Wednesday, October 19, 2011

Kicking the Can: A Modern Fable

I was inspired after reading a letter to the editor at The daily reckoning

Once upon a time, a group of bankers dropped a magic debt-can on the road. The can was full of nasty debt and it was very ugly. A group of the town’s leaders decided they didn’t like the can, so they gave it a little squirt of stimulus money and
kicked it down the road towards the hill on the outskirts of town. It rolled up
the slight incline and came to rest then rolled slowly back towards the town.

The leaders discovered that they couldn’t kick the can over the hill – it just kept rolling slowly back down the hill towards the town. And this magic can didn't just roll along the road like an ordinary can – the stimulus money vanished in a puff of
smoke and appeared in the banker’s pockets and then the debt in the can got

The can quickly grew into an ugly debt-filled barrel as heavy as concrete and so big that it couldn't be kicked down the road anymore.

The leaders asked the bankers what to do, and the bankers explained that the can was now dangerously toxic. It had to be kept out of the town. They explained that it had
to be launched with a special kind of explosive called Economic Bailout. This
explosive was made of magical future-money which the leaders took from their
people before the people had even made the money.

Each time th can was launched it got bigger, and each time it got bigger the leaders had to take more money from the people’s future to launch it away from the town.

After each explosion the people were left a little poorer, but the bankers got a little richer.

Strangely, as the people got poorer, the hill in front of the can seemed to get steeper, making the job even harder.At first one stick of economic-bailout dynamite was enough to blow the barrel-sized debt a huge distance and all the leaders and bankers congratulated themselves on a job well done.But gradually the magic barrel grew larger and the cement inside transmuted into toxic lead.It required much more financial dynamite to move it.

Soon the Economic Bailout Explosive wasn’t enough, the leaders needed to use Quantitative Easing Explosive. This was a magical explosive, which made people’s money decrease in value without even touching it.As the cylinder's flight arc grew shorter, the self-congratulations grew more strained.

Eventually tons of Quantitative Easing TNT barely made it roll a few meters up
the incline before stopping and rolling back again.The drum got so big that it finally turned into a storage-tank of toxic debt that glowed like radio-active fuel-rods. It crept ominously downwards towards the town at the bottom of the hill.

The leaders conferred with the most expert bankers and came up with a solution: Nuclear financial explosives would be used to create a massive European Bailout Fund
Rocket, propelling the toxic debt-filled tank right to the top of the hill.They reasoned that if the huge tank was propelled to the top of the hill, it would roll down the other side, magically turning the toxic waste into gold for everyone!
All would be well!

The appointed date came and every country had contributed to the Bailout Fund. The explosive yield and trajectory had been precisely calculated by people with PhDs in
Economics - so their qualifications to avoid magical thinking and perform
rigorous mathematical calculations (based on the inviolate and well understood
rules governing the behavior of money and markets) were impeccable.

Crowds gathered at the base of the hill, waiting to sprint over the hill and collect their gold.

All of the people’s remaining future money had gone into the bailout rocket. They had no money, no future and no food, so they were really quite eager to see the gold.

The leaders in their bunker gave the order. Fire!

The huge cylinder lifted off! Higher and higher it went trailing flames as the bailout money was consumed by the ravening afterburners! The leaders cheered from their bunkers. The bankers cheered as they stood on their magically-increasing piles
of cash! The people looked upwards nervously as the huge tank of toxic waste was
lofted overhead, propelled by a steady stream of money. The bailout money finally came to an end. The afterburners flared out but the tank continued to fly towards the peak ahead.

The magical toxic storage tank flew onwards, seemingly invincible..... and then it stopped suddenly at the crest of the hill as if it had run into a magical wall of
mathematical impossibility. Then slowly, almost imperceptibly, it started to roll... backwards! With gathering speed the colossal tank came thundering back down the hill.

The shocked crowds tried to escape but there were too many people for all to get out of the way.

Finally the rolling, roaring tank slammed into the town. Exploding, it flew apart spewing its toxic contents far and wide.

The survivors looked in dismay at the remains of their town. In the center of town
they saw a distress flag being hoisted above a bunker. The leaders were
trapped in their bunker, surrounded by the toxic waste and unwilling to wade
through it to escape.

So the survivors turned away from the ruins, ate the bankers and walked off to found a new town, based on sound economic practices....

Well, I did say it was a fable. We all know that the real ending would involve the bankers using the toxic-smeared leaders to shepherd the toxic-averse survivors into
docile herds, so that they could fleece and then eat them.

Saturday, September 3, 2011

Energy and Society Part 2,

I am going to engage in some speculation. Let us accept the following assumptions as a premise for this argument,

1. The economy is a chaotic system.

2. Both our markets and our economy are displaying classic chaotic bifurcating behaviour (they are bouncing up and down).

Question: Why the bifurcating behaviour? What is driving the instability?

I am going to argue that the answer is blindingly simple and very obvious when you think about it, but a full understanding requires some background knowledge.

