Peak Watch

The Sixth Extinction

Hope is the thing with feathers
That perches in the soul,
And sings the tune--without the words,
And never stops at all
    —Emily Dickinson

Hope is a duty from which paleontologists are exempt.... If hope is the thing with feathers, as Emily Dickinson said, then it's good to remember that feathers don't generally fossilize well. In lieu of hope and despair, paleontologists have a highly developed sense of cyclicity. That's why I recently went to Chicago, with a handful of urgently grim questions, and called on a paleontologist named David Jablonski. I wanted answers unvarnished with obligatory hope.
    —David Quammen

Occasionally I am asked what I think the future will look like, not just in the next few years or in 10 years, but several decades from now. Frankly, it's hard not to cringe, because my honest appraisal is not likely to be met with much enthusiasm. Some people harangue me via e-mail, asking why I don't write about over-population and other great disasters. Well, I write for the association for the study of peak oil & natural gas, so I usually confine myself to energy supply & consumption, alternatives to fossil fuels, and economic or scientific issues that bear on these subjects.

I've been accused of being ignorant of, or not caring about, the Big Planetary Issues. Today I depart from my usual stuff, not just to answer a few critics, but more importantly to put our current energy & economic problems in proper perspective.

If the 20th century was a time of expansion and growth for human population and economies, the 21st century will surely usher in a peak and decline in both. Today I talk about my "favorite" disaster, called The Sixth Extinction. Even in the age of politically correct environmentalism, most people could care less about the Earth's plant & animal species unless their decline bears directly and immediately on their own welfare. Accordingly, I will talk about some clear-cut examples where the health of the natural world adversely affects our future survival.

Before I do that, however, I want to touch on what I call, for lack of a better term, friedmanism.

I am referring to Tom Friedman, the influential Op/Ed columnist for the New York Times. I want to make it clear before I proceed that I am not launching a personal, ad hominem attack on Mr. Friedman. I'm sure he's a nice guy, sincere and well-meaning. However, he exemplifies an all-too-common way of thinking about the Big Planetary Issues that virtually guarantees that they will not get fixed.

Tom Friedman was zeroing in on Reality in his March 7th column The Inflection Is Near? but the Awful Truth was too much for him to handle.  

“We created a way of raising standards of living that we can’t possibly pass on to our children,” said Joe Romm, a physicist and climate expert who writes the indispensable blog climateprogress.org. We have been getting rich by depleting all our natural stocks — water, hydrocarbons, forests, rivers, fish and arable land — and not by generating renewable flows...

Over a billion people today suffer from water scarcity; deforestation in the tropics destroys an area the size of Greece every year — more than 25 million acres; more than half of the world’s fisheries are over-fished or fished at their limit...

One of those who has been warning me of this for a long time is Paul Gilding, the Australian environmental business expert. He has a name for this moment — when both Mother Nature and Father Greed have hit the wall at once — “The Great Disruption.”

“We are taking a system operating past its capacity and driving it faster and harder,” he wrote me. “No matter how wonderful the system is, the laws of physics and biology still apply.” We must have growth, but we must grow in a different way. For starters, economies need to transition to the concept of net-zero, whereby buildings, cars, factories and homes are designed not only to generate as much energy as they use but to be infinitely recyclable in as many parts as possible. Let’s grow by creating flows rather than plundering more stocks.

Gilding says he’s actually an optimist. So am I. People are already using this economic slowdown to retool and reorient economies. Germany, Britain, China and the U.S. have all used stimulus bills to make huge new investments in clean power. South Korea’s new national paradigm for development is called: “Low carbon, green growth”...

I eagerly await the day when the Laws of Thermodynamics have been repealed, a happier time to come when "net-zero" aluminum smelting generates as much energy as it consumes and Nissan Pathfinders have become perpetual motion machines. But let's examine why, aside from being uninformed about physics, Friedman is optimistic. The short answer is: he's got to be! Friedman has to be a "blue skies" kind of guy if he wants to be a mover and shaker, and a fixture at the New York Times. The alternative is quite literally unthinkable. What football coach, on the eve of the Super Bowl, would sincerely respond like this to a question about his team's chances in the big game?

That other team's pretty good... they're favored by 3 touchdowns, and for good reason... I don't think we can win this game, my guys are already whipped.... Honestly, we can't compete with them physically, that's the problem. We've got no shot.

This realistic coach would be fired in a heart-beat. A good football coach rallies his team, even if things look grim. But nothing important is riding on the outcome of a football game. 

Tom Friedman's job is to rally the Human Team, to make us all feel good about ourselves and our prospects. Cheerleading is deemed essential to leadership. Ben Bernanke did not think "the national housing boom is a bubble that is about to burst" in 2005. He was sticking to his story in 2007, long after housing prices took a nosedive. Here's another made-up example—all examples must be made up—that illustrates the point.

When asked if California could eliminate the growing $26.3 billion deficit in Sacramento, balance the state's budget, and make state government work again, Governor Arnold Schwarzenegger said "no way, Jose," referring to his earlier remark that there was "no way in hell" California would be able to balance the budget at this point. He added that "paring deficits in the absence of new revenues will probably wipe out most state jobs & services and California's bond rating will be total junk. The last one out the door should turn out the lights."

You'll never hear this in the real world, even if it's true. Governor Schwarzenegger will continue to rally the troops. California will not fold up its tent. The state will do something else instead, like stealing money from—sorry, I meant "borrowing money from"—local municipalities.

Although we humans have been trashing the planet, and continue to trash the planet, Tom Friedman must cling to positive illusions about outcomes. But such unreflective optimism is not supported by reality. Unless a miracle occurs, there is little doubt about the species extinction outcome in the 21st century if we keep doing what we're doing.

But the power of positive illusions is that "people who remain optimistic in the face of insurmountable odds are healthier and finally more successful than those who have a more realistic attitude." Thus friedmanism is almost universal among high-functioning, successful human beings. It thus afflicts almost all of our society's leaders and elites, i.e. those people who are charged with keeping the growth machine running.

Any salesman will attest to the upside of maintaining positive illusions, but there is a downside as well—bankruptcy and destitution.

The antidote to unwarranted optimism—Keanu Reeves takes the Red Pill, not the blue pill, in the movie The Matrix—also reflects the cause of The Sixth Extinction. Walt Kelly, the creator of Pogo, tried to put us on the road to sanity on a poster for the first Earth Day in 1970 (Figure 1).

Figure 1 — The road to sanity. It is only when we acknowledge that we—all of us, not just those guys over there—are the problem we're trying to fix that we can possibly do anything about the problems we create. This is the "consciousness" solution—we need a lot more of it. This is the opposite of friedmanism, in which often self-serving cheerleading is a substitute for thought & awareness. More darkly, the dyed-in-the-wool pessimist believes that with Homo sapiens, just as with any other species, what you see is what you get. In other words, Human Nature properly understood forms an insurmountable barrier to making real changes in our collective behavior. Thus over-population or the destruction of other species are non-preventable outcomes of the human condition, even if some people are aware of the need for change. For example, many marine biologists despair about extinctions in the oceans. These biologists are not optimistic, but they carry on, they still fight the good fight. Watch this video of oceanographer Jeremy Jackson talking how just how dire the situation in the oceans is.

We humans will have to sleep in the broken bed we have made unless—mirabile dictu—we undertake large concerted actions to clean up our act. Genuine progress is possible only if we acknowledge our sins, but doing so conflicts with friedmanism, which offers reassuring but unjustified optimism based upon naive overconfidence in human capabilities and total disregard for human failings.

Let's now turn the cause and some of the consequences of The Sixth Extinction.

The Holocene Extinction Event

The Holocene Extinction Event is the widespread, ongoing mass extinction of species during the present epoch (10,000 years ago—present). It is called the Sixth Extinction because there have been five other mass extinctions in the Phanerozoic Eon which started at the beginning of the Cambrian Period 543 million years ago.

1. The oldest mass extinction occurred at the Ordovician–Silurian boundary (≈439 Mya, [million years ago]). Approximately 25% of the families and nearly 60% of the genera of marine organisms were lost, including deep-shelf benthic faunas (trilobites, graptolites, and conodonts).
2. The next great extinction was in the Late Devonian (≈364 Mya), when 22% of marine families and 57% of marine genera, including nearly all jawless fishes, disappeared. This extinction decimated coral reefs, brachiopods, and calcareous foraminifera.
3. The Permian–Triassic extinction (≈ 251 Mya) was by far the worst of the five mass extinctions; 95% of all species (marine as well as terrestrial) were lost, including 53% of marine families, 84% of marine genera, and 70% of land plants, insects, and vertebrates. This extinction is called "The Great Dying."
4. The End Triassic extinction (≈199–214 Mya) was associated with the opening of the Atlantic Ocean by sea floor spreading related to massive lava floods that caused significant global warming. Marine organisms were most strongly affected (22% of marine families and 53% of marine genera were lost), but terrestrial organisms also experienced much extinction, including sponges, gastropods, bivalves, cephalopods, brachiopods, insects, and vertebrates
5. The most recent mass extinction was at the Cretaceous–Tertiary boundary (≈65 Mya); 16% of families, 47% of genera of marine organisms, and 18% of vertebrate families were lost. Most notable was the disappearance of nonavian dinosaurs, plus substantial to complete losses among such diverse groups as ammonites, rudists, and certain marine reptiles.

99.9% of all species that lived during the Phanerozoic are now extinct. Species go extinct as a matter of course. What marks a mass extinction is the rate of extinction. When the rate at which species go extinct far exceeds the background, or natural, rate of extinction, you have a mass extinction.

The "fossil" background rate has been estimated at 1 species per year. Another estimate gives 0.5–5 species/year.

