Each day the editors box at theoildrum.com gets about 100-150 emails. A few are spam. Many are form letters relating to energy. Many are from readers linking to energy news, etc. Others are from friends/staff. There are a number of ‘complaint’ emails too, usually ‘why don’t you write more on the environment?’ or ‘why haven’t you done a post yet on my new energy technology?’ etc. Given recent market and world events, I thought I’d go offtopic on a Saturday evening and share with you an email we received today. Plus it’s cathartic…;-)

(Vladimir Kush – Breach)
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From: (a reader in Vancouver BC)
Date: October 18, 2008 1:00:27 PM MDT
To: editors@theoildrum.com
Subject: content chnages

Hello. i am/was a frequent reader of your weblog for a while now, as last year i found it a valuable investment tool to find research that was under the radar. as this yaer has gone by however, the shift to a hairbrained ‘ecocentric’ left wingnut content has caused me to totally avoid your site. what i’m trying to tell you is this. the ENTIRE FKN WESTERN WORLD is full of left wing hairbrained ‘ecofarming’ nutcases with a non-factual axe to grind. Why is it that a decent site, with as close to useful facts as possible, has to degenerate into a fkn ‘eco-farming’ blog, that has NOTHING to do with the intricacies of oil production? talk about mission creep!
obviously a lot of it comes from the posters who have thier own agenda, but its your job to filter out the fkn ECO-FARMER loincloth crew and get back to what the blog was about.
if its not truly about that, then change your name to the ‘HairBrained PepperHaired Eco-nitwitz ‘ blog and we(intellegent types) can get it off our bookmark list.
thanks for the site, it was GREAT.

your truly,
a liberatarian capitalist.

I’d like to briefly highlight the bigger issues raised in this email. (Believe me we get worse). As the economy deteriorates, people naturally are going to be more emotional – stress/unease is transferable due to mirror neurons, herd-behaviour and the psychology of crowds. Civil discourse among thoughtful, intelligent, well meaning folk can then more easily become hijacked by ‘believers’ of all stripes. (It’s kind of funny that if we organized the totality of complaints we get in the inbox, they would mostly cancel eachother out (e.g. ‘we are beholden to right wing oil interests’ cancels out ‘we are beholden to left wing econutz’, etc.)

This is not a capitalist site. Nor is it a socialist, a communist, a fascist, or a green site. It is definitely not an investment site, though I expect it is often used as such, as we collectively were years ahead of the wall st analysts on crude supply plateau, declining net energy, and systemic risk (well, one year ahead on that one). However, I am sure we have capitalists, communists, socialists, fascists, and tarot card readers among our readership. I am almost completely certain we have at least one, if not several hairbrained pepperhaired eco-nitwits reading too. Theoildrum is a place for people to come to provide viewpoints presented with logic and evidence, that bear on our current energy predicament, now made worse by the global deleveraging of financial assets. From our Mission Statement:

The goals of The Oil Drum are as follows:

1. Raise awareness of energy issues

Most people are not aware of the problems we face or they underestimate their potential impact. Politicians and the traditional media have overlooked the problem, out of ignorance or due to a conflict of interest. We seek to fill the information gap, disseminating underreported facts and analysis.

2. Host a civil discussion

This website is a space where energy issues can be debated in a civil manner. Through the encouragement of evidence-based reasoning and logical arguments, we aim to host discussions with a depth and breadth absent from the traditional media or current political discourse.

3. Conduct original research in a transparent manner

We believe that the issues such as the timing and impacts of our supply and demand problems and the feasibility of alternatives to oil can be explored empirically, in an open and honest manner. Our site draws on the fast pace of the internet and the time-tested traditions of peer review in search of the truth, whatever it may be.

4. Create a global community working toward a common goal

Our society can only address a problem of this magnitude through cooperation. We seek to leverage the open nature of the internet to create a global forum for the discussion of energy problems and solutions. Your participation is welcome—if not necessary—for the improvement of our energy future.

(Source: Sitemeter); NB, October 2008 data is only for half of the month, obviously.

The above graph shows (apparently) a steady flow of hairbrained econitwitz reading the analyses our contributors put forth. I’m certain we could have significantly higher traffic if we wrote exclusively about energy investments and how to profit from peak oil (basically be short). But what good would this do in the long run? Just a paper wealth transfer from some, to others, and the transferees would probably spend it on something of higher energy footprint than the transferers. We have always hoped to have a greater impact than that. (Though I admit to periodic regrets of closing down my hedge fund to work in this area – I could have made a fortune….;-)

Regarding investment/intelligent types, one of the smarter investment analysts I get research from (unrelated to this site) had this to say on Friday:

People asking about gold weakness – in the medium term I think its a mix of higher inventories of physical like many other commodities we have heard about as shippers cant even get LOC’s to move the commodities from sellers to buyers and the system is still in logjam, as well as funds unwinding long positions.

Longer term I also think gold will underperform, this is where I get a lot of slack from people — first of all gold futures are still in some serious contango (I will revisit this later), gold is overowned, physical prices for delivery of coins and bars are 20-40% above spot prices on the screens and take days. People are playing gold for two reasons – inflation and the end of fiat/Armageddon trade. If you are long for end of fiat/Armageddon then you should be long in physical b/c you wont get paid being long GLD or gold futures when there is no one left to pay you, and I promise you that if fiat ends that will be the end of all contract law as well and civil society is pretty much over too.

So the other reason is inflation – well here is where one of my favorite macro trades lies – what I call inflation/deflation trade.
Short 30yr treasuries and short gold. If you believe in inflation over the next few years as the driver, then 30yr yields are at new all time lows recently, the govt is going to be issuing enormous amounts of long term paper and your downside to being short 30s is theoretically somewhat limited given where yields are. If we are in inflation then gold arguably is already pricing this in with its contangoed curve, interest rates likely will go to the moon and at 4% there is room to double digits easily.

On the other hand if we (as I believe) are in deflation due to the collapsing of lenders and forced mergers of banks which is destroying the money multiplier globally then gold will go to $200 if not lower and the long end is poised to go much lower and being short 30s will be painful but has some limit to where they can go on a yield basis.

The point of me posting this is not the investment advice (though I actually agree with it), is that, rightly or wrongly, there IS the possibility of the fiat/armageddon scenario being priced into conventional financial markets. The people making these bets likely don’t understand or appreciate ecology, systems analysis, or net depletion in relation to financial capital, but they connect the dots very quickly when it comes to money. Financial armageddon would mean the breakdown of our interconnected networks. Without those networks, we would revert to local sources of energy and food, eco-farmers (with or without loincloths) might just be your best friends. Renewable energy is an ecosystem service. Perhaps our inbox correspondent should become more familiar with the local natural capital in and near Vancouver. Just in case.

Bigger picture, NOW is the last critical chance to educate and generate discussion on regional and national scales on changing how we view energy. We are in the midst of what your investment crowd would term a ‘higher low’, in the long term uptrend of crude oil. The events causing crudes price drop, are simultaneously making the long term energy situation worse. Leanan has been providing links all week to the scale backs in capital spending among oil producers, cutbacks in production are expected at OPEC, projects will be scrapped, marginal, low EROI oil producing companies that need financing will likely go out of business, all the while ongoing net depletion of existing wells continues in the aggregate range of 4.5% per year. (Several on TOD staff are working on analyses on what all this may mean for world oil production.) The credit crisis and ‘investments’ are first and foremost on everyones mind. But without energy surplus in a usable form coupled with healthy planetary ecosystems there can be no growth. Withouth growth (or in the near term the perception of it), there can be no repayment of debt, and withougt debt there is no financial system as we know it.

As an editor, the reason I was compelled to post this publicly, is that I fear Gresham’s Law may end up applying equally well to people as it does to money. I sincerely hope that petty arguments, distractions, disparate viewpoints etc, do not take our contributors (and experts among our readership) limited time away from educating the public on the future of energy, which last I checked, remains intricately involved with our natural environment. Indeed, if/when faced with starving/freezing, or denuding the landscape, all signs point that we will choose the latter. Leaders in Italy are already making a similar choice this weekend, and the ethanol and tar sands scaling are evidence of trading natural capital not accounted for in the market for profit.
“

We are going to keep this site going as long as possible, as education and open (to a point) community discussion are some of the only tools we have to steer the aircraft carrier that is called modern society in a less precarious direction. We will probably never know the impact this site has had or will have on the global energy transition. Perhaps none. Perhaps we are changing things locally at the margin in lots of locales. Perhaps lots of people are starting to think in terms of ecological limits and natural capital as our real wealth, and making local civic changes. I don’t know the future – the variables are too many. But I do know that the internet is fast, and not only is the ‘good’ information about whats happening to our planet in real time found online, but the people reading it may be better able to visualize the bigger picture.

I am hopeful that we are making a positive difference. But I could just be an eco-nitwit.

< / Rant off>

With the dramatic increase in oil prices over the last decade, and even more dramatic dive since July, the perception of urgency to initiate long term energy changes is on a roller coaster ride of its own. As former Sec. of Energy James Schlesinger sums up “Americans have only two modes when it comes to energy – complacency and panic”. Unfortunately, as the global financial deleveraging grabs center stage, we have shifted to full complacency mode, while simultaneously our long term energy situation is deteriorating rapidly. Changing our energy mix and more importantly, how we use it, has been relegated to a ‘still important but not pressing’ issue, as concerns about credit, jobs, and 401ks override. After all, crude oil is under $70 per barrel, and gasoline is cheap and plentiful. What’s there to worry?

Below the fold is an energy report from the General Accounting Office presented to Congress in 1979, (hat tip Energy Maven), followed by my own conclusion. After reading the GAO report, it becomes clear, almost painfully so, that we have missed a generation of opportunity.
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This is the front of the 1979 GAO report. Click for larger image.

U.S. GENERAL ACCOUNTING OFFICE
WASHINGTON, D.C. 20548

FOR RELEASE ON DELIVERY
Expected at 9:30 a.m.
Monday, March 26, 1979

STATEMENT OF
J. DEXTER PEACH
DIRECTOR, ENERGY AND MINERALS DIVISION
BEFORE THE
SUBCOMMITTEE ON ENERGY AND POWER
OF THE
HOUSE COMMITTEE ON INTERSTATE AND FOREIGN COMMERCE
ON STANDBY ENERGY CONSERVATION AND RATIONING PLANS

Mr. Chairman and Members of the Subcommittee:

We welcome the opportunity to be here today. Our testimony today is based on

–the results of GAO work over the last two to three years in the energy conservation area as summarized in our recent report to Congressional Committee and Subcommittee Chairmen having responsibilities over energy programs (EMD-79-34),

–some observations included in our recent report on the energy and economic effects of’ the Iranian oil shortfall (EMD-79-38) and,

–the results of our initial analysis of the energy conservation contingency plans and gasoline rationing plan submitted to the Congress on March 1 by the Department of Energy (DOE).

