Swan Dive

October 9, 2006
     Against the background of everything else happening in the financial markets is the apparent circumstance of peak oil. Even The New York Times joined the chorus in a Sunday editorial, saying:

Our demand for petroleum products strains the limits of the global capacity to supply them. In past decades, if a pipeline broke in Nigeria, Saudi Arabia might compensate by setting workers to pumping more oil. Now, with little additional capacity, rising prices are necessary to balance out supply and demand.

     No more increasing capacity = peak oil.
     It's as simple as that. We now have nine and a half months of "rearview mirror" action to look back and see that world oil production has retreated from its all-time high of just over 85 million barrels a day (m/b/d) achieved in December 2005 (just as geologist Kenneth Deffeyes of Princeton had predicted). For 2006, production has remained in the 84 m/b/d range every month reported so far, while demand has exceeded that.

     Texas oil man Jeffrey Brown, a commentator at TheOilDrum.com, the outstanding oil discussion group on the Internet, makes the point that Saudi Arabia is at the same point statistically (in terms of ultimate recoverable reserves) that Texas was at in 1972 when production there peaked. The world's four greatest oil fields are in depletion (Burgan [Kuwait], Daqing [China], Cantarell [Mexico], and Ghawar [Saudi Arabia]) and these have accounted for over 14 percent of the world's oil production. (Ghawar alone accounts for over 60 percent of Saudi Arabia's production.) The North Sea has peaked and production there is "crashing." Venezuela has peaked and its oil is shitty heavy crude. Indonesia (an OPEC member) has peaked and is now a net oil importer. Nigeria's political chaos is making production increasingly difficult-to-impossible. Production in the Canadian tar sands is not making up for losses elsewhere. The US is down to about a four-year supply of conventional crude and condensates while we import 70 percent of the oil we consume. Discovery of new oil (including Chevron's largely hypothetical deepwater "Jack" finds) is barely covering a fraction of the world's consumption. So it goes....

     Where finance is concerned, the basic implication of peak oil is pretty stark: an end to industrial expansion (i.e. "growth"). All the alternatives to oil will not keep the industrial economies expanding -- they can only slow down a contraction, and only marginally so. The trouble with this picture is that finance is a system that uses paper markers to represent the hope and expectation for the expansion of wealth. These markers are currencies, stocks, bonds, option contracts, derivatives plays, and other certificates that are traded in open markets. If there is no longer any hope of increased wealth in the world, then all those tradable paper markers become losers. Their value unwinds and imagined piles of wealth evaporate into thin air.

     The unwinding process depends on the psychology of the people who own these certificates. If they do not understand the global oil situation and its implications, then they will continue to hope for and expect expanded wealth, and thus continue to regard their paper certificates as credible markers of value. And that is largely the case at the moment, since most of the playas in the financial markets are not paying attention to the peak oil story, or don't believe it is for real.

     Two special and transient circumstances are now propping up the financial markets. One is that for practical purposes the world is virtually at peak, meaning this is an extra-special time of strange behavior (like the point in the apogee of a steep sub orbital flight in which passengers become momentarily weightless). Supply and demand for oil are only beginning to go out of whack (that is, demand just barely exceeding supply). Even at this early stage, the oil markets themselves are showing stress, as hoarding behavior sets in and induces wider swings of price volatility. But these swings in oil prices -- such as the one we're in right now, where prices have crashed 20 percent since the panic buying (hoarding) of June and July -- send false signals to the financial playas. The main false signal is that all is well on the global oil scene...there's no real supply problem...and hence no threat to the continuing expansion of industrial production and its associated wealth-generating activities. This signal just tells the playas to buy more paper markers. Thus, the stock market goes up.

     The second special and transient circumstance is that so much wealth has already accumulated along the way to peak, that financial markets take on a life of their own -- as existing wealth "invests" itself in more paper markers hoping and expecting to "grow" into even more wealth. The problem here is that existing wealth is actually being squandered, since the paper markers will only lose value as the hopes and expectations vested in them dissolve in disappointment. But we haven't quite reached that point yet.

     In simply bidding the markets up, the system has spun off even more gobs of presumed wealth. Some of this "liquidity" -- say, in the checking accounts of people who work for Goldman Sachs -- has found its way into Manhattan condominiums, or Aspen McMansions, and filtered through the system to everyone from the lawyers who write up the pre-nuptial agreements to the guys who sell the furniture to the people who drive the delivery trucks that bring it to the door, to the men laying tiles in the new bathrooms.