Amphibian declines and extinctions are critical concerns of biologists around the world. The estimated current rate of amphibian extinction is known, but how it compares to the background amphibian extinction rate from the fossil record has not been well studied... These calculations suggest that the current extinction rate of amphibians could be 211 times the background amphibian extinction rate. If current estimates of amphibian species in imminent danger of extinction are included in these calculations, then the current amphibian extinction rate may range from 25,039–45,474 times the background extinction rate for amphibians. It is difficult to explain this unprecedented and accelerating rate of extinction as a natural phenomenon.

Living amphibians are not the only taxon (Phylum Chordata, Class Amphibia, Subclass Lissamphibia) affected. Reptiles, birds, fishes and invertebrates, and other classes are also dying out. Extinction rates exceed the fossil record background across the board. This is not a "natural" phenomenon if you rightly take human actions as part and parcel of Nature, not apart from it. Michael Novacek explains the sole cause of The Sixth Extinction (Figure 2). Figures 3 and 4 show some extinction data.

Figure 2 — Paleontologist Michael Novacek of the American Museum of Natural History explains The Sixth Extinction to an earnest but ultimately uncomprehending Charlie Rose. "Unfortunately when it comes to the sixth extinction, we don't have any argument about the cause. It's us. It's deforestation, destruction of habitats, overhunting, invasive species. These are kind of like the "Four Horseman" of environmental destruction that are contributing to the loss of species today. But what's important from the perspective of people like myself, who study this long history of organisms, is that this is major, this is a big deal. This is something on the scale of the Cretaceous Extinction, in the ball park. And we're in the midst of it. What an interesting time we live in, in some perverse way, you might say that we're witnessing the major events [mass extinctions] in the history of life in our lifetime." Novacek is the author of Terra: Our 100-Million-Year-Old Ecosystem—And the Threats That Now Put It At Risk.

Figure 3 — Declines since 1970 in marine, freshwater and terrestrial vertebrates. From Global Biodiversity Outlook 2, a publication of the of UNEP's Convention on Biological Diversity. "Based on published data from around the world, the Living Planet Index aggregates trends of some 3,000 wild populations of species. It shows a consistent decline in average species abundance of about 40% between 1970 and 2000; inland water species declined by 50%, while marine and terrestrial species both declined by around 30%"

Figure 4 — A summary of the IUNC's Red List of Threatened Species, taken from the blog Dodos Are Gone Forever (see here). Of the species evaluated, 37.8% are threatened with extinction.

In the interest of demolishing friedmanism wherever we find it,  let's read a now forgotten press release from 1998 describing the results of a poll commissioned by the American Museum of Natural History.

April 20, 1998. The American Museum of Natural History announced today results of a nationwide survey titled Biodiversity in the Next Millennium, developed by the Museum in conjunction with Louis Harris and Associates, Inc. The survey reveals that seven out of ten biologists believe that we are in the midst of a mass extinction of living things, and that this loss of species will pose a major threat to human existence in the next century.

Among the findings revealed by the survey, scientists identified the maintenance of biodiversity - the variety of plant and animal species and their habitats - as critical to human well-being; they rate biodiversity loss as a more serious environmental problem than the depletion of the ozone layer, global warming, or pollution and contamination. The majority (70%) polled think that during the next thirty years as many as one-fifth of all species alive today will become extinct, and one third think that as many as half of all species on the Earth will die out in that time.

[My note: This was 11 years ago. if 20% of all species alive in 1998 were predicted to go extinct in the next 30 years, I would say we're running right on, if not ahead of, schedule.]

In 1998, most biologists thought biodiversity loss was a more serious environmental problem than global warming. Nobody seems to have asked these underfunded biologists for their opinion since then, or asked them how things are going. No wonder. In 2009, all the politically-correct news focuses on the threats to human welfare posed by anthropogenic climate change. In response, Energy Secretary Steven Chu wants to further screw around with Nature to make 4th generation biofuels so we can all drive to Wal-Mart.

Apparently, biologists don't study a subject—all life on Earth and all the interdependent ecosystems upon which that life depends—that people deem important. What is the principal cause of The Sixth Extinction? This is taken from Are we in the midst of the sixth mass extinction? A view from the world of amphibians—

Human activities are associated directly or indirectly with nearly every aspect of the current extinction spasm. The sheer magnitude of the human population has profound implications because of the demands placed on the environment. Population growth, which has increased so dramatically since industrialization, is connected to nearly every aspect of the current extinction event.

Climate change merely adds to the extinction problem we've caused because we're not willing to put the brakes on our exponentially increasing population. Dr. Chu wants to create genetically engineered monocultures, a form of geoengineering to keep growth going. Thus some proposed "solutions" to mitigate global warming will just make an already bad situation worse. We have met the enemy, and he is us.

Let's press on. I briefly discuss some recent developments and findings concerning The Sixth Extinction.

Honeybees and Amphibians

In 2006, honeybees started disappearing. Scientific American tells the story of Don Hackenberg, a beekeeper who moves his hives from place to place to pollinate Florida melons, Pennsylvania apples, and California almonds. Business was brisk, but then an alarming thing happened—

... when [Hackenberg] came back a month later, he was horrified. Many of the remaining colonies had lost large numbers of workers, and only the young workers and the queen remained and seemed healthy. More than half of [his] 3,000 hives were completely devoid of bees. But no dead bees were in sight. "It was like a ghost town," Hackenberg said when he called us seeking an explanation for the mysterious disappearance.

Hackenberg was not the only victim.

[A] survey ... in the spring of 2007 revealed that a fourth of U.S. beekeepers had suffered similar losses and that more than 30 percent of all colonies had died. The next winter the die-off resumed and expanded, hitting 36 percent of U.S. beekeepers. Reports of large losses also surfaced from Australia, Brazil, Canada, China, Europe and other regions. More recent data are not available yet, but some beekeepers say they have seen their colonies collapse this [last] winter, too. [published in April, 2009].

The bee loss has raised alarms because one third of the world's agricultural production depends on the European honeybee, Apis mellifera the kind universally adopted by beekeepers in Western countries. Large, monoculture farms require intense pollination activity for short periods of the year, a role that other pollinators such as wild bees and bats cannot fill. Only A. mellifera can deploy armies of pollinators at almost any time of the year, wherever the weather is mild enough and there are flowers to visit.

The die-off of Apis mellifera is now called colony collapse disorder (CCD). Honeybee losses mounted in the 20th century.

Even before colony collapse, honeybees had suffered from a number of ailments that reduced their populations. The number of managed honeybee colonies in 2006 was about 2.4 million, less than half what it was in 1949. But beekeepers could not recall seeing such dramatic winter losses as occurred in 2007 and 2008. Although CCD probably will not cause honeybees to go extinct, it could push many beekeepers out of business.

Probably A. mellifera will not become extinct, at least in the foreseeable future, but that's actually begging the question, isn't it? If there were a single, remediable cause of the honeybee die-off, the question of possible extinction would lose much of its force. We need to know why honeybees are dying.

[We] ruled out many potential causes for CCD and found many possible contributing factors. But no single culprit has been identified. Bees suffering from CCD tend to be infested with multiple pathogens, including a newly discovered virus, but these infections seem secondary or opportunistic much the way pneumonia kills a patient with AIDS. The picture now emerging is of a complex condition that can be triggered by different combinations of causes. There may be no easy remedy to CCD. It may require taking better care of the environment and making long-term changes to our beekeeping and agricultural practices.

Honeybees are dying of everything, just like AIDS sufferers with weakened immune systems. This points to environmental stress as the primary cause of the ongoing demise A. mellifera. If we continue to degrade the environment, the stresses on bees will increase. This will further weaken the bees, which will result in more die-offs, which will increase the probability of extinction over time. Barring extinction, honeybee population declines could easily be severe enough to preclude industrial scale pollination for the various fruits and nuts we eat.

Amphibian declines are a second smoking gun pointing to general environmental degradation as the primary cause of species die-offs. This is described in A view from the world of amphibians—

Paradoxically, although amphibians have proven themselves to be survivors in the past, there are reasons for thinking that they might be vulnerable to current environmental challenges and, hence, serve as multipurpose sentinels of environmental health. The typical life cycle of a frog involves aquatic development of eggs and larvae and terrestrial activity as adults, thus exposing them to a wide range of environments. Frog larvae are typically herbivores, whereas adults are carnivores, thus exposing them to a wide diversity of food, predators, and parasites. Amphibians have moist skin, and cutaneous respiration is more important than respiration by lungs. The moist, well vascularized skin places them in intimate contact with their environment. One might expect them to be vulnerable to changes in water or air quality resulting from diverse pollutants... [etc.]

Chytridiomycosis, a disease of amphibians caused by a newly discovered pathogenic fungus called Batrachochytrium dendrobatidis (Bd), appears to be the proximate cause of many amphibian extinctions. But the root cause is general human degradation of the environment which makes weakened (reduced) populations of frogs (all toads are frogs), salamanders, and caecilians vulnerable to new pathogens.

A new and significant threat to amphibians is a virulent, emerging infectious disease, chytridiomycosis, which appears to be globally distributed, and its effects may be exacerbated by global warming. This disease, which is caused by a fungal pathogen and implicated in serious declines and extinctions of >200 species of amphibians, poses the greatest threat to biodiversity of any known disease... A general message from amphibians is that we may have little time to stave off a potential mass extinction...

Amphibians may be taken as a case study for terrestrial organisms. They have been severely impacted by habitat modification and destruction, which frequently has been accompanied by use of fertilizers and pesticides. In addition, many other pollutants that have negative effects on amphibians are byproducts of human activities. Humans have been direct or indirect agents for the introduction of exotic organisms [introduced predators]. Furthermore, with the expansion of human populations into new habitats, new infectious diseases have emerged that have real or potential consequences, not only for humans, but also for many other taxa, such as the case of Bd and amphibians.

[My note: The origin of Frog Chytrid as an amphibian pathogen and how it has spread around the world is not precisely known, but the leading theories support human meddling.]

Amphibians are victims of The Sixth Extinction and this die-off is a harbinger of more losses to come in other plants and animals.