LACK OF NATIONAL ENERGY CONSERVATION PROGRAM

Before discussing the conservation contingency and gasoline rationing plans, let me spend a few moments addressing the Nation’s continuing reluctance to develop an effective energy conservation strategy. Our reliance on crude oil imports has increased substantially in recent years and could reach 12 or 13 million barrels per day (B/D) by 1985. The current Iranian oil situation, which once again has jarred our complacency, is still only one of a series of events which underscores the importance of moving forward in the energy conservation area.

The world is likely to continue to experience periods of tight supply and upward pressure on prices in the next few years. The time is approaching when crude oil production capabilities will peak. While we now are faced with the need for quick actions to meet the problems created by the Iranian oil shortfall, we also must face up to the reality that we cannot continue to rely on short-term crisis management in the energy area and that now is the time to get our energy conservation act together.

We believe a strong, coordinated national energy conservation program cannot only mitigate the adverse impacts of future Iranian-type situations, but more importantly it would reduce the likelihood of oil embargoes being used as a weapon against the United States. Further, a strong conservation program is also needed to allow an orderly transition to renewable resources. Our February 13, 1979, letter to the Chairmen of Energy-Related Committees and Subcommittees highlighted the following three overriding problems which, in our opinion, must be solved before the Nation will achieve any significant level of energy conservation:

–A lack of specific planning and direction from the Government in the energy conservation area. In our June 30, 1978 report (EMD-78-38), we concluded that the Federal Government had not developed an overall energy conservation strategy for the Nation. While DOE generally agreed with our position, no strategy has been forthcoming.

–The absence of an aggressive, coordinated effort by the Government to conserve energy in its own operations and facilities. We have issued a series of reports on various Federal in-house conservation programs which show the lack of commitment by the Administration to aggressively pursue energy conservation within the Federal Government.

–The failure to develop, and have approved by the Congress, emergency energy conservation and gasoline rationing plans. While the Administration submitted such plans earlier this month, it took over 3 years to develop them.

We are concerned with the Administration’s apparent failure to place any level of priority on the development of the contingency plans. As we pointed out in our earlier Iranian report, while we may be able to manage with the loss of Iranian oil production, there is virtually no more slack left in the system. The loss of any other major oil supplies could be devastating, particularly in view of the state of our preparedness to deal with supply interruptions. Recent events regarding the Iranian situation illustrates this point.

The U.S. has commited itself to reduce oil consumption this year by five percent, or about one million barrels of oil per day, as part of the International Energy Agency’s response to the Iranian oil situation. But, there was no plan in place to achieve such a reduction. At this point, a wide range of possible actions are being considered. We were not able to obtain, from DOE, information on the specific proposals being considered because they are under consideration by the White House. Thus, we cannot respond to your specific request to comment on how DOE will manage the five percent cutback.

In our earlier report, however, we did comment on a number of possible actions which may be implemented including voluntary energy conservation measures as well as a number of actions designed to substitute coal, natural gas, and nuclear power for crude oil. Based on the information which has been available, we have reservations about the likelihood of achieving the energy savings which DOE has estimated for voluntary energy conservation. In addition, the possible fuel substitution measures being considered will require that many institutional and administrative barriers be overcome, which likely would limit this contribution for the next 6 to 9 months. (Attachment I contains a more detailed discussion.)

While we certainly would not play down the efforts needed to meet this current contingency, the fact remains that there are no DOE plans which could be implemented quickly if this country or our allies should suffer further supply interruptions. While we must deal with the current crisis, over the longer term emergency planning efforts should be focusing on the question of “What actions could be undertaken to deal with various levels of supply shortfall such as a loss of Saudi Arabian oil, or a loss of all OPEC oil?” The Nation cannot afford to be ill-prepared in the face of these potential threats.

STANDBY ENERGY CONSERVATION AND RATIONING PLANS

The Energy Policy and Conservation Act (EPCA) required DOE to prepare, for the Congress’ approval by June 1976, standby energy conservation plans and a standby gasoline rationing plan. Once approved by the Congress, these plans would be available for implementation during a severe energy supply disruption or to fulfill U.S. obligations under the International Energy Program whereby member nations have agreed to share the burden of a future embargo or shortage situation.

The standby conservation plans finally submitted by DOE to Congress on March 1 consist of the following three measures:

–Weekend gasoline sales restrictions.

–Building temperature restrictions.

–Advertising lighting restrictions.

DOE estimates the total oil savings from these three measures to be 610,000 B/D. To implement and enforce these measures for a 9-month period would cost the Government about $16.4 million.

Our analysis of these three proposed measures indicates that while the plans have the potential for helping manage a future petroleum shortage, the extent to which the plans are enforceable or will achieve the level of savings DOE predicts is unclear. Also, implementation of the plans likely would impact adversely on certain industries. (Detailed comments on these plans are included as Attachment II.)

Regarding the proposed gasoline rationing plan, DOE recognizes, and we concur, that rationing is a very expensive measure to be used only in an extreme gasoline shortage. There is no such thing as a “perfect” rationing plan, as tradeoffs must be made to balance off (1) equity and (2) administrative workability and costs of implementation. In essence, rationing would be a $2 billion program designed to reduce long waiting lines at gasoline stations. It would not result in any gasoline savings, but would simply allocate available supplies among end users.

In its development of the plan, DOE has, in several instances, decided on provisions which are easier and less costly to administer over alternatives which might result in more equitable distribution of ration allotments. DOE is relying on the “white market” to correct any imbalances that may occur. Two instances which stimulated a number of adverse comments during the public comment period pertain to

–making gasoline available for commercial use, and

–matching up ration allotments and physical supplies of gasoline in all States.

Changes DOE made from an earlier version of the plan will result in commercial firms as a whole receiving fewer ration allotments than under the previous version. Public comments received on the provision strongly opposed the change, and DOE recognizes that firms will end up purchasing over $12 billion of additional ration allotments on the “white market.” However, DOE believes the plan will be significantly easier and cheaper to administer.

DOE is aiso relying on the “white market” to match up the physical supplies of gasoline with ration allotments in all States. Because DOE plans to issue ration allotments based on a nationwide average, but will initially distribute supplies of gasoline based on historical State usage, nine States will initially receive ration allotments 10 percent or more higher than their supplies of gasoline, while 10 States will receive initial supplies of gasoline 10 percent or more higher than their ration allotments.

The “white market”, however, will be a costly program for drivers in certain States. Drivers in States with historically higher than average gasoline consumption will purchase excess ration allotments at $1.22 per gallon from drivers in States with lower than average consumption rates.

Questions of equity are raised here, since 11 States would each have to pay out $10 million a month or more to maintain their gasoline usage at 20 percent less than normal, while 10 States could cut their consumption by 20 percent and still be recipients of over $10 million a month from sales of excess allotments. DOE recognizes these potential imbalances, but believes that trying to correct them would place a much greater administrative burden on DOE and make the rationing plan more complicated and expensive.

Another provision in the plan pertains to the manner in which DOE will distribute ration coupons to the public. Earlier work by us revealed problems with DOE’s plan to primarily rely on financial institutions for issuing coupons to the public. The current plan has little discussion of this very important aspect of the plan. (Detailed comments are included in Attachment III.)

Overall, we are concerned with the lack of priority DOE has attached to the completion of the standby conservation and rationing plans. While changes have been made in the rationing plan DOE inherited in January 1977 from the previous Administration, we question whether over 2 years were needed to accomplish the changes. The conservation plans have remained essentially unchanged since 1977, except for some additional energy and economic analyses accompanying the plans.

Once the rationing plan is approved by the Congress, at least 6 – 8 months more work will be needed for further development. DOE’s past record of slippage does not speak well for the degree of priority we can expect to be awarded completion of work on the rationing plan if the Iranian situation should ease.

Mr. Chairman, this concludes our statement. We will be happy to answer any questions the Subcommittee miqht have.

Attachments I, II, and III are omitted, but can be reviewed a PDF in the original document, found here.

One part of Attachment of III is of particular note. It is called

Alternatives to Rationing

DOE, in a section on alternatives to rationing in its regulatory analysis of the plan, briefly discussed the concept of a gasoline excise tax. The excise tax would raise the price of gasoline to the market-clearing level, thus balancing supply and demand. The proceeds from the tax would be rebated to consumers to offset the burden of the tax. According to DOE the excise tax could be achieved with much less administrative complexity than a rationing plan. As a result, an excise tax would be implemented more quickly, would cost less, and would require fewer personnel to administer.

DOE has not pursued the idea of an excise tax further because the EPCA explicitly precluded any plan from imposing a tax. (emphasis mine)

Since the writing of this government report, the USA has burned 193 billion barrels of oil, and the world over 750 billion. Irrespective of how much is left, it is certain that what remains is 750 billion barrels less than it was in 1979, and that the oil that is gone was incredibly cheap.

It’s a good thing we used the oil wisely.

Our current economic goal is growth, conventionally measured by Gross Domestic Product. As has been oft written here (and many other places), GDP is a poor measure of actual ‘growth’ as it includes items such as crime and pollution as ‘positive’ and does not account for negatives such as loss of ecosystems, and declining human well being. A more holistic measure of ‘growth’ is the Genuine Progress Indicator (GPI), shown in contrast to conventional GDP in the above graphic. Note that it peaked in 1979, the exact year of this report.

It is time that Wall St, Main St and our government come together in the current crisis to address something deeper and longer lasting than this quarters earnings or how our 401ks are faring. This (temporary) price drop in oil is perhaps one of our last opportunities to invest low cost fossil fuels into building appropriate renewable energy that will create jobs now, and put in place infrastructure for basic goods (heat, electricity, and food) for decades into the future. Perhaps more importantly, it is time Americans became accountable for our ends, instead of focusing on the means – this will require the tough but necessary choice of using less throughput, especially energy. Though it may ‘seem’ unimportant given the current world situation, I cannot forsee a better time to follow some of the GAO recommendations from what was the energy crisis dress rehearsal of 30 years ago.

We were warned.

Last weeks Debate Fact Check #1 highlighted the realities of offshore drilling often glossed over in political discussions. Tonight, with less than 3 weeks remaining before the national election,we will view the final head-to-head presidential debate. Beyond the immediate concern of roiling financial markets, candidates are at least somewhat aware of the complex challenges that lie ahead in the coming energy transition. One popular (and pleasing to the ear) phrase that is frequently used is ‘Energy independence’. In my opinion, true energy independence, if possible, will require significantly more focus on reducing energy demand than on increasing energy supply, something we are hearing little about (perhaps because its…err…less likely to win votes?) A slightly different take on this was posted here 2 years ago summarizing Council of Foreign Relations report on the infeasibility of energy independence.)

Below the fold is the second in a series of brief fact-checking exercises regarding the major energy issues in the campaign by Professor Cutler Cleveland.
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Senators McCain and Obama—and every President since Richard Nixon—have argued that energy independence should be at the core of national energy policy. Energy independence typically is defined as zero reliance on energy imports. The underlying assumption is that relying on “unfriendly” Middle East nations for energy is bad for our economic and national security.

