what would otherwise be breathtaking double standards).

That is why I will argue tomorrow that Russia should accept Georgia’s territorial integrity and international mechanisms for addressing these conflicts, and withdraw troops to their previous positions. And, in the light of Russian actions, the EU should review – root and branch – our relationship with Russia. We should continue to strengthen the transatlantic relationship and may need to meet more regularly as the G7. We are also reflecting on the Nato response. We must re-evaluate the alliance’s relationship with Russia, and intensify our support to Georgia and others who may face Russian aggression .

So the thing to do if we are unhappy with Russia is to “strengthen the transatlantic relationship”, ie to fall in line even more rigidly behind Washington’s (provenly toxic) positions? Doesn’t this sound like hiding in mama’s skirt (or rather, behind papa’s big fists) in a schoolyard fight one started?

More interestingly, this is where we see the absolute cowardice in Brown’s position: more regular meetings of the G7 means that there won’t actually be a confrontation with Russia about its membership in the G8, just more meaningless meetings without Evil Russians to pretend that we’re “standing up to them” (safely from a distance). And “reflecting” on NATO’s response. That has to be the lamest, weakest line – in diplo-speak, it means, basically, “please stop hitting us, we agree to everything, just give us the time to set our ties properly before we say yes!”

But, as we know, the target here is not Russia, it’s the public over here, and what matters is the repetition, yet again, of the words “Russian aggression,” along with more calls for “Atlanticism”, ie deciding to not have a common European position and impose division by preeemptively aligning with the extremist position coming from Washington. Bluster, posturing and empty threats that look so manly.

The strangest part is that Russia responds, mostly with surprise, by pointing out that this is empty bluster – and this is taken as yet more aggression (they are contradicting, or worse, mocking, our leaders again!) rather than at simple face value. Clearly they do not play the same game.

No nation can be allowed to exert an energy stranglehold over Europe and the events of August have shown the critical importance of diversifying our energy supply.

Hmmm… Right after “Russian aggression” comes energy. Again, the target is not Russia, but the uninformed public and the naive punditry. As far as I can remember, the war did not cause any disruption in supply – indeed, as the tension between Russia and Georgia built up and turned into actual war, oil prices were collapsing… (for other reasons, but still). The markets obviously took a pretty relaxed view of the impact of this conflict on energy supplies. And the markets are always right, as Brown himself endlessly reminds us (and indeed he will do so before this article is over).

Some pipelines were temporarily cut as conflict raged, but the significance of that is rather different from what pundits might think. The Baku-Supsa oil pipeline was closed, but this was significant only insofar as the much larger Baku-Tbilisi-Ceyhan (BTC) pipeline had been closed the week before (because of events in Turkey which were, as far as I can tell, totally unrelated to the Georgian crisis) and the route to Supsa was used as a substitute. The Baku-Erzurum gas pipeline, which follows the same route, was also closed, but that pipeline only supplies Turkey with small volumes of gas. Despite multiple claims by the Georgians to that effect, the pipelines were not attacked by Russia (something that BP, which operates all of them, confirmed repeatedly) – but that, of course, did not prevent pundits from saying it did happen (or that it “could” have happened), nor of falsely linking the overall closure of the BTC pipeline to the Russian intervention.

The result is again, “Russian aggression” and “pipeline closed” beign closely associated in everybody’s minds. And hey, “energy stranglehold” and “Russia” in the same sentence is all good – it takes attention away from “energy” and “European policies” (or the lack thereof).

The tenfold increase in the world oil price in the past decade has demonstrated that diversification from oil is also an economic necessity.

A rare sane sentence in that article – the content of which will of course be ignored as that apparent sanity is used for other purposes than actually solving problems.

The UK will go from being 80 per cent self-sufficient now to having to import almost two-thirds of our gas and more than half of our oil by 2020 – precisely as markets become more volatile as more people chase fewer natural resources. And with states such as Russia increasingly using their energy resources as policy tools it is apparent that the security grounds for this shift are stronger as well.

So, as long as the UK had enough oil for itself, all was fine, and all discussion of energy dependency was unnecessary (yes, I distinctly remember mockery coming from across the channel and directed at the many continental European countries that worried about long term supplies in the not so distant past). but now that the UK is running out of oil and gas for itself, it becomes an overwhelming issue that hysterically drives everything away – and has to be imposed on the rest of Europe – which are cowards if they don’t join in.