Peak Fish

A study of fisheries data in 2006 concluded that if the current trend in marine species population declines continues, all such populations will have collapsed by 2048 (Figure 5).

Figure 5 — The graph is based on results reported in Impacts of Biodiversity Loss on Ocean Ecosystem Services by Boris Worm, et. al. (Science, November 3, 2006). "Globally, the rate of fisheries collapses, defined here as catches dropping below 10% of the recorded maximum, has been accelerating over time, with 29% of currently fished species considered collapsed in 2003. This accelerating trend is best described by a power [function], which predicts the percentage of currently collapsed taxa as a function of years elapsed since 1950... The data further revealed that despite large increases in global fishing effort, cumulative yields across all species and large marine ecosystems had declined by 13% (or 10.6 million metric tons) since passing a maximum in 1994." This last text puts peak fish in 1994.

As I said earlier, people don't seem overly concerned about plants and animals unless their decline has an immediate negative impact on human welfare. It's hard to get people worked up about amphibian extinctions in the tropics. (Go here for the full text). That being the case, try this on for size—

Human-dominated marine ecosystems are experiencing accelerating loss of populations and
species, with largely unknown consequences. We analyzed local experiments, long-term regional
time series, and global fisheries data to test how biodiversity loss affects marine ecosystem services across temporal and spatial scales. Overall, rates of resource collapse increased and recovery potential, stability, and water quality decreased exponentially with declining diversity. Restoration of biodiversity, in contrast, increased productivity fourfold and decreased variability by 21%, on average. We [Worn, et. al.] conclude that marine biodiversity loss is increasingly impairing the ocean's capacity to provide food, maintain water quality, and recover from perturbations. Yet available data suggest that at this point, these trends are still reversible.

It's not clear how many species in the oceans will actually go extinct in the 21st century as opposed to becoming very rare. In either case, you can forget all about eating the wild-caught seared sea scallops at The Aquagrill in SoHo, no matter how much money you have. But I don't want to make light of the fact that vast numbers of people depend on seafood for their survival. Good arguments can be made for giving up seafood altogether if eating it is discretionary. Any fish, crustaceans or mollusks you might eat in 2048 will have to come from aquaculture (Figure 6).

Figure 6 — World fish production and seafood consumption, 1976-2030 from the FAO's The State of World Fisheries and Aquaculture. "By the year 2030, aquaculture will dominate fish supplies and less than half of the fish consumed is likely to originate in capture fisheries." You can see peak fish (from capture fisheries) in the data. Of course, aquaculture has its own problems: "Without proper management, aquaculture can put a great deal of strain on the surrounding natural ecosystems. The high densities of organisms, high artificial feed inputs and the subsequent generation of heavy organic loads in the water stream are the primary sources of most of the environmental problems associated with aquaculture."

The FAO's projections for wild-caught fish production in 2030 are a tad optimistic in view of the results of Boris Worm and his colleagues (Figure 5). We would reasonably expect all the world's fisheries to collapse long before the ocean is devoid of healthy fish populations.

Dr. Worm believes the fisheries collapse is still reversible.

According to Mr Worm, it can. "The data show us its not too late. We can turn this around." The answer he says is to create more marine parks. "But less than one percent of the global ocean is effectively protected right now," Mr Worm said. "We won't see complete recovery in one year, but in many cases species come back more quickly than people anticipated — in three to five to ten years. And where this has been done we see immediate economic benefits."

The researchers have concluded that restoring marine biodiversity through an ecosystem based management approach is the only way to reverse the trend. That will require "integrated fisheries management", pollution control, maintenance of essential habitats and the creation of marine reserves.

They say doing nothing would impose a serious threat to global food security.

Depleted fisheries are another tragedy of the commons. Will a miraculous change in human predation of marine species preserve wildlife in the oceans? I'll let you be the judge.

Planet of Weeds

If you read only one article or book on The Sixth Extinction, I recommend David Quammen's Planet Of Weeds (originally published in Harpers, October, 1998). You've probably already thought about the obvious question: Will Homo sapiens become a victim of its own misdeeds?

Now we come to the question of human survival, a matter of some interest to many. We come to a certain fretful leap of logic that otherwise thoughtful observers seem willing, even eager to make: that the ultimate consequence will be the extinction of us. By seizing such a huge share of Earth's landscape, by imposing so wantonly on its providence and presuming so recklessly on its forgivingness, by killing off so many species, they say, we will doom our own species to extinction. This is a commonplace among the environmentally exercised. My quibbles with the idea are that it seems ecologically improbable and too optimistic. But it bears examining, because it's frequently offered as the ultimate argument against proceeding as we are.

[Paleontologist David] Jablonski also has his doubts. Do you see Homo sapiens as a likely survivor, I ask him or as a casualty? "Oh, we've got to be one of the most bomb-proof species on the planet," he says. "We're geographically widespread, we have a pretty remarkable reproductive rate, we're incredibly good at co-opting and monopolizing resources. I think it would take really serious, concerted effort to wipe out the human species." The point he's making is one that has probably already dawned on you: Homo sapiens itself is the consummate weed [or weedy species, as Quammen explains in the article.]

I agree with Jablonski. It seems that nothing short of a catastrophic bolide impact, oceans filled with hydrogen sulfide oceans or a near-by gamma-ray burst will kill us off, though we can expect human populations to be much reduced in the future. I doubt global warming will do it. And what will happen “after” the extinction?

What will happen after this mass extinction, assuming it proceeds to a worst-case scenario? If we destroy half or two thirds of all living species, how long will it take for evolution to fill the planet back up? "I don't know the answer to that," he said. "I'd rather not bottom out and see what happens next." In the journal paper he had hazarded that, based on fossil evidence in rock laid down atop the K-T event and others, the time required for full recovery might be 5 or 10 million years. From a paleontological perspective, that's fast. "Biotic recoveries after mass extinctions are geologically rapid but immensely prolonged on human time scales," he wrote. There was also the proviso, cited from another expert, that recovery might not begin until after the extinction-causing circumstances have disappeared. But in this case, of course, the circumstances won't likely disappear until we do...

... Even rats and cockroaches are capable -- given the requisite conditions; namely, habitat diversity and time -- of speciation. And speciation brings new diversity. So we might reasonably imagine an Earth upon which, [5 to] 10 million years after the extinction (or, alternatively, the drastic transformation) of Homo sapiens, wondrous forests are again filled with wondrous beasts. That's the good news.

I can't top David Quammen. As he says, in some millions of years the planet will fill up with life again—that's the good news.

Contact the author at [email protected]

Is Business-As-Usual Likely In A Peak Oil Scenario?

But the guessers, in fact, know no more than the common people and sometimes less, even when, or especially when, they gave us the illusion that we were in control of our destinies.

Persuasive guessing has been at the core of leadership for so long, for all of human experience so far, that it is wholly unsurprising that most of the leaders of this planet, in spite of the information that is suddenly ours, want the guessing to go on. It is now their turn to guess and guess and be listened to.

Some of the loudest, most proudly ignorant guessing in the world is going on in Washington today. Our leaders are sick of the all the solid information that has been dumped on humanity by research and scholarship and investigative reporting. They think the whole country is sick of it, and they could be right. It isn't the gold standard that they want to put us back on. They want something even more basic. They want to put us back on the snake oil standard.
   —Kurt Vonnegut, A Man Without A Country

In The Radical Hypothesis, I explored the plausibility of whether economic growth can continue in the 21st century under conditions where CO₂ emissions—a proxy for fossil fuel consumption—are falling (Figure 1). The world experienced phenomenal economic growth in the 20th century, but history suggests that the concomitant historical rise in emissions was a necessary condition of that growth. The rule is expressed in (1) & (2).

(1) If the global economy grows, then CO₂ emissions grow

It follows that—

(2) if CO₂ emissions are not growing, the global economy is in recession ^{see footnote 1}

See Carbon Dioxide Emissions Declined by 2.8% in 2008; Transportation-Related Emissions Down 5.2% (Green Car Congress, May 20, 2009) and The Radical Hypothesis, Figure 2. Emissions were not growing in 2008, so it follows (logically, empirically) that we must have been in recession (which we were).

Figure 1 — A conceptual depiction of the Radical Hypothesis. Economic growth (dotted line) has always been accompanied by growth in CO₂ emissions (black line). Emissions are a proxy for fossil fuels consumption. Now, at the Turning Point, the consensus view sees economic growth diverging from emissions growth, which contradicts our historical experience as stated in rules (1) & (2) above. Thus the Radical Hypothesis rejects the idea that emissions have been a necessary condition for economic growth. A third alternative, a reduction in the carbon intensity of economic growth, is also shown (dashed line). Carbon intensity is a measure of how much carbon equivalents (CO₂e) are emitted per capita of GDP. In this case, economic and emissions growth are still tightly linked (only the rate of emissions growth has changed).

Emissions are seen as falling in the 21st century for one or both the following reasons:

• Depletion of fossil fuels leading to permanently declining production rates for oil (starting in the medium term) and for natural gas & coal (starting some number of decades hence)
• Voluntary efforts to cut emissions to mitigate climate change by switching from fossil fuels to renewable "clean" energy (wind, solar, biomass-to-liquids conversions, etc.)

If voluntary efforts are not made or fail, regardless of the depletion outcome, the consensus view—typified by Joe Romm of the influential Center For American Progress or the President's science adviser Dr. John Holdren—sees business-as-usual (BAU) as continuing in the 21st century (Figure 2).

Figure 2 — A modified version of the business-as-usual (BAU) scenario depicted in The Radical Hypothesis. Economies (dotted line) and CO₂ emissions (black line) grow unchecked in the 21st century. In a BAU scenario with peak oil, emissions are still presumed to increase steadily, not decrease (dashed line), as technology readily fills the gap (e.g. coal-to-liquids replaces lost oil production). See below for a more thorough discussion.