The argument for energy independence is flawed for economic, strategic, and environmental reasons:

1. “Unfriendly” nations are not our primary source of oil. Only 44% of U.S. oil imports are from members of OPEC, the international oil cartel that is dominated by Middle East producers. Canada and Mexico are the two largest single sources for imported oil in 2007. (Editors note: through 6/08, Mexico has dropped to #3, though this changes seasonally and may revert in 2nd half of year)

2. The U.S. oil resource base is depleted to the extent that it could not yield the roughly 3.7 billion barrels of oil the U.S imported in 2007 (not to mention the additional refined products imported). Domestic oil is far more expensive to produce than oil in most other regions, especially OPEC nations. Increased reliance on domestic oil will put upward pressure on oil prices.

3. Increased U.S. production would have little impact on the level or volatility of oil prices. The price of oil is determined in a global market by a complex array of forces including speculation, weather, geopolitics, decisions by OPEC, and most importantly, by market fundamentals–short and long run supply and demand forces. At the margin, producing decisions made in the U.S. have little influence on this process.

4. Global price determination also means that energy independence won’t protect our economy from supply disruptions abroad. A refinery strike in Venezuela, civil war in the Niger Delta, and other similar events could quickly reduce oil production. Oil instantly becomes more expensive everywhere — the UK, Japan, China, and the U.S. all pay pretty much the same price.

5. The sensitivity of our economic well being to changes in the price of oil stems from the overriding importance of oil to human existence, not to our dependence on imported oil per se. A nation can reduce its economic vulnerability to oil price increases only by using less oil in total, regardless of whether it is produced domestically or imported.

6. Oil imports are a hedge against domestic supply disruptions. For example, the hurricanes of 2005 that damaged New Orleans and other Gulf Coast communities also damaged refineries, causing an immediate gasoline shortage in a number of southern U.S. cities. But increased imports of gasoline from Venezuela and other nations offset the loss of domestic supply, and thereby helped mitigate the increase the price of gasoline.

7. The costs of substitutes for oil (ethanol, electric cars, fuel cell propulsion) are more expensive than oil, and will be for at least the next decade. Forcing a transition to these fuels now will raise costs and prices. Many substitutes also carry a significant environmental cost.

8. The U.S. cannot wall itself off from the international energy market. We import oil from Venezuela, electricity and natural gas from Canada, and wind turbines from Denmark. We export coal to the Netherlands, motor gasoline to Mexico and photovoltaic modules to China. The nation benefits from energy trade. For example, weak European natural gas demand in 2007 released additional LNG to the global market, and thus helped keep U.S. natural gas prices at a record low compared to fuel oil. Cutting ourselves out of the increasingly interconnected global trade in energy would raise domestic energy prices. Zero net imports is also impossible to achieve in the foreseeable future.

9. Energy independence would not significantly reduce the risk of terrorism. Terrorism thrived when oil was $10 per barrel—it doesn’t need $100 a barrel oil. Terrorism can be done on the cheap: the 9/11 Commission found that those attacks were accomplished with as little as $500,000.

10. Energy independence would accelerate climate change. A push towards independence would inevitably lead to increased reliance on our substantial domestic resources of coal, the most carbon-intensive energy source.

The notion of energy independence is comforting and makes for a great sound bite, but it is not a sound basis for a national energy policy

Professor Cutler Cleveland
Boston University
10/15/2008

Some of Dr. Clevelands previous work posted on theoildrum:

Presidential Energy Debate Fact Check #1 – Is Offshore Drilling the Answer? Cutler Cleveland
On Energy Transitions Past and Future – Cutler Cleveland
Ten Fundamental Principles of Net Energy Analysis – Cutler Cleveland
Energy Return from Wind – Cutler Cleveland and Ida Kubiszewski

As the world gradually awakens to the concept that all wealth cannot be measured by digits in the bank, the global economic and political elite have been meeting to potentially form a “new Bretton Woods,” kick started by global guarantees of banking deposits, direct government investment in banks, and global rate cuts. Though the markets have so far reacted with glee (or short covering), pumping fiat money into the system with no biophysical linkage to the real economy has (at least) two major problems. First, it accelerates the growing gap between financial capital and real capital, and second, it tacitly acknowledges that our current “ends” are acceptable, and that all forms of capital can and should continue to be directed towards the positional consumption of “stuff” that our culture currently advocates (perhaps via momentum alone). In crisis times such as these, our leaders would do well to recognize that the human economy is a subset of a larger, finite system, and is subject to the natural laws forthwith. A plethora of new economic, psycholgic, and neuroscience research also suggests that “more” does not equate with “better”. Below the fold is a guest commentary explaining these themes from my thesis co-advisor, Robert Costanza, director of the Gund Institute for Ecological Economics at the University of Vermont.

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The current financial meltdown is the result of under-regulated markets built on an ideology of free market capitalism and unlimited economic growth. The fundamental problem is that the underlying assumptions of this ideology are not consistent with what we now know about the real state of the world. The financial world is, in essence, a set of markers for goods, services, and risks in the real world and when those markers are allowed to deviate too far from reality, “adjustments” must ultimately follow and crisis and panic can ensue. To solve this and future financial crisis requires that we reconnect the markers with reality. What are our real assets and how valuable are they? To do this requires both a new vision of what the economy is that what it is for, proper and comprehensive accounting of real assets, and new institutions that use the market in its proper role of servant rather than master.

The mainstream vision of the economy is based on a number of assumptions that were created during a period when the world was still relatively empty of humans and their built infrastructure. In this “empty world” context, built capital was the limiting factor, while natural capital and social capital were abundant. It made sense, in that context, not to worry too much about environmental and social “externalities” since they could be assumed to be relatively small and ultimately solvable. It made sense to focus on the growth of the market economy, as measured by GDP, as a primary means to improve human welfare. It made sense, in that context, to think of the economy as only marketed goods and services and to think of the goal as increasing the amount of these goods and services produced and consumed.

But the world has changed dramatically. We now live in a world relatively full of humans and their built capital infrastructure. In this new context, we have to reconceptualize what the economy is and what it is for. We have to first remember that the goal of the economy is to sustainably improve human well-being and quality of life. We have to remember that material consumption and GDP are merely means to that end, not ends in themselves. We have to recognize, as both ancient wisdom and new psychological research tell us, that material consumption beyond real need can actually reduce our well-being. We have to better understand what really does contribute to sustainable human well-being, and recognize the substantial contributions of natural and social capital, which are now the limiting factors in many countries. We have to be able to distinguish between real poverty in terms of low quality of life, and merely low monetary income. Ultimately we have to create a new model of the economy and development that acknowledges this new full world context and vision.

This new model of development would be based clearly on the goal of sustainable human well-being. It would use measures of progress that clearly acknowledge this goal. It would acknowledge the importance of ecological sustainability, social fairness, and real economic efficiency. Ecological sustainability implies recognizing that natural and social capital are not infinitely substitutable for built and human capital, and that real biophysical limits exist to the expansion of the market economy.

Social fairness implies recognizing that the distribution of wealth is an important determinant of social capital and quality of life. The conventional model has bought into the assumption that the best way to improve welfare is through growth in marketed consumption as measured by GDP. This focus on growth has not improved overall societal welfare and explicit attention to distribution issues is sorely needed. As Robert Frank has argued in his latest book: Falling Behind: How Rising Inequality Harms the Middle Class, economic growth beyond a certain point sets up a “positional arms race” that changes the consumption context and forces everyone to consume too much of positional goods (like houses and cars) at the expense of non-marketed, non-positional goods and services from natural and social capital. Fore example, this drive to consume more positional goods leads people to reach beyond their means to purchase ever larger and more expensive houses, fueling the housing bubble. It also fuels increasing inequality of income which actually reduces overall societal well-being, not just for the poor, but across the income spectrum.

Real economic efficiency implies including all resources that affect sustainable human well-being in the allocation system, not just marketed goods and services. Our current market allocation system excludes most non-marketed natural and social capital assets and services that are huge contributors to human well-being. The current economic model ignores this and therefore does not achieve real economic efficiency. A new, sustainable ecological economic model would measure and include the contributions of natural and social capital and could better approximate real economic efficiency.

The new model would also acknowledge that a complex range of property rights regimes are necessary to adequately manage the full range of resources that contribute to human well-being. For example, most natural and social capital assets are public goods. Making them private property does not work well. On the other hand, leaving them as open access resources (with no property rights) does not work well either. What is needed is a third way to propertize these resources without privatizing them. Several new (and old) common property rights systems have been proposed to achieve this goal, including various forms of common property trusts.

The role of government also needs to be reinvented. In addition to government’s role in regulating and policing the private market economy, it has a significant role to play in expanding the “commons sector”, that can propertize and manage non-marketed natural and social capital assets. It also has a major role to play as facilitator of societal development of a shared vision of what a sustainable and desirable future would look like. As Tom Prugh, myself, and Herman Daly have argued in our book “The Local Politics of Global Sustainability,” strong democracy based on developing a shared vision is an essential prerequisite to building a sustainable and desirable future.

Conclusion

The long term solution to the financial crisis is therefore to move beyond the “growth at all costs” economic model to a model that recognizes the real costs and benefits of growth. We can break our addiction to fossil fuels, over-consumption, and the current economic model and create a more sustainable and desirable future that focuses on quality of life rather than merely quantity of consumption. It will not be easy; it will require a new vision, new measures, and new institutions. It will require a redesign of our entire society. But it is not a sacrifice of quality of life to break this addiction. Quite the contrary, it is a sacrifice not to.

Dr. Robert Costanza
Gund Institute for Ecological Economics
Rubenstein School of Environment and Natural Resources
The University of Vermont

email: Robert.Costanza@uvm.edu
http://www.uvm.edu/giee

Previously, Herman Daly wrote a guest post on the Steady State Economy, outlining core suggestions on how to overhaul our banking, financial (and value) systems. I encourage everyone to read it (if short on time, please read the conclusion). Professor Daly was Senior Economist at the World Bank before leaving to teach Ecological Economics at University of Maryland’s School for Public Policy. He was also the catalyst for me to leave my own financial career and return to school to study the real economy (i.e. what we call the human economy is only a small part of a larger closed system). Below the fold are his thoughts on the current crisis (current being defined as last 30-40 years or so). (For comparison, here are links to what ‘mainstream’ economic icons George Soros, and Bill Gross are saying.)

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The current financial debacle is really not a “liquidity” crisis as it is often euphemistically called. It is a crisis of overgrowth of financial assets relative to growth of real wealth—pretty much the opposite of too little liquidity. Financial assets have grown by a large multiple of the real economy—paper exchanging for paper is now 20 times greater than exchanges of paper for real commodities. It should be no surprise that the relative value of the vastly more abundant financial assets has fallen in terms of real assets. Real wealth is concrete; financial assets are abstractions—existing real wealth carries a lien on it in the amount of future debt. The value of present real wealth is no longer sufficient to serve as a lien to guarantee the exploding debt. Consequently the debt is being devalued in terms of existing wealth. No one any longer is eager to trade real present wealth for debt even at high interest rates. This is because the debt is worth much less, not because there is not enough money or credit, or because “banks are not lending to each other” as commentators often say.