1. Mathematically, what does the economy look like?

To understand the driver of the instability, we need to tackle another issue: Mathematically, what does the economy look like – what drives the economy?

As a first order approximation, the answer is simple and obvious. The economy grows exponentially. The expansion is a requirement of the Fractional Reserve System. To quote Wikipedia : “Fractional reserve banking involves the creation of money by the commercial bank system, increasing the money supply.” The amount of money in circulation (the money supply) each year MUST increase, in order to make the Fractional Reserve system work. This has a tendency to create inflation if it is not balanced by an equal increase in GDP.

In simple, non-maths terms the economy MUST grow by a few percent every year.

The reason for this is simple. If the amount of money in circulation increases, but goods produced do not increase, then you have more money chasing the same quantity of goods, so each “unit” of goods will be “worth” a higher amount of money. Actually it is much more complex than that (look up “Velocity of money” as a starting point) but that is a good first-order explanation.

So. The mathematical description of the economy is very simple – money supply must expand exponentially (driven by the nature of the Fractional Reserve system), and the underlying productivity that the money “maps” to must expand with it.

Failure of expansion in either the money supply or GDP will result in problems.

If money becomes unavailable (as occurred during the depression) then the Fractional Reserve System fails – there is no money available to pay debt so debts are defaulted on. Since money (in our system) is based on debt, the default causes the money to “disappear” (the debt is “written off” by the bank), and this reduces the amount of money in circulation, exacerbating the problem (as occurred in the Great Depression).

John Maynard Keynes had the insight that this problem can be fixed by central banks – they step in and inject money into the system to “re-inflate the economy”. Once the amount of money in circulation is once again in line with the required growth rate, the normal investments that businesses need to do (in order to grow) can be carried out, and growth returns. (Again, this is a grotesque simplification – but good enough for a first order understanding. For more detail read the Wiki article).

Since the 1980s our economy has been dogged by a series of recessions, which the Central banks have responded to by injecting cash (another simplification, but it will do).

The cash injections worked, but a pattern emerged: as a rough approximation, it is fair to say that each recession required more central banking intervention than the last – culminating in the 2007/2008 GFC, which required unprecedented intervention. The GFC was odd, in that the interventions don’t seem to have worked.

2. On Bubbles.

The injection of money into the economic system is meant to encourage investment in productive businesses and thus re-start growth. However recent decades have seen a different pattern. Injection of money has led to investment in a series of “bubbles” and in intangible “Financial Instruments” rather than investment in productive businesses (i.e. businesses that produce tangible things).

The most recent bubble was the housing bubble. A house has a limited “lifespan”, so the value of a house should depreciate as it ages. However, in recent years the value of a house has gone up, not down.

In common with other bubbles has been a faith in the “Greater Fool” theory: The theory that you can buy an object at an inflated price now and sell to a “Greater Fool” for an even more inflated price later – even though the value of the object should have depreciated.

Why would people invest in a depreciating asset - and thus implicitly trust to the “Greater Fool” theory? The answer is obvious. They do this if there is money to invest and no better investment available.

If you can’t invest in a sound business (a business that produces something new of tangible value) then you invest in a bubble (depend on a Greater Fool).

So a bubble requires two elements:
i) A supply of cash, looking for investments.
ii) Limited sound business investments.

3. Putting it together.

So suddenly Keynes isn’t working. Why not? The answer is obvious. The Economy has two parts which must “map” to each other:

i) Money supply

ii) GDP (a proxy for "stuff made" or productivity).

We have just said that it appears that productive investments don’t seem to be available – so any expansion of GDP is due to phantom bubble blowing, not real productivity.

Injecting money only works if it can engender “real” growth. If the production of tangible goods is not an option, the money leads to a bubble, which collapses. A fair description of the last 15 years.

The Dow Jones has collapsed to a level below where it was in 2000 (in real terms). US GDP should probably do the same and if the US dollar continues to decline the value of the US economy (in real terms) probably will drop to pre-2000 levels (it may have already, I haven’t done the maths).

So now we can answer the question: Why is the economy undergoing a chaotic bifurcation?

The Keynes strategy was designed to deal with a contraction in money supply. But money supply maps to underlying productivity. What if the problem is a contraction in the ability to grow? This won't be cured by adding money - the money needs to be invested in growth.

A few simple data points:

i) Growth of economies is correlated with growth of consumption of energy supplies. Recent studies that found a possible weakening in this correlation for developed nations failed to consider the fact that the energy consumption had simply been outsourced to the manufacturing nations. (See the Bundeswehr study referenced in Part 1 for more discussion and references).

ii) Oil production peaked and plateaued in around 2005. (See the Bundeswehr study referenced in Part 1 for more discussion and references).

iii) Energy and mineral resources required to extract energy and minerals is increasing exponentially as the quality of resources decreases (see here and here for discussion.).