Without urgent action we risk sleepwalking into an energy dependence on less stable or reliable partners.

That sentence would be correct with another verb tense: “without action we sleepwalked into an energy dependence on less stable or reliable partners.” The dependence is already there: oil is now mostly controlled by countries that fit that description, and any one of a dozen of them can wreak havoc on the global market by withholding production. Think Saudi Arabia or Russia, or course, but also Iran, Venezuela, Nigeria, Angola, Kuwait – or, more interestingly, China, Norway, Iraq or Brazil – or the USA. Any country that can take a million barrels per day of capacity from the global market can cause a massive price hike. The impact of Gustav in the coming days could give yet another demonstration of that state of fact.

And an important point to note is that oil produced in the UK or the US does not belong to UK citizens or the US citizens, it belongs to the oil companies that have acquired the rights to the relevant fields – and they can do whatever they want with that oil, starting with selling it to the highest bidder. which means, of course, that even a self-sufficient country’s citizens will need to pay the full market price for oil, just like the citizens of oil-poor countries: neither owns any oil reserves…

As to gas, its reserves are even more concentrated than those of oil, with Russia, Iran and Qatar controlling over two thirds of the total. And there is no global market, as gas only goes where infrastructure, ie pipelines and LNG terminals, will take it – under the long term contracts that such infrastructure requires to be financed and built. So gas, in a very practical sense, belongs as much to those that have long term supply rights at the end of the pipeline as to those that actually have the reserves. In that case, the dependency goes both ways, and the partners have a serious incentive to deliver – and indeed Russia has: it certainly has been a highly reliable supplier over the past 40 years, even through the Soviet period, the break-up of the Soviet Union and the chaos that followed.

That is why we in the UK are putting in law our commitment to cut CO2 emissions by 60 per cent by 2050, looking to replace our ageing nuclear power plants, to encourage greener fuels to power our homes and businesses and to transform the way we travel.

Nice non sequitur. Let’s remind people that we’re also pretending to be green, and that this supposedly helps on the separate problem of oil use. Let’s provide a further gentle push for nukes (which provide electricity, not transport, today) and biofuels (which are an absurdity from every perspective in Europe) and altogether pretend we have policies in place, without ever mentioning demand reduction or even energy efficiency.

Europe also needs to take action.

Oh yeah, let’s pretend too that the UK are leaders, and that (the rest of) Europe has done nothing on the energy front for all these years. The arrogance and hubris is, as usual, breathtaking.

Tomorrow’s summit must add urgency to the work on Europe’s energy agenda. We must more rapidly build relationships with other producers of oil and gas. Our response must include a redoubling of our efforts to complete a single market in gas and electricity, a collective defence to secure our energy supplies.

Sigh… The single market, as I wrote in the FT last year, encourages market players to invest in gas-fired plants, as they are easier to finance and less risky in the short term. Gas-fired plants mean more demand, for a very long time, for the very gas that we are warned Russia threatens to withhold from us. Even if we find alternate suppliers (would Earlier Evil Country Iran do, if they were ever in a position to export gas?), would it not be a better bet to, you know, not increase our demand for gas? The fact that this question is not even touched by Brown demonstrates, more than anything else, that he is not interested in solutions but in finding scapegoats to blame and to use to rebuild his reputation for toughness and decisiveness.

And, if I may be impertinent once more, what exactly does he mean by “building relationships with other suppliers?” Entering into long term supply contracts? Building infrastructure that links their supplies with our markets via an unbreakable physical link? (you know, what Germany, Italy and France have done with Russia) Or invading them, rewriting their oil laws, and giving away their reserves to oil majors (which, as Iraq amply demonstrates, does not work, as the locals usually get uppity when they see that they are being looted)?

I will also be pressing European leaders to increase funding for a project to allow us to source energy from the Caspian Sea, reducing our dependence on Russia.

