Peak Watch

A Shale Gas Boom?

But I think you also have to be impressed by the credulity of the people who invested and the desperation and almost the laziness—the lack of due diligence of the people who pumped their money in. I mean, when it comes right down to it, people really don’t know much about this world, and they’re looking for some kind of Virgil to give them a tour through it. And they don’t really do much investigating, and they just—they defer far more to someone like [Madoff] than they would in circumstances where the stakes are much lower
    —David Margolick, a writer for Vanity Fair, speaking on NPR about Bernie Madoff's victims

With the release of the Potential Gas Committee's 2008 year end assessment last week, there was a fresh wave of enthusiasm for replacing oil or coal with natural gas. The PGC, led by Dr. John B. Curtis of the Colorado School of Mines, found a lot of new resources in their reevaluation of potential shale plays.

The Potential Gas Committee (PGC) today released the results of its latest biennial assessment of the nation’s natural gas resources, which indicates that the United States possesses a total resource base of 1,836 trillion cubic feet (Tcf). This is the highest resource evaluation in the Committee’s 44-year history. Most of the increase from the previous assessment arose from reevaluation of shale-gas plays in the Appalachian basin and in the Mid-Continent, Gulf Coast and Rocky Mountain areas...

The Potential Gas Committee reports its gas resource assessments biennially in three categories of decreasing certainty—Probable, Possible and Speculative. For each category, a minimum, most likely and maximum volume is assessed for each of 89 geological provinces in the Lower 48 States and Alaska. The mean values shown in Table 1 below were calculated by statistical aggregation of the minimum, most likely and maximum traditional values for each resource category...

[My note: see the link above to view Table 1. Figure 1 shows the major U.S. shale basins.]

Figure 1 — The major shale plays in the United States, from a report by Navigant Consulting, Inc. for the Clean Skies Foundation sponsored by Chesapeake Energy Corp. (CHK). Some of the biggies in or starting development include the Antrim (#1), Barnett (#3), the Haynesville (#10), the Marcellus (#13) and the Bakken (#2).

If you add up the mean values for Traditional Gas Resources, which includes shale gas, and Coal Bed Methane, you get the 1,836 Tcf of potential resources. If you throw in the EIA's proved reserves, the total resources are 2,074 Tcf in the Lower 48 and Alaska. Curtis explained that his tally represents the ‘technically recoverable’ gas resource potential of the United States. At current consumption rates, the new total represents about 100 years of supply. If speculative resources (500 Tcf) are excluded, we would still have about 75 years of supply.

Suffice it to say that there is little reason to doubt that the potential natural gas resource base in the United States is very large. The hidden problem with such estimates relates to whether the gas is economic to produce, an issue which is outside the PGC's purview.

Let us assume for now that all the gas (2,074 Tcf) that might be there is actually there. Let's further assume that it is indeed technically recoverable and economic to produce at a "reasonable" price, which I will leave undefined. What would we do with the gas?

We have two energy problems in the medium to long term, climate change and peak oil. (In the very long term, all bets are off.) Consequently, shale gas has been proposed as a temporary (a few decades) solution to both. We can—

• use natural gas to replace liquid fuels in transportation, especially as a replacement for diesel in long-haul trucking. This is the (T. Boone) Pickens Plan, which is currently dead in the water. Pickens expressed his excitement about the PGC reports, saying that "the 2,074 trillion cubic feet of domestic natural gas reserves cited in the study is the equivalent of nearly 350 billion barrels of oil, about the same as Saudi Arabia’s oil reserves." Pickens is selling his plan—he knows better than to spout nonsense like this. ASPO-USA commentator Tom Standing did an excellent job of analyzing the energy density issues and practicalities (e.g. compressed natural gas versus liquefied natural gas) of replacing diesel with gas. It would take decades build out the supply chain (e.g. swap petroleum gas stations for natural gas stations). Robert Rapier also wrote an analysis worth reading on this subject.

• use natural gas to replace coal in electricity generation to reduce CO₂ emissions. Dr. Joseph Romm of the influential Center for American Progress is already calling the potential shale gas play a game-changer. The imminently practical idea is to ramp up under-utilized natural gas power generation capacity to replace base-load coal. Geoffrey Styles' analysis Shale Gas and Climate Change provides an excellent overview, so I won't repeat the details here. Even if you don't believe we are going to make an 80% reduction in our emissions by 2050—I don't believe it—official policy is to act as though we are going to do so. We now have the makings of a de facto moratorium on coal (and here). We seem to be unwilling to build new nuclear capacity. It is theoretically possible for wind to provide 20% of our electricity by 2030, but there are many practical, economic & political barriers to success. Thus it would behoove us to switch to natural gas at large-scales if we want to maintain a functioning electricity grid 10-15 years from now. This is my current view, but the political winds could change quickly as the Great Recession grinds on.

If we are at the beginning of a long term shale gas boom, it is clear we can put the gas to good use. But that's a big IF. Before we make a policy commitment to a natural gas future, we must be certain the gas will be there.

Let's return to the real world, a messy place where some potential gas resources may not exist, or may not be economic to produce. Things get complicated here, but don't they always?

Shale Gas Economics

At first glance, increased shale gas production (Figure 2) looks like a textbook case of resource economics. A "new" technology (horizontal drilling & hydraulic fracturing) combined with rising price (Figure 1) boosts recoverable reserves over time.

Figure 1 — The history of natural gas wellhead prices since the 1970s, from the EIA. Volatile prices have increased since about 2002, but have fallen lately during the downturn.

Figure 2 — Increased shale gas production with a risked estimate out to 2018, from a Tristone Capital study (October, 2008)  described in the Oil & Gas Journal's Study analyzes nine US, Canada shale gas plays. These are risked production additions — "the study expects companies ultimately to recover from these resources 261 Tcf of gas, based on various risk factors applied and a long-term average gas price of $8.50/MMbtu. Without the risk factors, Tristone Capital says these shales have a 743-Tcf recovery potential." The Horn River and Montney shales are in Canada, so they don't appear in Figure 1.

Tristone Capital's future production estimate depends on a long-term average price of $8.50/Mcf (per thousand cubic feet abbreviated as Mcf, equivalent to million British Thermal Units, abbreviated as MMbtu). The required price is well over the 15-year average of ~$5.50/Mcf.

What average natural gas wellhead price allows the shale boom to continue? Shale gas economics is a contentious issue. One camp believes that shale gas is economic at—and will keep future prices in—the $5-6/Mcf range. I'll call these analysts the optimists.

The other camp believes the marginal cost of shale gas production is $7-8/Mcf, and perhaps much higher depending on the shale play. These are the pessimists. Let's break down the arguments.

Barclays Capital stock analyst Tom Driscoll is an optimist. On May 27, 2009, Platts quoted Driscoll as saying—

"Conventional gas is being displaced by unconventional gas," Driscoll said and it may take "20 years for natural gas prices to recover."

"The emergence of low-cost unconventional, and especially shale gas, resources may lead to lower than expected natural gas prices for the next five to 10 years," Driscoll said. "Shale -- along with other low-cost unconventional gas -- could provide 75% to 90% of new gas supply over the next several years and set the marginal cost of new supply."

Despite the nearly 50% cut in rig counts since their peak in the fall of 2008, Driscoll estimates that fourth-quarter 2009 gas production numbers will show no decline from fourth-quarter 2008 numbers...

He said he estimated the market will average 4 Bcf/d worth of oversupply this year and 3 Bcf/d worth of excess gas in 2010.

Driscoll said the more productive horizontal rigs are profitable at prices "materially below" $6/Mcf, which just keeps gas flooding into the market even as cash prices plummet.

[My note: Driscoll and others also project that shale gas may provide up to 40% of U.S. supply by 2013.]

This is a very bullish forecast. Despite reduced rig counts, and despite the likelihood that we will have low or average gas prices over the next few years due to the recession and oversupply, the market share of shale gas grows and grows. This forecast looks like a high-wire act that defies not only gravity, but also the laws of supply & demand. One wonders what the minimum price is that makes shale gas unprofitable. $4.50/Mcf? $3.50/Mcf?

Another optimist, Ziff Energy, tells us how much gas is produced from shale now.

Ziff Energy Group forecasts unconventional gas production will supply 53% of US gas needs by 2020, up from 30% in 2000.

Ziff Energy's Shale Gas Outlook to 2020 says shale gas production in 2008 was more than 5 Bcfd (8% of North American gas production), with 70% coming from the Barnett shale in the Fort Worth basin of Texas.

In the future, the report sees increased gas coming from the Barnett, Fayetteville, and Woodford shales as well as many other plays such as the Haynesville, Marcellus, Horn River, Utica, and Gothic. The report expects in 2020 that North America will produce 87 Bcfd compared with 70 Bcfd in 2000.