Can the economy grow fast enough in real terms to redeem the massive increase in debt? In a word, no. As Frederick Soddy (1926 Nobel Laureate chemist and underground economist) pointed out long ago, “you cannot permanently pit an absurd human convention, such as the spontaneous increment of debt [compound interest] against the natural law of the spontaneous decrement of wealth [entropy]”. The population of “negative pigs” (debt) can grow without limit since it is merely a number; the population of “positive pigs” (real wealth) faces severe physical constraints. The dawning realization that Soddy’s common sense was right, even though no one publicly admits it, is what underlies the crisis. The problem is not too little liquidity, but too many negative pigs growing too fast relative to the limited number of positive pigs whose growth is constrained by their digestive tracts, their gestation period, and places to put pigpens. Also there are too many two?legged Wall Street pigs, but that is another matter.

Growth in US real wealth is restrained by increasing scarcity of natural resources, both at the source end (oil depletion), and the sink end (absorptive capacity of the atmosphere for CO2). Further, spatial displacement of old stuff to make room for new stuff is increasingly costly as the world becomes more full, and increasing inequality of distribution of income prevents most people from buying much of the new stuff—except on credit (more debt). Marginal costs of growth now likely exceed marginal benefits, so that real physical growth makes us poorer, not richer (the cost of feeding and caring for the extra pigs is greater than the extra benefit). To keep up the illusion that growth is making us richer we deferred costs by issuing financial assets almost without limit, conveniently forgetting that these so?called assets are, for society as a whole, debts to be paid back out of future real growth. That future real growth is very doubtful and consequently claims on it are devalued, regardless of liquidity.

What allowed symbolic financial assets to become so disconnected from underlying real assets? First, there is the fact that we have fiat money, not commodity money. For all its disadvantages, commodity money (gold) was at least tethered to reality by a real cost of production. Second, our fractional reserve banking system allows pyramiding of bank money (demand deposits) on top of the fiat government?issued currency. Third, buying stocks and “derivatives” on margin allows a further pyramiding of financial assets on top the already multiplied money supply. In addition, credit card debt expands the supply of quasi?money as do other financial “innovations” that were designed to circumvent the public?interest regulation of commercial banks and the money supply. I would not advocate a return to commodity money, but would certainly advocate 100% reserve requirements for banks (approached gradually), as well as an end to the practice of buying stocks on the margin. All banks should be financial intermediaries that lend depositors’ money, not engines for creating money out of nothing and lending it at interest. If every dollar invested represented a dollar previously saved we would restore the classical economists’ balance between investment and abstinence. Fewer stupid or crooked investments would be tolerated if abstinence had to precede investment. Of course the growth economists will howl that this would slow the growth of GDP. So be it—growth has become uneconomic at the present margin as we currently measure it.

The agglomerating of mortgages of differing quality into opaque and shuffled bundles should be outlawed. One of the basic assumptions of an efficient market with a meaningful price is a homogeneous product. For example, we have the market and corresponding price for number 2 corn—not a market and price for miscellaneous randomly aggregated grains. Only people who have no understanding of markets, or who are consciously perpetrating fraud, could have either sold or bought these negative pigs?in?a?poke. Yet the aggregating mathematical wizards of Wall Street did it, and now seem surprised at their inability to correctly price these idiotic “assets”.

And very important in all this is our balance of trade deficit that has allowed us to consume as if we were really growing instead of accumulating debt. So far our surplus trading partners have been willing to lend the dollars they earned back to us by buying treasury bills—more debt “guaranteed” by liens on yet?to?exist wealth. Of course they also buy real assets and their future earning capacity. Our brilliant economic gurus meanwhile continue to preach deregulation of both the financial sector and of international commerce (i.e. “free trade”). Some of us have for a long time been saying that this behavior was unwise, unsustainable, unpatriotic, and probably criminal. Maybe we were right. The next shoe to drop will be repudiation of unredeemable debt either directly by bankruptcy and confiscation, or indirectly by inflation.

As people following our energy situation are aware, many if not most energy stocks are down 60-70% or more from their summer highs. In a bizarre but not completely surprising announcement after the close (we knew someone was liquidating), Chesapeake, (the US largest natural gas producer) CEO Aubrey McClendon has been involuntarily liquidated out of his rougly 30,000,000 remaining shares of CHK in the past 3 days due to margin calls. CHK, which in July was over $70 per share, hit as low as $11.99 today, and then had a 38% rally to close at $16.52 on 5 times normal volume. We don’t typically comment on individual stocks or price movements on TOD but this and related NG stock developments could have a significant impact on the industry’s future – CHK and XTO in addition to being top 2 gas producers also operate over 12% of our nat gas rigs. In addition to McClendons margin call, Chesapeake also announced further reductions in capex budgets going forward which means lower natural gas production, and thus higher prices, ceteris paribus. To make things more complicated, the majority of complicated financial hedges undertaken by CHK, are at Morgan Stanley, which fell to single digits today, (but is rumoured to be being bought out by Citi tonight after the close). This is all very good news for natural gas prices but bad news for the North American energy situation.
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Mr. McClendon, who has been recently highlighted in national TV commercials about expanding future of natural gas usage as recently as July held 33,500,000 shares which at one point traded over $70 per share.

“I am very disappointed to have been required to sell substantially all of my shares of Chesapeake. These involuntary and unexpected sales were precipitated by the extraordinary circumstances of the worldwide financial crisis. In no way do these sales reflect my view of the company’s financial position or my view of Chesapeake’s future performance potential. I have been the company’s largest individual shareholder for the past three years and frequently purchased additional shares of stock on margin as an expression of my complete confidence in the value of the company’s strategy and assets. My confidence in Chesapeake remains undiminished, and I look forward to rebuilding my ownership position in the company in the months and years ahead.”

This news was on top of an announcement to substantially reduce 2009 and 2010 capital expenditures (drilling).

Many (all?)natural gas companies stocks have been in freefall this week, though in hindsight that was perhaps fast money front running the rumour of margin calls on McClendon. But concerns about CHK were real, as pointed out in this Bloomberg story

Investors are concerned that Chesapeake and other U.S. oil and gas producers have hedging contracts with financial firms and other counterparties that won’t be able to pay for their output at the agreed-upon prices because of the global credit crisis, said Robert Goodof, who helps manage $25 billion at Loomis Sayles & Co. in Boston.

Chesapeake also has so-called knockout swap contracts on more than one-third of its 2009 production, and those deals don’t obligate the buyers to take gas when prices drop to $6.28 per thousand cubic feet of the heating and power-plant fuel, according to analyst Joseph Allman of JPMorgan Chase & Co. in New York. U.S. gas futures dropped to $6.65 today and have plunged 50 percent since the end of June.

According to Allman, Morgan Stanley is Chesapeake’s biggest counterparty. Morgan Stanley shares fell 39 percent, dropping for a fifth straight day, after Moody’s Investors Service said it may cut the investment bank’s credit rating.

Allman said that if gas falls to $6 per thousand cubic feet, Chesapeake would have to sell $3.5 billion of assets.

“In our view, getting through 2009 is tough, but Chesapeake has a lot of non-producing assets it could sell and discretionary spending it could cut,” Allman said.

Investors were ostensibly concerned about a natural gas train wreck if Morgan Stanley were to go under, that would cause Chesapeake to follow. I just can’t imagine that happening. The government might let Chuck E Cheese go under, but not our largest natural gas producer and rig operator. I was thinking during the day that the financial types that were shorting Chesapeake and other nat gas companies into the ground (and buying Credit Default Swaps just like they did with Lehman and AIG) would pat themselves on the back for making good coin, then go home to find no heat, plastic bottles or diapers. Yet another juxtaposition of money and energy…But it becoming more clear that hedge fund margin liquidations are contributing to the equity sell-off. The margin clerks typically are instructed to start liquidating positions at 3pm if the account hasn’t come up with margin – all week the volume in the days final hour dwarfed the trading earlier in the day. This has been a vicious cycle as banks are reducing leverage and increasing margin requirements for clients – more selloff equals more margin calls equals more selloff. Personally, I think its worse ‘this time’ because of the number and size of hedge funds, which became more popular after outperforming the bear market of 2000-2003. But I think we’ve seen ‘peak hedge fund’.

Finally, as discussed 2 weeks ago after the first cap-ex cut by Chesapeake, the marginal cost of natural gas is over $8 per MCF, and the average cost being close to $6 in North America. Natural gas is on average getting more expensive to procure. Now that capital is less available, we are going to see more and more production cuts. We need to analyze what it really means – 5% drop? 15% drop? Aubrey McClendon has been seen on TV advocating the Pickens Plan to use natural gas as a vehicle fuel. I wonder if recent events will change the landscape of our natural gas industry and this plan. At prices during mid-day today, I was wondering if ExxonMobils $40 billion in cash (less $10 billion in debt they could just assume) might be put to work. The landscape has seemingly changed daily. I think even people who have never had an ecology class or never heard of theoildrum understand, or at least have an inkling, that natural gas and oil are more precious than dollar bills. Is it too early for nationalization of the energy industry?

Here are some previous TOD posts discussing the natural gas situation in North America, and although we have ‘more’ gas recently, it comes at higher costs:

An Update on the Energy Return on Canadian Natural Gas
At $100 Oil, What Can the Scientist Say to the Investor?
Ten Fundamental Truths about Net Energy
The North American Red Queen – Our Natural Gas Treadmill
A Net Energy Parable – Why is EROI Important?
Natural Gas and Complacency

Please add any comments or links below.

(EDIT: It seems that the contagion spread to CHKs financial twin, XTO, where it was just announced that their Chairman has been selling stock:

XTO Energy Inc. (NYSE: XTO – News) announced today that during the past week Chairman and CEO Bob R. Simpson sold 2.8 million shares of XTO common stock. This sale satisfied all considerations for debt, personal interests and family liquidity. As a Company founder, Mr. Simpson continues to own 6.8 million shares of XTO and has options to purchase an additional 4.0 million shares.

Of equal concern is that CHK operates 130 rigs, and XTO 70, which is fully 1/8 of rigs drilling for natural gas. (1600)

And a bigger question is: WHAT ARE THESE VERY WEALTHY PEOPLE DOING BUYING THEIR OWN STOCK ON MARGIN ?
Having worked for a decade on Wall St, I know the answer to that, and the mechanisms underlying this behaviour are why I see our current situation as unsustainable, even if we were to find more gas and oil. The dopamine feedback loop for more, culturally defined, is nearly unstoppable.

This is a post run just over a year ago, by emeritus TOD contributor Stoneleigh. It was instructive as much as it was prescient. Both Stoneleigh and her writing partner Ilargi at The Automatic Earth have had a consistently, and unabashedly phenomenal, call with respects to the financial and debt crisis. It is certainly not over, but we now begin to see the impacts such a crisis on future energy supplies – it’s like losing the battle as well as the war. Still, the quickness of the deterioration in the economy may be a blessing in disguise – more resources left in ground for some better planned use.