BTC already exists, than you very much. There is no gas available in the Caspian (even including Iran) to make a pipeline from over there worthwhile unless it is filled with Russian gas. Nabucco is a non-starter, if its goal is to avoid Russian gas. But hey, let’s keep on repeating “Nabucco, Nabucco, Nabucco” like a mantra, and discreetly pushing the completion date by a year each year, so as to look like we’re finding other sources of gas.

I will encourage European partners to use our collective bargaining power rather than seek separate energy deals with Russia. And because the environmental necessity is urgent, we must deliver an ambitious 2020 climate and energy package by the end of this year.

Again, will anybody EVER tell me what a common bargaining position towards Russia would be? and how would it be determined? According to energy consumption? To gas consumption? To gas imports? To gas imports from Russia? And, presuming that a joint position is reached, what will happen, beyond merging into one giant EU-Russia contract the relatively small number of existing bilateral contracts? A better price? (what would be better? a different index to oil? A non-indexation to oil? who will decide what price formula is most advantageous?) And if a “better” price is obtained compared to the existing framework, who gets the difference? but, more genrally, what will prevent Russia to use the “energy weapon” against Europe any better than it can prevent it against France or Germany? How will gas be allocated in the case of cuts by Russia?

As long as nobody even makes suggestions to all these questions, these ideas for a “common negotiating position” towards Russia are just pointless blather, bluster and, more to the point, a distraction.

More than 10 years ago Alexander Solzhenitsyn – who died just days before this latest chapter in the history of his country – wrote: ‘We were recently entertained by a naive fable of the happy arrival of the end of history, of the overflowing triumph of an all-democratic bliss; the ultimate global arrangement had supposedly been attained. But we all see and sense that something very different is coming, something new, and perhaps quite stern. No, tranquillity does not promise to descend on our planet, and will not be granted us so easily.’ The past few days have seen some of his predictions realised.

Meh. I have not found the original quote, but I’m pretty sure that he did not have Russia in mind when he wrote this – but rather the USA. (Accurate info here welcomed)

This is why the changing global order cannot be governed by institutions designed in the middle of the last century. We now know how much more we have to do to create an effective system of international rules. We must strengthen the system of global governance to meet the challenges of our interdependent world. We must reshape our global architecture to meet the new challenges: climate change, energy security, poverty, migration. And in doing so we must stand up for both our vital interests and our essential values.

Another non sequitur. I’m sure that the institutions Brown has in mind have only one member with veto rights, and he’s so proud that he has the right phone number to know beforehand when the veto will be used.

:: ::

Mr Brown: in order to stand up to your values, you must be true to them. In order to stand up for your vital interests, you have to ensure that you actually have those interests (and not those of a very small subset of the people you claim to represent) at heart.

But again, this is not about policies. They’re pathetic. This is about politics, and stories. and Brown is selling the irresistible story of the good guys standing up to the evil enemy that seems to be threatening us. That this is is distracting us from policy is not an unwanted side effect, it is the very purpose of articles like this one.

but if nobody calls him on it, then … it works. And it gets repeated by people, like Jeremy Leggett, an otherwise respected peak oiler, and it gets legitimized even in otherwise skeptical crowds. (this post is already long enough as it stands, but you can read my debunking of Leggett’s article here).

Meanwhile, our aggressive grandstanding is fast alienating Russia, which might one day wonder why we think we have a God-Given Right to receive any of the gas under their toundra. The mindless posturing has very real consequences in the real world.

Bleh.

I have been gently chided on the internets for not doing any Countdown diaries since the oil prices have started going down. While the giddiness and glee demonstrated by many in the traditional media and elsewhere invites little but ridicule, as demonstrated by this graph below, prepared for the Oil Drum, some serious questions have been raised and deserve answers.

So, beyond the semi-glib answer that nothing much has in fact happened in the oil markets in the past month (after all, the recent decline is still smaller, in percentage terms, than several others in the past couple of years), here are a few points worth making.

An installment of the Countdown to $200 oil series

[break]

“It was speculation and the bubble has popped”
“Such small variations in demand or supply cannot explain such price changes”
“What about the Iran war premium – that’s speculation right?”
“Demand is down (in the US), prices will go down back to normal”
“Asians will reduce their demand too”

Many don’t agree with my assertion that speculation has little or nothing to do with the run-up in oil prices, and consider that the brutal price increases, followed by just as brutal price decreases, cannot be explained by fairly small changes in supply or demand figures.