[My note: "Bcf" stands for billion cubic feet and "Bdfd" is the daily rate. U.S. dry gas production was 20.56 Tcf in 2008. The production rate was 56.33 Bcfd. The U.S. consumes more gas than it produces, getting the rest from Canadian and liquefied natural gas (LNG) imports. Conventional gas production peaked in the 1970's in the United States. New supply from unconventional tight gas (and some coal-bed methane), along with imports, filled the supply/demand gap. As Figure 2 shows, shale gas is a johnny-come-lately on the gas scene.]

The biggest booster is the man who is selling shale gas—Chesapeake CEO Aubrey McClendon.

At Chesapeake Energy's recent shareholder's meeting, Chairman and CEO Aubrey McClendon suggested that the increased use of natural gas would be a way to help the U.S. stop indirectly funding nations that are "declared enemies" and would benefit the environment as well. McClendon said the lack of availability of natural-gas-powered cars in the U.S. is "the most frustrating part of my existence today" and pointed out that General Motors manufactures 12 car models throughout the world that come off of the assembly line ready to run on natural gas, yet there are no such models in the U.S.

McClendon knows how to sing the right notes, but I thought his "most frustrating part of my existence" statement is a bit overdone. What do the pessimists—they would prefer to be called realists—say about all this? And how would optimists respond?

Art Berman, a Houston geologist and columnist at World Oil Magazine, does not believe most shale gas wells are economic unless operator costs go down, gas prices rise sharply, and high average prices are sustained. Talking about the Haynesville in A Long Recovery for Natural Gas Prices, Berman says—

Drilling and completion costs [in the Haynesville] vary from $7.5 to $10.5 million per well. The marginal cost for operators to find and develop natural gas reserves is $7 to 8/Mcf, and current netback prices in the play are less than $3/Mcf. The threshold netback gas price for a better-than-average 5.5 Bcf well to break even is $7/Mcf at NPV10 (Bodell and Pittinger, in press). For companies that have favorable hedge positions, realized gas prices for 2009 will be as high as $6.50/Mcf and $6.00/Mcf for 2010. This means that the play is marginally commercial today for operators with favorable hedge positions, but not commercial based on cost and price fundamentals.

Berman's argument is based on current (and likely future) gas prices, a minimum ultimately recoverable per well, and "all-in" costs of about $7.50/Mcf, not on the impressive initial well flow rates often reported in Rigzone. At current prices, the netback of $3.25/Mcf barely covers operating costs, so no Haynesville well is economic and rates and reserves simply do not matter. Berman's analysis of the Barnett is just as bad—

Shale gas is not commercial at any "reasonable" price because the costs are too high—I once calculated that at ~$12/Mcf only slightly more than 50% of Barnett Shale wells would break even or more money. I am now working on a re-evaluation of the Barnett Shale 11,500 wells later. The average per-well EUR is about 0.6 Bcf—pathetic! The cost is staggering—more than $30 billion and most of it hopelessly non-commercial...

[My note: quoted from an e-mail from Berman. 0.6 Bcf includes vertical wells, about 1/3 of the total drilling in the Barnett play. The average estimated ultimately recoverable (EUR, reserves) for horizontal wells is ~0.75 Bcf.]

But what about our classic case of resource economics? Prices rose (Figure 1) and shale gas production increased (Figure 2). That would seem to belie Berman's pessimism—the proof is in the pudding. What's the problem?

The wrench in the works is that operators appear to have lost money producing shale gas. McClendon recently stated that "we believe that Chesapeake's strong financial condition and extensive hedges provide us with ... [the] flexibility to make prudent natural gas revenue maximization choices." No doubt Chesapeake will try to maximize their revenue, but do they have a strong financial condition? Berman says No—

I have worked through the 10-Ks of most of the major shale players (Chesapeake, Petrohawk, Range Resources, etc.)—they’re all taking a bath financially but put on a brave face, and have huge debt. As long as their stock price is good, the executives get rich so why do they care? The analyst community is so naive about true costs that they believe the propaganda.

[My note: Chesapeake has 14.4 billion in senior debt and their stock price is faring badly. "CEO Aubrey McClendon has come under some well-deserved fire for his high compensation in the face of poor results and a declining stock price. He was paid a one-time $75 million bonus at the end of 2008—suspicious timing given that the stock had lost most of its value in recent months and Mr. McClendon had lost his entire stake in the company to margin calls."]

Most shale operators work on borrowed capital—who is going to lend that kind of money [~$150 billion for the ~30,000 wells required to quadruple shale gas production] to companies like HK [Petrohawk] and CHK [Chesapeake] that are already in debt up to their eyeballs?

[My note: The 10k is a document filed with the SEC that contains ... the same financial statements the annual report does in a more detailed form.]

I entirely agree with Berman's take on things here. There's no dearth of clueless analysts—I've read or listened to more than a few. Berman's deeper point about propaganda is also right on the mark. In the Age of Hype, the Ponzi Scheme and the Swindle, why wouldn't some natural gas companies want to get in on the deal?

Other analysts like Ben Dell, a senior energy analyst at Bernstein Research in New York, are suspicious about corporate reporting of returns on shale wells.

In a March 27 research note, [Dell] notes “a growing discrepancy between the internal rates of return (IRR) presented in corporate presentations and company reported ROACE (return on average capital employed)... For example, in many plays companies claim to generate IRR’s above 100% at $7.50/mcf gas or claim that their production is economical even at $2-3/mcf gas prices, but at the same time report 6-7% ROACE at a corporate level over the last 3 years, when the average gas price was $7.50/mcf.”

Titled “Why the Haynesville Won’t Work…at $4, $5, or $6/mcf gas”, Dell posits that companies are overstating production, understating costs, or there is a terminology gap at work. For example, a producer could say the IP rate of a well (Initial Production) is 8 mmcf/d (million cubic feet per day). But was that a 30 day average, as is normal, or was it a 12 hour average just after coming online. These HD wells can decline in production so rapidly sometimes that for stock promotion purposes, companies issue figures that may have been correct for a short time, but have no context and are not really “best practices” type numbers.

Dell also questions if the all in costs of a well are being amortized properly into the economics that appear in a company’s press release. If the cash operating cost of a well is $3/mcf, which is the number that appears in a release that does not include the $4-7 million it cost to buy the land and drill the hole - costs that Dell suggests basically doubles the breakeven level of the well to $6/mcf. And to get an acceptable return - even to generate enough cash to drill the next well - would be $8/mcf.

Dell's analysis and Berman's are the same in all the essentials. Let's sum up the situation so far—

• Shale gas operators are up to their eyeballs in debt. They would need to borrow vast sums of money—Berman suggests it would take ~30,000 wells and ~$150 billion—to get shale gas up to 40% of total U.S. dry gas production by 2013.
• Shale gas operators can't possibly make money at current natural gas prices, or medium-term future prices if these are close to the 15-year average (~$5.50/Mcf).

The situation is actually worse than our summary indicates. Shale gas wells have very steep decline rates. Consider the Griffith #1 well in the Haynesville as reported at Rigzone.

The Griffith #1 well located in Desoto Parish, Louisiana was completed and brought online in January 2009. The exact reading for total gas produced from the Haynesville shale [Griffith #1] and shipped to market through March 10, 2009 is reported at 568,856 Mcf or .568 Bcf...

The Haynesville Shale play is a new play less than one year old and there is limited data to work with to determine the decline rate for Haynesville Shale wells. [Mainland Resources, Inc.] believes that the recoverable reserves for the Griffith well may ultimately be from 7.5 Bcf to 15.81 Bcf. The 15.81 Bcf rate was determined by a reserve report for the Griffith #1 done by T.W. McQuire & Associates, Inc., prepared pursuant to U.S. Securities legislation. The ultimate recovery was determined by using a type curve that uses 80% decline for the first year, followed by 30% decline for the second year, 15% decline for the third year, and then a 10% decline over the remaining expected life of the well. This decline was derived from the Deutsche Bank report issued in 7/08 based on a study of various shale plays.

[My note: The quoted .568 Bcf is over the first 40 days of operation. Using a type curve to figure declines in the Haynesville may be misleading. Berman's observed decline rates for the Barnett Shale are as follows:

Year 1:  65%;
Year 2:  53%;
Year 3:  23%;
Year 4:  21%;
Year 5:  20%;
Year 6:  17%;
Year 7:  21%

Berman notes that "there is no empirical justification to lower terminal decline rates to 10%/year, and there is no factual  evidence for the declines used in Years 2 & 3 by Deutsche Bank. This is what happens when bankers try to  do petroleum engineering and geology. They have used a model to get these declines but have not bothered to calibrate it against the only shale play in the world with enough production history to it compare to."]

The Griffith #1 well may or may not turn out to be a winner, but the reserves (7.5-15.8 Bcf) seem inordinately large for a shale gas well. Steep declines several years into production, even when there is a high initial flow rate, largely determine what the well reserves will be, which Berman calculated as only 0.6 Bcf on average for the 11,500 wells drilled in the Barnett Shale.