Below the fold, a reprint of Stoneleigh’s excellent primer on the credit crisis. Right about now is when it starts to impact the energy world. (Sorry- Word count not working.)
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We have been living in inflationary times, for as long as most of us can remember. The money supply keeps expanding and prices increase over time as a result. Central bankers have many tools at their disposal which they can use to tweak the economy-–they can raise or lower interest rates, can control reserve requirements for fractional reserve banking and can inject liquidity into the banking system, among other things – and we have become used to thinking that they can prevent the kind of ‘economic accidents’ that previous episodes of excess have led to in the past. Especially in recent years-–since the apparently successful containment of the dot com aftermath–we have acted as if risk were a thing of the past. Sliced, diced and spread around Wall Street and the rest of the global financial system, risk has seemed tamed, contained and controlled, until last week that is.

For years, industry insiders and so-called experts have proclaimed the virtues of slicing, dicing, and repackaging risk. They waxed on about how borrowers and savers, and society as a whole, could only benefit from such machinations. They suggested any sort of exposure could be disbursed and dissipated to the point where it essentially disappeared. Some even claimed that the crises of the past would no longer exist.

Yet amid the hype and assurances, few supporters spoke of the dark side of wanton and widespread risk-shifting. They didn’t seem — or want — to acknowledge that by combining complicated risks in unfamiliar and unnatural ways, the end result could be an uncontrollable monstrosity—one that eventually turned on its masters.

Nor did they heed the notion that by scattering risk into every nook and cranny of the global financial system, the vast web of overlapping linkages virtually guaranteed that serious problems in one sector, market, or country would trigger far-reaching shockwaves.

All of a sudden, markets are reeling around the world, deals are unraveling, the mainstream press is talking about a credit crunch and the world’s central bankers are injecting unprecedented amounts of liquidity to calm the markets. Risk has made a comeback, and in that environment the evident concern of the central bankers does not seem very reassuring.

The Dot Com Crash and Money Dropped From Helicopters

As the dot com boom morphed into the dot com bust (threatening to become a full-blown meltdown by the end of 2002) central bankers cut interest rates drastically and held them down for a long period of time.

In 2001, the US Federal Reserve Bank, the spigot of credit in America’s debt-based economy, drastically slashed its interest rates 84 %, from 6.5 % in 2001 down to 1 % in 2002. The Fed did so because the collapse of the dot.com bubble in 2000 had so damaged US financial markets (the NASDAQ fell by 80 %) the Fed feared a depression could result.

As Ben Bernanke was preparing to take over from Alan Greenspan at the Federal Reserve, he promised to drop money from helicopters if necessary to prevent deflation. Having spent his academic career studying the causes of the Great Depression, Bernanke understood the danger of deflation and was determined to avoid the liquidity trap by maintaining the demand for credit. As good as his word, Bernanke, and Greenspan before him, oversaw a doubling of the money supply since 2000. Adjusted for changes in the money supply (inflation), real interest rates (the nominal rate minus inflation) were negative for several years. Instead of dropping money from helicopters, Bernanke dropped free debt.

Real Interest Rates (Nominal Rate Minus Inflation)

The key in all of this is not inflation, as most believe. The Fed says they are most worried about inflation risks, but the reality is that they are most worried about deflation risks. Always. Always deflation. The Fed has no choice but to always remind us that the risks are tilted toward inflation, just as the Treasury Secretary, whichever one happens to be in office at the time, must always say that the U.S. maintains a strong dollar policy, even if monetary policy and fiscal policy are conspiring to devalue the dollar.

Fractional Reserve Banking and the Expansion of the Money Supply

Fractional reserve banking allows banks to lend into existence money they do not have (on the assumption that their depositors will not all want their money back at once), provided that they keep a certain percentage of their deposit base with the Federal Reserve to cover withdrawls. Ten percent would once have been a typical figure, but since the 1990s, the Fed has deliberately shepherded reserve requirements down, essentially to zero, through dropping required reserve percentages, reducing the categories of funds needing a reserve and allowing funds to be swept from a reservable category to a non-reservable category overnight (using sweep accounts). As reserve requirements have fallen, banks have been able to expand the money supply far more rapidly than would previously have been the case, at the cost of removing the cushion they previously held as insurance against financial accidents. As with everything else, the resilience has been stripped from the system in the name of efficiency, in this case in the use of capital to generate maximum returns.

The Housing Bubble and the Debt Mountain

The combination of drastically reduced reserve requirements and negative real interest rates predictably led to a borrowing binge of epic proportions, increasing what was already a dangerous level of indebtedness. Many of those whose fingers had recently been burned in the stock market turned to real estate, and, by extension, all of the supporting industries surrounding it. People moved to larger properties, bought investment properties, renovated, upgraded and re-equipped. The surge in demand, and depreciation of the currency through rapid expansion of the money supply, led to a huge increase in property prices. This enabled owners to use their appreciating properties as ATMs, at first using the windfall for luxuries, but increasingly relying on it to fund basic living expenses through refinancing. This created both a debt mountain and a structural vulnerability to a fall in property prices.

Banks offered credit to those further and further down the credit-worthiness scale, with scant regard to the ability of those borrowers to repay their loans. Instead of holding debt on their own books as they would once have done, banks now make their money from fees and sell the loans on to investors as mortgage-backed securities. As they no longer bear the risk of default, they are unconcerned about it. They often asked for little or no information from prospective borrowers – often no proof of income, employment or even identity – leading to the label of ‘liar’s loans’.

With rates so low, borrowers were far more concerned with the level of monthly payments than with the balance outstanding. Exploiting this blinkeredness, banks offered a range of loans called neg am ARMs – adjustable rate mortgages with negative amortization. Borrowers were offered low ‘teaser’ rates for the first few years, paying less than the interest owed on their loan during that time, while the unpaid interest was added to the principle in the meantime. Often they signed the loan documents without understanding the concept of teaser rates. At the end of the teaser period, the full monthly interest payment would be due on the now larger principle at the new prevailing interest rate. As interest rates have increased recently, monthly payments on resetting ARMs are often set to more than double. In October of this year, $50 billion dollars worth of ARMs will reset, with a further $30 billion a month doing the same for over another year.

Marginal borrowers, who were often already only barely affording their existing payments, are highly unlikely to be able to afford the new ones. Their only recourse would be to sell, but falling prices have made this difficult. Some are already in negative equity – owing more on their home than its current market value. Foreclosure lies ahead for many, but mass foreclosure sales will depress property prices, exacerbating the debt problem for a wider range of borrowers. Even many quite high-income families have been enticed into a lifestyle their income could not support, and could find that falling property prices push them over the edge. As sales will be very challenging, and bankruptcy laws have been tightened, many people could be tethered to unpayable debts for a prolonged period.

Financial Engineering – Hedge Funds, Derivatives, Leverage and the Repackaging of Risk

[In December 2006], another bit of news reached us: the derivatives market , in which hedge funds tend to speculate, has reached a face value of $480 trillion…30 times the size of the U.S. economy…and 12 times the size of the entire world economy. Trading in derivatives has become not merely a huge boom or even a large bubble – but the mother of a whole tribe of bubbles…dripping little big bubbles throughout the entire financial sector.

The ability to expand the money supply almost infinitely has been seized on by financial engineers interested in finding new and tempting ways to dress up leverage – seemingly eliminating risk while actually making it endemic through the financial system. The resulting derivatives have been called ‘financial weapons of mass destruction’ by Warren Buffet.

In order to sell mortgage-backed securities to investors, banks packaged them into different risk tranches of Collateralized Debt Obligations (CDOs) – investment, mezzanine and equity – concentrating the lowest risk elements in funds able to earn an investment grade rating. In order to sell the higher risk tranches, banks commonly set up hedge funds with enough seed capital to sell the securities to themselves. As housing prices rose, the securities appeared less risky, and so were able to attract outside investment and to be leveraged by being used as collateral for further loans. High performing funds, during the era of rising house prices, were tremendous engines of credit expansion.

Alternatively, equity and mezzanine tranches were often sold to large institutional investors, such as pension funds, willing to unwittingly accept illiquid securities with fictional marked-to-model valuations ultimately based on the ‘documentation’ provided with liar’s loans. These investors were chasing yield without realizing that they were chasing risk. The practice was colourfully referred to by insiders as ‘landfilling toxic waste’.

Rather than selling the risky securities, banks could also keep them, and the cash flows they generate, but insure them against default through a Credit Default Swap (CDS) – swapping the risk of default for a cash payment. The underwriting institution can then aggregate the CDS income stream into pools, themselves divided into tranches with different risk profiles. These synthetic CDOs are based, not on cash flows derived from borrowing money, but on cash flows derived from insurance premiums paid to cover the risk of mortgage default. Institutions can even insure against the risk of default on securities they do not own – creating synthetic CDOs and effectively shorting subprime mortgages or risky corporate bonds while once again hugely expanding supply of leveraged credit. Any default could therefore result in claims to underwriters many times as large as the supposed value of the underlying securities.

The danger is that underwriting institutions willing to accept huge amounts of risk in exchange for apparently being paid to do nothing, may not actually have the ability to pay out on default. The original institutions did not seem to ask too many questions of those to whom they had readily assigned the risk of default, but risk does not go away merely because one institution has paid a fee to another. The risk guarantee is only as good as the credit worthiness of the guarantor, and one commentator has described many credit default swaps as being guaranteed by Madame Merriweather’s Mud Hut in Malaysia.

International banking rules say that banks have to hold a certain level of spare funds (or reserves) to protect themselves from the danger that their loans might turn bad. However, since the banks had sold the risk of default on to somebody else, they could now argue that they did not need to hold these funds.

To anybody outside the world of finance, this might look odd (after all, the banks were still making loans); but the regulators accepted this argument, since the risk had moved, in accounting terms. And that let the banks free up funds to make even more loans. It was the financial equivalent of calorie-free chocolate: almost too good to be true.

Conflict of Interest – The Role of the Ratings Agencies

The ratings agencies that grade securities for investment purposes, and also depend on doing business with the same institutions whose bonds they rate, gave high ratings to mortgage-backed securities and did not lower them even as the housing bubble began to deflate. As the securities were not actively traded in a liquid market, the nominal marked-to-model valuations remained constant, and so did the ratings until recently. The danger is that lowering ratings below investment grade would force many institutions to sell them, potentially forcing those ‘assets’ to be marked-to-market where real bids, or the lack of them, would result in real market valuations. That would revalue a whole asset class at a stroke – revealing that the Emperor had no clothes.

It was a responsibility that ratings agencies were unwilling to take until forced by Bear Stearns’ declaration that two of its hedge funds were essentially worthless. A small percentage of mortgage-backed securities funds have since been down-rated and more have been placed on watch, but as yet there has been no real price discovery. Many investors are currently locked into hedge funds, delaying asset sales, but financial institutions can only maintain their solidarity for so long before they will have to act to extract what value they can from their collateral, even if that amounts to only pennies on the dollar. Ratings are likely to be downgraded only when they absolutely have to be. Ratings agencies have made it clear that rating securities does not mean that they do due diligence.