Today I explore assumptions about BAU scenarios under the assumption that we have now reached the peak of oil production rates or will shortly. This is the "peak oil" hypothesis. If oil production peaks in 2020 or later, then current concerns about peak oil are unfounded. Time will tell, but the peak oil hypothesis is now gaining wide acceptance. Today I assume the peak oil hypothesis is correct for the sake of analysis.

BAU In A Peak Oil World

Those concerned about anthropogenic climate change routinely refer to future CO₂ levels in the atmosphere of 550 ppm (parts-per-million) or greater (Figure 3). Business-as-usual, in which economic and emissions growth are not constrained, is assumed in all these cases.

Figure 3 — An assumption of very high levels of CO₂ in the atmosphere (up to 750 ppm) taken from the congressional testimony of climate scientist Ken Caldeira (February, 25, 2009). Caldeira was testifying about the effects of ocean warming on coral reefs: "Coral reefs are unlikely to survive in regions colored yellow, orange, or red. In the absence of strong policy, atmospheric CO2 will reach 550 ppm in several decades. Our analysis show that before the industrial revolution when atmospheric CO2 level was about 280 ppm, 98.4% of coral reefs were found near open ocean waters with an aragonite saturation state above 3.5. With a CO2 stabilization of 450 ppm only 8% of coral reefs would be surrounded by open ocean waters with aragonite saturation state above 3.5, and with a stabilization level of 550 ppm no existing coral reefs would be near such waters."

There is every reason to believe that a doubling (or more) of CO₂ in the atmosphere over pre-industrial levels (~275-280 ppm) would be catastrophic for the world's coral reefs. The relevant question here is whether anthropogenic emissions could ever get this high in world in which oil production has peaked, and in the absence of significant carbon-cycle feedbacks (e.g. large methane releases from hydrates or Arctic permafrost—atmospheric chemistry converts most methane to CO₂). This feedbacks caveat can't be taken for granted, of course.

The peak of world oil production, defined simply here as a permanent, growing gap between an insufficient supply and potential demand, will presumably cause large crude oil price spikes in the future. Such spikes are called "oil shocks" by economists. Historical experience strongly suggests that oil shocks precede and (in part) cause recessions (Figure 4).

Figure 4 — Nominal and inflation-adjusted crude oil prices 1970-2009, taken from Steven Kopits' Oil: What Price Can America Afford? Oil shocks precede and are a major cause of recessions. The latest example is the price shock of 2007-2008 in which both the oil price rose sharply in 2007 just before the Great Recession began in December, 2007. The literature on the connection between oil shocks and recessions is large, and the results connecting such shocks with recessions are robust. Economist James Hamilton of the University of California (San Diego), who recently testified before Congress, is an expert on the link between oil prices and recessions. Read Hamilton's Causes and Consequences of the Oil Shock of 2007-08 (2009) and Oil and the Macroeconomy (2005).

Thus, in a peak oil future—

1. business-as-usual (BAU) assumes economies & emissions grow without limit, BUT
2. an insufficient oil supply creates oil price spikes
3. such oil shocks reduce fossil fuel demand across the board, thus reducing CO₂ emissions
4. the permanent peak & decline of oil production itself, aside from the direct effects of oil price shocks, will reduce emissions over time (the dashed line in Figure 2) if fossil-fuel based substitutes are not immediately available
5. if CO₂ emissions are not growing, the economy is in recession

Rising emissions, a proxy for fossil fuel consumption, appear to be a necessary condition (#5) supporting past or future economic growth. Thus, given the well-supported assumptions #2 through #4 above, we are not entitled to conclude that—

• Business-as-usual (BAU) will continue if the peak oil hypothesis is correct

The consensus takes the view that business-as-usual can continue, even in a peak oil scenario. To support this assumption, the consensus invokes assumption (3) as stated in The Radical Hypothesis.

(3) Technological progress marches on and improvements are always sufficient to meet our needs (including our need for energy)

To support the assumption of business-as-usual, even after peak oil has occurred, technologies such as coal-to-liquids conversions are assumed to provide seamless, just-in-time substitutes for oil production shortfalls. Thus "technology fills the gap" as shown in Figure 2.

A few examples will make the consensus position clearer. Here is a report on Ken Caldeira's remarks at last year's American Geophysical Union meeting (Scientific American, December 18, 2008).

Caldeira reported on recent forecasts of how the climate would respond if the world completely stopped using oil today. In the one case, it is replaced with coal-based liquid fuels and in the other with renewable resources, such as wind, solar, or nuclear power.

The results are clear, Caldeira said. If liquefied coal powered the world's vehicles ... the Earth would warm 2º Celsius (3.6º Fahrenheit) by 2042, three years sooner than if society continued to use oil. If, however, society replaces oil with renewable energy, that 2º C rise would occur in 2056, 11 years later than with oil.

The reality, Caldeira said, is that we will never run out of oil. As it becomes scarcer and more expensive to extract, industry will switch to other fuels for economic reasons. The danger is that coal will likely appear to be the cheapest alternative.

So rather than view peak oil as a climate savior, he said, those scientists, engineers and economists should see the end of oil as a "new challenge" to efforts to cut carbon dioxide emissions.

[My note: As reported in Nature, "Caldeira and colleagues used a climate and carbon cycle model to look at how running out of oil could affect future climate scenarios." Here's the abstract: "A coupled climate and carbon (CO₂) cycle model is used to investigate the global climate and carbon cycle changes out to the year 2300 that would occur if CO2 emissions from all the currently estimated fossil fuel resources were released to the atmosphere. By the year 2300, the global climate warms by about 8 [°C] and atmospheric CO2 reaches 1423 ppmv (parts-per-million-by volume)."]

At issue here are Caldeira's working assumption that 1) it is possible to quickly (instantaneously) replace oil with liquefied coal and 2) his implicit assumption that economic growth will continue unabated even if we are "running out of oil." Another issue, which I will not pursue here, is how little bang for the buck we get by replacing oil entirely with renewable sources such as biofuels or wind-driven electric transport instead of liquefied coal—locking in a 2°C temperature rise above pre-industrial levels is delayed only by 11 years! Even the oil to liquefied coal conversion makes only a tiny difference.

Using a coupled climate and carbon cycle model is appropriate if you want to want to estimate future anthropogenic emissions from presumably vast fossil fuel resources, but such a model does not capture what might actually happen "on the ground" in the real world. A prompt transition from oil to coal-based liquids is clearly impossible, as I'm sure—I'm hopeful— Caldeira would admit (Figure 5).

Figure 5 — Making the transition from oil to liquefied coal, from Volume II of the report of the Task Force on Strategic Fossil Fuels (2007). In the "high oil price" case, which is very likely in a peak oil scenario, it will takes more than 20 years for the U.S. to achieve 2 million barrels-per-day of from coal-to-liquids conversions if the required investments are made over time. I also note that very efficient coal-to-liquids conversion is not yet an off-the-shelf technology, although the Fischer-Tropsch process itself is many decades old. The Rand study Producing Liquid Fuels From Coal states that "liquid yield from direct liquefaction is very process dependent, but, in general, yields are projected to be considerably higher than those of Fischer Tropsch CTL plants designed with current commercial technology. Based on conceptual designs of two-stage and catalytic multistage direct-liquefaction CTL plants, prospective yields are reported to be between 2.7 and 3.0 barrels per ton of as-received coal" (page 27).

Caldeira's model, like every other model used to predict climate outcomes, does not take real-world economic conditions into consideration. Such modeling presupposes—the assumption is unstated and unexamined—continuing economic growth, even in a business-as-usual scenario where peak oil occurs. 

The recent work of Pushker Kharecha and James Hansen, Implications of "peak oil" for atmospheric C02 and climate, provides a second, more complete, case where economic growth is likely overstated (Figure 6).

Figure 6 — In the BAU scenario (top, left) oil peaks before 2025 (blue line) but coal emissions (orange line) still grow without limit out to 2100. The Less Oil Reserves ("peak oil") scenario (bottom, left) assumes the coal phase-out case (top, middle), so coal emissions are limited by policy, not economics and technology.

Kharecha and Hansen met a lot of hostility in the climate community for even raising the question of what peak oil's effects on emissions would be. They should be commended for sticking to their guns and publishing anyway. However, their standard BAU assumption does not jibe with the probable economic consequences of peak oil. I have taken the liberty of modifying their BAU graph in Figure 7.

Figure 7 — A modified business-as-usual scenario. Kharecha and Hansen's future coal emission curve (solid orange line) has been replaced with a more realistic scenario (dashed orange line) which takes future recessions and the timing of technological fixes into account. Coal emissions still grow, but not nearly at the pace envisioned in most BAU climate scenarios. One could make a similar change to projected coal emissions in the Less Oil Reserves scenario as well.

Current calculations of business-as-usual in a peak oil scenario are, practically speaking, almost useless. Allow me to repeat my summary, suitably modified, from The Radical Hypothesis.

1. Mitigating climate change or overcoming limits on available fossil energy will require or force massive decreases in CO₂ emissions over the 21st century.
2. Economists assume future generations will be richer than the current one The belief that economic growth is a necessity and will continue in the 21st century is not debatable.
3. The idea that 2.9% annual economic growth in the 20th century depended on a steady rise in CO₂ emissions is rejected.
4. The assumption that economic growth in the 21st century growth will take place without an accompanying rise in emissions is justified by the stipulation that technological progress solves all problems as stated in (3) above.

Even in the peak oil case, our ability to carry on business-as-usual is not questioned. The assumption of continued economic growth (#2, #3) remains unassailable. The assumption of just-in-time technological fixes (#4), which is contradicted by Figure 5, is also not debatable. In all BAU scenarios, it is presumed that energy technology (coal-to-liquids, biofuels, electric cars, any or all of these) will seamlessly step up to replace oil as the need arises. This assumption is not yet proven, and it appears to be tragically unrealistic.