And we only hear about the successful wells, the creme de la creme. It would be unusual to find a story at Rigzone that reads like this—

Desoto Parish, Louisiana -- March 13, 2010

Mainland Resources, Inc. announced today that their Bogus #2 well in the Haynesville showed weak flows in the first few weeks after production began ... Spokesman John Q. Smith said "we probably won't get 0.3 Bcf out of the damn thing... We'll never get our money back." He called the results "very disappointing." ... Smith concluded that "drilling this well was a complete waste of time and money."

When we consider disappointing wells and high decline rates in successful wells, it is clear that getting shale gas up to 40% of U.S. production by 2013 is not only very expensive—$7.5-10.5 million for drilling & completion according to Berman—but also requires poking a lot of very expensive holes in the ground.

One problem with analysts like Tom Driscoll, who is a stock analyst working for Barclays, which is a bank, is that they remember how to add but they've "forgotten" how to subtract. This applies straightforwardly to the shale gas play. The usual human bias, as evidenced in Rigzone stories, is to play up the successes and ignore the failures, as Nassim Taleb pointed out in his book Fooled By Randomness. We see the single entrepreneur who succeeded on TV, but we never hear about the 10,000 who failed. This introduces a significant skew into the data being examined.

I do not mean to make a sweeping generalization. Paul Horsnell, who is an oil market analyst at Barclays, knows what he's talking about.

The optimists' response to all this bad news is summed up by Keith Shaefer's Natural Gas: Costs go down as learning curve goes up. To give the opposition equal time, I will quote it at length.

Operating costs are still coming down in North American natural gas and oil plays. This isn’t showing up as reduced all-in costs on the financial statements of these energy producers just yet, but it will.

Costs are lowering for two reasons. One is demand destruction, which has cut in half the number of rigs drilling for oil and gas in North America. This has meant that rig rates have also dropped—energy executives are saying they see 20%-35% cost reductions year over year. Lower drilling costs have an obvious impact on profitability.

The second is that companies in both the US and Canada are figuring out how to properly frac these new unconventional gas plays—both tight gas and shale gas...

Calgary based securities firm Tristone Capital says wells in the Montney gas play on the BC-Alberta border are now 8-10 mmcf/d [million cubic feet], about twice what they were when the play first started.

... the energy producers are learning how to frac these plays much better, using special mixes of chemicals and water to get the most oil or gas out of these new, very tight reservoirs. It can sometimes take some expensive trial and error on how to get that frac formula right.

Tristone estimates the average break even level of these new shale plays is now hovering around $5/mcf, with the best plays already at $4, and as the learning curve goes up, the cost curve will continue to go down, taking the break even price for natural gas production down with it.

What will likely mask these costs on the financial statements of these companies is the huge land acquisition costs these companies had to pay for these unconventional plays. As an example, British Columbia in Canada has sold their land rights at an average $680/hectare (1 hectare = 2.5 acres) compared to $3511 per hectare over the same time frame in 2008 -- and B.C. has the new Horn River Basin in the north and part of the Montney gas play along the Alberta border. Both 2007 and 2008 saw huge land cost increases across North America as companies rushed in to buy up acreage...

Until some of these high land costs are amortized out, don’t expect to see the “accounting” cost of finding a barrel of oil [gas] -- usually shown as DD&A - Depletion, Depreciation and Amortization—on the balance sheet, to go down much, even though “real” costs are dropping a lot.

So when people ask “Where is all the cheap gas?”, it’s here, and it’s getting cheaper by the month, but it might not show up in the companies’ financial statements for awhile.

It appears Tritone has changed its tune, revising its $/Mcf from $8.50 (Figure 2) to $5. This story says that 1) previous "all-in" costs of $7.50 or more were due to expensive land acquisition; 2) oilfield expenses are declining as rig rates go down; and 3) operators are ascending the learning curve for shale drilling, which lowers costs and boosts reserves & flows. These factors imply that fewer wells will produce more gas due to "more productive horizontal rigs," as Driscoll maintains.

Berman's response?

If shale operators cannot substantially reduce their costs, I doubt that most of them can survive a year or so more of low prices (Barclay's "low camp" $5-6/Mcf) because their marginal cost of production is $7-8/Mcf, much less find $150 billion or so for more unprofitable drilling.  I believe that the cost of services will escalate at a higher rate than cost, and will never drop to meet low price (except for possibly too brief a period for most operators to take advantage of).

Actually the frac costs keep increasing because operators are now commonly using 10-12-stage fracs that cost millions.  Rates are higher but at what cost and for how long?  The key here is that the extra cost may only accomplish a rate acceleration and not an increase in reserves.  In the Barnett Shale, the average horizontally drilled and fractured wells only have ~25% more reserves than vertical wells but 3x the cost!  This talk about lowering operating cost and increasing reserves is more propaganda, and most cost benefit is more than negatively compensated by more interest expense on debt.

Let's sum up.

A Shale Gas Boom?

Will we have a shale gas boom? I've described the contentious argument among those who follow the natural gas industry. Generally, my sympathy lies with skeptics like Art Berman. As someone who has written extensively about peak oil, I've encountered the human proclivity to hype a situation far beyond any semblance to reality time and time again—the Jack #2 discovery in the Gulf of Mexico comes to mind.

Nevertheless, I'm going to say the jury is still out on this one. That's not a cop-out, because the verdict will be in very soon, certainly within the next few years. Art Berman is making specific predictions, just as Driscoll, Shaefer, and Ziff Energy do. Berman surmises that natural gas prices may stay below or in their average range (~$5.50) for a few years based on a host of new factors that include greater availability of tight gas from the Rockies and increased LNG imports. If Berman is right, we will not see large increases in shale gas production through 2011, or some companies will go belly up, or both.

Promoters like T. Boone Pickens and Aubrey McClendon have offered us a Golden Vision of a future powered by natural gas. Their forecasts assume a shale boom that will last for decades. But we shouldn't count our chickens before they're hatched. It costs us very little to take a wait & see attitude on the shale gas boom—we'll know soon enough if it's for real.

Contact the author at [email protected]

Bad Signs, New Bubbles

Starting with the tulip bulb mania in the 1630s, bubble after speculative bubble has been erased from the popular memory: the South Sea bubble in the early 1700s; the Mississippi bubble, which caused a stock market crash in 18th-century France; the Florida real-estate bubble in the 1920s; the stock market crash of 1929; the stock market crash of 1987; the Nikkei bubble, which began in 1991; and the Nasdaq bubble of 2000 [and now the Housing Bubble of 2006]
    —from Saving Capitalism and Ending Poverty

The speculative bubble always comes to an end--and never in a pleasant or peaceful way
   —John Kenneth Galbraith, quoted in 1999

The rise in oil prices (and commodities generally) driven by speculation that I described in Mr. Market Gets It Wrong Again is now the conventional wisdom among observers who aren't directly vested in blowing a new bubble. The economy is on its knees, but Americans must cope with daily increases in the price of gasoline.

Higher oil prices drive up fuel costs, which dampens consumer spending on other goods.

"People say it doesn't matter until gas gets to $3 or $4 a gallon," said Peter Beutel, an oil analyst at Cameron Hanover. "But every time it goes higher it takes that much more money out of consumers pockets."

Beutel can even tell you how much. For every 10 cent rise in gas price, people can spend $40 million less a day on other things...

"Crude oil prices appear to have been divorced from the underlying fundamentals of weak demand, ample supply, and high inventories," Adam Sieminski, chief energy economist at Deutsche Bank, wrote in a recent note.

So far, so good, but then this CNN Money story takes an odd turn.

The rise in [oil] prices is instead being driven by a falling dollar and investor interest.

A falling dollar is causing oil to rise as investors buy crude as an inflation hedge. Money is also coming out of bonds and other safe haven investments and back into oil, stocks and riskier assets as early signs suggest the economy may be improving.

[My note: The falling dollar/inflation hedge angle is correct.]

While motorists may be miffed to learn that Wall Street is the main driver for the recent run-up in fuel prices, it's probably not such a bad thing that investors are expressing confidence in the economy. Renewed lending and job creation will likely outweigh any pain people may feel from paying higher gas prices.

Whoa, Nelly! Job creation? Renewed lending? This is hogwash. Here's another example from Reuters' James Pethokoukis, who is blogging on money & politics.

"There is a debate going on whether the spare capacity opening up will allow inflation to stay low for a prolonged period of time, but markets don't seem to be buying this view," said Sarah Hewin, senior economist at Standard Chartered.

Markets' inflation fears appear to stem from the potential impact of quantitative easing, as well as the recent slew of positive economic data, Hewin said.