Moody’s: “Moody’s has no obligation to perform, and does not perform, due diligence.”

S&P: “Any user of the information contained herein should not rely on any credit rating or other opinion contained herein in making any investment decision.”

What then is the purpose of a ratings agency?

Private Equity and Leveraged Buyouts

As the housing market was beginning to decline in late 2006, the market for private equity deals, or leveraged buyouts, was taking up the slack and feeding the credit expansion boom. Private equity was able to use a small amount to borrow huge sums of credit in order to take large companies private, with the underwriting banks able to sell the resulting securities to investors. The target companies were then often asset stripped, loaded up with debt and sold back to the public in a private equity ‘strip and flip’. In this way, private equity was able to play off the public markets, extracting real value through the use of cheap credit loaned into existence for the purpose.

Many of these huge deals are now threatened, as investors are no longer willing to purchase the securities generated, leaving the underwriting banks holding the risk. Bridging loans are becoming ‘pier loans’ as they no longer lead anywhere.

The Inverted Pyramid – Money versus Credit (or Hyperinflation versus Hyperexpansion)

Money and credit are not the same thing, although people currently use them interchangeably. Money is a physical commodity, while credit is virtual wealth borrowed into existence. Money can be subject to inflation, either by printing currency or by debasing specie (reducing the precious metal content of coins), but does not disappear. Credit, on the other hand, can expand dramatically through financial alchemy, but has no physical existence, although its effects are certainly tangible.

Because credit is used as a money substitute in the financial markets, it acts as an inflationary force in the asset markets (and this spills over into the real world as the imaginary wealth thus created leads to overconsumption and malinvestments), but it is all ephemeral – in the end, it is still credit, not money. As soon as money is needed in lieu of credit, such as has now happened in the CMO and CDO markets, it becomes clear that the money simply isn’t there.”

Weimar Germany or present day Zimbabwe are examples of hyperinflation, but the Roaring Twenties and our situation are instead examples of credit hyperexpansion. Inflation is a chronic scourge, but credit expansions are self-limiting – they proceed until the debt that creates them can no longer be serviced, at which point that debt implodes in a sea of margin calls.

There is actually very little real cash out there relative to credit. The “sudden demand for cash” is in fact the world’s biggest margin call to date.

The value of credit is only as good as the promise that stands behind it, and when that promise cannot be kept, value abruptly disappears.

Let’s suppose that a lender starts with a million dollars and the borrower starts with zero. Upon extending the loan, the borrower possesses the million dollars, yet the lender feels that he still owns the million dollars that he lent out. If anyone asks the lender what he is worth, he says, “a million dollars,” and shows the note to prove it. Because of this conviction, there is, in the minds of the debtor and the creditor combined, two million dollars worth of value where before there was only one. When the lender calls in the debt and the borrower pays it, he gets back his million dollars. If the borrower can’t pay it, the value of the note goes to zero. Either way, the extra value disappears. If the original lender sold his note for cash, then someone else down the line loses. In an actively traded bond market, the result of a sudden default is like a game of “hot potato”: whoever holds it last loses. When the volume of credit is large, investors can perceive vast sums of money and value where in fact there are only repayment contracts, which are financial assets dependent upon consensus valuation and the ability of debtors to pay. IOUs can be issued indefinitely, but they have value only as long as their debtors can live up to them and only to the extent that people believe that they will.

Essentially, the gargantuan edifice of leveraged debt that has been accumulated during the years of credit expansion can be described as an inverted pyramid. Its point rests squarely on those at the bottom – for instance the subprime mortgage holders who’s relatively modest debts have been leveraged into trillions of dollars worth of derivatives. Each dollar of subprime mortgage debt probably underpins at least a hundred dollars of additional debt, and these loans will go into default en masse once the ARMs begin to reset in earnest. The leverage that has magnified gains on the way up, will magnify losses in a debt implosion on the way down.

Until now, his debt was an asset of the fund, and was being used as collateral against loans ten times its value. But the moment that Mr. Jones gave up on the idea of home ownership, the value of his mortgage simply disappeared. The paper asset, which derived its value from Mr. Jones’s promise, was destroyed. This had a cascading effect, since Mr. Jones’s mortgage was being used as collateral to borrow money to buy even more subprime mortgages, many of which were also defaulting. Assets purchased on borrowed money were now worthless. Only the debts remained, and suddenly there was more debt than the original amount that investors had put into the fund. These original funds would be needed repay the debts incurred by the fund. Nothing is left to return to investors.

Liquidity Traps and the Mood of the Market

Central bankers act as midwives for credit expansion – manipulating the cost of credit in order to encourage borrowing and lending. However, this cannot continue indefinitely as it does not occur in a vacuum. Central bankers have a range of options open to them, but ultimately the financial circumstances, and the mindsets, of both borrowers and lenders are important to whether or not credit expansion can be maintained.

The Fed really only can do two things. They can lower margin requirements for banks, the amount of capital they have to hold to make loans. That it has already driven to basically zero. So the Fed cannot allow banks any more “leeway” than it already has.

They can also perform open market money operations like REPOS and coupon passes. The Fed calls up big banks and buys their government bonds out of their portfolio. But they don’t buy them with real money; they buy them with credit newly created just for that purpose. The big bank can then lend that credit out in a much greater amount because the Fed only requires them to keep a small fraction of that credit to support whatever the bank wants to lend out. This is our wonderful fractional reserve system. If everyone went to the bank to get their “savings” at once they would find that they could get out less than 1%.

But here is the key. The bank must ultimately be willing to lend it and then find some investor to borrow it. This has been no problem whatsoever over the last several years. Now most investors realize that they have too much debt, that their level of income cannot support it. Banks realize this too and have increased their lending requirements. The last borrower is always the most aggressive speculator.

So most market participants are now looking for ways to pay back debt (deflation) just when the Fed is desperate to get investors to borrow more (inflation).

This conundrum is a form of liquidity trap – a shortfall in demand for credit that the policy tools of central bankers have great difficulty influencing. Keynes referred to this type of scenario as “pushing on a piece of string”. We are still in the early stages of this credit crunch and as yet, the Fed has not employed all the tools at its disposal. Most notably, it has not yet cut interest rates, likely due to recent Chinese threats to dump the dollar.

As the dollar should benefit from a flight to quality as credit spreads (the risk premium over treasuries) widen, there should be scope to cut interest rates later in the year. It is likely, however, that this will be less effective than the Fed would hope.

The theory is flawed. Central banks promising new credit to strapped banks only helps them with their current problems. It will not get new credit into a system that can’t take anymore. Banks, given their situation, are reducing drastically their new commitments, as they should. Borrowers can’t afford to borrow more.

The continuation of the credit expansion will remain dependent on a supply of ready, willing and able borrowers and lenders, and those already appear to be in short supply.

A trend of credit expansion has two components: the general willingness to lend and borrow and the general ability of borrowers to pay interest and principal. These components depend respectively upon (1) the trend of people’s confidence, i.e., whether both creditors and debtors think that debtors will be able to pay, and (2) the trend of production, which makes it either easier or harder in actuality for debtors to pay. So as long as confidence and productivity increase, the supply of credit tends to expand. The expansion of credit ends when the desire or ability to sustain the trend can no longer be maintained. As confidence and productivity decrease, the supply of credit contracts.

A significant headwind faced by the central bankers is the dramatic change in the mood of the market in recent weeks. It is said that humans have only two modes – complacency and panic, and markets, being a human construct, are no exception. The current mood of the market is one of fear, and if fear becomes panic, it can remove liquidity from the market far faster than even a central banker can pump it in. Actual cash is in short supply, and the many investors are afraid that the game of musical chairs will end before they can grab one of the very few chairs. If they do manage to find a chair, it will be difficult to convince them to part with it, no matter what the inducement. Risk has made a definitive comeback.

Deflation and the Mother of All Margin Calls

A credit expansion cannot be sustained indefinitely. At some point the burden of debt begins to stifle the ability to produce. The debt industry can take on a parasitic life of it’s own, becoming an integral part of the culture, from the level of the individual, as documented by James Scurlock in Maxed Out, to the level of corporations and government. The attention paid to assessing credit ratings, monitoring credit activity, hounding defaulters, writing off bad debt, juggling minimum payments, thinking of creative ways to exploit leverage, and encouraging every last entity to take on more debt in order that predatory lenders might wring out every last penny of profit, is attention not paid to productive activities of the kind that build successful economies. Eventually, it requires so much energy to maintain that economic performance suffers and extracting sufficient profit to cover interest payments on ever-increasing credit balances becomes impossible. A mood of conservation eventually takes hold, replacing the expansionary fervour, and reducing the velocity of money.

When the burden becomes too great for the economy to support and the trend reverses, reductions in lending, spending and production cause debtors to earn less money with which to pay off their debts, so defaults rise. Default and fear of default exacerbate the new trend in psychology, which in turn causes creditors to reduce lending further. A downward “spiral” begins, feeding on pessimism just as the previous boom fed on optimism. The resulting cascade of debt liquidation is a deflationary crash. Debts are retired by paying them off, “restructuring” or default. In the first case, no value is lost; in the second, some value; in the third, all value. In desperately trying to raise cash to pay off loans, borrowers bring all kinds of assets to market, including stocks, bonds, commodities and real estate, causing their prices to plummet. The process ends only after the supply of credit falls to a level at which it is collateralized acceptably to the surviving creditors.

In such an environment, financial values can disappear very quickly, leaving behind only stranded debt. All it takes for an asset class to be devalued is for as few as two parties among many to agree to a new lower price. The remainder need do nothing, other than refrain from disputing the new valuation, for their net worth to fall. In this way, a few discounted house sales can bring down the value of a neighbourhood, and that lost value, which may have been underpinning a hundred times its worth in leveraged debt, is magnified through the inverted debt pyramid. The majority who do nothing end up watching the investment value of their assets plummet, while the owners of debt attempt to call in whatever value they can, from wherever they can, through margin calls.

The United States faces a severe credit crunch as mounting losses on risky forms of debt catch up with the banks and force them to curb lending and call in existing loans, according to a report by Lombard Street Research.

“Excess liquidity in the global system will be slashed,” it said. “Banks’ capital is about to be decimated, which will require calling in a swathe of loans. This is going to aggravate the US hard landing.”

“The complexity of this era of credit liquidation,” as Robert Smitley wrote of the Great Depression in ’30s America , “is far too great for the mob mind to grasp. It is hardly possible for them to see the picture wherein about $700 billion dollars of physical and intangible wealth is attempting to be turned into about $5 billion dollars of money.”

How much intangible debt now needs to be squeezed back into how much real money? It would be easier to find a cheap mortgage – with no ugly ARM once the teaser is finished – than guess at those numbers today.