Let me try to explain again why, in today’s conditions, small variations have precisely such consequences.

In a market where supply is plentiful, balancing the market will be done by supply adjusting, ie the price will be such that just the required volume of oil is extracted to fulfill demand, and no more. In that case, competition between suppliers plays in full, and the price will the be the marginal cost of supply, is the cost of the most expensive barrel needed to fulfill exactly demand. All cheaper producers will get that same price (and will make a nice profit the cheaper their costs are), and those that are more expensive won’t produce. In such circumstances, variations in demand (or new supply coming online) can only cause price to move slowly along the production cost curve, and bigger price movements usually come from “above ground” factors, ie geopolitical crises that include a risk of major disruption of supply.

But if you move to a market where supply is fully used to satisfy demand, you enter a whole new world. In that case, if potential demand still increases, there is no supply in the short term to fulfill such demand, and the absolute requirement for physical balance of the market translates (beyond using stocks, which can only be temporary) into a need to destroy demand, ie for some potential users to forego using oil. As we all know, oil is really convenient, and we are all unwilling (and, in many cases, unable) to stop using it. And yet the demand destruction needs to happen. In the short term, that requires prices to go high enough to convince someone to stop using the stuff, either because s/he can’t afford it, or because s/he chooses an alternative which is less convenient but cheaper and, at such level of saving, worth the hassle. In such circumstances, short term price movements can and will be quite violent. In fact, any event that disturbs supply, any news that shows that demand was higher than expected, or supply less than hoped, or that suggest that demand will be higher than thought, or supply lower than expected, will push prices up immediately (and the opposite news, down, of course), because thee news translate into a unbalance between supply and demand and a bigger need for demand destruction (conversely, a lower need for such).

• So, a pipeline blows up in Nigeria – bam, 200,000b/d of (high quality) oil off the market, demand destruction is needed!
• Ben Bernanke suggests that a recession is unavoidable – psssh, prices go down as a slower economy will translate into less demand for oil, and thus less demand destruction will be required;
• Oil storage goes up – aha, demand was lower than we thought (or supply higher) in the last month, and there will be less need for demand destruction in the next one!
• Bush agrees to direct talks with Iran – bam, the war premium goes down, as the probability of an oil-supply-endangering conflict (which would cause a massive and brutal need for demand destruction, unless strategic storage is tapped) goes down.

In fact, in the past month, these was a succession of news that all went in the same direction. In the same week, Bernanke was extremely bearish on the economy, oil stocks were higher than expected, and talks with Iran happened. Each of these took about 3-4% each from the price of oil, bring the price down by more than $15 in 3 days.

And any time this happens, speculators are wrong footed and they need to close out their positions, which usually reinforces temporarily the underlying movement (haha! so there are speculators! And they push prices around! Well, yes, there are speculators – but, for the most part, they follow the market rather than driving it. Any price overshoot is usually temporary. And they do provide valuable services, by bringing in liquidity to prices – and by providing willing counterparties to those that want to buy hedges – you know, like airlines that buy futures or options for their supply over the next few months or quarters at prices to protect themselves – and their fares – from yet higher prices).

:: ::

One point that needs to be made again is that demand destruction in the US (or even in Europe, where it is hapoening too) is not enough on its own to bring prices down, because it needs to be larger than the supply growth in the rest of the world to limit the requirement for further demand destruction and price rises, given that production is still largely stagnant. And the problem is that demand is not growing just in China and India, thanks to rapid growth, it is also growing massively in oil producing countries themselves (Saudi Arabia, Iran, Russia, Venezuela), which often subsidize gas and which can afford it given that they have a natural hedge against (the subsidy gets bigger when oil prices are higher, ie when their own income is bigger, and the income growth is larger than the subsidy growth for those that export any volumes). In fact, most of the demand destruction happens in price sensitive places, like the poorest oil-importing countries (but they weren’t burning much of it anyway), and the rich world (which can still afford oil, but consumes lots of it). But we can’t be sure it happens fast enough to actually cause prices to go down because of what’s going on in the rest of the world.