But she added: "We don't buy the view that the extent of QE we have seen will bring a resurgence of inflation -- at least until the end of 2010 and we think U.S. Treasury yields may have backed up too far."

Hewin is probably right to say that a new resurgence of inflation will be delayed until sometime in 2010, but a recent slew of positive economic data? Give me a break!

Although brilliant self-deception allows most of us to get through life, I don't think now is the time to rely on that often helpful quality.

A plausible, albeit unpleasant, view of the future is emerging which explains heightened inflation expectations contributing to bubbly speculation in commodities. Baseline Scenario's Simon Johnson and Peter Boone outline this trend in The Bubble Next Time. I will return to this article, but here is their conclusion.

The balance of global power is shifting. Japan was perceived as a great powerhouse until 1990 — deflation, the lost decade, and demographic decline have ended that. America and Europe both have years ahead of low interest rates, balance-sheet problems, and sluggish growth. Brazil, China, South Korea, Russia and the like used to be called emerging markets; now they’ll be known simply as the New Rich.

This view, if correct, has profound implications for economic conditions in the OECD (developed) nations and future global energy consumption. Let's start with the prognosis for the United States.

Dim Prospects for Consumption

The credit & debt bubble in the United States is unwinding. Many Americans are down for the count, and will likely lie prone on the canvas for some time to come. The economic fundamentals are absolutely clear on this point as shown in the first three graphs.

Figure 1 — The net worth of American households from Calculated Risk, based on data in the latest Flow of Funds Report from the Fed. You can see the bubbles. Net worth has fallen back to a value typical of the period 1987-1995. Will we see household net worth fall to levels last seen in the 1970s?

Figure 2 — Taken from Jobless Recovery Redux? from the San Francisco Fed. Calculated Risk provides data on previous jobless recoveries. Unemployment rose for 15 months after the 1990 recession officially ended. Unemployment rose for 19 months after the 2001 recession officially ended. The official U3 unemployment number is 9.4%, well below recent Blue Chip (and Fed) forecasts. The U6 number, which includes people whose hours have been cut back and those who have given up looking for work, is 16.4%. The current "Great Recession" is far worse than 1990 or 2001. The "jobless recovery" shown is probably too optimistic, but still shows U3 unemployment above 9% in 2012. The San Francisco Fed reports that there are additional reasons for pessimism, for example "[the data] suggests that, more than in previous recessions, when the economy rebounds, employers will tap into their existing workforces rather than hire new workers. This could substantially slow the recovery of the outflow rate and put upward pressure on future unemployment rates."

Figure 3 — Mortgage debt (blue lines) versus equity (red line) from 1945 to the present, taken from T2 Partners' More Mortgage Meltdown. They estimate that house prices must fall another 5-10% before reaching the longer term (Case-Shiller, Lawler) trend line, but typically in a post-bubble period prices fall below the trend line before bouncing up again.

This data represents a small but significant subset of all the trends showing the deterioration of conditions on Main Street. It is easy to reach the following conclusions—

• Growing mortgage debt driving lower household net worth will depress consumer spending in coming years. It will take at least two more years for house prices bottom-out.
• Growing unemployment through mid-2010 combined with high jobless rates thereafter will also depress consumer spending in coming years. Remember, the U6 (all the unemployed and unwillingly underemployed) is now at 16.4% and will likely surpass 20% before the worst is over. Is the Employment Picture Really Better Now Than in 1933? gives an interesting perspective on this problem.

Personal Consumption Expenditures (PCE) made up 72% of 2009:Q1 Gross Domestic Product (GDP, output) according to the preliminary numbers provided by the Bureau of Economic Analysis. It appears that no significant turnaround in consumption is possible before 2012 in the best case. Even if the NBER were to call (in retrospect) an end to the Great Recession in the 2nd half of this year or the 1st half of 2010, GDP growth will be sluggish at best for quite some time thereafter.

What is obvious to me and untainted economists will also be obvious to analysts getting paid to advise Wall Street banks, hedge funds and private equity.

Future Investments In the United States?

It is hardly an exaggeration to say that when the dust settles, Too-Big-To-Fail Finance will be in better shape than any other segment of our economy. The Treasury (with Congressional approval) and the Fed have paid off (socialized) the bank losses and guaranteed bailouts on future losses. Quantitative easing makes their product—money—dirt cheap. If you can obtain money at little or no expense to yourself and then lend it out at higher rates of interest, the future looks very bright indeed.

There is no compelling reason to believe the trends shown in Figure 4 will not continue after the Great Recession ends.

Figure 4 — Financial profits share of GDP versus debt as a percentage of GDP. T2 Partners made this graph based on Federal Reserve and BEA data as of 2007:Q2. The debt line (red line) may flatten out a bit but is unlikely to decrease. The recent disruption of financial profits (black line) is temporary. Bank losses were covered by the Treasury and the Fed. The remaining banks will be stronger than ever.

When the downturn bottoms out, the banks will be flush with money made available by the Federal Reserve. Quantitative easing and deficit spending will continue because tightening interest rates or cutting government spending would put us back into the Great Recession, Phase II. Our debt will continue to be backed by the Chinese, Japan, oil exporters and many others for the time being. Paul Krugman is urging policymakers to stay the course, and I believe they will.

The rationale of Paulson, Summers, Geithner & Company for saving the banks—we will foster a recovery by getting credit flowing again to over-leveraged consumers—looks like a cruel hoax when viewed in light of fundamental data shown in Figures 1-4. And continuing the spending spree, wherein we borrow from the future to provide artificial lift to the present, is ultimately a Disaster of Biblical Proportions—one can easily imagine a day when 50% of government expenditures go toward interest on the debt, but that's not my main focus today.

Getting back to Big Finance, the only remaining question for them is: where will they invest all that cash? It won't be in the United States.

Many parts of the American landscape resemble a burnt out husk. Take commercial real estate (New York Times, June 8, 2009)—

Talk of American infrastructure tends to focus on inadequacies: roads that need to be repaired or widened, bridges fortified, electrical grids updated. All the more striking, then, that America’s retail infrastructure — its malls, supercenters, big boxes and other styles of store-clumping — has come to be characterized by rampant abundance. This has been a decades-long trend. But it has taken the economic downturn, with chain stores liquidating, mall tenancy slipping and car dealerships scheduled for closure, to focus popular attention on the problem with our retail infrastructure: there is too much of it.

A recent book, Retrofitting Suburbia, by Ellen Dunham-Jones and June Williamson, notes that in 1986, the United States had about 15 square feet of retail space per person in shopping centers. That was already a world-leading figure, but by 2003 it had increased by a third, to 20 square feet. The next countries on the list are Canada (13 square feet per person) and Australia (6.5 square feet); the highest figure in Europe is in Sweden, with 3 square feet per person.

Allow me to repeat Figure 5 from my article Let It Burn.

Figure 5 — FIRING UP the economy. From Calculated Risk’s early report on government stress testing for banks. Note the relative size of residential mortgage + home equity + commercial real estate + credit cards (taken together) as opposed to commercial/industrial loans. The numbers cited are for potential losses, but the absolute sizes can be calculated by using the loss numbers and the percentages.

As with overbuilt commercial real estate, making large future investments in residential mortgages, home equity, and credit cards amounts to throwing good money after bad. Let's return to Simon Johnson and Peter Boone's thesis of a great economic shift in from West to East and South.

The Bubble Next Time

The new credit & debt bubble will take place in Asia, South America and "even Africa."

The next global bubble is already under way. What happens when the most powerful nation in the world, with a reserve currency everyone trusts and holds, decides to push a big credit expansion — again, at the instigation of our financial sector? The creditworthy borrowers this time are not in the United States — they are in Asia, Latin America, and even Africa. They have little debt and great prospects; for a mere 1 percent per year they can borrow American dollars, spend the funds at home, and turn paper money into real assets. Every great bubble begins with a truly convincing shift in fundamentals.

In the 1990s this was called the “carry trade.” You borrowed from the Japanese at 1 percent and bought anything outside Japan that yielded a bit more (including United States subprime mortgages). The coming American carry trade is the same thing: it weakens the dollar, lifts the economy out of recession through exports, and creates inflation that reduces the real value of our debts. This can last quite a while — both the Treasury and the Fed are sure that early attempts to tighten policy prevented serious recoveries in Japan in the mid-1990s and in the United States toward the end of the 1930s.

I could quarrel with the idea that the American "carry trade" will "lift [our] economy out of recession through exports" but the rest—a weakened dollar, inflating away the debt—looks right.

I keep wondering what it is we will export. Software? No, we export software jobs. Cars and auto parts? That part of our shrinking manufacturing sector just took a huge hit. Caterpillar excavators and pipe layers? Probably, yes. Semiconductors, pharmaceutical preparations, and telecommunications equipment? Yes. Farm (food) exports? Yes, again.