Senators Obama and McCain are both aware that energy is central to Americas future. However, they differ on the details, and since confidence and authority can sway peoples beliefs, it is important, as always, to ‘check the facts’. In last nights debate, Obama, while pointing out the US holds 3% of world oil reserves but uses 25% of world oil production said that we need to ‘change the way we view energy in our lives’ (to me implying that becoming energy independent is unlikely). In contrast, while McCain agreed on ‘ridding ourselves of dependence on foreign oil’, his discussion of the “Drill Here Drill Now” strategy implied that such a plan would achieve both lower prices and more energy independence. How much of the energy debate issues are ‘politics’ vs. facts?

Below the fold is a guest commentary by Professor Cutler Cleveland, providing a needed ‘fact-check’ on recent political claims being made on offshore drilling.
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FACT CHECK

In the run-up to the election, this is the first in a short series of brief fact-checking exercises regarding the major energy issues in the campaign.

Senators McCain and Obama have expressed support for increased offshore oil drilling as part of their respective plans for energy. Senator McCain specifically suggests that opening offshore waters in the U.S. to oil exploration will (a) significantly increase domestic production, and (2) put downward pressure on oil prices.

Is this true? The short answer is no.

The federal government controls access to the Outer Continental Shelf (OCS), which refers to the submerged lands under the ocean farther than about 3.3 miles from the coast (about 10 miles from Texas and the Gulf coast of Florida). Land closer than that is under state jurisdiction; land beyond about 230 miles is in international water. Beginning in 1982, Congress passed and has subsequently renewed moratoria on the leasing of federal land off the coast of all states except Texas, Louisiana and parts of Alaska. All existing moratoria on leasing in the OCS will expire in 2012. Debate now centers on whether or not to renew the moratoria.

The Minerals Management Service (MMS) of the U.S. Department of Interior estimates that there are about 86 billion barrels of technically recoverable oil in the federal Outer Continental Shelf; the Lower 48 OCS accounts for about 59 billion barrels. By way of comparison, U.S proved reserves of oil are about 21 billion barrels.

The Energy Information Administration (EIA) of the U.S. Department of Energy used the MMS data to assess what impact a lifting of the ban in 2012 for the Lower 48 OCS would have on U.S. oil production. Basically, the EIA estimated what fraction of the technically recoverable oil would be economical to recover, and how fast it could be produced after 2012. Leasing would begin no sooner than 2012, and production would not be expected to start before 2017. The EIA found that access to the Pacific, Atlantic, and eastern Gulf of Mexico regions would not have a significant impact on domestic crude oil production or prices before 2030. Total domestic production of crude oil from 2012 through 2030 is projected to be 1.6 percent higher than in EIA’s “no access” reference case.

The effect of that quantity of oil on the price of oil would be indiscernible. Oil prices are determined on the international market, and the addition of about 0.16 million barrels per day from the OCS in 2030 to total world oil production would have no significant impact on oil market fundamentals. The world consumed about 86 million barrels per day in 2007, and will consume about 112 million barrels per day in 2030, according to EIA forecasts.

Adding the Alaska OCS to the mix would not appreciably alter this conclusion, as that oil would be even more costly and in terms of dollars and time compared to Lower 48 OCS resources.

Thus, lifting the ban on offshore drilling will not significantly increase domestic production, nor will it put downward pressure on oil prices.

There may be other arguments for offshore drilling, such as domestic job creation and tax revenue, improved balance of payments, among others. But those are subjects for another analysis….

Professor Cutler Cleveland
Boston University
10/08/2008

Sources:
–Energy Information Administration, Impacts of Increased Access to Oil and Natural Gas Resources in the Lower 48 Federal Outer Continental Shelf, Annual Energy Review 2007.
–Minerals Management Service, Assessment of Undiscovered Technically Recoverable Oil and Gas Resources of the Nation’s Outer Continental Shelf, 2006.

Some of Dr. Clevelands previous work posted on theoildrum:

On Energy Transitions Past and Future – Cutler Cleveland
Ten Fundamental Principles of Net Energy Analysis – Cutler Cleveland
Energy Return from Wind – Cutler Cleveland and Ida Kubiszewski

In what feels like the middle of a multi-round heavyweight bout, the world financial markets continue to be buffeted tonight, following the recent trend of lower equities, stronger dollar (vs Euro, SF and Sterling), sinking energy and commodities prices and considerably less confidence in the overall system than in weeks prior. Theoildrum.com has historically focused on the biophysical aspects of a world economy based on energy (and occasionally the human aspects that impact energy demand). Most research here attempts to predict what world oil and gas production might look like in a future where depletion inexorably overtakes technology, and the costs of procuring large amounts of quality fuels continue to increase. However, the spiralling of recent events make it likely that, at least for a time, be it a week – or several years – oil and gas depletion might be more than offset by the reduction in demand due to the manifold implications of the reduction in global financial leverage and resulting credit contractions and dislocations in the real economy. The linkages between finance and energy are becoming more direct, but I’m quite certain there are many under the surface we are yet unaware of.

Below are a few article links followed by some open ended questions. Please deposit data, charts and links of relevance.
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From Nouriel Roubini’s article in Forbes:

In a solvency and credit crisis that goes well beyond illiquidity, no one is lending to counter-parties as no one trusts any counter-party (even the safest ones), and everyone is hoarding the liquidity that is injected by central banks. And since this liquidity goes only to banks and major broker-dealers, the rest of the shadow banking system has no access to this liquidity as the credit transmission mechanisms are blocked.

From Bloomberg, on European Union Leaders Stop Short of Regional Plan on Bailouts:

Sarkozy said that “all actors” must be supervised, including rating firms and hedge funds. Executive-pay systems must also be reviewed, he said.

“We want a new world to come out of this,” Sarkozy said. “We want to set up the basis for a capitalism of entrepreneurs, not speculators.”

Anticipating increased spending, declining tax revenue, and government bank takeovers, they called for “greater flexibility” in the application of European Union competition and budget rules.

And in addition to an earlier announcement that Germany would guarantee all bank depositors (much like Ireland announced last week), HYPO did get a 50 billion Euro government led bailout. This on the heels of BNP Paribas buying out Fortis earlier today.

Tonight the Euro continues to weaken, and is now at levels not seen since late 2004. It is difficult to keep tabs on all that is happening, both globally, nationally, and locally. My personal view of our future continues to be a probabilistic distribution of many possible outcomes, the odds and timing of each, periodically adjusted based on the actions and feedbacks of important world actors. The ‘public’ is likely to become as important an actor as any.

The odds that peak oil is now behind us are now (in my opinion) nearly 100%. The odds of global economic expansion (and growth) now being over are also high (this has been oft-analyzed but here is a good overview of the reasoning). Whether we will have inflation or deflation of ‘money’ (as opposed to the four real capitals: natural, built, social and human), is still an open question and depends on what path world central banks choose. History suggest that the news has been so bad for so long that we are due some respite from concerted central bank intervention that props up confidence and the markets for a time. But history has been based on growing energy surplus, and ultimate confidence that one will get a return OF capital in addition to a return ON capital. Thus, the current financial/energy landscape may accelerate the popular modern timing of exchanging bank digits for real capital from the end of ones career, to somewhat earlier. Yes, this time it may be different.

Recent events are certainly stirring the pot of possibilities – here are a few questions for general discussion: (no right or wrong answers…;-)

- If/when the dollar rally ends will the oil sell-off end as well? Or do they have fundamentally different causes? (Here I would suggest that oil selloff is largely capital flow/hedge fund driven, and dollar rally has been largely flight to quality and repayment of debt denominated in dollars and leverage is mandatorily reduced.) (Note: Dollar rally vs Euro is 82% correlated with rise in 30 Yr Treasury prices

-What impact would a demise of the Euro have on the future for energy? (Note: tonights ECB call for ‘greater flexibility’ does not seem consistent with formal limits on borrowing and fiscal deficits by EU members under the Stabilization Pact)

-Will the fall out from the credit crisis cement peak ‘energy’? (Presumably, we are headed for a depression and concomitant demand reduction – will the time gap brought about by credit crisis in creating/financing of new energy infrastructure now be overtaken by ongoing depletion in coal, nuclear, and oil industries?)

-Given what is happening, would a ‘fast-crash’ scenario be, in many respects, preferred to a long drawn out slow crash? (In the sense that a fast crash leaves more quality resources in the ground, and creates enough pain and recognition that our current ‘ends’ are not the best way to spend our remaining fossil energy surplus?)

-If Peak Oil means the end of growth (I think this likely but not certain), what do people do with IRA’s/401ks that aren’t due to be redeemed for 10-30 years?

-Would a concerted 100 basis point global ease this week do anything?

-What other Black Swans could make this situation better, or worse?

It seems (at least one) genie is out of the bottle. The time to ask comfortable questions and get comfortable answers may be passed. But uncomfortable answers probably still have a window.

Note: This is an updated version of a post from earlier this week. Some more recent quotes have been added at the end of this post.

Despite recent optimistic news on new shale gas reserves, the totality of North American natural gas production remains on a treadmill, as the grim EROI reaper has relentlessly raised the marginal cost of producing- to currently above the price of natural gas futures. While shutting in production is not easy to do once wells are drilled, low prices with rising cost structures can put the crimp on future expansion. Chesapeake (CHK), the largest US natural gas producer and operator of land rigs, announced last evening they will be curtailing production, cutting their rig count and reducing capital expenditures. (Of course, it is possible that this is the first example of an energy production casualty due to the credit crisis if the reason for this capex drop is lack of easy funds…)

In recent years, each time Chesapeake Chairman Aubrey McClendon announces some production or capex decreases, it has marked a bottom in the commodity (see graphic below fold). As this will surely be followed with similar announcements by other E&Ps in the near future (I expect Sanridge Energy and Petrohawk Energy soon), there will soon be a drop in monthly gas production–perhaps as much as 5%.

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(Note: Most of TOD:USA is still at ASPO – sincere apologies to everyone I missed at that conference- I will be unable to add comments to this post as I am taking a 7 day hiatus from technology)

Here are some of the historical oildrum posts on net energy, increasing costs of North American Natural Gas, and the related issues:

An Update on the Energy Return on Canadian Natural Gas
At $100 Oil, What Can the Scientist Say to the Investor?
The Energy Return on Time
Peak Oil – Why Smart Folks Disagree – Part II
Ten Fundamental Truths about Net Energy
The North American Red Queen – Our Natural Gas Treadmill
Energy From Wind – A Discussion of the EROI Research
A Net Energy Parable – Why is EROI Important?
Natural Gas and Complacency

Here are some details from Chesapeakes announcement last night:

It will temporarily cut production by a net 100 million cubic feet per day in the Mid-Continent, where wellhead prices of $3 to $5 per thousand cubic feet were “substantially below” break-even. That is 4 percent of its total capacity.

“Chesapeake will monitor market conditions and bring curtailed natural gas production volumes back on stream as prices improve,” Chief Executive Aubrey McClendon said.