Anything that encourages demand reduction elsewhere (like lower subsidies) helps to bring prices down, but it’s by no means obvious that we’ve reached price levels that are sufficient to cause overall demand stagnation in the face of flat or quasi-flat production. Oil producers have little or no incentive to boost their production if they expect prices to keep on creeping up (and they can help that trend by, precisely, investing less), and it’s not clear what substitutes are available in any meaningful volumes.

So, at this point, I’m still happy to continue my “Countdown to $200 oil series” and see no reason why the recent lull in prices would be a sign of a serious trend change in the market.

In fact, I’ll say again that our energy policies should focus on one thing first and foremost: demand reduction. Any reduction in demand that we manage in excess of what market forces would (precisely) force us to do will get prices down, and will save us a lot of money – and the smartest demand destruction is the permanent kind, that brings savings every month and every year rather than one-offs like giving up a trip.

We have to reduce our demand. Let’s do it in an organized way rather than a panicked, haphazard, inconsistent way. And that’s where government can help, by providing longer term pespective, informing citizens, pushing infrastructure in the relevant direction, and bringing up standards that apply to all equally and guide individual behavior in the right (Energy Smart) direction.

Price mechanisms work, but they are brutal, hurt the poor the most, and cause unnecessary disruption to economic activity, and pain to many. And they are fickle, as the current volatility (which, as I explained above, is likely to remain) causes rapidly changing signals which prevent decisions from being taken.

Al Gore has made a major speech in Washington this morning, setting out an ambitious goal for the USA to produce all of its electricity from carbon-free sources by 2020. I thought I’d comment on the technical feasibility of the plan, and the underlying economics of such an endeavour.

from the Department of Energy’s recently published study about bringing wind power to 20% of total generation

The short answer is: while 100% is probably unrealistic, it’s not unreasonable to expect to be able to get pretty close to that number (say, in the 50-90% range) in that timeframe, and it is very likely that it makes a LOT of sense economically.

Disclosure (or reminder): I am an investment banker for the energy sector. I do a lot of work with the wind sector, as the posts in my wind power series attest, but not only. Whether a pipeline or a wind farm, the job of a project financier is to ensure that the projects make sense for all interested parties (including the regulator) in the long run, and wind projects have to meet the same hurdles as other power plants or oil fields. Thus I’m supposed to remain level-headed when discussing wind projects!

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Today, the USA generates roughly 4,000 TWh of electricity from close to 1,000 GW of installed capacity:

It is important to note right away that MWs of capacity and MWhs of generated electricity are by no means proportional. There is more gas-fired capacity than coal-fired capacity (440GW vs 330GW), but coal-fired plants generate two and a half times more power (2,000 TWh vs 800 TWh). It is useful to note in that respect that the capacity utilisation of non-hydro renewables are pretty close to that of the overall system (with 100 TWh generated from 26GW of capacity in 2006).

Today, a plan to be in a position to generate between 2,000 and 3,000 TWh of electricity from renewables (taking into account the 1,000 TWh per year provided by nuclear and hydro, which are expected to remain in place) will necessarily focus to a large extent on the large-scale development of wind farms, which is the only renewable technology which is already industrially tested and has a levelised generation cost in the same range as today’s conventional power sources, in the single-digit cent-per-kilowatthour range. Solar is likely to play its part as well: it will keep on growing massively from its current low levels, but more effort is still required to bring its cost down from the current 20-30c/kWh range, something which is expected to happen in the next decade.

Source: McKinsey Global Institute

For the simplicity of this discussion, I will focus on wind, given that it presents a bigger challenge on the intermittency front (which the inclusion of solar can only help improve), and that it would drive the ecohnomics of such a plan given its larger scale deployment.

The main questions, of course are as follows:
1) is it technically feasible to build the requisite capacity within 12 years?
2) what will it cost, and what will it mean for power prices?
3) how can the intermittency issue be dealt with?

Technical feasibility
To get 2,000 TWh of electricity from wind, roughly 800GW of wind power capacity would be needed, considering that windfarms would get an annual production equivalent to 2,500 full hours (a pretty conservative estimate, given that the existing wind farms are closer to 3,000 hours today). 800GW is roughly equal to 30 times the currently installed capacity (which should reach about 23GW at the end of this year) and 100 times the capacity installed in 2008 (expected to be close to 8,000MW, after 5,000MW were installed in 2007).

