Wednesday, November 27, 2013

Oil and economy: Understanding the risks [Part 1]

In my last post on the bitumen bubble I was prompted with some questions on the global situation. My answer has become quite complex, so it's been made now into it's own post.

Hi Richard. Just how does this madness end? In terms of the larger, global Carbon Bubble, the world seems content to continue defying gravity - for now.

The world is not so much content as the banking system and those invested in such a system are content. Pete McMartin put out a great piece recently "who pays for climate change?":
As usual, there were fundraising drives. Emergency response teams were dispatched. Government dedicated relief funds and promised to match private donations. The chaos on the ground and the rising death count was leavened — here, anyway — by Feel Good stories of charity.

But this time, something was different. Typhoon Haiyan was so abnormally big it left behind more than a devastated Philippines. It left in its wake a heightened sense of the global divide of climate change. The rich play, the poor get their homes flattened. And the poor, who are most affected by climate change and least able to mitigate its effects, are growing increasingly angry.

At the United Nation’s Framework Convention on Climate Change, now being held in Warsaw, Poland, the Philippines climate negotiator Naderev Sano, who drew a direct link between Typhoon Haiyan and climate change, first thanked the developed countries for their help, then told them that the poor countries of the world need more than their charity. And he was not the only delegate there to do so.

They needed compensation, he said. They needed a global fund established to mitigate the damage the big greenhouse gas-emitting countries were causing. And they needed those rich countries to accept their moral responsibility for doing the most harm over the longest period to the global climate.
He then vowed to starve himself until they did.
So, referring to the world as a singlular entity I don't think is correct, much of the world is at the tipping point already, it's a small minority driving the status quo. As I wrote in my (incomplete) coverage of the 2012 budget:
A few other paragraphs confirm for me that the government believes fully in climate change and that it is occuring now and is inevitable as earlier signs have indicated.

Canada’s Economic Action Plan laid the groundwork to establish a world-class research station in the North. As announced by the Prime Minister in August 2010, the station will be located in Cambridge Bay. Once established, the station will provide a year-round presence in the region and anchor the network of research infrastructure across Canada’s North, making a significant contribution towards the Government’s Northern Strategy. The Government will be announcing next steps in the establishment of the Canadian High Arctic Research Station in the coming months. Combine the link, the "research station", and the explicit mission we have for research directly from section 3.1:

The Government’s science and technology strategy, Mobilizing Science and Technology to Canada’s Advantage, emphasizes the importance of ensuring that federally supported research contributes to the commercialization of new products, processes and services that create high-value jobs and economic growth.

Guided by this strategy, the Government provides significant resources to support research, development and technology. It's not unreasonable to assume the research station will be heavily involved in arctic mining research as thats one of few products, services, or processes that can be commercialized. This compliments another paragraph in regards to climate change (from the section on GMO research):

•Increasing the competitiveness of the forest industry. Spruce trees are the most widely used species in Canada’s forest plantations. Researchers at Universit√© Laval are working to develop tools and protocols that make it possible to select high-performance spruce trees with better quality wood and high potential to adapt to climate change. Government and industry have partnered to transfer molecular breeding technology to commercial application across a broader range of tree species, to increase the competitiveness of the Canadian forest industry.
I'm more convinced than ever now that the government's climate change strategy is adaptation and not prevention (indeed I believe they believe it is now impossible to prevent). Take note of the wording "better quality wood with high potential to adapt to climate change". It's current tense and matter-of-fact.

I anticipate most policy will be geared towards adaptation with climate change simply becoming a reality.
There is no "seeming" about it, adaptation, not prevention or mitigation, is the chosen path forward. Any talk otherwise by the major powers in control of this situation is just talk, or in the case of carbon trading or taxing, a scam meant to inflate an economic bubble greater than the current currency bubble itself. Explaining why this is would require an entire post on it's own (which I will do one day if I get the time), but I can sum up the logic simply as: If currency is backed by future production then currency itself can not be the limiting factor in future production. Proponents of these systems simply do not understand how the monetary system operates making the implicit assumption that currency represents historic wealth (or a store of value) rather than future wealth.

I am wondering whether the industrialized and developing nations aren't locked into some fossil fuel extraction paradigm they cannot shake.

The paradigm they can not (or more accurately will not) shake is that of infinite growth and debt.

I posted yesterday a great set of youtube videos that explain the infinite debt monetary system really well, but something Mike Malony doesn't get into, or perhaps himself doesn't understand, is that the USD isn't backed by nothing literally - rather it is backed by future production, future production made possible by the people, powered by oil.

It is the burning of carbon (though more recently banking shell games and fraud) which enables the current standard of GDP. Andrew Leach recently put out a great analysis of pipeline efficiency and the obsession with "productivity" which provides, in example, an explanation of the paradigm world governments are currently trapped within, deliberately by the banks.
The CEPA study is the perfect example of what’s wrong with using I/O models to measure the benefits of infrastructure, either existing or proposed.