But is all of this enough to turn sluggish growth into prosperity? A weakened dollar makes imports more expensive, which reduces them. The same inflated dollar encourages exports. But without a massive infusion of new investment in America's manufacturing base, there are limits on how much our exports can grow. Will these investments get made? (I discussed the importance of exports/imports for the U.S. economy in Real GDP and the Oil Shock of 2007-08).

Mostly, the United States will export credit.

The new bubble remains in its formative stages because the global economy is still in terrible shape, as detailed in Martin Wolf's The recession tracks the Great Depression (Financial Times, June 16, 2009). As the emerging economies crawl out of the muck created by the collapse of the Housing Bubble and the Oil Shock, banks on Wall Street, in London, Switzerland, and Paris, in Tokyo, in Dubai or Singapore, and offshore in the Caymans will be able & eager to provide inexpensive dollars to emerging economies to get them back on a rapid growth track.

Johnson and Boone conclude—

Perhaps this is the greatest foreign-aid package of all time. But are we [in the United States] re-establishing our global leadership, albeit in a strange way, or just throwing all pretense to strategic leadership out the window? And are we laying the foundation for a truly massive international debt crisis?

We're not re-establishing our global leadership, that's for sure.

A Dress Rehearsal

From Main Street's point of view, the current "rally" in oil prices and the S&P 500 is a lot of hot air. The alleged "green shoots" benefit monied interests in New York.

Fed officials take comfort in other developments in financial markets. Though mortgage rates have risen, many other private-sector borrowing rates are coming down. For example, the London interbank offered rate [LIBOR] -- the rate at which banks make short-term loans to one another -- has declined. Rising stock prices are also helping improve financial conditions and bolster household wealth.

"Conditions in a number of financial markets have improved since earlier this year," Mr. Bernanke said last week in testimony to Congress.

I'm sure families who are losing their house—they can't refinance now because of the rise in mortgage interest rates—will be overjoyed to hear that the LIBOR interbank lending rate has declined. Reporters at CNN Money and other fish swimming in the Wall Street water pick up the "green shoots" theme and mindlessly repeat it. I heard one CNBC commentator say he wished consumers would join the rally and spend more money! 

Life is pain, and anyone who tells you different is selling something.

Simon Johnson recently posted a Five Point Summary of where we stand. Items #4 and #5 are of interest here.

4. The consensus from conventional macroeconomics is that there can’t be significant inflation with unemployment so high, and the Fed will not tighten before late 2010.  The financial markets beg to differ – presumably worrying, in part, about easy credit leading to dollar depreciation, higher import prices, and potential commodity price inflation worldwide.  In all recent showdowns with standard macro models recently, the markets’ view of reality has prevailed.  My advice: pay close attention to oil prices. 

5. Emerging markets are increasingly viewed as having “decoupled” from the US/European malaise.  This idea was wrong in early 2008, when it gained consensus status; this time around, it is probably setting us up for a new bubble – based on a “carry trade” that now runs out of the US.  The ”appetite for risk” among investors is up sharply.  The G7/G8/G20 is back to being irrelevant or merely cheerleaders for the financial sector.

I do pay close attention to oil prices, and being somewhat knowledgeable about them, I believe a purely speculative play must collapse. To be successful, a bubble must be grounded in reality. You can't have a Housing Bubble if nobody wants houses. You can't have an oil price shock if demand for the stuff is about 4 million barrels-per-day below capacity.

The price may not crash all the way down to $25/barrel as I said in Mr. Market, but come August and September, the blue skies of Spring will give way to the storm clouds of Fall.

Along with Simon Johnson, I believe easy credit (aka. quantative easing) will eventually lead to "dollar depreciation, higher import prices, and potential commodity price inflation worldwide." But not yet. It's illuminating to observe the religious war that has broken out among economists.

Something akin to a religious war has erupted among economists on the next move for the Fed. One camp worries that higher long-term interest rates could choke off the recovery. As a result, they argue the Fed should ramp up its purchases of Treasuries to push rates lower. Others think rising rates are a clear signal that the market is worried about inflation. They want the central bank to check out of the Zero Interest Rate hotel as soon as possible.

To counter the financial crisis, the Fed has raised new reserves for the banking system to almost $900 billion by purchasing all sorts of assets, including toxic mortgages, from the banks. Some economists think these reserves are inflation-rocket-fuel.

Others argue that the reserves are not really money because they are not being used. They think the reserves could be drained before spilling over into the market.

"The Fed is not printing money and passing it out on the street corner so it jingles in everyone's pocket," said Jim Glassman, senior economist at JP Morgan Chase.

[My note: No kidding, Jim. Note to Helicopter Ben: send some of that money our way!]

"There is almost a semi-religious view that money, in-and-of-itself, causes inflation," said Bill Cheney, chief economist at John Hancock Financial Services, in Boston. "Money, sitting it a bank as excess reserves, won't do anything. Half of the problem with the economy now is that consumers aren't doing anything with it," Cheney added.

[My note: Why do you think consumers aren't doing anything with it, Jim? And also, the last time I checked earlier in this article, consumer spending was 72% of GDP.]

The markets don't believe "excess reserves" ($900 billion) parked at the Federal Reserve will be "drained" without being loaned out. I can't take this outcome seriously either. Americans trying to repair balance their sheets don't need more credit, but perhaps would-be consumers in Morocco, Malaysia, Chile, Egypt, Brazil and India might be able to put it to good use.

Nevertheless, commodity traders pricing in their expectations about inflation are doing so too early. Indeed, such trading is self-fulfilling because bidding up oil contributes to inflation. The state of the global economy does not justify bidding up oil.

We are now witnessing a dress rehearsal for The Bubble Next Time. The current commodity inflation foreshadows the real thing, which I expect to begin in earnest next year or the next. Finance types are chomping at the bit to blow a new bubble—Simon Johnson called this a heightened "appetite for risk." Our outsized banking sector, which has been the beneficiary of so much government largess and lack of regulation, will have free rein in this matter.

Johnson notes that "emerging markets are increasingly viewed as having decoupled from the US/European malaise." He believes this is an illusion that will foster the carry trade bubble. It is an illusion, but here's the bottom line for the longer term—

The pain for Asian economies, means they have to rethink the old model of "Asians make it, Americans buy it," and start boosting domestic consumption, Masahiro Kawai of the Asian Development Bank (ADB) Institute said last week.

"This pattern (of US consumption propping up Asian growth) is rapidly changing and I believe that this change is not simply a temporary phenomenon. It is going to be more permanent, or at least semi-permanent," Kawai told a seminar held by the Association of Southeast Asian Nations (Asean).

"Asia should remain the factory of the world, but Asians have to start consuming more. Asians have to start spending more," he said.

The historical convergence is nearly perfect. Finance must find new places to invest, but the United States, Europe and Japan are tapped out. The Asians and others must kick old habits and boost domestic consumption. It's a marriage made in Heaven. On a normal development path, it would take decades for emerging economy markets to reach the size of those in the developed world. The Big Banks can step in to "speed up" the process if they can persuade emerging economies to drink some of the bubbly. I don't think it will be a hard sell.

Assuming the Bubble Next Time thesis is correct, where does that leave us? We will eventually get inflation rates over and above the 1-2% currently priced in. Burgeoning consumption in emerging economies will cause commodity prices to soar again as they did in the period 2003-2008:H1. The sky will be the limit for a barrel of oil. The United States economy will remain in the doldrums for many years. This is a worst of both worlds scenario. We hope for the best, but in 2009, why shouldn't we expect the worst?

Oh, by the way, did I forget to mention that we are now living in the peak oil era? That is definitely going to make all this a lot more "interesting" than it already promises to be.

Contact the author at [email protected]

Peak Oil = Peak Demand?

I think it would be a good idea
   — Mahatma Gandhi, when asked what he thought of Western Civilization

Captain Renault: I'm shocked, shocked to find that gambling is going on in here!
Croupier: [hands Renault a pile of money] Your winnings, sir.
Captain Renault: [sotto voce] Oh, thank you very much.
   — Casablanca

Yesterday a news item appeared on the front page of this website with the headline "CERA Official Acknowledges “Peak Oil is Here”. Unfortunately, this report was a little premature.

Speaking at the Center for Strategic & International Studies (CSIS) in Washington DC on 8 June, CERA Global Oil Group Managing Director Jim Burkhard began and ended his talk by stating that “CERA acknowledges that peak oil is here, you heard it from a CERA person.”

[My note: Burkhard spoke at CSIS's  Transforming The Transportation Sector: Energy Security, Climate Change And Transportation meeting.]

What could this be about? I looked further, downloading the audio for the meeting (mp3, large file, Burkhard is introduced at 1:14:20). The CERA official began his presentation like this—

[There are] two things I'm going to talk about. One, peak oil and how peak oil has arrived. And two, share an idea about how the low cost electric car, especially in Asia, could be a long-term game changer.