The number of its operated drilling rigs will fall to about 140 rigs by the end of this year from 157 now, and that will stay steady for the next two years, the company said.

Here is a price chart of Chesapeake above a price chart of natural gas, showing the last 2 times CHK reigned in production:

CHK and NG price charts. Red dots indicate capex reductions (Thanks Chris Meeks – Johnson Rice)

Marginal Cost for North American Nat Gas Production (Johnathan Wolff, Credit Suisse Equity Research)

From the Credit Suisse Report (9/8/2008)

Economic Breakeven Gas Price Rises to $8.16 per MMBtu: We now estimate that the economic breakeven (for a 10% return) NYMEX natural gas price to be in the $8.16 per MMBtu, up from a Q108 estimate of $7.81 per MMBtu (see Exhibit 8). The components of our break even analysis include $3.47 for direct cash costs (lease, operating, production taxes, G&A and interest), a 35% tax rate and $3.00 per Mcfe for D,D&A (versus the industry average $2.49 per Mcfe rate in Q2) reflecting a more “current” cost of adding fully developed reserves. We also “gross up” the NYMEX price needed to get a 10% return by adding a typical industry average basis differential of $0.60 per MMBtu. We then compute the price needed to achieve a 10% after-tax return.

As shown in Exhibit 4, the price needed to get returns has risen dramatically in recent years from about $4.47 in 2003 to $7.05 by 2006 and $8.16 today (and should rise to $8.27 in 2009). Cost inflation has been much more secular than cyclical in our opinion amid an industry shift to poorer reservoirs (i.e. tight gas, shales) that require deeper drilling and complex and long horizontal completions. Likewise, we see a continuation of secular cost inflation (albeit at a slower rate) amid a continued shift to lower quality, deeper reservoirs in the U.S.

Similar proclamations, about costs rising faster than the underlying commodity have been voiced regarding oil as well:

9/12 SAME IRR’s AT $100 AS WE USED TO HAVE AT $40-$50 PER BBL
Wood Mackenzie Richard Lines, head of petroleum economics, “Companies are making the same internal rate of return on big, capital intensive projects at $100 a barrel as they were four to five years ago at $40 because costs had risen so dramatically and fiscal terms deteriorated.”

9/16 OIL PRICE FALL PUTS PROJECTS AT RISK
CEO of TOTAL “Few projects have been given final investment decisions over the last two to three years because their economics have been so marginal and the overall risks have gone up,” adding this would impact the amount of oil supply in the market.

9/17 OIL FIRMS PRODUCING AT A LOSS DUE TO LOW CRUDE PRICES
“For the first time in the history of the Russian oil industry, a remarkable threshold has been achieved — Russian oil producers are transferring everything they get from customers for crude oil exports to the budget,“ (Moscow Times –UBS Analyst)

In 100 years, we will still have hundreds of billions of barrels of oil underground. The question comes down to cost, which is a function of the merging of technology and depletion. As energy costs rise, dollar costs accelerate until we reach a point where marginal projects (especially in a fragile credit environment) are scrapped. This in turn puts a cap on production, which (assuming demand remains constant) raises price. Aubrey Mclendon’s recent strategy is thus consistent with Hotelling Theory, which predicts that as acknowledgement spreads about intermediate and long term scarcity of a commodity, some of it will be saved in situ, to maximize total future rent (e.g. sell 10% less gas, but at 20% higher prices or some such). A critical analysis would be to see how much of total oil and gas is ‘fixed’ vs ‘marginal’. In other words, low EROI reserves that were still being pulled out of small wells in the Gulf of Mexico due to very low marginal costs, became energy sinks after Hurricane Ike necessitated repair/rebuild. The cost from this point forward was too high. How much of the oil and gas circulating in the world system was discovered and is being extracted on infrastructure built long ago…..?

What does this all imply for natural gas (and oil) production and prices going forward? What % of production will be rise to ‘the marginal BTU’ in coming years? What happens as EROI of conventional hydrocarbons approaches unity? For the oil and gas cornucopians out there – how much will it cost to maintain current production for the next decade, let alone increase it?

The Red Queen wants to know.

(UPDATE 9/26: Here are some thoughts from Johnson Rice natural gas analyst Chris Meeks, where Nate got the above CHK/NG charts)

THE THESIS:

Nat gas is going to rally …. I will tell you how.

THE LOGIC:

Today on my screen the NG/1 price of natural gas is $7.83/mcf. Many people think this is the price E&P companies get for their natural gas. Nothing could be farther from the truth. The table below shows what different Hubs are paying for natural gas this morning. Note that all but the Hubs in the East are well below the NG/1 contract…many are well below. Most notable are the Hubs in the West (Opal, Blanco, and Cheyenne) with an average price of $4.47/mcfe and in Canada where nat gas is currently $6.09/mcf.

Now here is where the rubber meets the road. The prices below are the prices paid to E&P companies for gas delivered to the Hub. E&P companies have to process and transport the natural gas to the Hub in order to realize this posted price. A guesstimate of processing and transportation costs is about $0.50/mcf, or $0.50 below prices quoted at the Hub. Add royalties to the land owner (on average 20%) and production taxes (another 5%) and an operator in the West is probably netting back something like $2.97/mcf for their gas ($4.47 less $0.50 less 20% less 5%). Simply put, with nat gas at current prices they are losing money, and you don’t drill new wells if you are losing money. Economics are not much better for operators delivering into other Hubs. Few E&P companies can make money at current nat gas prices with all-in costs (F&D, LOE, G&A, taxes, royalties).

Because nat gas prices are extremely dynamic, many of the larger E&P companies hedge out future production to negate price risk. But, here is the problem: over 40% of the 1,853 rigs currently drilling for nat gas in the US are operated by privately owned, much smaller companies that as a general rule do not hedge out future production. That’s 800 rigs. CHK recently announced it is cutting its rig count by 10%; CHK will still operate 140 rigs. They can do this because they have extensive hedges in place above $8 for 2008 and 2009 that make it possible. Other E&P companies both private and public have not hedged and cannot drill through this low price environment. You can take it to the bank: other public companies will cut their rig counts very soon. Private companies do not make announcements that they are cutting rigs, they just do it. With the nat gas prices below I can assure you the private companies will be laying down rigs. THEY SIMPLY WON’T DRILL WELLS TO LOSE MONEY. They will cut capex and curtail production. If these low natural gas prices last much longer, Aubrey’s statement that the rig count could go down as many as 400 rigs will come true.

The production response to a lower rig count is pretty quick. A lower rig count means lower production, which means higher prices. I am a dumb geologist, but I know that. Add to the mix: we have had two hurricanes (which caused more damage than people think in the Gulf) that will take an additional 300 bcf out of the nat gas supply; oil is $100 per barrel (have you seen the storage levels of crude oil, gasoline, and heating oil?); winter is just around the corner, and you have the perfect recipe for a strong rally in nat gas. It is coming…stock market meltdown or not.

Let’s get real here. These low [non-Hub] prices are not sustainable. Under the current price scenario the Barnett, Haynesville and a few other smaller trends would be the only economic plays in the US. The US consumes on average about 70 Bcf of nat gas a day. If the Barnett and Haynesville were in full throttle they might produce 15 Bcfpd at peak. That is 5 years out at the earliest. We still need to supply 55 Bcf a day of demand. That gas has to be imported or produced somewhere else in North America. The only way that happens is if gas is priced where E&P companies can make money, and that, my friends, is well above the current price. Nat gas prices are going up. Nat gas prices have to go up.

Update by Gail the Actuary

I talked to Nate and am adding a few perspectives from recent business magazine articles:

One of Chesapeake’s problems comes from its hedging activity. According to Business Week:

Oil Producers’ Bad Bets

Producers’ attempts to hedge against falling prices are falling victim to the oil market’s volatility

Trying to guess whether oil prices, which jumped by as much as 25%, to $130, on Sept. 22, will surge or slump? Don’t look to the commodity producers for answers. Even companies pumping oil out of the ground don’t have a clue where prices are headed. In this volatile market, several industry players have made ill-timed bets that have wiped out their profits. . .

That’s essentially what happened to Chesapeake Energy (CHK), Newfield Exploration (NFX), Noble Energy (NBL), Range Resources (RRC), and others in the latest quarter. As energy prices reached new heights, the companies’ core businesses pumped out healthy profits. But those earnings evaporated as a result of their trading operations. “A lot of people got creamed,” says industry analyst Stephen Schork.

Another part of its problem comes from its leverage. According to WSJ:

Cash-Rich Oil Firms Snap Up Assets

The turmoil on Wall Street is reshaping the U.S. oil industry, forcing debt-laden smaller producers to sell assets and creating opportunities for larger, cash-rich companies that until recently had been criticized by investors for spending too conservatively. . .

Oil prices, though still high by historical standards, have declined more than 25% from their July peak. Natural-gas prices have fallen even more sharply as rising production has led to fears of a looming glut. And many energy companies have seen their share prices plummet 40% or more from their highs in June or July.

The shift has led to a scramble for cash just when the global financial crisis has made it hardest to come by.

Chesapeake, the U.S.’s largest producer of natural gas by output, Monday said it would cut capital spending by $3 billion, or 17%, through 2010. To help fund its drilling program, the company said it will sell $13 billion of assets during that same period.

According to Oil & Gas Journal, part of the problem is current oversupply of gas, and resulting low price:

Chesapeake Energy slashes drilling budget

HOUSTON, Sept. 25 — Chesapeake Energy Corp., the second-largest independent and third-largest overall producer of natural gas in the US, is slashing its drilling capital expenditure budget by $3.2 billion, or 17%, for the second half of 2008 through 2010.

Company officials blamed a 50% drop in gas prices since June and the possibility of an emerging gas surplus in advance of increased demand from the US transportation sector.

“Expect other firms to follow Chesapeake’s lead and lay down rigs as well,” said analysts in the Houston office of Raymond James & Associates Inc. “We continue to see reduced drilling activity (lower rig count) as necessary to balance the natural gas market. Still, this may lead to the decline in activity about a quarter earlier than we anticipated.”

The above article goes on to say that production is expected to continue to rise, even with the reduced rig count:

Moreover, Raymond James noted, “This does not seem to be a fundamental savior for gas prices since Chesapeake still plans to increase its production by 16% year-over-year despite 11% less rigs.”

Forbes’ view is similar. Chesapeake is cutting production because of the current oversupply and resulting low price:

Analysts praise company’s decision to cut drilling

Analysts on Tuesday praised Chesapeake Energy Corp.’s decision to reduce drilling for natural gas amid concerns of a gas surplus.

Oklahoma City-based Chesapeake Energy (nyse: CHK – news – people ), the largest producer of natural gas in the U.S., said Monday that it is cutting its capital budget by $3.2 billion, or 17 percent, from the second half of 2008 through 2010. The company said the move is in response to an approximately 50 percent decrease in natural gas prices since June 30 and concerns about the possibility of a gas surplus in advance of increased demand from the U.S. transportation sector.