Given these trends it is obvious that the quantity of resources available to do useful work for society is going to struggle to keep up with growth. This is reflected in an increase in prices for these resources – making investment in any resource-requiring production (i.e. any production of tangible goods) difficult. This clearly encourages investment in “phantom” productivity – bubbles and intangible “services” or products.

If the growth in money supply over recent years was invested in phantom bubbles, then of course it will collapse until it represents the value of the “real” economy.

This is seemingly well under way.

But there is an underlying issue: The Fractional Reserve System REQUIRES growth. If growth is not possible, then this system is fundamentally unsound.

So here is the issue in a nutshell: The Keynes policy approach addresses an issue with money supply. It would allow money to be invested in growth. But what we have is an issue with growth. The system is much more complex than I have indicated, but this fundamentasl mismatch is (I believe) at the core of the problem.

It is simple, and (when you think about it) obvious.

The bifurcation(s) must drive a decrease in complexity until a stable system evolves. If growth is less possible, a new system must evolve.

Energy and Society Part 1

A complete version of the Bundeswehr (German Army) study is now available. Amazingly, they seem to be interpreting things in quite interesting ways. In many ways it looks spookily familiar – first in their reference to a bifurcating chaotic system, and second in their comment that “All other subsystems have developed hand in hand with the economic system. A disintegration can therefore not be analysed based on today’s system. A completely new system state would materialise.”Excerpts from the Bundeswehr study:
The phenomenon of tipping points in complex systems has been known for a long time and is referred to as “bifurcation” in mathematics. Tipping points are characterised by the fact that when they are reached, a system no longer responds to changes proportionally, but chaotically. Currently, reference is made to potential “tipping processes” most notably in the field of climate research. At such a point, a minor change to one parameter – in the case of the climate, a change in temperature – would have a drastic effect on an ecosystem.At first glance, it seems obvious that a phase of slowly declining oil production quantities would lead to an equally slowly declining economic output.Peak oil would bring about a decline in global prosperity for a certain length of time, during which efforts could be made to develop technological solutions to replace oil. Economies, however, move within a narrow band of relative stability. Within this band, economic fluctuations and other shocks are possible, but the functional principles remain unchanged and provide for new equilibriums within the system. Outside this band, however, this system responds chaotically as well.From the perspective of economics, at least one border of the band can be identified: an economic tipping point exists where, for example as a result of peak oil, the global economy shrinks for an undeterminable period. In this case a chain reaction that would destabilise the global economic system and cause a clear shift in the analytical framework for all other security consequences would be imaginable. The course of this potential scenario could be as follows:[Short Term]1. Peak oil would occur and it would not be possible, at least in the foreseeable future (153), to entirely compensate for the decline in the production of conventional oil with unconventional oil or other energy and raw material sources. The expression “foreseeable” is very important in this context. Ultimately, it leads to a loss of confidence in markets.In the short term, the global economy would respond proportionally to the decline in oil supply (154).
  1.  Increasing oil prices would reduce consumption and economic output. This would lead to recessions.
  2.  The increase in transportation costs would cause the prices of all traded goods to rise (155). Trade volumes would decrease. For some actors, this would only mean losing sources of income, whereas others would no longer be able to afford essential food products.
  3.  National budgets would be under extreme pressure. Expenditure for securing food supplies (increasing food import costs) or social spending (increasing unemployment rate) would compete with the necessary investments in oil substitutes and green tech.
Revenues would decrease considerably as a result of recession and necessary tax reductions.[Medium Term]In the medium term, the global economic system and all market-oriented economies would collapse.
  1.  Economic entities would realise the prolonged contraction and would have to act on the assumption that the global economy would continue to shrink for a long time (156).
  2.  Tipping point: In an economy shrinking over an indefinite period, savings would not be invested because companies would not be making any profit (157). For an indefinite period, companies would no longer be in a position to pay borrowing costs or to distribute profits to investors. The banking system, stock exchanges and financial markets could collapse altogether (158)
  3.  Financial markets are the backbone of global economy and an integral component of modern societies. All other subsystems have developed hand in hand with the economic system. A disintegration can therefore not be analysed based on today’s system. A completely new system state would materialise.
Nevertheless, for illustration purposes here is an outline of some theoretically plausible consequences:
  •  Banks left with no commercial basis. Banks would not be able to pay interest on deposits as they would not be able to find creditworthy companies, institutions or individuals. As a result, they would lose the basis for their business.
  •  Loss of confidence in currencies. Belief in the value-preserving function of money would dwindle. This would initially result in hyperinflation and black markets, followed by a barter economy at the local level.
  •  Collapse of value chains. The division of labour and its processes are based on the possibility of trade in intermediate products. It would be extremely difficult to conclude the necessary transactions lacking a monetary system.
  •  Collapse of unpegged currency systems. If currencies lose their value in their country of origin, they can no longer be exchanged for foreign currencies. International value-added chains would collapse as well.
Mass unemployment. Modern societies are organised on a division-of labour basis and have become increasingly differentiated in the course of their histories. Many professions are solely concerned with managing this high level of complexity and no longer have anything to do with the immediate production of consumer goods. The reduction in the complexity of economies that is implied here would result in a dramatic increase in unemployment in all modern societies.
  •  National bankruptcies. In the situation described, state revenues would evaporate. (New) debt options would be very limited, and the next step would be national bankruptcies.
  •  Collapse of critical infrastructures. Neither material nor financial resources would suffice to maintain existing infrastructures. Infrastructure interdependences, both internal and external with regard to other subsystems, would worsen the situation.
  •  Famines. Ultimately, production and distribution of food in sufficient quantities would become challenging.
The report runs to 112 pages, a link to it is available from the Energy Bulletin review here.