First, peak oil. Peak oil has arrived. We at CERA do believe peak oil has arrived. Some of you who are familiar with CERA's work may find that surprising. Ah, but not at all. Let me clear up some confusion. You may think I'm talking about peak oil on the supply side, the thought that we've reached a geological point where we've produced more than half the world's oil. And we could have a day-long debate on that particular perspective on peak oil, but the peak oil I'm talking about is peak oil in transport fuel demand for light-duty vehicles ... peak oil demand in the United States and Europe. We've reached it...

Thanks for clearing up my confusion, Jim. For a minute there things got a little topsy-turvy for me.

What about this "peak demand" view? Like Gandhi's view of Western Civilization, I think it would be a good idea. If only life were that simple. Here is Burkhard's sole presentation slide.

Figure 1 — The CERA view of long-term U.S. gasoline demand. "Slower Growth in Fleet Miles and Greater Fleet Efficiency." This forecast pertains to "light-duty vehicles" only (no long-haul trucks, backhoes, tractors, et.al.).

Burkhard speaks to why CERA expects peak demand for petroleum gasoline in the United States.

One, the biofuels mandates. Two, the lower growth in VMT (vehicle miles traveled). Since 2005 it's been flat... [VMT declined in 2008 and is declining so far this year] ... This is a trend that we haven't seen in many, many years, and it happened before the depths of the recession...

Another factor is  the fuel economy legislation. That's having a real impact, again it takes time for this to filter through... we don't change the transportation paradigm overnight. We certainly don't expect that, but the fuel economy legislation will have a big impact in the long-term.

And lastly the Great Recession is intensifying these trends. We hope that this is a temporary influence... [then he shows Figure 1].

[My note: Burkhard then goes on to say that U.S. gasoline demand (in barrels-per-day) is still larger than China's entire consumption. He also says Europe has reached peak demand. I didn't—couldn't—listen to the whole thing. Mea Culpa.]

These remarks are based on CERA's report Drivers Turn the Corner in the United States released on June 19, 2008. Oil prices were soaring at the time. Such prices were seen as triggering a long-term shift toward fuel efficiency.

Though the current U.S. economic slowdown explains some of the decline in gasoline demand, long-term shifts in consumer behavior that began as much as two years ago in response to high prices are the key drivers to lower demand, the report says.

[My note: I can't read the report without paying for it. It costs the usual 1000 bucks, I suppose.]

After the economic meltdown in 2008:Q3, oil (and gasoline) demand and prices in the United States fell dramatically. Thus in early 2009 a spate of stories appeared proclaiming that peak demand had arrived.

CERA is whistling past the graveyard because it is very likely that we really are in the post-peak oil era (my column, February 19, 2009). The view that non-OPEC production has peaked is now going mainstream (Wall Street Journal, May 4, 2009).

Raymond James notes that non-OPEC oil production apparently peaked in the first quarter of 2007, and given precipitous falls in oil output from Russia to Mexico, there’s not much hope for a recovery. OPEC production—and thus global output—peaked a little later, in the first quarter of 2008, Raymond James says.

Analysts at Barclays and Deutsche Bank, among others, see falling non-OPEC output in future years, but CERA is still holding out, saying they "saw no immediate non-OPEC fall." (Reuters, April 1, 2009). On March 27, 2009 Reuters reported—

Lower oil prices, which have fallen around 65 percent from record highs last July, have put at risk around 7.6 million barrels per day of new planned oil capacity by 2014, [CERA] said.

Lower investment prospects prompted CERA to revise its global oil production capacity outlook to 101.4 million barrels-per-day for 2014, versus a "pre-collapse" forecast last year that capacity would grow to 109 million barrels-per-day by 2014.

Current EIA data puts world oil (all liquids) supply at 83.86 barrels-per-day in May, 2009. OPEC's crude oil spare capacity is set at 4.34 million barrels-per-day, which yields a total of 88.2 million for world liquids capacity. CERA's downward revision would thus require the world to add 13.2 million barrels-per-day of capacity between now and 2014.

This outlook might fly in Disney World, but it is clearly impossible in the Real World. This leaves CERA with a public relations problem. Not only must they disavow their fantasy forecasts, but they must also explain away the fact that the oil production will probably never exceed its July, 2008 peak.

CERA must have been thinking really hard in the first half of 2008 about how to spin the fact that global demand was growing but supply could barely rise to meet it. And then it must have come to them like a bolt from the blue—peak demand! This is an ingenious solution. The oil supply doesn't have to grow anymore because we don't need it to. World oil production capacity doesn't matter anyway. We can acknowledge peak oil without acknowledging peak oil.

And so in June, 2008 when things looked bleak for the oil supply, CERA issued its report Drivers Turn the Corner in the United States. CERA knew, as many of us did, that demand would surely collapse with prices over $140/barrel and stay down for a long, long time.

Jim Burkhard's talk describes the latest version of CERA's peak demand story. This narrative should hold up over the next few years as actual global demand remains below capacity. Eventually increased oil demand in the emerging BRIC economies (Brazil, Russia, India, China) and the Persian Gulf will overwhelm any efficiency gains achieved in the OECD. Gasoline demand in Japan, the United States and Europe will rise again, but may not reach previous levels. Unemployment (and under-employment) will be very high in the United States for some time to come. Japan and Europe are still reeling. And so on.

When CERA's peak demand story eventually fails, they will need to change their tune again. For now they've got some breathing room. Sometime after 2011, when 2007-08 global oil demand levels reappear, CERA will go back to saying that geopolitical "above ground" factors (Chavez’s Bolivarian socialism, chaos in Iraq, unrest in the Niger Delta, under-investment in the Persian Gulf) are holding down the oil supply. They’ve got to blame somebody—what else can they do?

A VERY Brief Rebuttal

You will find a summary of current American oil policies in my Obama Tackles the Liquid Fuels Problem (with many additional links, ASPO-USA, May 28, 2009). This article includes almost all the information  you need to evaluate Burkhard's peak demand remarks and Figure 1, including an analysis of new CAFE standards and our prospects for oodles of ethanol by 2030. Figure 2 is the only thing I have to add.

Figure 2 — Taken from the Union of Concerned Scientists' Running Out of Gas. You can see that the rate of growth of gasoline consumption slowed for a while when CAFE standards were first introduced. Consumption then started rising again because 1) greater efficiency makes driving cheaper and 2) standards were not toughened after the mid-1980s. The former is related to Jevons Paradox (i.e. the rebound effect).

Future gasoline consumption in the United States depends on the design & implementation of specific policies affecting it and general economic conditions. There is considerable uncertainty about both. It is not enough to present Figure 1 and tell a simple peak demand story as Burkhard did, but CERA's real mission is not to make accurate assessments.

Marketing Is Everything

The triumph of sales over substance is nearly complete in the United States. CERA, which is a subsidiary of IHS Energy, is selling reports at $1000 a pop, consulting services, whatever. Let's not kid ourselves. To that end let's listen in on the IHS, Inc. F408 (Qtr End 11/30/2008) Earnings Call.

Moving now to our consulting business [including IHS CERA], it continues to be soft yet profitable. It accounted for 8% of our fourth quarter revenue and was down 24% organically compared to last year. A slight uptick in the percentage of total revenue represented by our consulting business is reflective of the addition of Global Insight. If you look at just the legacy IHS business and exclude IHS Global Insight, consulting represented 6% of total revenue for Q4...

To be clear we remain committed to our consulting business and we have seen modest improvements in our pipeline at IHS CERA and continue to focus on larger individual consulting opportunities. Lastly as we get into the back half of 2009 we also will have the benefit of more favorable year-over-year comparisons. Finally the remaining product offerings are grouped into the other category.

This category includes events and conferences like CERA Week coming up in February...

Success in sales depends on telling a happy story and walking the corridors of power. CERA, with its highly visible chairman Daniel Yergin, is adept at both. The peak demand story is a winner. Talking a good game makes all the difference Inside The Beltway.

People concerned with the economic problems attending peak oil—myself included—have labored under the mistaken assumption that winning an argument with CERA about the world's upstream exploration & production prospects matters. I don't think it matters at all, at least not as far as CERA and the Powers That Be are concerned. If CERA is making money and telling a good story, and they are, they are winning as far as IHS is concerned. The peak demand story maintains the status quo, so everybody in our Nation's Capital is happy too. Win-win.

Putting down a loosely organized group of peak oil activists—the phrase "loosely organized" overstates the case—was worth the risk for CERA back in 2006. Peak oil is not good for business.

CERA's win-win story promotes complacency in the face of an upcoming & ongoing catastrophe, but in 21st century America such obvious truths seem beside the point. The United States is now structured like the CBS television show Survivor—it's every man for himself in this game. The current economic crisis didn't pull us together. We've seen that Wall Street will do just about anything to aggrandize itself at Main Street's expense, and Washington helps them do it.