To build 800 GW in 12 years would require a significant increase in annual installations – but actually not an unrealistic one.

The Department of Energy recently published a study about bringing wind power to 20% of total generation, which provides the following timeframe:

This is for a less ambitious plan: 300GW by 2030, so you’d roughly have to quadruple that to get to 800GW by 2020, but one might note that the DoE only expects 4GW to be built in 2008, ie less than the reality without any big plan to boost things up… A realistic target would be to have 80GW of installations, ie 10 times this year’s level, within 5 years. That would give the time to ramp up production, by building factories, training workers, and ensuring that the supply chain follows suit. What would make this possible is for the industry to have the certainty that the investment are required.

What has hampered the development of the industry has been the regulatory uncertainty, in particular in the US with the long saga of the timely renewal (or not) of the PTC (“production tax credit”, the federal 10-year tax credit equal to 2c/kWh for power from renewable sources), which caused demand to crash and then brutally rebound from one year to the other. This caused installed capacity to collapse several times in the past few years in the US, causing mayhem in the industry worldwide:

Source: AWEA

With predictable, guaranteed demand over the next decade, the industry could step up its investments across the supply chain in order to provide the requisite number of generators. The technology is understood, it calls upon industries that are much larger than the pure wind sector (mechanical engineering and civil works, mainly) and which have a large employment pool. Access to resources is tight today, as it across all industry, but we’re not talking world-changing volumes either (for instance, if you count about 50 tons of steel per MW, you’d need 4 millon tons of steel per year, ie less than a percent of total world production). And again, a strategic plan with predictable production figures and guaranteed demand would allow to lock in supplies early on in the process, providing stability (and early cahsflows) to all suppliers down the chain.

In terms of wind resources, the USA has more than enough potential to find enough sites to install such capacity with wind resources providing cost competitive production , as noted in the DoE report (which alos notes that more than 1,000GW could be connected to the existing grid at low cost):

Altogether, the plan would require boosting investment in wind production capacity to about $100-150 billion per year, a significant number but hardly one that would require a complete retooling of the US economy. With a stable regulatory framework (presumably provided if this were made a national priority) and guaranteed demand (which could come via very simple mechanisms, like a feed-in tariffs, ie mandatory purchases by local utilities at regulated rates), there is absolutely no reason to doubt that this could be done.

I’ll address the requirement to boost the grid separately below.

the economics of such a plan
Wind power economics are quite simple: most of the levelised production cost per MWh comes from the initial investment. It is thus naturally sensitive to investment costs, and even more so to financing costs, both of which are determined at the time of construction. Once a windfarm is built, its production costs are essentially set for the rest of its operating life, ie 20-25 years. The fixed nature of its cost base makes it a difficult bet in a deregulated universe, where prices can swing wildy (including to low prices that can be insufficient for the windfarm to service its debt burden, thus the requirement for feed-in tariffs or similar mechanisms to guarantee a floor to wind electricity). But such fixed prices make wind a great proposition at times of increasing oil&gas costs: wind power prices will NOT increase even if oil & gas or coal prices continue to go up, as is quite possible.

Thus wind power is a wonderful hedge against future energy prices. And given that today it already costs less than power from a ges-fired plant (the plants that typically drive the price of electricity on wholesale markets), it is both competitive and likely to remain so in the coming years.

And given the cost structure of wind, a very simple way for government to support wind at very little cost would be to provide funding for the sector at low interest rates. One big advantage of government is its ability to borrow at lower rates – indeed, government sets the lowest rates that are by the rest of the economy. By passing on its low cost of funding to wind developments, the final cost of wind power could be lowered significantly, and passed on to consumers (banks would still be required to hold onto operational and other risks linked to wind production, they would just get cheaper funding for that specific purpose, which the’d have to fully pass on to projects. Germany has successfully used such a mechanism for years).

Studies in Germany and Denmark show that wind power lowers wholesale prices by 30 to 70% when wind blows, and that the overall savings for consumers far outstrip the cost of guaranteeing to wind producers a regulated tariff. Ironically, the more wind power there is in the system, and the lower the wholesale marker price will be most of the time, which means that the regulated tariff remains a necessity to ensure that wind producers are able to pay off the debt linked to their initial investment. But that regulated tariff is known, is realtively low, and,again, will not need to increase over time, thus ensuring to consumers similarly stable retail prices.