     The basic insanity of a system that presumes vastly increased wealth where none will occur, has led to further distortions in finance. The most obvious one is the so-called housing bubble. The misplaced extreme expectation in the ever-increasing value of paper wealth, led to the hijacking of mortgages by financial playas who bundled them into odd lots of tradable debt (promises to pay) and used them to leverage abstruse bets (hedges) on the behavior of other kinds of paper markers (currencies, interest rate differentials, commodity prices) -- very profitably as long as all playas believed that industrial societies that run all oil would continue to grow, to produce more wealth. The level of abstraction in these rackets -- their distance from the reality of productive activity --is self-evident.

      But they were so successful that the profligate creation of ever more mortgages became an increasingly reckless and irresponsible enterprise. Contracts were made with house-buyers who had no record of credit worthiness and often no real proof of income. Contracts were made on terms (interest payments) that were deceptive, even ruinously false, for the house-buyers. The reckless reassignment of lending risk into ever more abstract layers of deferred obligation, and the ease of credit that ensued, allowed millions of ordinary people to acquire real property on unrealistic terms, which had the affect of bidding up the price of houses that these owners will eventually have to surrender for nonpayment.

      That process is now underway. The reckless creation of mortgages had the further effect of stealing demand for house-building from the future. So many new houses were built and then sold to people who will probably have to surrender them, and then so many more beyond that were built in the expectation and hope that reckless mortgage creation would continue forever, that there is now a massive over-supply of total existing houses while the pool of suckers for new ruinous mortgages has shrunk to zero.

      Similar excesses in all the other lending and debt sectors, including "non-performing" credit card obligations and government deficits, will also unwind and thunder through the system.

      Meanwhile, the false signal from the oil markets that has been broadcasting for eight weeks will come offline and a new signal will come on as prices go back up. The pause in bidding for future oil induced by the panic over-buying of the summer will end. The heating season is here. It's 40 degrees out in upstate New York this morning and the furnace is cranking. The Chinese and the Indians and even the people in France have not stopped using oil, even if Americans have put their Winnebagos up on blocks for the season.

     As the price of oil goes back up, the financial markets will get a new signal that running industrial societies has just gotten more expensive again. That will dampen hopes and expectations for increased wealth from these societies. Meanwhile, the air will be coming out of millions of mortgages, and the loss of value will spread among playas holding these bundles of mortgage debt (i.e. promises that money spent on houses is being paid back, which it won't be). At the same time the houses themselves will lose value as the pool of potential buyers shrinks to nothing. That is, the inflated value (high price) of these assets will deflate.

     As this occurs, there will be far fewer wage-earners putting up additional houses, fewer furniture sales, fewer trips by delivery truck drivers and fewer tile-jobs in the McBathrooms.

     This is why I view the fall melt-up of the stock markets as a swan dive. We're at the apogee now, just as the world is at the apogee of its oil production. I confess, I thought the reality of our economic predicament would be recognized by the playas and their markets sooner than it has. It turns out the the chief luxury of the final cheap oil blowout has been the artificial support of unrealistic hopes and expectations.

Comments

[Weaseldog]

Nice Post Jim.

[dangerbird]

Again. My case makes itself for me.

[Weaseldog]

How are the Congressional Pedophiles that you worship, doing today Dangerbird?

Is there anything you'd like to say in the defense of your Child Molesting Owners?

What are the current Pedophile Talking Points?

[Steve B]

Jim,

You're just a bit early on your prognostications. Witness the Dot Com Crash: like some folks found 1998 or 99, it can be surprisingly hard picking the exact moment that crowd euphoria peaks. It'll happen though, and the delay will just make the reversal all the more dramatic. Twenty or 50 years from now, it'll seem like you were spot on.

Nice post.

[mr. x, now Mort]

Nice post on peak oil, I agree. As to the stock market and housing bubble, they are easily explained with three words: "Other people's money".

[dangerbird]

I wouldn't know, yippie. Why don't you blindly throw some more bombs. Keep flailing away like a madman. Maybe one of your blind punches will hit.

[KJ]

Nice of you to skip the iraq bs, this is why people read your well informed blogg.

[Hincho]

Jim's piece reminds me of Kurt Vonnegut's novel "Galapagos," in which the world is suffering a economic depression (people have suddenly agreed that their currencies, which aren't backed by anything, aren't worth squat). The book focuses on a group of people who, despite the collapse of civilization, are going on a vacation trip to the Galapagos Islands. They remind me of present-day American citizens -- hauling ass in their SUV's, desperately trying to convince themselves that having fun, no matter the cost, will regime-change reality.

[dangerbird]

Ah yes. The crack-heads of doom continue hitting on the pipe, even though it is played out. There's nothing left in that bowl man. Its played. You have to move on(.org), to the next crack vile of doom.

[kd]

Good post, Jim.

*

And in the midst of it all there's the Texas boondoggle:

http://en.wikipedia.org/wiki/Trans-Texas_Corridor

[grok]

While hunting with a TV changer, I came across a series of shows where people would buy real estate, do stuff to it and sell for a hefty profit.