Monday, August 15, 2011

Off Grid

I am building my home “Off the Grid”. I’m doing this for both practical reasons and philosophical reasons. Practically, I want to increase my resilience in the face of possible dislocations. Philosophically, I want to reduce my ecological “footprint” on the Earth. But this is where I’ve run into a philosophical dilemma: What is “Off the Grid”? Even a caveman depended on other cavemen.

The notion of the lone, off-grid homestead simply doesn’t work in practice.

Your homestead is only truly "Off the Grid" if you are willing to mine your own iron ore, smelt it, forge it into a saws and axes, cut down your trees and then work the timber to make your own furniture. Along the way you also need to build your cabin, grow your own vegetables, hunt your own meat, spin your own fibers, make your own clothes, carry your own water, grow your own medicines, make your own preserves for winter, mold your own candles, and cast your own pot-bellied stove from more of that iron that you smelted. Oh – and don’t forget to make your own gunpowder, temper your own springs, find your own flint, pour your own bullets and cast your own gun barrels, so that you can deal with the ferals that try to eat your chickens each night.

There aren’t enough hours in a day.

Mankind specialized for a reason. You need friends - particularly if security is an issue. If you look at places where self-sufficiency needed to be combined with some level of security (villages in South America, Afghanistan, Africa, etc), the pattern is always the same – small farms radiating out from a small central town or village. The village both allows people to specialize, and provides the security associated with nearby neighbors. Villages are connected by a network of roads to allow further specialization and associated commerce.

This is why I didn’t go down the “isolated farmstead” path. My homestead is being built on an acreage that is less than ten minutes’ walk from the center of a small town. There are three neighboring farmsteads within a kilometer on one side of my property and within half a kilometer on the other side we have a small school, a petrol station/shop, a country pub and a half dozen of the town’s residences.

Our water, electricity and heating, are not dependent on the grid so we have some built-in resilience, but we do have easy access to the advantages of a community within walking distance. Access to community doesn’t reduce resilience – it enhances it.

Off-grid doesn’t mean “hermit”. We all need community. You need to either find one, or build one.

Tuesday, August 9, 2011

Squeezing the Margins and the Emerging Growth-Crunch

So London is burning, Arctic ice set a new low for July, Italy looks like defaulting, Stock markets are crashing, mints can’t keep up with the demand for gold and silver, our Super funds are toast, sales of guns and survival food are setting records in the US, world food production is down, Syrian troops are killing their citizens so fast that they needed to order more ammo, and the news agencies are way too busy to even mention the growing casualties from starvation in Africa, oh…. And the wrong person got eliminated in Master Chef.

How are we enjoying the world resource shortage growth-crunch so far?
I have written previously about the problem of declining resource quality - it leads to squeezed margins, and our lifestyle is fed from those margins. As we bump up against the squeezed margins it stunts economic growth, because real growth needs real resources. If resources are limited real growth stops. The limit is, of course signalled by price. As the price of oil (and just about every other commodity) rises we feel it as a squeeze on discretionary spending.... and then we feel it as an economic downturn.
The part of my brain labeled "Physics" has no problem thinking about limits to growth and diminishing returns. However the "Economics" section of my brain struggles with these thoughts. An economy that stops growing enters into recession or depression - it must be stimulated to re-start growth. The "Economics" section of my brain has no tools to describe non-growth. Our economic paradigm does not allow a long-term hiatus from growth. A non-growing economy collapses. I suspect I am not alone in not dealing well with this topic.

The reason that the markets have crashed is said to be because of the downgrade in US debt. So investors responded to the US debt downgrade by dumping shares and buying US debt.

WHAT!!??!! That doesn’t make sense. I submit that the US debt downgrade was not a cause, it was a trigger. The CAUSE is that people sense that something is wrong and that the “something” is not confined to the US, it is systemic. The US debt downgrade was a symptom, as are the problems in Europe, the Middle East and Africa. Investors see symptoms all around them and they don’t feel in control. They are seeking relative safety – even the relative safety of downgraded US debt.

Although people sense that there is something really wrong, they don’t know exactly what it is – so they lose confidence. Since financial markets are based on confidence, the first casualty is the financial markets.