If anything, wind is likely to stabilise prices, or even bring them down whatever the prices of oil, natural gas or coal. Also, as the DoE report notes, beyond the potential benefits of reducing greenhouse gas emissions, switching to wind would have massive advantages in terms of lower water use for the power sector.

The DoE study concluded that the cost of strengthening the grid would be around $20 billion in today’s dollars. Given the larger scale of the Gore plan compared to the DoE plan, a cost of $100 billion for grid reinforcement seems a reasonable estimate, which would represent less than 5% of the total investment programme,and thus have a similarly minor impact on ultimate production costs.

Dealing with intermittency
Of course, the big question with such an ambitious plan is how to deal with the intrinsic intermittency of wind power, which may not be available when electricity is actually needed. Given that power is almost impossible to store (except where hydro is available on a large scale, and pending potential progress on batteries), this is a very real issue.

But there are actually several answers to that:

• one is that, provided that the network is able to shift electricity around, you can rely on the fact that the USA has several independent wind regimes, and thus that there will almost always be wind somewhere that can be carried around. Obviously, this does mean a serious effort to reinforce the network, and to connect the now mostly separate regional grids, but that’s precisely where the federal government could have a decisive say within such a plan, and push a reinforcement and development of the grid on a coordinated national basis. As a good example coming from a territory which is much smaller than the USA, (but which also has at least 3 independent wind regions) I note that the French grid operator, RTE, long extremely wary of wind power and its unreliability, had this to say in its latest annual report (big PDF, in French, see p.49):
  

  The second point is about wind’s contribution to peak demand: despite wind’s intermittency, wind farms reduce the need in thermal power plants to ensure the requisite level of supply security. One can speak of substituted capacity.
  The capacity substitution rate (ratio of thermal capacity replaced to installed wind capacity) is close to the average capacity factor of wind farms in winter (around 30%) for a small proportion of wind in the system (a few GW). It goes down as that proportion increases, but remains above 20% with around 15GW of wind power.

  Similarly, the UK network operator put up a report that noted that the expected intermittency of the national wind portfolio would not appear to pose a technical ceiling on the amount of wind generation that may be accommodated and adequately managed. The DoE, in its own study, hasidentified the improvements that would be require to the network to absorb more wind power and be able to use it around the country:
  ;

• the second answer is that spare capacity will be needed occasionally, and that this is actually not a big deal. As noted at the beginning of this post, gas-fired capacity is already used at much lower overall rates than coal-fired plants. They can be kept in place. With 440GW of gas-fired capacity, and taking into account the oil-based, nuclear and hydro capacity, demand can be assured at pretty much any point in the demand curve even without wind. The important thing to note is that keeping that capacity in place does not mean using it. MWH substitution does not require MW substitution to the same extent:
  
  from the UK study linked to aboveCarbon emissions come from using the capacity, not from keeping it available. Using that capacity every now and then will generate some emissions, but that will only represent a small fraction of today’s emissions, especially supposing that it is coal-fired capacity that is eliminated thanks to the arrival of wind and solar. And as many gas-fire plants are already geared, to a large extent, to be used only for fractions of the time, their economics will easily tolerate such use. It should also be noted that the production profile of solar and of offshore wind matches electricity demand a lot better than onshore wind, so their development (which I ma voluntarily ignoring here) will further help in that respect;
• the third answer is that there are a number of small changes to electricity consumption patterns that can be used to reduce the requirement for peak capacity. Industry has long agreed to sign interruptible contracts, benefitting from lower prices for power in exchange for the right by the utilities or the network to cut them off at short notice; a lot of our power consumption is not time sensitive and could thus also be made to switch off in times of need. And this is an area where government could easily play a role, by mandating standards for all electricity consuming equipment, making them able to “talk” to the network and indicate their status (not interruptible, interruptible at identified times, interruptible at will).

Overall, network operators with actual wind experience seem confident that a combination of additional investment, smart grid management, and maintaining available (but not using much) a large gas-fired capacity can make it possible to cope with large amounts of wind power in the system.