Having voted myself off the island—or did I get voted off?—some time ago, I can speak freely about what's happening. But CERA successfully plays the insider game. CERA may whistling past the graveyard, but I doubt they care as long as sales are brisk.

I am genuinely sorry that things have come to such a pretty pass in the United States. But that's just the way it is as far I can see.

Contact the author at [email protected]

The Decline of the American Empire

[T]he decline of Rome was the natural and inevitable effect of immoderate greatness. Prosperity ripened the principle of decay; the causes of destruction multiplied with the extent of conquest; and, as soon as time or accident had removed the artificial supports, the stupendous fabric yielded to the pressure of its own weight. The story of its ruin is simple and obvious; and, instead of inquiring why the Roman empire was destroyed, we should rather be surprised that it had subsisted so long.
    —Edward Gibbon, from the Decline and Fall

Perhaps you have noticed a common theme in my recent columns. Each policy proposed to solve our economic, oil or climate problems I have examined has a fatal flaw, and often more than one. New initiatives always seem dead on arrival.

Cap & Trade is not likely to be enacted but if it is, the law would raise energy costs while making only token CO₂ emission reductions as in Europe. President Obama put forward a proposal to think about, not build, an expanded passenger or freight rail system in the United States. A "harmonized double standard" for increased CAFE fuel efficiency mandates that cars average 39 miles-per-gallon by 2016, which probably translates to 29 miles-per-gallon in EPA bureaucratese.

On the economic front things are the same. Change we can believe in quickly morphed into a doomed attempt to return our flawed banking system to business as usual. As the Fed and the Treasury continue to bail out the banks, Arianna Huffington tells Tech Ticker's Aaron Task that

... the [Obama] administration is avoiding the big problems [in finance]...Tim Geithner and Larry Summers were creatures of Wall Street... [and they] are like people who still believe the world is flat. They see everything revolving around the Earth and in their case that's Wall Street. That's not good if you're producing maps to navigate.

Even if we require a functioning financial system to speed any "recovery" we might get, few are thinking about what those banks will invest in after our economy bottoms out. More McMansions in the exurbs? More shopping malls? Who will buy these houses miles from nowhere? And then fill up the GMC Yukon to shop at Saks and eat at the Cheesecake Factory? Some over-leveraged consumers will gas up & go, but most will not, at least not as frequently as they used to. People need to pay down their debt as they try to hang on to their low-paying jobs. Our FIRE economy (Finance, Insurance, Real Estate) will try to blow another bubble, but we're quickly running out of quality assets whose value we can inflate.

The theme that unites our flawed responses to economic and energy problems is futility, defined as

1. The quality of having no useful result; uselessness.
2. Lack of importance or purpose; frivolousness (unworthy of serious attention)

We can not seem to escape futility's vicious circle.

Figure 1 — As problems become more intractable over time, our resistance to making real changes to confront those problems, our social inertia, becomes more entrenched. Thus the solution to debt-based economic problems is more debt. The solution to liquid fuels problems is marginally more fuel efficient cars, not alternatives to driving. We study an expansion of the rail system instead of building it to provide an actual alternative to flying or driving between cities. We dream of hypothetical biofuels in the far-off future to solve an oil supply problem in the here & now.

Salon's Andrew Leonard quotes Kevin Phillips, whose book Bad Money has the subtitle "reckless finance, failed politics and the global crisis of American capitalism."

Bingeing on debt is reckless, and financialization has a long record of being a dangerous late stage in the trajectory of previous leading world economic powers. Moving money around instead of making things is always dicey, and the U.S. transformation has been the most grandiose to date...

Money is "bad," in the historical sense, when a leading world economic power passing its zenith -- before the United States, think Hapsburg Spain, the maritime Dutch Republic (when New York was New Amsterdam), and imperial Britain just before World War I -- lets itself luxuriate in finance at the expense of harvesting, manufacturing, or transporting things. Doing so has marked each nation's global decline. To institutionalize the dominance of minimally regulated finance at this stage of U.S. history is a bad idea.

[My note: Phillips wrote this before the meltdown in 2008:Q3. "finance at the expense of ... manufacturing" — look at Figure 2.]

Figure 2 — From Mark Perry at Seeking Alpha. On June 1, 2009 General Motors entered Chapter 11 bankruptcy (more below). Say goodbye to Pontiac, Saturn and Saab. GM will sell the Hummer division.

Phillips is talking about the Decline of the American Financial Empire. When our society "luxuriates in finance at the expense of harvesting, manufacturing or transporting things," we cling to the status quo instead of acting to solve the problems confronting it. We dig our heels in, our inertia grows stronger. The problems (too much debt, too little oil) do not go away. Unattended to, they get worse, as do the eventual consequences of inaction.

All my recent articles on the economy or energy describe futility.

Futility manifests itself in several ways, including—

• paralysis or indecisiveness
• frivolousness, money-seeking at the expense of others ("greed is good")
• the triumph of wishful thinking (unfounded hope or fantasy) over substance
• political in-fighting and corruption
• passivity or apathy

I'll tell a few stories to illustrate three of these ubiquitous signs of decay.

Indecisiveness

Upon assuming his duties as the Secretary of the Department of Interior (DOI), Ken Salazar extended the review period of President Bush's midnight plan to expand offshore drilling from 60 to 180 days. The Washington Post's Plan, Baby, Plan described the policy change—

Mr. Salazar's 180-day extension of the comment period is the first of four actions that he says will give him "sound information" on which to base a new offshore plan for the five years starting in 2012. He has directed the Minerals Management Service and the U.S. Geological Survey to round up all the information they have about offshore resources within 45 days. This will help the department determine where seismic tests should be conducted. Some of the data on the Atlantic are more than 30 years old.

The secretary will then conduct four regional meetings within 30 days of receiving that report to hear testimony on how best to proceed. Mr. Salazar has committed to issuing a final rule on offshore renewable energy resources "in the next few months"...

[My note: There's no final rule yet.]

Mr. Salazar's announcement was also notable for what it didn't do. Much to the chagrin of some environmental advocates, it didn't take offshore drilling off the table. Nor did it cut oil and gas interests out of the discussion. That's as it should be.

The new DOI Secretary's wish-washy attitude toward offshore drilling appears to have been among his most important qualifications for the job. He's not for offshore drilling, but he's not against it either. Salazar's announcement was notable for what it didn't do and nothing would happen before 2012 in any case. That's how it should be opined the Washington Post. Salazar then trotted off to meet the public in Atlantic City, New Orleans, Anchorage, and San Francisco to get some expert opinions.

Surfers splashed with organic chocolate "oil spills" and environmentalists dressed as jellyfish and furry polar bears gathered in San Francisco on Thursday and gave a theatrical message to Interior Secretary Ken Salazar: Don't start new drilling off California's coast.

Undoubtedly a bunch of people drove to the meeting, did their jellyfish/furry polar bear thing for Salazar's benefit, and then drove home. You can't have it both ways—either stop driving or start drilling. Make up your mind, do something, Mr Secretary. Tienes huevos!

As we further deplete our oil reserves, our lethargy on new drilling turns into paralysis. Efficiency gains lowering our fuel demand will be offset by future production losses. Our dependency on imported oil, which now stands at 64% of our consumption, will not go away. The problem will become more acute as we compete with China and other emerging markets for barrels. Yet we do nothing as we make a desperate, last ditch attempt to preserve Happy Motoring.

Frivolousness

Investors hoping for immediate hefty returns are now speculating in stocks and commodities in the midst of the biggest economic downturn since the Great Depression (Figure 3).

Figure 3 — Four Bad Bears posted by Calculated Risk from dshort.com. There has never been a stock market rally like this one in a slumping economy (bear market) that is still months away from hitting bottom.

General Motors filed chapter 11 bankruptcy on Monday this week. The move portends the further loss of tens, probably hundreds, of thousands of jobs for autoworkers, dealers and parts suppliers. What happened that day? The Dow Jones went up 221 points. The oil price jumped $1.77 per-barrel as it surged past the $68 mark. Bloomberg reported Crude Oil Rises to Highest Since November on Manufacturing Gain. Manufacturing gain?

Crude oil rose to the highest level since November as China’s manufacturing expanded and U.S. industrial output shrank less than forecast, signaling that fuel demand may increase...

[My note: Oh, I see. The manufacturing gain was in China!]

“We’re certainly on our way to $70, if not $75,” said Stephen Schork, president of Schork Group Inc. of Villanova, Pennsylvania. “That seems to be the number everyone is talking about. Given the technical momentum in this market, you cannot bet against it and step in front of this train.”

Technical traders watch for patterns on charts for clues to price direction, and may sell or buy based on those signals...