History suggests that a continuation of business-as-usual in a peak oil scenario is implausible. But granting that I could be wrong, I urge climate scientists and policy-makers to at least examine the assumption of future economic growth made possible by our presumably limitless technological prowess.

2010-2020 — The Decisive Decade

If the peak oil hypothesis is correct, world oil production will be (at best) flat or in decline by 2020. During this same period, the United States may (or may not) implement a cap & trade system to rein in CO2 emissions. The proposed legislation aims to cut emissions 17% below 2005 levels by 2020. Emissions declined in 2008 following on the oil shock of 2007. The financial meltdown in 2008:Q3 guarantees a similar emissions decline in 2009.

As I described in The Reign of Error, Europe already has a cap & trade system in place. Europe's carbon market, created under the Kyoto Protocol, has not actually resulted in reduced emissions in the Eurozone. This sleight-of-hand is due to allowable offsets whereby a putative reduction outside of Europe (e.g. in Asia, or Africa) is counted as a reduction within Europe. At best, Europe has reduced the carbon intensity of any economic growth that took place since the formation of the carbon market. The proposed cap & trade system in the United States contains the same loophole.

Assuming that peak oil occurs in the next decade, and the currently envisioned cap & trade system, which goes into effect in 2012, is actually implemented, we can expect an overall decline in carbon emissions in the United States during the period 2010-2020. If growing emissions are a necessary condition for economic growth, as I have argued here and in The Radical Hypothesis, it follows that the American economy will shrink, not grow, in the coming decade.

If world oil production peaks, I predict most people will forget about terrifying business-as-usual climate scenarios. Instead, they get down to the hard business of replacing oil by any means possible. If the economy is shrinking, any means necessary will be used to jump start growth.

Thus, the years 2010-2020 will likely be the decisive decade of the 21st century. We should know by 2020 whether economies can grow as emissions decline. The result will define our response to anthropogenic climate change in all the decades to follow. We will know whether the consensus view espoused by Al Gore and many others is, as I have believed all along, a politically expedient "green jobs" fantasy.

Contact the author at [email protected]

Notes

1. In the propositional calculus, which is a subset of 1st order logic, (1) implies (2) by a rule of inference called modus tollens:

(1) if P, then Q

(2) if NOT(Q), then NOT(P)

Q is said to be a necessary condition for P, and P is a sufficient condition for Q.

This has the same form as (1) & (2) in the text. I could simply have said, more intuitively, that "Recessions cause reduced emissions," which is roughly equivalent to (3)—

(3) If the economy is not growing, then CO₂ emissions are not growing

In all cases relating to the economy and anthropogenic emissions, proposition (3) appears to be true. The problem with proposition (3) is that it is not true in all cases, i.e. it is false. It implies the false statement (4), which again is derived by modus tollens—

(4) if CO₂ emissions are growing, then the economy is growing

Proposition (4) is false because emissions could be rising (e.g. due to carbon-cycle feedbacks, volcanic eruptions) for reasons other than economic growth. This is the same as saying that rising emissions are not a sufficient condition for growing economies. In fact, business-as-usual scenarios say that rising emissions (of all sorts) will have disastrous consequences for economies (contradicting propositions (3) & (4)).

Of course I am arguing that rising emissions in the 20th century have been a necessary condition for economic growth. Sorry to put you through this. I used to be theoretical linguist and logician a long, long time ago in a galaxy far, far away.

A Resurgence In China?

同舟共濟
"same boat, mutual help" (help one another, we're all in the same boat)
   —Chinese saying

If you plan for a year, plant a seed. If for ten years, plant a tree. If for a hundred years, teach the people. When you sow a seed once, you will reap a single harvest. When you teach the people, you will reap a hundred harvests.
   —Kuan-Tzu (Taoist, died 645 BC)

China is a big country, inhabited by many Chinese.
   —Charles De Gaulle

The world's hopes for economic growth now revolve around a resurgence in China. The IMF recently upped their forecast for China, and now expects GDP growth to be 7.2% in 2009. In a similar move, the IEA issued a bullish oil demand forecast, saying that it expects global crude consumption, led by China and other emerging-market states, to grow 1.4 million barrels-per-day (mb/d) to 85.2 mb/d in 2010. Everybody, including those predicting our imminent demise from an inadequate oil supply, is gung-ho on China.

I have my doubts about these stories, and so does Hugh Hendry of Eclectica Asset Management. The Financial Times spoke to Hendry on July 5, 2009 about why he is bearish on China. What Hendry said makes a lot of sense.

... [people think] China is very much [like] Santa Claus. China ... has the prospects of bestowing all of us gifts, and the gift of a great escape [from the global recession]. And I dramatically ... want to take that on.

China, I believe, and the Asian surplus [savings] countries, are the most exposed, the most vulnerable, in this whole episode. And while that sounds fanciful, I can point to the even more dramatic correction in their trade statistics, in their stock market, etc.  And the flaw that they have is that they've swapped a dependency on foreign capital for a dependency on foreign demand. OK? There's no change, as I see it, between 1998 and today. Secondly, I believe that this presence of leveraging by households, and the corporate sector, where we  [in the United States] took leverage [debt] to something like 4 times the GDP of the country... what we were doing is, we were overstating the size of America, by bringing [in] future consumption and spending it today... So, it's almost as if Bernie Madoff were responsible for the accounting of [U.S.] GDP. And if he'd been responsible, he would have overstated it.

Now, I think that China looks like an investor in a Madoff fund. [They] bought into a [scenario] which was fictitious. Now, if you go back to 1989 in Tokyo, at the height of the bubble [in the Japanese stock market] and you looked at the projection of nominal GDP [in Japan] looking forward, it was a continuation of 5 to 6% per annum in perpetuity. The reality, however, according to the post-bubble difficulty, is that nominal GDP expanded as 1% per annum, which created an enormous surplus capacity, which has destroyed the profits of the corporate sector... Now, that's my feel, that China and its contemporaries have built productive capacity, not only to service a $14 trillion economy [in the U.S.], but to service an economy in America which they believed would be $20 trillion in 7 years time... My fear is that it could be closer to $15 trillion... so I see China as a deep out-of-the-money, call option on America. China only has a chance of succeeding if the American economy proves to bigger and bounces back. And I don't see the prospects of that happening.

[My note: GDP is gross domestic product, the value of all final goods & services in a given country. This is my transcript of the video interview with Hendry, but you must actually watch the video (and others) to get a sense of just how smart this man is.]

Hendry's contention that the newfound "wealth" fueling ever greater debt & spending in America was illusory should no longer be controversial. It was indeed a ponzi scheme in which we spent—borrowed from—future income to pile up immediate gains, just as Madoff found new investors to pay steady 12% dividends to older ones. All these schemes have now collapsed. See my essay Bad Signs, New Bubbles (and other articles referenced therein) for some related commentary.

China is now in trouble to the extent to which they were caught up in our foolish behavior. Indeed, China was almost as complicit in seeding the meltdown as Wall Street was. China and the United States have been referred to as the G2, and for good reason.

The dysfunctional symbiosis between the two countries should be a familiar story by now: Americans consume more than they produce, the Chinese produce more than they consume. Americans are spendthrift, the Chinese are parsimonious. The Chinese make the stuff Americans buy. Americans run large trade deficits, while the Chinese have a large trade surplus. The Chinese manipulate the value of the Renminbi (the Yuan) to keep the imbalance going. The Chinese buy our debt but will not abandon the dollar to protect their investment—Chinese purchases of U.S. Treasuries have actually accelerated over the past year, but not at the same rate as we have grown the debt (Figure 1).

Figure 1 — From the New York Times' China Grows More Picky About Debt, May 20, 2009. Note the middle panel showing the rise of China's purchases of Treasuries in 2008-2009.

Let us accept the reasonable premise that the American economy is going nowhere for a long time to come. Thus, the rampant consumption half of the China-America G2 equation is kaput. We need to get a sense of the extent to which the Chinese economy can be decoupled from the American economy. So, the question is how much can the Chinese economy grow independently of dismal economic performance in the United States (and Europe, Japan, etc.)?

To show why Hendry's argument that China is not Santa Clause makes sense, I need to bore you with the size of the Chinese economy, their trade balance with the United States, and the recent dramatic drop in their exports. Truly, economics is a dismal science.

China On The Ropes?

No one seems to know (to a reasonable approximation) just how big the Chinese economy is. Last February, Euromonitor reported, based on a World Bank survey, that the size of China's economy had been overstated by 40% in 2005. The revised number, based on a purchasing power parity (PPP) adjustment of GDP, was $5.3 trillion. Some economists make a much lower assessment.

Take China. At its most basic level, GDP is the total market value of final goods and services a nation produces in a given year. Andy Xie, a Shanghai-based independent economist, puts China’s GDP at $4.1 trillion to $4.3 trillion. Xie isn’t alone. Some put the figure at $4.4 trillion...

Xie’s calculations are as follows. China’s exports were about $1.4 trillion last year, while total labor income was about $2.4 trillion, capital income was about $550 billion and government income was about $600 billion. Then he subtracts about $800 billion to account for the depreciation of roads, properties and other facilities.

[My note: The Chinese economy is approximately 1/3 the size of America's according to Xie's estimate.]

The overall size does matter, because if China is going to lead us to the Promised Land, they must be able to generate enough additional economic activity to fulfill that promise. We see from Xie's breakdown that China's net exports added $1.4 trillion to China's GDP, which is about 33% of the total. We can take that as a relative share regardless of the overall size. How are China's exports doing? Black Swan Capital believes it is China Panic! Time.

Figure 2 — China's exports month-to-month percent change, official statistics since September, 2008. Jack Crooks of Black Swan LLC. says "China is dead in the water without exports. They are in panic mode. That is why they are flooding their economy with massive amounts of capital and suppressing any hint of [dissent] everywhere. That is why they have chased out the major financial news outlets, and forced them to take all cues from the state. But no matter how many bridges they build, excess capacity they expand, stock market propping they do, dollar reserve currency jawboning they employ, or internet sites they shut down, it doesn’t change the fact that exports have crumbled and until Mr. US Consumer starts buying again, it will get worse instead of better."