While a goal of 100% of carbon-free electricity is probably unrealistic, it therefore seems possible to get pretty close to that, especially if nuclear and hydro are included in the mix. A plan that announced a specific goal of 40-50% of wind-generated electricity by 2020 and 10-20% of solar, with the appropriate feed-in mechanisms, demand guarantees for manufacturers and investment in the grid would therefore be realistic, make economic sense, and fulfill two major strategic goals: reduce carbon emissions, and lower fossil fuel demand.

It is oddly fitting that we touched $100 oil on 31 December and got halfway from $100 to $200 oil on 30 June – so we’re on track to reach $200 oil by 31 December this year (in case you’re wondering: +42% and again +42% from that level = +100% from the initial level).

It is also fitting that on that same date, the International Energy Agency published one of its gloomiest ever analyses of the oil markets, asserting that oil prices are justified by fundamentals

It said: “Like alchemists looking for a way to turn basic elements into gold, everyone wants a simplistic explanation for high prices,” bluntly adding: “Often it is a case of political expediency to find a scapegoat for higher prices rather than undertake serious analysis or perhaps confront difficult decisions.”

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I have been told by a reliable source that the IEA has been forbidden by the US administration from updating their absurdly cornucopian oil supply and demand scenarios until the report that comes out late this year (after the election); that report, which will publish the result of a “bottom-up” analysis (ie a summary of all existing oil fields, their production and/or prospects) is expected to show that oil production is unlikely to reach the levels that so many have blithely assumed – notably on the basis of previous optimistic IEA reports. The IEA, which was deeply unhappy about the current lies to was supposed to present and support, has been leaking word of the expected content of that new report for many weeks now, including an increasingly alarmist tone in its official reports, such as today’s Medium Term Market Outlook:

“Structural demand growth in developing countries and ongoing supply constraints continue to paint a tight market picture over the medium-term,” the IEA said in its Medium-Term Oil Market Report, released on Tuesday in Madrid.

“Poor supply-side performance since 2004, in the face of strong demand pressures from developing countries, has forced oil prices up sharply to curb demand,” the watchdog added.

Strong demand, disappointing supply. Hmm, where have I read this already?

The IEA said that despite billions of dollars of investment, the challenge of pumping ever more oil out of their aging fields is proving so great that non-Opec countries will in the next five years have to rely on biofuels, such as corn-based ethanol, for 50 per cent of their growth in overall fuels.

The fast decline of fields – especially in the North Sea and Mexico where production is shrinking by more than 20 per cent each year – means that 14.8m of the 16m barrels of new supply from non-Opec countries over the next five years will go to making up for losses from old fields producing less and less each year.

This is one of the most important trends in current oil markets: the depletion of existing fields, and the decline in their production. It’s long been discussed in specialised sites like this one but it’s been ignored in the “serious” media for too long. and yet, discussions of new fields coming into production cannot paint a correct picture of future production trends if these declines are not deducted to get net production increases.

And the stark truth is that in most of the world, the declines are bigger than the new capacity additions. This is particularly true in “friendly” production zones like the North Sea, Mexico or even Russia, where overall decline rates are dizzying and actually impact global production numbers significantly.

But Opec is also struggling, with project delays impacting its ability to add new capacity. The IEA substantially downgraded its expectations for Opec crude capacity from 2008-2013, cutting earlier forecasts by 1.2m b/d.

The IEA said it believed Saudi Arabia was having bigger problems than the kingdom, the world’s largest exporter, was willing to admit to, despite its national oil company having gone to great lengths last month to reassure energy ministers gathered in Jeddah that, except for Khursaniyah, its capacity editions were running on schedule.

Now the IEA is getting close to heresy territory, noting that Saudi claims about its ability to maintain or increase its production should be met with increasing skepticism.

Of course, none of that is news  for readers of this site or even of my Countdown to $200 oil series, but, as we know, we’re not Serious People – but the IEA is the ultimate in Seriousness, so this is big news. And I say that quite seriously (pun intended):  many governments, and countless businesses, not to mention pundits, use the IEA numbers religiously when preparing scenarios, business plans or pontificating. Changing these underlying numbers will have MAJOR impact on public discourse on energy.

It’s maybe not too late yet.