Ideally, pipelines would be cheap to build, would use little energy, and thus would allow resources to reach their markets at minimal cost, maximizing the value realized from extraction of our scarce resources. By enhancing the value of resources, efficient transportation would enhance the implied productivity of labour in the resource sector. The method used in the CEPA study would value a pipeline system which was costless to operate at something approaching zero, and leave us all wishing for more expensive pipelines so that they’d have more economic impact. If you can’t see how that’s backwards, you’re just not giving it enough thought.

The CEPA study looks at the annual operating revenues of pipelines, and treats those as a shock to the economy – money which would not otherwise be spent. Of course, nothing could be further from the truth. Operating revenue of pipelines is revenue not earned by resource production or refining, depending on the dynamics of the particular energy market, or money not saved by consumers at the pump. This is not money which is magically added to the economy. Rather, it’s part of the value of resources lost to the costs of transporting them to market. The higher the transportation costs, the lower are taxes, royalties, net revenues to producers, margins of refiners or the higher are consumer costs. These lower margins would either mean less employment or lower wages or both in the upstream sector, while higher costs would lower welfare for consumers, all as a result of the lower productivity that we’re told is a source of great benefit to the economy. It’s as close to zero sum as you can get.
Leach unfortunately doesn't go far enough in his analysis to realize that's the same across the board, that the entire economy is now looking at "cost for cost's sake" as an indicator of economic health. You now look at central banks saying "there is no inflation so we're keeping rates at zero", but their entire idea of inflation is off base:
Perceptions can be skewed by big-ticket items, like houses and the appliances needed to fill them. A look at the cost of daily or weekly needs provides a different picture, one of mostly weak increases and equally narrow growth declines.

Inflation — like the data shows and the Bank of Canada keeps reminding us — is nowhere close to being a problem that would require jacking up interest rates.

That’s not likely to happen for another year at the earliest — not until the Canadian economy is chugging steadily along and inflation is holding around the central bank’s ideal 2% target.

For now, the consumer price index is struggling to stay around the 1% mark.

Unless there is deflation somewhere, prices are still rising [overall] and the cost of living for consumers is still going up,” says Mel Fruitman, vice- president of the Consumers Association of Canada.

“The ordinary consumer doesn’t look at the inflation number put out by StatsCan, they look at how much it costs them every month to live. We’re not seeing any decline there,” he says.

“At the end of the year, we’re still going to have less in the pocket than we did last year, no matter what. All we know is that if inflation is high. It’s going to cost us more to live. If inflation is low, it’s not going to cost us as ‘much’ more.”

Philip Cross, former chief economic analyst at Statistics Canada, says the difference in price perceptions comes from comparing everyday items to durable goods with longer lifespans.

“We buy groceries. We fill up with gasoline. So, we see price increases in these areas,” says Mr. Cross, now a private consultant.
Inflation is not only being hit by excessive monetary printing, but also by a major increase in the cost of energy. In other words, not only does a unit of energy now require more monetary units to purchase, the energy itself is also providing less of a return compounding the problem. Government's are hiding massive inflation (really devaluation) by both exporting this inflation to other countries (through the practice of free trade agreements) and by comparing the price of hamburgers and TVs. The CPI in it's current form only accurately describes inflation if you have enough disposable income to actually buy products across the board, for the poor whose spending is limited the necessary items they need to buy are all incredibly inflated leaving them little money to "save" on the cost of a TV.

Utilizing this skewed inflation scheme government's are justifying rapid amounts of currency creation which is supposed to "fuel growth" and "recovery", however with an energy supply that has now become many hundred times more expensive than conventional oil production the excess energy (wealth) required to actually create real growth is gone. All growth, all growth estimates, all budget estimates, are being based on a record low interest rate environment. Just imagine what Alberta's budget would look like with normal interest rates attached to the debt, or Edmonton's arena. As a society we're calling this sort of deficit spending "affordable" because of record low emergency interest rates and the normalized expectation that the required productivity needed to service these debts is possible, this expectation is based on our recent historical observation of energy ratios. We're still spending like oil has a 100:1 ratio, when in reality it now has closer to a 5:1 ratio. That's a massive amount of expected future wealth that has just evaporated, yet we are not accounting for this evaporation in our expectations moving forward.

A good example of the mentality here would be someone who makes over $100,000 and has adjusted their lifestyle to make use of that sort of income suddenly losing their income source. While the very reality of perhaps a new income level of only $30,000 is obvious and apparent, the mentality of the person is likely still stuck in the spending patterns of a $100,000 income. It's very easy and natural to move up the chain of a standard of living, it's very challenging to move down the chain. High cost hydrocarbon energy is the entire world moving down the chain together, and stimulus is an attempt to counter that. This is evident by the continual "ceiling to growth" we continue to hit:
Customers at St. Albert gas stations were in for a surprise Thursday morning as fuel prices dropped to about 99 cents. Some may have welcomed the reduced hits to their wallets but economists warn that lower gasoline prices also point to possible shifts in the local economy.