Crooks may be exaggerating a bit, but not by much. China's export income is going downhill rapidly. The decline is consistent with Hugh Hendry's view that "China ... and the Asian surplus [savings] countries, are the most exposed, the most vulnerable" to the economic meltdown. But why has the IMF raised their GDP forecast for China? Why has oil consumption rebounded (Figure 3) from it's January/February low?

Figure 3 — China's oil imports, a partial update to a chart I used in my Trouble With Oil Down the Road, published on October 22, 2008. At that time I was still predicting phenomenal growth in non-OECD oil consumption up to 2011 and beyond. Now I am not so sure. The most recent data is from Platts.

The Chinese "demand" surge after February was partially due to stockpiling while prices were low, but they must now build additional storage facilities to expand their strategic reserves (Reuters, March 9, 2009).

China plans to build a second-phase strategic reserve that will nearly triple the first batch to 280 million barrels [from 100 million barrels] by 2011, and industry executives have said the current storage capacity has already become a hurdle to bringing in more imports.

China's massive stimulus program (taken as a percentage of GDP) accounts for most of the increase in their oil consumption and estimates of higher (7.2%) economic growth for 2009 (Business Week, April 22, 2009).

Things are looking up for Xugong Group, China's largest heavy machinery maker. Driven by Beijing's five-month-old $586 billion fiscal stimulus, sales of its bulldozers, wheel loaders, and construction cranes reached an all-time high in March, a spokesman says...

Across China, steelmakers, cement producers, and construction companies are seeing sales soar as Beijing's stimulus plan opens the spigot on funding for railways, airports, and power plants. The economic surge isn't just about earth-moving. The Shanghai stock market is up 35% so far this year, one of the fastest-growing bourses in the world. The long slumbering property market is showing signs of a revival, with sales volume growing 29% in seven of China's biggest cities including Beijing, Shanghai, and Chongqing in the first two months, says Jing Ulrich, managing director of China equities at JPMorgan Chase in Hong Kong, though prices have not yet recovered. And in March auto sales grew 27.2%, following a cut in taxes on smaller vehicles that took effect on Jan. 20 and helping first-quarter sales grow a respectable 3.9%.

Apparently, the stimulus is so large that China's GDP is growing over and above huge export losses. But is this strategy sustainable? China is flooding its domestic market with new loans. We all know what happens when you do that.

China’s new lending more than doubled in June from a month earlier, increasing concerns bad loans and asset bubbles will emerge amid a credit boom. New lending was 1.53 trillion yuan ($224 billion), the central bank said on its Web site today, bringing total lending this year to 7.4 trillion yuan. The calculation for new loans is preliminary, the central bank added.

The government is countering an export collapse by flooding the economy with money to fuel domestic demand. Rapid credit growth poses a risk to the nation’s lenders and a concentration of credit in some industries and businesses may damage the stability of the financial system, the banking regulator said yesterday.

“Excess liquidity is fueling speculation and that means asset bubbles and wasteful investment,” said Isaac Meng, a senior economist at BNP Paribas SA in Beijing. “Expect credit to slow dramatically in the second half [of this year].”

Veteran China watchers like Michael Pettis do not believe that China's short-term stimulus strategy can be sustained without causing more problems than it solves. The longer term solution for China requires them to make the transition from savings & exports to a more balanced economy that enables more domestic spending & imports.

Doing the Right Thing

Western observers seem to be unanimous in their view that China must re-balance their economy. Here is Martin Wolf of the Financial Times talking about how the world might crawl out of the Great Recession.

You want expanded demand in the rest of the world. Well, who are [in] the best position to expand demand? Obviously countries with very strong balance of payment positions, with very strong current account surpluses and reserves: countries like Germany, Japan, and China. [If] they don't expand demand relative to supply, then I think we have the danger of chronic excess capacity in the world, chronic deflationary pressure. In other words, the whole world starts looking like Japan in the 1990's: that's sort of my worry...

[My note: Hugh Hendry, voicing Wolf's fears, refers to a state of "chronic excess capacity" in China. Capacity was built-up to service a future exports market which is very unlikely to exist.]

So we do have to expand demand. Now [to] understand completely, we take the case of China, which is simply the most important single country ... they can't change the structure of their economy, the structure of demand, overnight, except through a massive fiscal boost, which is what they're now doing, they're engaged in a huge investment program, and in the short-run that’s the right thing to do. In the long-run, however, it is right for the Chinese to try and absorb more of their production at home and re-balance their economy with more service production which would generate actually many more jobs. They have not done a good job of generating jobs recently, because their development path has been quite capital-intensive, much too much dependent on investment and household disposable income is only 40% of GDP which is why they're not benefiting fully. So what I suggested ... is [that] China should forget having a GDP target, instead of having an 8% growth GDP target, it should have a real domestic demand target. It should think of its policy in terms of generating real domestic demand, [and] GDP will follow.

Wolf's key point for our purposes is that China "can't change the structure of their economy, the structure of demand, overnight." This indisputable observation lies behind Hugh Hendry's take on China's medium term economic prospects, which he regards as rather dismal outside of the enormous stimulus they are currently applying. But what does "long-run" mean? Surely a significant expansion of Chinese domestic income & demand will take a decade or more.

University of Maryland professor Peter Morici's Recalibrating U.S.-China provides a thorough review of the issues facing the U.S. and China if they are to break out of the dysfunctional—the New York Times suggests "codependent"—economic relationship shown in Figure 4.

Figure 4 — Balance of trade between the U.S. and China from Peter Morici's Recalibrating U.S.-China. On the left the blue bars show China's rising trade surplus with the United States. On the right the blue bars show America's growing trade deficit with China. The last year shown is 2008, and no doubt the trade balance is changing in 2009. See Morici's paper to see the graphs at full scale.

I recommend reading Morici's paper for an in-depth analysis of what needs to happen to put both economies on a sound footing. The bottom line is that the trade imbalances shown in Figure 4 need to be adjusted so as to be in rough equilibrium.

Rome Wasn't Built In A Day

Nouriel Roubini’s RGE Monitor forecasts 7.0% GDP growth in China in 2009 and 7.7-8.0% growth in 2010. While such growth rates seem high to those living in the United States, these anemic numbers worry the Chinese leadership because their economy is not expanding fast enough to provide work for the many millions entering their job market each year. RGE Monitor notes that domestic consumption is holding up due to the stimulus from a low base of 36% of GDP, but “China is not able to take up the global slack stemming from increased savings by the U.S. consumer.” Diminished exports and high unemployment will continue to be a drag on Chinese economy over (at least) the next few years.

I often think of oil demand in the United States and China (taken together) as a zero-sum game. China’s expanding industrial capacity requires ever more oil, while America’s shrinking capacity means that China consumes the oil we would have consumed had we not become a “service” economy. While America’s real estate expansion—now over, I think—has required more and more oil in the transportation sector, we did not see a concomitant increase in our shrinking manufacturing sector. China stepped in to fill the production gap, so their oil consumption grew rapidly. If America’s industrial capacity (to service both domestic consumption and exports) were to expand in future years, oil demand in that sector would also grow.

If the zero-sum view is correct, putting the two economies on more wholesome footing would not significantly change the overall oil demand growth picture over the long term. This is yet another reason that the peak demand view of CERA, Energy Secretary Steven Chu, and others is complete nonsense. The only way China & America (again, taken together) have reached peak demand is if both countries experience, each in its own way, a “lost decade” (now longer) as Japan did in the 1990s. This is actually a possible outcome. However, CERA and Dr. Chu think we’ve reached peak demand but will still enjoy vigorous economic growth. That’s the nonsense part of the story.

I started with Hugh Hendry’s plausible view that China overshot the mark in building up capacity to service export markets (in the United States, Japan, and Europe) which have now collapsed. Thus, China now needs to turn their economic focus inward, not outward. It is not clear that China has fully absorbed this lesson. Their complaints about the unstable dollar being the world’s reserve currency are valid, but miss the main point.

China was enjoying double digit GDP growth during the years when their oil demand was surging. With their economic growth slowing, I expect China’s future oil demand growth to be below trend (Figure 3). In the longer term, Chinese oil demand will substantially depend on re-balancing their economy vis-à-vis the United States. Until such a time as China develops its domestic market and implements monetary reforms (e.g. letting the Yuan float), their economy and oil demand will not return to pre-crash growth levels. China’s economy will not see sustained double digit growth again unless substantial re-balancing takes place.

Restructuring the Chinese economy will take many, many years—Rome wasn’t built in a day.

Thus I take issue with the IEA’s (currently) bullish view of oil demand growth in China in 2010. I also do not see how a depressed world economy will drive a surge in oil demand in 2010, or in 2011 or, depending on how things go, in 2012-2013. However, oil prices may rise significantly because prices have an unfortunate tendency to reflect excess liquidity in the market rather than supply & demand fundamentals. At some point in the coming decade, we will revisit the oil shock of 2007-2008. (See the postscript).

The future is always impossible to predict, but my general view is that the future looks worse than the present, not better, unless the world’s major players make a conscious effort to change course. The need for change is reflected in the problems facing China (and the United States) I have described. Thus the G20 leadership, who will meet in Pittsburgh in September—only a few miles from where I’m sitting—need to define & implement policies to change the way the world works instead of posing for group photos and eating beef au jus.

I’m not going to hold my breath waiting for the G20 to depart from business-as-usual.

Contact the author at [email protected]

Postscript

Lest we forget this strong possibility, I casually throw Figure 5 on the table for your thoughtful inspection...