A US downgrade will not be the root cause of GFC II – the US downgrade is a symptom of a deeper issue. GFC II will be a consequence of the sense of uncertainty triggered by an emerging awareness that there is a systemic problem that is not confined to the US.

Population and the associated resource shortage is the elephant in the room. Nobody dares say it, so the cause of all of these growth-related problems stays a mystery.

Friday, June 24, 2011

When growth stops.... Why the CDS trade is a symptom of catabolism

An interesting point about the CDS trade occurs to me.

As you know, you don’t have to actually have exposure to Greek debt to buy a CDS to protect against a Greek “credit event”. The trade in derivatives of this kind leads to correlated systemic risk (a well-known issue). However there is another, less obvious and more philosophical problem:

It favours destruction over creation.

Once you buy a CDS on Greek failure it is in your interest to trigger the failure, so you short the currency, spread rumours of defaults, etc.

Philosophically it is probably true to say that over the last 3 decades the focus of the financial sector has moved increasingly away from its roots – moving from fostering productivity to embracing and creating destruction. I haven’t seen this stated elsewhere, so here is my suggested progression and timeline:

1. Early 1700s to early 1980s. Emphasis on using capital to foster growth (lending money to build businesses, commerce, transport, etc.).

2. Late 1980s, 1990s, early 2000s. A move by financial institutes away from using capital to support the creation of physical product to investing capital in markets that are increasingly detached from real, tangible products. Emphasis on “synthetic products” such as CDOs SIVs etc, where the emphasis was on “using money to make money” with little actual connection between these “sliced and diced” products and any real creation of physical products. The underlying physical objects that “collateralised” these synthetic products weren’t in any way changed in value by the slicing and dicing, yet the resulting products were inexplicably increased in value by the slicing and dicing process.

3. Early 2000s to now. Increased use of “Derivatives”. Essentially placing bets. No physical production or real creation here – it is worse than a zero-sum game because the house takes a percentage. Succeeding in a derivative bet usually requires something to go wrong or fail – and increasingly it turns out that the entity placing the bet had a hand in the failure. The size of the derivative market is many times the size of the real economy, so it is now quite obvious that derivatives market is completely unrelated to real productivity – the focus is instead on negative events and ways to identify, predict or create them.

If our financial institutions are a reflection of the allocation of our efforts, then we have progressed from a long period (centuries) of physical production, through a period of unproductive resource allocation (which mainly served to enrich the financial markets at the expense of the “margins” in productive growth), to a period with a destructive focus that is several sizes larger than the regular, productive portion of the economy. This destructive focus tends to destroy production-oriented entities in order to enrich financial entities.

So the CDS derivative is more than just a new financial product, it is a symptom of something. There is an underlying problem. If the markets could be productive I believe they would be. Catabolism is an ongoing process, even in healthy organisms. But when catabolism exceeds anabolism it is a sign of either starvation (no inputs) or sickness (no ability to process the inputs). I believe that our society can still process inputs, so we are left with the alternative… there aren't enough inputs.

...And we are back to my point about diminishing returns from declining resource quality.

Monday, April 4, 2011

I promised to enlarge on some of the scenarios. Here they are:-
Positive Scenario:
The Japanese economy never recovers from the consequences of the earthquake/tsunami/nuclear damage suffered in 2011. The cost of rebuilding is simply too much for an economy already heavily in debt. Japan's firesale of US treasuries in 2012 leads to a crisis in the US economy in 2013. With debt growing in both nations and without tangible goods or resources in proportion to these debts, they both experience a currency crisis.

Australia's economy survives because Australia is essentially "An island of coal and iron floating in a sea of natural gas". As the US and Japan decline, their resource usage drops in a quite pecipitous fashion and they start shipping bits of themselves overseas to pay the bills. Thus in Australia by 2016 we have plenty of low-cost oil and catabolised resources.

This scenario would involve a brief period of dislocation, followed by rich opportunities.

Negative Scenario:

Being a small resource-rich nation we effectively have a target painted on us. But could a full invasion be effectively mounted and the logistics maintained in a resource-constrained environment? I'm not convinced that a full conquest of Australia could be achieved by a resource-starved nation.

There are two invasion scenarios that I find plausible:
1. Partial invasion.
The invader puts troops on the ground to control some strategic resources (Coal mines, uranium, etc) and the ability to export them (road/train lines and a few ports). The rest of the country is not controlled, but kept destabilised. It is worth noting that China already owns many of our mines and quite a bit of our gas. If resource contention became an issue, China could consider itself quite justified in putting troops on the ground at these locations - purely to protect their interests. The US has invaded countries "in the national interest" with much weaker justification than this.

2. A de-facto invasion by refugees. (It is worth noting at this point that I financially support Amnesty International because I think that Australia's treatment of refugees is embarrassing. I am not anti-refugee, nor am I a xenophobe. I'm not claiming that refugees are in some way evil - because there, but for the grace of God, stand I. I'm looking at what real hurting people would do if faced with a plausible scenario.)

And I think that a refugee crisis is a highly plausible scenario.