“Investors are hopeful that the economy will be buoyant during the second half of the year, which will lead to increased crude-oil demand,” said Michael Lynch, president of Strategic Energy & Economic Research, in Winchester, Massachusetts. “There are also hopes for a strong driving season.”

The peak U.S. gasoline consumption period lasts from late May’s Memorial Day holiday until Labor Day in early September, as Americans take to the highways for vacations... Gasoline for July delivery rose 2.9 cents, or 1.5 percent, to end the session at $1.9243 a gallon in New York, the highest settlement since Oct. 9.

“As we get into the $70 to $75 range, we’re going to be talking plus-$3 gasoline by the end of the summer,” Schork said. “If you’re going to tell me plus-$3 gasoline is sustainable in this economy, then kudos to you. I just don’t believe it.”

[My note: I described the current speculation in oil in Mr. Market Gets It Wrong Again. I described how traders who are all doing the same technical analysis act in concert to drive the price up or down in The Price Is Not Right.]

Bullish stock and oil moves on the day General Motors filed for bankruptcy were frivolous—these are not signs of an economic comeback.

What should be taken seriously is the orgy of escalating fuel costs that will accompany the recent spike in oil prices. Only a few traders will make money from these price movements, but everyone else will suffer. Investors are hopeful of a strong summer driving season? As they drive up gasoline prices for cash-strapped Americans amidst the worst economic downturn in 75 years? The price increase was based on a flimsiest of indicators, a slight decrease in China's Purchasing Managing Index.

Figures from the state-sanctioned China Federation of Logistics and Purchasing yesterday said that its Purchasing Managers' Index (PMI) fell slightly to 53.1 from 53.5 in April, but given that any number above 50 represents growth, it still marks an increase in output and orders.

At best speculators in oil are rationalizing sociopathic behavior by citing mediocre Chinese manufacturing numbers while U.S. industrial output shrinks less than expected. At worst they all think they're Gordon Gekko. Excessive speculation (gambling) by investment banks, regular banks, hedge funds, pension funds, and the rest got us into this economic mess. What is the answer to the problem of excessive speculation? More speculation of course!

Gambling neither reflects nor signals green shoots in our economy. The only possible outcome of running up oil prices would be to squash an incipient recovery should one appear. This behavior reveals a society that can't regulate its markets properly, a society where oil prices are not related to supply & demand and stock prices are not related to a company's earnings. If we no longer pay heed to poor fundamentals, speculation reflects futility.

Wishful Thinking

Consider the recent rise in the Conference Board's Consumer Confidence Index (and Figure 4).

The Conference Board Consumer Confidence Index™, which had improved considerably in April, posted another large gain in May. The Index now stands at 54.9 (1985=100), up from 40.8 in April. The Present Situation Index increased to 28.9 from 25.5 last month. The Expectations Index rose to 72.3 from 51.0 in April.

Figure 4 — Consumer Confidence since 1978. From Jim Puplava's Financial Sense. The "Present Situation" Index (blue) remains at a low level not seen since 1992 and 1982.

The Consumer Confidence Survey™ is based on a representative sample of 5,000 U.S. households. The monthly survey is conducted for The Conference Board by TNS. TNS is the world's largest custom research company.

Consumer expectations are getting better. That's good for spending, right?  MarketWatch took note in Consumer confidence, or consumer hope?

They call it "consumer confidence," but the numbers released Tuesday by the Conference Board might better be pegged as "consumer hope." There's a big difference, namely that confidence translates into spending, while hope is just a good feeling.

The Conference Board's measure of consumer confidence was up 35% from April, the fourth-largest jump in the 32-year history of the index. The move left consumer confidence in positive territory at 54.9, the highest it has been in eight months. The gain was far bigger than economists expected.

Consumers clearly believe the worst is behind this economy and the market, when it's not clear at all to the experts that the U.S. can avoid another leg down -- or worse -- en route to a broad-based recovery.

Consider that there was a big increase in the percentage of consumers expecting the economy to generate new jobs, despite no evidence that the current economy can actually achieve that.

Consumers expect inflation at a rate north of 5%, even though government numbers have been showing price deflation; that disconnect should undermine confidence. And while rising gas prices were cited as dampening confidence in 2008, consumers appear to be ignoring the action in gas prices now.

More consumers are now expecting the economy to start generating jobs, whereas most economists believe it will be late 2010 before the jobs numbers become positive. More consumers expect hyperinflation north of 5%, whereas the current numbers put future inflation at 1-2%. Where do these unfounded hopes or expectations come from?

Eric Janszen at Tulip took a close look at consumer confidence (aka. sentiment) after the Conference Board's latest survey. You would think confidence would correlate with job prospects, right? It does not. Consumer confidence follows the stock market! Specifically, sentiment corresponds to the Dow Jones Industrial Average (DJIA).

Figure 5 — Consumer Confidence versus the Dow Jones Industrial Average (DJIA) since 1998. Janszen's comment: "Except for a brief period in 2005 and 2006, consumer sentiment and the DJIA strongly correlate. Rising unemployment starting in early 2007 overwhelmed the DJIA as the key consumer sentiment driver; consumer sentiment peaked in early 2007 before the DJIA peaked late in the year. The DJIA and consumer sentiment declined together during the recession so far, since late 2007, until recently when the DJIA and consumer sentiment re-connected."

Janszen believes "the DJIA index is used by the FIRE Economy financial media [e.g. CNBC] to sell the current state of the economy [to consumers or investors]... The DJIA has virtually no economic significance compared to the broad stock indexes such as the S&P index and the NASDAQ that have many times the capitalization of the DOW." In a related development, bankrupt General Motors and insolvent Citigroup were dropped from the Dow index on June 1st. They were replaced by Cisco Systems and Travelers, respectively. That should improve consumer expectations considerably!

Bullish speculation in stocks bolsters consumer confidence based on ... nothing at all. Confident consumers are seen as prone to spend more money, which begets bullish speculation. Many Americans think the worst is behind us. They expect a wave a new jobs to appear any day now. This is wishful thinking.

The fundamentals of our vaporous economy are terrible. This speculative frenzy doesn't change the sorry state of Main Street. It's just a lot of hot air on Wall Street, which is trying to re-inflate stock prices. This new equities bubble (Figure 3) is like some bizarre Wheel of Fortune—round and round it goes, where it stops nobody knows.

All this behavior is utterly futile if our goal is a sound economy & recovery.

I could tell stories like this all day long, touching on political infighting, corruption or undue influence up and down the Wall Street-Washington corridor, or the docility of our passive citizenry brought about by 30 years of consumer training. I would run out of time long before I ran out of material.

Everything—I mean every single thing—is broken, including health care costs & coverage, the energy markets, the economy as a whole, public education, physical infrastructure, insurmountable deficits at the local, state and Federal levels, etc.

Can We Put Humpty Together Again?

Humpty Dumpty sat on a wall,
Humpty Dumpty had a great fall.
All the king's horses,
And all the king's men,
Couldn't put Humpty together again
   —A Nursery rhyme

Is there any hope? I'm talking about real hope, not the daily barrage of pernicious nonsense that passes for serious discourse in the United States. No radical transformation of our society will occur unless we can overcome our social inertia. We would need to get serious, escape futility, do real things again.

The first step would be to acknowledge what a sorry state we're in. Speaking with Bill Moyers back in September, Kevin Phillips didn't think soon-to-be President Barack Obama would level with the American people about how bad things are. If the President indeed understands the depths to which we've sunk, he has not come clean with us—you don't rock that boat.

History suggests that we will not be able to put Humpty Dumpty together again. Imperial greatness reaches an apogee and then follows a downhill trajectory. We had it good once, but now we cling to old dreams—like Rome, we prop them up with Edward Gibbon's artificial supports—instead of confronting unpleasant realities. The old vitality is gone. In the United States we carry out studies explaining why the cost of nuclear power is prohibitive. The Chinese build nuclear power plants. 

America is like an Obsessive-Compulsive who has lost his keys and keeps looking for them in the same drawer over and over again. We never tire of making the same mistakes, believing that "More Is Better" without acknowledging that it was this kind of flawed thinking that got us into this predicament in the first place.

Here's what Paul Krugman said about California, which is a complete mess.

California, it has long been claimed, is where the future happens first. But is that still true? If it is, God help America...

What’s really alarming about California, however, is the political system’s inability to rise to the occasion...

... and you have to wonder if California’s political paralysis foreshadows the future of the nation as a whole.

Don't worry about it, Paul. The future looks like California just as it always has. As Gibbon said of the Romans, prosperity ripened the principle of decay, the causes of destruction multiplied and eventually the stupendous fabric yielded to the pressure of its own weight.

In the near future I'll get back to writing about our futile efforts to put 1 million plug-in hybrids on the road by 2015 and similar fantasies. And if I'm alive in 20 years, I'll write another article called The Decline & Fall of the American Empire.

Contact the author at [email protected]