The first was a mansion in ca. that was dated abit bought for 1.1 million , spent 300k doin' floors, decks new countertops. Now this house had corinander fake stone countertops but not in fashion anymore. The floor was replaced at great cost. Deck too.

What they didn't do. They didn't set up any energy saving devices, structures, installations, etc. Zero. Not one thought on energy use.

I believe they flipped the house and made .7 MILIION.

In another episode they had a hispanic group buy and renovate 5 small working class houses on the same street. They were in rough shape. Replaced windows, repaired exterior and sheetrock. New waterheaters, painted, repaired replaced floors. Energy was discussed in water heater use. I think they made 55 k for all 5 houses.

My belief is there is alot of fluff in the high end market.

[grok]

Are "MURICANS going to let eee-ran explode a nuk-lear bomb?

[Barry]

The 'boy king' must be having a fit - the U.S. Navy commissioned a new carrier after 'daddy' - and everyone knows Georgie Boy is the 'war prezdunt' - the shame, have they no sensibility at all?

[dangerbird]

Its nuk*u*lar, Grok. Kaynt youins' talk raht aynglish?

[Hincho]

That's right, Dangerbird, keep on playin' that gee-tar! It's all a Neil Young feel-good trip! I guess you take "Keep on rockin' in the free world" literally. I don't; neither does Neil.

[grok]

The crack-heads of doom continue hitting on the pipe, even though it is played out.

DB you *crack* me up.

aRE YOU CALLIN' THE 'MURICAN PEOPLE CRACKHEADS BECAUSE OF THEIR ADDICTION TO THE HYDROCARBON CIVILIZATION?

Shame on you!

Don't you know IT'S NON-NEGOIABLE!

THE AMERICAN WAY OF LIFE WILL CONTINUE FOREVER AND EVER AMEN.

And then the 'muricans closed their eyes and dreamed of unearned riches, one-arm bandits and the lovely aroma of Cheez Doodles.

[SqueakyFrump]

I enjoyed yesterday's Sunday Los Angeles Times editorial piece "Living Large---There'll Soon be 300 Million of Us. But Don't Worry, There's Plenty of Room", written by Gregg Easterbrook of the Brookings Institution. Oh, he's just sooo optomistic. He cites the USGS's 40-year supply figure....that "the global economy is likely to have moved beyond petroleum before the oil runs out"........immigrants are a "net plus" to the economy. As for suburban sprawl, we could stop it by imposing taxes, but 'what right do those ensconced in nice communities have to deny the same chance to others?". Oh...and rising population is a fantastic achievement: It means "ever-more people get to experience love, hope, freedom and the daily miracle of the rising sun". And people will read this drivel and believe it

[Dave]

CNN Headline news yesterday (Sunday) had piece with the commentator asking the expert talking head if this was a "Crash". The expert said no just a mild geographicly determined correction. No need to worry because everyone has already made so much money in the last five years so what if they lose 10 or fifteen percent. The wagons of everything is normal don't worry and be happy are circling.
What is to be done with my 401K funds ? Any ideas ? The only loot I have is a small house in the city that I owe 44 thou. on and is worth presently only about 55. The 401 K in a "stable value fund" is about what I have to go into this shitstorm with and I'm sort of spooked about how to deal with it all. I have no credit card debt and am presently working in a very energy intensive sales position. ? What would you suggest fellow bloggers ? Inquring paranoids want to know !

[grok]

The Japanese market became so frenzied in the days before the real estate crash that the land in Tokyo owned by the royal family was valued more than all of California.

This crash plunged Japan into a 13 year deflationary economy.

Remember in 1985 we thought at that time they were going to surpass us in GNP.

[grok]

Dave,
Find a job or series of skills that go into the future. Localize your living arrangements...can you walk, bike, take public transportation, rideshare 20 minutes to do everything assciated with living? Be local.

[kd]

Amazing, Dave, that your house (even a small one) in the city is worth only 55 thou. What city?

Good advice from Grok.

Be thankful you're not in debt, beyond the house (& 44 -- relatively speaking -- is not much).

Strong family ties, good friendships important, too.

[Mike Church]

I believe in Peak Oil as a near-future eventuality, but I don't know how we'll forecast when it hits until we're there.

The Hubbert curve is the derivative of a logistic curve; it works from the assumption that cumuluative oil production is logistic with respect to time. Problem is, logistic curves are notoriously difficult to forecast if one is before or not much after the curve's inflection point (halfway, where the derivative is at a maximum and therefore per-diem oil production is at a peak). The early phase of a logistic curve looks just like an exponential curve; there's a slight deviation but it's practically impossible to separate that from the noise, except in an extremely low-noise world (oil, with its geopolitical and economic inputs, is not one of them). Likewise, technological and industrial progress have been roughly exponential for a long time, and if they're going to plateau, they haven't shown any indication of where yet.