As at 2011, the population of Indonesia is around 250 million. This exceeds their carrying capacity and consequently fishing grounds in Indonesia are in critical decline, as is the productivity of much of the land. A major event is going to happen there, it is only a question of when. Right after that there is going to be a refugee problem.

Here is a detailed scenario from the more extreme end of the "Plausible" scale:-
In 2012 Indonesia suffers from a particularly hot dry period and crops die in the field - local farms produce less than half the usual yield. Fishing grounds that were previously overfished are now drawn down further and they vanish entirely. At the same time the price of oil spikes. Energy and food costs cripple the average Indonenesian worker, who is already on a bare subsistence wage. Businesses fail. Poverty becomes widespread and protests sweep through Indonesia. Hunger spreads and 20% of the Indonesian population are at risk from starvation. Tens of millions of Indonesians are impacted and desperate people look at desperate options.

Fishing depleted grounds is less profitable than people-smuggling and many Indonesian fishing boats turn to this enterprise. Indonesian people-smugglers start shipping people to Australia in huge numbers.

Two thousand fishing boats represents a tiny percentage of the Indonesian fishing fleet - but it is enough to completely overwhelm Australia's border patrols. Each boat makes a trip every 2 weeks and each carries an average of 40 regugees. Some of these boats are turned back, but many make it through. Within 6 months the number of refugees hitting Australian shores has reached six hundred thousand. It becomes obvious that Northern Australia is the victim of a de-facto invasion. Lawlessness breaks out in parts of Western Australia and Queensland as the ability to supply this number of refugees with staples begins to fail.

High-profile targets are overrun by refugees in an effort by the refugees to secure attention and food. Civic centres are first, but the next highest profile target in Northern Australia is mines and resources. These are occupied by refugees and the resources are shut in. Every time the problem is resolved a new band of refugees repeats the tactic. Resource production is brought to a near halt.

China owns many of the mines and gas resources in the area. They send troops to defend their national interest. The troops drive the refugees out and occupy the facilities with armed guards who (unlike the Australian troops) are willing to shoot on sight. The situation worsens as refugees riot and loot entire towns. Australian troops respond, but the troops are massively outnumbered and unable to respond to every call for help. Refugees establish control of some areas and settle down to farming and local manufacturing. The previous incumbents are dead or displaced. As news reaches Indonesia that there is land going for free in Australia, more refugees set off for Australia. The Australian Navy simply cannot deal with this number without a change in the Rules Of Engagement and the political will to issue a "shoot to kill" change to the Rules Of Engagement is lacking. Even if such a change was made, there is some doubt that Australian Naval officers would be willing to fire on unarmed refugees. Within a year the number reaches 1.4 million.

Indonesian refugees declare their historic claim to Southern Irian Jaya (also known as the far north of Australia). They use asymetric warfare tactics to drive out the locals and control local resources. Australia's economy is crippled by a de-facto insurgency occurring in Northern Australia.

This scenario would involve a longer period of dislocation. Opportunities would still exist over the long term.

Saturday, April 2, 2011

Declining Resource Quality and the Consequences for Australia.

I’ve discussed the networked resource issue before, here:

and here:

But I want to return to it now and enlarge on how it will play out here in Australia.

I wrote this because I felt that there is a mathematical limit to declining resource quality - and every resource company is experiencing declining quality. There is an inflection point and asymptote that seems to be triggering some strange economic consequences. I wanted to express this in terms that anybody could understand, so I tried to write as accessibly as possible (no equations, only very simple graphs, and definitely no use of the word "asymptote"). This lead to me writing an initial article for “The Oil Drum”:

The problem is that the people in charge of resources are typically only in charge of one resource. While working for one of the “Big 4” consultancies I dealt with these people every day - I am convinced that there is no conspiracy of silence about resource problems. The people in charge are worried that their production is becoming increasingly uneconomic (even at higher selling prices), but from their perspective there is still plenty of their particular resource, it simply requires more money/inputs to extract the resource because the quality is far lower than it used to be.

Unfortunately, nobody is in charge of looking at the sum of the inputs and comparing it to the sum of outputs..... well actually there is an entity in charge, but the entity in charge is "The Market". In the discussion in the second link I discuss market signals and answer the question "How would the inflection point be signalled?"

The short answer is... look around you. Double dip recessions, widespread unemployment, spiralling resource costs, social unrest in multiple countries, non-resource producing countries struggling with decades-long economic contraction that no stimulus packages seem to help (i.e. the ongoing Japanese "lost decades" and the current US and European issues) and, of course, margins so thin that processes cannot cope with any form of major dislocation.

Our economic system was designed for a growth paradigm. If declining resource quality starts to constrain the net amount of free resources then growth cannot occur (yet we will have the illusion of growth because the gross amount of resource extraction continues to grow). When net growth stops, the market signals this event... but the signals are hard to read because gross growth is ongoing (at least for a while). Gross growth is continuing even though net growth is cannibalised to provide the resources for gross growth. The market responds with spiralling prices for inputs.