Figure 5 — Ka-Poom! The economies of China and the United States are coming more into balance some years from now only to be blown up by Peak Oil

The Radical Hypothesis

Plus ca change, plus c'est le meme chose
   — an old saying

And what rough beast, its hour come round at last,
Slouches towards Bethlehem to be born?
   — from The Second Coming, a poem by W. B. Yeats

It is hardly an exaggeration to say that humanity has reached a fork in the road, and future generations await our decision. Our energy & economic prospects are at stake, and these two necessities are inextricably linked. At such turning points, it is natural for apprehension to cloud our judgment. We want to hang on to what we have, or improve upon it, but our uncertainty is greater than our ability to discern the long-term future. The only things that seem clear are that the future will not resemble the past, and must not resemble it.

Today I make some elementary but crucial observations about the relationship between fossil fuel energy and economies. I go on to question normal assumptions about future economic growth.

A revolutionary idea about energy and economies which is meant to banish our uncertainty and apprehension has taken hold among our decision-makers and elites. I call it the Radical Hypothesis (Figure 1).

Figure 1 — A conceptual depiction of the Radical Hypothesis. Economic growth (dotted line) has always been accompanied by growth in CO₂ emissions (black line). Emissions are a proxy for fossil fuels consumption. Now, at the Turning Point, economic growth diverges from emissions growth. A third alternative, a reduction in the carbon intensity of economic growth, is also shown (dashed line). Carbon intensity is "a measure of how much carbon equivalents (CO₂e) are emitted per capita of GDP."

The decoupling of economic and emissions growth after the Turning Point is not usually seen as a radical departure from the norm because it is (now) the consensus view. I have intentionally turned this generally accepted view on its head to put it in clear perspective.

Given the historical trend shown in Figure 2, we might plausibly expect an outcome like that shown Figure 3. I call this the Conservative Hypothesis.

Figure 2 — Taken from How Can We Reconcile Growth, Emissions and Resources? by Simon Roberts. The slides from his presentation can be found here. Emissions shrink during recessions. No doubt a similar decrease is happening now during the Great Recession (2007-?).

Figure 3 — A conceptual depiction of the Conservative Hypothesis. At the Turning Point, shrinking emissions (black line) are accompanied by shrinking economies (dotted line). Economic abatement does not necessarily follow emission reductions due to technological progress (see below). Thus, the economic growth curve might be flatter or steeper, but the global economy (GDP per capita) must diminish in the conservative view as available fossil fuel energy declines.

At issue is the true nature of modern civilization's relationship to fossil energy. What we know historically is expressed in proposition (1).

(1) If the global economy grows, then CO₂ emissions grow

It follows that—

(2) if CO₂ emissions are not growing, the global economy is in recession (like now).

It is not the case that—

if CO₂ emissions grow, then the global economy grows

because emissions could rise for all sorts of reasons unrelated to economic growth

The consensus, politically-correct opinion, represented (for example) by Al Gore or Obama's science adviser John Holdren, says that a past tight correlation between economic and emissions growth does not necessarily imply that modern economies have depended on burning fossil energy to fuel growth. The Radical Hypothesis says you can have your cake (grow the economy) and eat it too (reduce emissions).

Logically speaking, the radical position contradicts proposition (1). It thus goes against our historical experience. The Conservative Hypothesis takes our previous experience (Figure 2) at face value—reducing emissions will reduce economic growth. You can not have your cake and it eat too. This is very much a minority view.

The Radical Hypothesis rests upon the complex assumption (3).

(3) Technological progress marches on and improvements are always sufficient to meet our needs (including our need for energy)

At the Turning Point, and "forever" after, technological improvements permit the decoupling of economic growth from fossil fuels consumption. For example, wind or solar replace coal, biofuels replace oil, etc. Net energy calculations (EROEI) don't matter because they are based on present science & technology. Technological improvements will enhance energy extraction efficiency in all areas (e.g. in biomass to liquids conversions, or even in exploitation of oil shales, should it come to that).

Some taking the conservative view reject assumption (3) outright—we have run out of technological solutions to our energy predicament. Others grant that some technological progress will take place, but reject the notion that such progress will be sufficient to break our dependency on fossil fuels to achieve economic growth (proposition 1). The latter expresses my own view.

Our expectation of reduced CO₂ emissions over time is due to two factors:

• resource constraints (e.g. the peak of oil production rates, or peak natural gas and coal some decades hence)
• pro-active measures taken to reduce emissions to mitigate climate change in 21st century (e.g. policies that encourage switching to renewable "clean" energy sources, a moratorium on new coal-fired plants and a phase-out of old ones, and so forth)

Those adapting the Radical Hypothesis either deny that limits on exploitable fossil energy exist, or adopt the fall back position that fossil fuel resources don't matter due to the inevitable dominance of "clean" energy made possible by technological progress. If resource limits do not exist and or pro-active measures are not taken—or don't work because technological progress comes up short—we get a business-as-usual (BAU) scenario as shown in Figure 4. In this case, future economic growth would be taken for granted because nothing has changed.

Figure 4 — A business-as-usual (BAU) scenario. In this case, the best science available assures us that humanity faces a climate catastrophe in this and coming centuries. The BAU scenario is impossible if 1) prompt (between now and 2040) resource limits exist or 2) technological improvements do indeed come to the rescue. Assuming CO₂ emissions rise at a rate of 2 ppmv/yr, we will reach 450 ppmv (parts per million by volume) in the atmosphere in 2041 (from ~386 ppmv now). Alternatively, the world might follow a reduced carbon intensity path (as shown in Figure 1) whereby carbon emissions grow at a slower rate. The science says that such a reduction will help, but not enough to avoid dangerous anthropogenic interference with the climate (e.g. we will get catastrophic sea level rise).

I've only scratched the surface of interlinked economic & energy problems in this brief introduction. Let's explore another facet of the Radical Hypothesis.

Discounting the Future

Human beings discount the future, whereby "society places a lower value on a future gain or loss than on the same gain or loss occurring now. And so do economists because—

If people’s preferences count and if people prefer now to the future, those preferences must be integrated into social policy formulation. Time-discounting is thus universal in economic analysis, but it remains, as it always has, controversial.

In 2005 the British Government asked Sir Nicholas Stern to review the economics of climate change. The end result of Brown's request was the Stern Review on the Economics of Climate Change published in late 2006.

To my knowledge, no comparable review has ever been carried out to work out the economics of resource depletion. The so-called Hirsch report comes closest, but has neither the scope (in terms of economic analysis among other things—Stern's report is more than 576 pages long) nor the weight of a report specifically requested by (then) British Chancellor Gordon Brown. This is not an accident. Rather, it follows from the general acceptance of the Radical Hypothesis (Figure 1), in which our reliance on fossil energy is devalued, and the presumed continuation of technological progress as stated above.

Stern's conclusions were (and still are) controversial because he used a very low discount rate, as explained in Frank Ackerman's The Stern Review vs. its Critics: Which Side is Less Wrong? Ackerman's review, along with Figure 5, provide a simple but good-enough introduction to discounting in general and how it relates to climate change in particular. I thus quote Ackerman at length—

... In Stern's view, inaction on climate change would lead to damages worth at least 5% of world output per year, and, depending on how the damages are calculated, perhaps as much as 20%. Most of these damages could be prevented, according to Stern, by spending 1% of world output annually on mitigation...

The discount rate is central to the economics of climate change. When costs are incurred to reduce emissions today, the benefits of reduced climate change will occur decades or centuries later. How much less valuable are those benefits, because they will happen in the future? At a discount rate near zero, future benefits are almost as valuable as if they occurred today, implying that it is “worth it” to take action now to secure those future benefits. At a high discount rate, future values fade rapidly into insignificance, implying that very little climate mitigation is “justified” by its (heavily discounted) benefits in generations to come.

Economic theory distinguishes between two components of the discount rate: the “rate of pure time preference” that would apply if all generations had equal incomes; and a growth-related rate, assuming that if the future will be richer than the present, then there is less need to make investments on their behalf today.

Stern endorses the philosophical argument that present and future generations are of equal ethical standing, implying that pure time preference should be zero. Your granddaughter is no less important than your daughter simply because she will be born a generation later. Other economists frequently object that people display impatience and short time horizons at a level incompatible with zero pure time preference. Moreover, a rate of precisely zero causes technical problems in some economic theories. Perhaps to avoid this technical issue, Stern introduces a miniscule rate of pure time preference, 0.1% per year, based on an arbitrary estimate of the annual probability that the human race will not survive.

Like other economists, Stern includes a second part of the discount rate, tied to economic growth. His discount rate thus becomes the rate of growth of per capita consumption, plus 0.1%. Since economic growth averages 1.3% in his model, his discount rate averages 1.4%. Other economists assume both a more substantial rate of pure time preference, and a larger growth-related component, yielding discount rates as high as 6%. The difference this makes is enormous: $100 of benefits 100 years from now would be worth $25 today at a discount rate of 1.4%, versus $0.25 at 6%. In short, economic analysis can “see” much more of the future at a discount rate as low as Stern’s, but becomes myopic at a rate as high as 6%.

[My note: so, the discount rate = the rate of pure time preference (0.1%) + the economic growth rate (1.3%) = 1.4%/year.]

[My note: I emphasize the "arbitrary estimate of the annual probability that the human race will not survive."]

Figure 5 — From The Ethics of Climate Change by John Broome, Scientific American, June, 2008. William Nordhaus of Yale is one of Stern's severest critics. As the image text states, his "6 percent discount rate places far less value than Stern's rate of the well-being of future generations."

Before examining Stern's low discount rate, let's make sure we understand the answer to a key question: why discount future goods & services at all?  Ackerman alludes to a "future ... richer than the present." John Broome, cited in Figure 5, fills in some of the details—

The Richer Future
Why discount future goods at all? The goods in question are the material goods and services that people consume—bicycles, food, banking services and so on. In most of the scenarios predicted for climate change, the world economy will continue to grow. Hence, future people will on average possess more goods than present people do. The more goods you already have, the less valuable are further goods, and so it is sound economic logic to discount them. To have one bathroom in your house is a huge improvement to your life; a second bathroom is nice but not so life-changing. Goods have “diminishing marginal value,” as economists put it.