Point is, at fifty thousand feet, we just don't know when "peak" is. We may have passed it; it may be 10 years off. It's almost certainly a reality, but absolutely no one knows when it will come because the data is at best semi-conclusive.

I think these "sky is falling" projections actually harm the credibility of Peak Oil. We're a nation that has grown accustomed to living in Third Turning fear. In May '99, virtually every school in the country looked to single out its "weird kid" and find out if he was stockpiling bombs. In 2002, we were all freaked out about terrorists. In fall '05 the world was freaked out about heating oil prices in a "colder than average winter" 2005-6. (In fact, it was warmer than average and the heating oil never dried out.) Then we freaked out about 2006 superhurricanes, but those never happened either.

The future is just inherently unpredictable, and for someone to say that "the crash" will come on October 24, 2006 at exactly 3pm is just going to kill that person's credibility at 3:01. What virtually everyone agrees upon, however, is that oil depletion is a near-future problem and that, if not, we still have to worry about global warming and its potential for catastrophic climate change.

In any case, while I personally believe Peak Oil is going to "hit" relatively soon, I don't think more than 20% of the U.S. population will even use or understand those words. More likely, the crisis period will be blamed on proximate causes (housing crash, credit events), just as the Great Depression was blamed on the 1929 stock crash when the underlying causes were more complex.

My belief may be optimistic, but I see a traumatic 2-3 years following the housing crash (to "kill off the weak") but a long-standing reduction in standard of living only around 10 to 20%. (Think of a gentle upward curve with a much steeper camel's hump; the backside of the hump has a downslope, but the decline will stop and reverse.) There's so much fat in our society-- paperwork, hierarchy, outdated protocol-- that we can boil away 50 percent of our "activity"/complexity and only lose about 10% of our utility. Are we really going to miss overpaid NYC realtors when "natural" selection sends them all into retail? Apartments will still be bought and sold without them. Our society is full of fat and (from a subjective-utility point of view) gross inefficiency. We use most of our money to get more money and most of our efforts to get more opportunities to bust our asses. This is fine to a degree but it doesn't make much sense after a while. What happened to travel, culture and the arts?

In any case, Peak Oil will provide an opportunity for smart young people to push out the incompetent fuckers (of whom Bush is a figurehead, but it certainly doesn't stop with him) running this society, and they won't leave peacefully any other way, so I'm all in favor of it.

[Artie]

"The problem here is that existing wealth is actually being squandered, since the paper markers will only lose value as the hopes and expectations vested in them dissolve in disappointment. But we haven't quite reached that point yet."

Let's see, Jim, you predicted the Dow would hit 4000 in 2005, yet here we are at record highs.

What will it take for the rest of us to reach your depths of skepticism and cynicism?

[Weaseldog]

Mike Church, I don't see much of our retail industries as being of much utility after the crash.

How many, "Hello Kitty" outlets does the world need?

There's a lot of junk items being sold today, that will have to compete with food purchases on a more even footing. If someone is trying to decide between buying cereal and milk and getting a memory upgrade for an MP3 player, the cereal and milk will win.

[Euthydemos in Athens, GA]

With regard to the comment:
"the hijacking of mortgages by financial playas who bundled them into odd lots of tradable debt (promises to pay) and used them to leverage abstruse bets (hedges) on the behavior of other kinds of paper markers (currencies, interest rate differentials, commodity prices) -- very profitably as long as all playas believed that industrial societies that run all oil would continue to grow, to produce more wealth."

There is a good discussion of these strange financial hybrids called "Voodoo Debt and the Coming Recession" by Bill Fleckenstein at
http://tinyurl.com/kjq8e

It begins;
"The eyes tend to glaze over at the mention of "collateralized debt obligations" (CDOs) and "credit default swaps" (CDSs). That's understandable, they have proved somewhat incomprehensible, even to the professionals. That's why I referred to them as "financial dark matter."

"While CDOs and CDSs are hard to fathom, a disruption in these risk-filled markets would become all too comprehensible to average folks -- as the aftermath would bring serious turmoil in real estate and the economy."

He describes some details of a particular risk trnache. Then...

"I believe that the CDO and CDS markets (the lower-grade tranches in particular) will be ground zero in any financial dislocation."

He concludes: "Loose mortgage loans that prolonged the boom will worsen the bust. Homebuyers are now going to pay the price for their 'buy now, worry later' spending spree. … With market manias, self-feeding greed on the way up turns into self-feeding fear on the way down. That time is near."

Sounds like another fellow traveler, Jim!