The market is telling us that this overshoot period will, unfortunately, end – in fact it is ending right now (at least for nations that don't produce resources at a net resource profit).

Despite the vilification that "Limits of Growth" received, the process is playing out before our eyes, right now. It just isn't manifesting in the way that was expected.

We live in a resource-producing nation, so this could represent a huge opportunity for us and our children - Australia could do well as it cannibalizes non-resource producers. But first we need to get through the resource contention and economic turmoil of the next 10-15 years.

The risk to us here in Oz is threefold:
1. Resource contention. A country with resources effectively has a target painted on it, if it exists in a world sufferring from resource issues. But how effectively can war be waged in a constrained resource environment? More on that later.
2. Economic turmoil. We are networked into the world economy. This is going to hurt. However we have survived a few dislocations already and come out in better shape than the rest of the world.
3. A refugee crisis. An influx of refugees that exceeds our ability to care for them is a very plausible scenario. More on this later.

And the upside? If we can avoid the pitfalls above, we could come out of this able to choose the people we want and cannibalize the resources we need. Not pretty, but somewhat brighter than some other nations.

So in this scenario (scenario, not prediction) we would face a tough decade or two (maybe very tough), then emerge into a period of catabolic rebuilding.

Tuesday, January 25, 2011

Networked Resources, Declining Quality and the Peak Oil Argument.

The Peak Oil argument focuses on the question "How much oil?" We spend a lot of time discussing the exact inputs for Hubbert Linearization projections of URR, in order to calculate the moment of Peak Oil. Sadly, the question of “How much oil?" is a lot more complicated than it seems.

As I have said previously, theoretical discussions about oil reserves are pointless. In theory, the amount of oil available is an arbitrary number. Oil can be made from any organic source: coal, NG, biomass, or whatever. If enough energy is available, it can be made from CO2 and water.

This applies to ALL resources. Minerals can be extracted from sea water if access to energy is unconstrained.

Here is my point in what I will call a “thought bite”:
Resource constraints are about reserve QUALITY, not reserve QUANTITY.

Low quality is what is killing us, not low quantity. Alternately, we could argue that the constraint is low energy. If energy was cheap and unlimited, then recoverable resources would be unlimited. We need to look at the availability of oil within a networked system, not just as an isolated resource.

The fact that the word "liquids" is now being used instead of oil is frankly inconvenient to people who fly the Peak Oil banner. We typically conflate the two words by issuing a hand-waving argument that amounts to "When oil peaks, liquids will peak". But frankly this argument represents a chink in our armour - “unconventional oil" and all sorts of other non-oil liquids are now counted under the broad category of "liquids".

Synthetic and other manufactured liquids don't fit neatly into our Hubbert Linearization model. In fact, they will invalidate the model until such time as we can prove (not deliver hand-waving argument, PROVE) that production of these liquids is limited, irrelevant, or correlated with oil production). What we need to prove is that there is a practical limit to production of synthetic "liquids".

Many factors impact on this practical limit. In my last post at TOD I looked at the interactions that would ultimately limit production ( I'm not sure I can put a provable numeric limit on production. Nor can I put a provable date on the Production Peak for liquids. But I can show that we have evidence that these points are either close or past.

A Different Way to Look At It.
Consider the situation here in Australia. We mine iron (and zinc, silver, aluminium, coal, NG, and lots of other stuff - but let's stick to considering iron).

Historically, it was quite possible to refine iron from very low quality sources. Vikings would smelt iron from a layer of iron-rich mud that got deposited as a layer in bogs and swamps ( This was a very energy-intensive process and consequently a sword was an item of great value - passed down from father to son.

However, when we started mining iron in Australia the ore was very pure. Steel could be made cheaply from our ore. As mining has continued in Australia we have consumed the high-quality ore and been forced to mine ores of lower quality – and even change to different types of ore.

At first this was not an issue. There is a simple mathematical reason for this. If your ore drops 1% in quality, from 90%pure to 89% pure then the increase in effort required to produce a given quantity of steel is negligible (around 1% extra energy required) - however the picture is very different at low ore qualities. If you drop 1% in quality from 2% pure to 1% pure ore then the amount of ore you must process to get the same amount of steel doubles. Consequently the energy required doubles (or near enough). Energy consumption required to process the ore increases geometrically as ore quality drops.

The energy required starts from almost negligible, initially rises very slowly, then passes through an inflection point, and from there rises at a frightening rate.

Similarly, we find that other factors are following a similar pattern to further complicating the extraction of resources. For example, depending on the resource, one or more of these is likely to be true:
- The amount of overburden that must be removed is constantly increasing
- The depth of the mine is constantly increasing, with associated complications
- Political/physical/geographical constraints are adding risk and difficulty
- The physical type of resource extracted is increasingly lower-quality (for example we now accept brown coal instead of anthracite and in place of free-flowing light sweet crude we now search for tar sands and oil shales).