Although oil supplies continue to ramp up, Alberta still lacks the ability to move a large amount of its product out of the province, said John Rose, chief economist for the City of Edmonton. This keeps prices at the pump low but could drive investment out of the province in the long run, he said.

“Over the last couple of months we've seen a very significant gap open up. Great for refiners, that supports their margins. Great for people who are buying gasoline because it helps to drive gasoline prices down,” he said. “But in terms of continuing investment in the oilsands, not such great news.”

Gasoline made out of the oilsands is a relatively expensive product compared to other sources of oil, said Rose.

In order to create increased investment and production, Alberta oil should sell for no less than $60 to $80 a barrel. Once the price drops below that number, and Alberta finds no additional pipeline capacity in the United States, the West Coast or Eastern Canada, Rose said oil companies may start backing away from major projects.
I would actually submit that with currency inflation the "floor" price is no longer $60, but actually $80 with a new ceiling of $100. I've been documenting the economy bouncing between these two limits for some time and so far every prediction based on them has turned out. This is again a function of a severe underestimation of how fast the cost of living is actually rising.

What risks are the federal and Alberta government exposing us to by recklessly committing us to a truly high-cost, high carbon unconventional petroleum?

The number of risks from pursuing these projects grows exponentially everyday, while the number of benefits is approaching zero. This has been the centralized theme of my opposition to the oilsands. They are an economic blackhole whose wake of destruction outweighs the wealth remaining that would be needed to repair this destruction.

Perhaps the scariest thing about them is that because they represent a downgrade globally in the general quality of energy and thus available future wealth by the time the reality of the destruction reaches an obvious crisis point governments will be so indebted they will be unable to mitigate the damage just as Japan, after decades of deflation and stimulus spending, now does not have the resources to address Fukushima and so decided a coverup will work just as well. In fact Japan is only being kept in economic limbo because of the support they receive from the U.S. which has now entered it's own liquidity trap and will be unable to help them much longer at which point it's likely Japan will have to default and Fukushima will go unaddressed.

As real wealth evaporates governments are going to accelerate "cost cutting" measures to balance budgets. I think Lac-Megantic shows the end result of that pretty well:
LAC-MEGANTIC, Que. - Ottawa and Quebec shared a rare moment of solidarity Thursday, agreeing to split the estimated $190 million price tag to decontaminate the devastated town of Lac-Megantic.
The company responsible has already gone bankrupt leaving the government, meaning the people, to pick up the tab. There are many, many, more Lac-Megantic or Fukushima scale disasters waiting for us over the coming years as maintenance costs continue to be cut and infrastructure spending falls further behind, as we are now seeing in Quebec with the Champlain bridge. All of this cost cutting, deferring maintenance, and halting infrastructure spending to "balance the budget" in the 90s (and now) was simply an attempt to mask a declining standard of living but ignoring those costs don't make them go away, it simply deferred and amplified them into the future.

The short term risk to Alberta, and Canada, by pursuing the oilsands is an unpayable monetary, structural, and environmental debt. What good is a twinned highway to Fort McMurray after these projects die off? Infrastructure spending happening today in Alberta is not to support the people, it's to support the industry. It's shortsighted, and a major waste of non-refundable wealth. Alberta literally spends all of it's wealth on the industry that's providing the wealth in the first place and increasingly has to cut back on social service to meet this growing cost of infrastructure. Alberta provides perhaps the most minimal and privatized service in every department of all provinces across the country even as it's population and tax base is growing. This does not indicate wealth in my books, Alberta's collective wealth is decreasing overall.

The medium term risk (which partially addresses your second question regarding shale oil) is that as energy supplies get tighter and more expensive, market volatility is going to rise.

Alberta's come out with the cute name of "bitumen bubble" to essentially describe periods of market activity that don't favour it's economics, perhaps similar to how a gambler may grasp at straws for arbitrary reason to explain why "their system" was defeated. As you've eluded to with your new post on these shale gas finds and your second question bitumen's demand is highly dependant on the availability of higher quality energy sources. However, Shale Oil - while being a higher quality than bitumen is of a lower quality than conventional oil. Everything I've stated above remains true, whether we're talking shale oil or bitumen society as a whole is looking at a downgrade, and not an upgrade, of collective wealth. I'll get more to shale oil in a separate post. The irony of oilsands or shale oil developments is that they need a good availability of higher quality energies to subsidize the cost of production and ensure energy stability, on top of government subsidies and the subsidy provided by cheap liquidity in the form of low-interest loans.

The long term risks? Leaked Climate Change Report Predicts Violent, Poorer, Sicker Future

I will get to the meaning of shale oil for the oilsands in a separate post as it's a fairly complex subject on it's own.

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Richard Fantin is a self-taught software developer who has mostly throughout his career focused on financial applications and high frequency trading. He currently works for CenturyLink

Nazayh Zanidean is a Project Coordinator for a mid-sized construction contractor in Calgary, Alberta. He enjoys writing as a hobby on topics that include foreign policy, international human rights, security and systemic media bias.

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