This geometric increase in difficulty as quality declines is a well known relationship and not terribly controversial. However the consequence is dramatic. This raises an important question. How widespread is this phenomenon right now? How far along the geometric curve are we?

Where Are We?
To answer this, let us look at a range of both energy and non-energy resources:
1. Oil. We have gone from oil gushing from wells at energy returns of at least (estimated) 100:1 to oil that is manufactured by digging up tar-soaked sand and refining this using a series of energy and resource intensive processes for an energy return that is estimated to be in single digits.
2. Coal. When I was a boy at school we were taught that there were three main grades of coal: Anthracite, bituminous coal, and brown coal. Anthracite was the stuff we used and exported. Bituminous got used a bit inside Australia, but wasn't worth exporting. Brown coal was useless waste that you dug through to get to better grades. But then, when I was a kid I was also taught that the population of Earth is 2.3 Billion people. The situation now is that Australia’s production of anthracite is declining. Even brown coal is mined and exported.
3. Iron. Australia used to export high-grade hematite ore (96% of iron ore exports). Those days are drawing to a close. We now increasingly mine and export a different kind of ore - Magnetite. Magnetite is a chemically different and lower-grade ore that must be processed to increase its grade before it is shipped.
4. Other industrial metals. Silver is an interesting metal. Despite a dramatic increase in price, demand continues to rise, driven as much by its value as an industrial metal as by its status as a precious metal. We are producing more of it every year here in Australia. The attached graphic (of waste rock produced while mining silver) pretty much says it all.

I think that tells us where we are in the curve doesn't it?

So. To produce energy we are finding that we must invest a geometrically increasing amount of energy. Because of the increasing difficulty, we also need to invest a geometrically increasing amount of other resources (eg steel) which in turn requires a geometrically increasing amount of embedded energy to produce (mostly coal and oil).

Obviously this gets us into a positive-feedback loop. We need more energy in order to produce more energy.

Our Position.
So here is a recap of our position:
1. Historically our prosperity has been based on the fact that producing resources yielded more resources than it costs. This resource “profit” is a requirement for all other productivity. Our economy requires this profit. Ultimately, our society and our civilization are built on the simple fact that more energy and resources are produced than are consumed in the production process.
2. However the cost (expressed in terms of energy and resources) to produce energy and resources (which was previously relatively flat) is starting to rise geometrically, and there are positive feedback effects in place.
3. This will result in less "net resources" for our society and this trend will continue to worsen geometrically.
4. Our economy depends on a steadily expanding resource base. We are facing an ongoing decrease in net availability of resources. This will lead to a decline in the economy. This decline will have a knock-on positive feedback effect:

NOTE: My concern is that the progression is geometric. The problem is almost negligible until you hit the inflection point and then the curve goes vertical.

This progression will end when the geometric curve reaches the inflection point and starts to go vertical - because at that point the diminishing returns from energy will rapidly lead to a resource squeeze that will cause our society to go through some marked changes.

How would you know that you are approaching the inflection point? Here are some signs:
- Increasing resource/commodity costs. Oh dear.
- Since money is a proxy for the net resource "profit", if this "profit" starts to decline you would start to see financial problems. Again... oh dear.
- You would start to see graphs that "hockey stick" upwards. Such as the attached "waste rock.jpg".... Oh.... Dear.


My point reduced to a “thought bite”:
Economically recoverable resources in a good economy may be beyond the reach of a declining economy.

.....So, to return to the original question - “How much oil do we have?" There are two answers:
1. In theory we can make arbitrary amounts of oil. So we have near-infinite quantities.
2. In practise at some point (probably within the next few decades) we will find that we can not even produce all the oil that is currently listed in "reserves" because this stuff is going to take more energy and resources to produce than we have readily available. Some of this oil may be produced gradually, in coming decades, but not at any significant production rate. The rest will stay as a reserve that is not commercially recoverable in a declining economic environment.

Some of the really “hard oil” may never be produced because the economy may not be able to put together the prodigious combination of energy and resources necessary to find and produce oil in impossibly difficult locations.

Oil and resources that are economically recoverable today may not be economically recoverable if the economy declines.

Discussions of Hubbert Linearization to produce URR and from there project an exact date for Peak Oil are interesting but no longer relevant. It is time to start preparing for a future that is not like the past.

I joined the Peak Oil movement so that we could mitigate the effects of PO and ensure a bright future for my children. I believe that we have passed an inflection point. That battle is lost.

The future will not be like the past. We must deal with multiple related and interacting problems - resource depletion, climate change, population overshoot, and resource contention. I don't think that the result will be "Mad Max", but it won't be "lawyers and accountants chatting over white picket fences in suburban bliss" either.

We need to move away from trying to define exact global URR. The problem is more complicated than that. It is a problem of quality not quantity. It is true that we have a problem of decreasing geological availability, but the problem presents itself in the form of declining quality squeezing us at the economic margins, not a problem of simple unavailability.