I am more interested right now in Stern's calculation of future economic growth at 1.3%/year than the laudable ethical stance implicit in his choice of a near-zero rate of pure time preference (see my remarks at the end). How did Stern arrive at this growth rate?

Beyond the human preference for the here & now, the stipulation of continuing economic growth is just what it appears to be—it's an a posteriori (experience-based) assumption based on past growth in the 20th century. As Ackerman notes in a longer treatment of the Stern Review, the 1.3% average growth rate is a "plausible" choice among others—

This is not to say that Stern’s specific discount rate is precisely correct; it is hard to be confident of Stern’s 0.1% annual risk of global catastrophe, an admittedly arbitrary estimate. The 1.3% average growth rate of per capita consumption is plausible but far from proven to be correct. A balanced conclusion might be that Stern demonstrates that 1.4% is among the plausible discount rates – and that such low rates have profoundly different implications from rates like 5-6%, used in many other analyses.

Simon Roberts, who is referenced in Figure 3, tells us more about Stern's average growth rate and provides some perspective on the unassailable presumption of continuing economic growth. Here are his informal remarks—

Economic growth. Actually, it’s quite a recent concept, because up until about a hundred years ago, the way that you get more money is by having more people or raising taxes, or invading other countries. It was only about a hundred years ago which is to say, you can actually produce greater value than you need merely for subsistence.

So, the idea of economic growth is comparatively recent. The last century is the economic growth century, really. What it means is that government policy is about encouraging economic growth, without encouraging a rise in prices, which means inflation. That’s the language of what we want governments to do, and the other point about it, it must continue. You can’t question the need for growth. Also, to leave the markets to sort out the appropriate mix between the factors of production, but the market is a way to achieve it and also technology will deliver....

So, let’s just see what the Stern Review, a year old, to see what Stern said about growth. How much should it be? Here’s an extract I found at about page 200, global GDP is around 2.9% on average for the last century. Therefore, projections for growth “to continue at that rate does not seem unreasonable”, and that’s it! That’s the only basis for picking that number 2.9%, but that’s what it says there. I can’t find anymore details about it within the Stern review.

[My note: The actual quote is on page 182 (chapter 7) and reads as follows: "But given that the growth rate of global GDP was around 2.9% per year on average between 1900 and 2000, and 3.9% between 1950 and 2000, projecting world growth to continue at between 2 and 3% per year (as in the IPCC SRES scenarios, for example) does not seem unreasonable." Stern believes we should devote 1%/year of global GDP to mitigating climate, so we get the plausible but arbitrary value of 1.3%/year.]

[My note: My own view is that for almost all people throughout prehistory and human history before the 20th century, a standard assumption was that—outside the occasional disaster—future generations would be no worse off than the present generation.]

Let's sum up.

1. Mitigating climate change or overcoming limits on available fossil energy will require or force massive decreases in CO₂ emissions over the 21st century.
2. Economists assume future generations will be richer than the current one. Stern's estimates economic growth in the 21st century to be 2-3%/year based on an average growth rate of 2.9% in the 20th century. Less the 1% devoted to climate mitigation, he comes up with a "plausible" value of 1.3%.
3. The conservative idea that 2.9% annual growth in the 20th century depended on a steady rise in CO₂ emissions is rejected—this is The Radical Hypothesis. The belief that economic growth is a necessity and will continue is not debatable.
4. The assumption that economic growth in the 21st century growth will take place without an accompanying rise in emissions is justified by the stipulation that technological progress solves all problems as stated in (3) above.

There's a whole lot of assuming going on here. The apparent contradiction is the use of a posteriori reasoning to justify future economic growth (#2), while rejecting such reasoning when evaluating the need for a concomitant rise in CO₂ emissions (#3).

The $64,000 Question

It is far easier to envision shrinking economies in 2009 than it was in 2006 when William Nordhaus was criticizing Stern's choice of a low discount rate in evaluating how much we must invest to fight climate change. Shrinking economies are driving lower emissions now, but it is not hard to imagine that lower emissions might constrain growth in the future. The Conservative Hypothesis (Figure 3) simply extrapolates past trends, and thus does not require a big leap of faith like the Radical Hypothesis (Figure 1) does.

Stern's choice of a near-zero time preference in which future generations are valued as highly as the present one expresses an idealistic ethical stance. In reality, the present generation will always take care of its own needs before seeing to those of future generations. The climate science tells us we must invest heavily now to preserve a high quality of life in the future, but current actions (e.g. the pending Cap & Trade legislation) suggest that preserving something close to the status quo is the path we will pursue. For example, we may follow the less carbon intensive path shown in Figure 1. See my essay The Reign of Error for some discussion.

Will we have economic growth in the 21st century? That's the $64,000 question. I've described the Radical Hypothesis and the assumptions that underpin it. Whether you believe those assumptions will hold up is another matter. The relationship between energy and economy is complex, and I should probably do some kind of follow-up.

But that's enough to chew on today. As newsman Ed Morrow used to say, good night & good luck.

Contact the author at [email protected]

It's Not Black Or White

2009:H2: [We have] a cyclical bull market as the economy stabilizes and OPEC maintains cuts to draw inventories to 10-year average levels. We are raising our end of 2009 WTI [West Texas Intermediate crude oil] price forecast to $85/bbl from $65/bbl.
   —Goldman Sachs, June 3, 2009

I admit the human element seems to have failed us here.
   —General "Buck" Turgidson, from Dr. Strangelove

Layer upon layer of confusion pervades the discussion of why oil prices have been so volatile over the last 3 years. People often yearn for simple explanations. Some want somebody to blame, while others hold on to cherished theories. In these cases observers demand a Black Or White view of events which caricatures more complex realities.

I was reminded of these tendencies when a friend told me about Matt Taibbi's Rolling Stone article The Great American Bubble Machine. Taibbi trashes Goldman Sachs, accusing them of blowing or taking advantage of one bubble after another—the run-up to the the Crash of 1929, the Tech Stocks (dogfood.com) fiasco, and the Housing Craze. It's a great read and chock full of damning information, at least for those of us who can still concentrate long enough to get through something longer than a 140-character Tweet. 

In the interest of full disclosure, I must admit to a tinge of jealousy here because Taibbi despises Goldman Sachs even more than I do and expresses his contempt so well ^{see note 1}. And of course he writes for Rolling Stone and I don't! But seriously...

My problem with Taibbi's account is his Bubble #4, called $4 A Gallon. I need to quote this at some length.

With the public reluctant to put money in anything that felt like a paper investment, the Street quietly moved the casino to the physical-commodities market—stuff you could touch: corn, coffee, cocoa, wheat and, above all, energy commodities, especially oil. In conjunction with a decline in the dollar. the credit crunch and the housing crash caused a "flight to commodities." Oil futures in particular skyrocketed, as the price of a single barrel went from around $60 in the middle of 2007 to a high of $147 in the summer of 2008...

That summer. as the presidential campaign heated up, the accepted explanation for why gasoline had hit $4.11 a gallon was that there was a problem with the world oil supply.... But it was all a lie. While the global supply of oil will eventually dry up. the short-term flow has actually been increasing. In the six months before prices spiked, according to the U.S. Energy Information Administration [EIA], the world oil supply rose from 85.24 million barrels a day to 85.72 million. Over the same period, world oil demand dropped from 86.82 million barrels a day to 86.07 million. Not only was the short-term supply of oil rising, the demand for it was falling - which, in classic economic terms, should have brought prices at the pump down.

So what caused the huge spike in oil prices? Take a wild guess. Obviously Goldman had help – there were other players in the physical-commodities market – but the root cause had almost everything to do with the behavior of a few powerful actors determined to turn the once-solid market into a speculative casino. Goldman did it by persuading pension funds and other large institutional investors to invest in oil futures – agreeing to buy oil at a certain price on a fixed date. The push transformed oil from a physical commodity, rigidly subject to supply and demand, into something to bet on, like a stock. Between 2003 and 2008, the amount of speculative money in commodities grew from $13 billion to $317 billion, an increase of 2,300 percent. By 2008, a barrel of oil was traded 27 times, on average, before it was actually delivered and consumed.

Hold your horses, Matt! Did you happen to notice that the demand number you cite (86.07 million barrels-per-day) is higher than your supply number (85.72)? I give you Figure 1.

Figure 1 — All liquids data for supply and demand from the EIA from 2007:Q1 (quarter 1 above) to 2008:Q4 (quarter 8). Taibbi quotes the 2008:Q2 numbers (quarter 6).

Demand easily outstripped supply as 2007 wore on, and as oil prices rose, demand started easing as supply strained mightily to rise enough to bring the market into equilibrium in the summer of 2008. There is no reason to think, as Taibbi claims, that oil prices should have been falling while demand still exceeded supply, even if the former was falling and the latter was rising—July, 2008 was the historical peak supply month at 86.653 million barrels-per-day. Finally, after 6 straight quarters in which supply fell short of demand, the market achieved a very temporary balance in 2008:Q3.

Figure 1 illustrates the early stages of the peak oil problem. Production was unable to rise in a timely fashion to meet burgeoning new consumption in the emerging economies (China, India, etc.). July, 2008 was the only time that all-liquids supply ever surpassed 86 million barrels-per-day, and there is a good chance that it will never exceed that level ever again (or 87, or 88, or something in the 86-88 range).

But what about the oil price? Taibbi believes speculators drove prices in 2008:H1 far beyond where they should have been. And he's right! But multiple factors were pushing up the price. What caused gasoline prices to shoot up over $4/galllon is not a Black Or White issue. It was not exclusively EITHER bloodsucking speculation OR supply & demand fundamentals (OR hedging against a constantly falling dollar since 2003). All these problems combined to create a record high of $147 for a barrel of oil on July 12, 2008, and there is a subtle relationship among these factors.

The mature, calm observer see shades of gray and multiple causation. Black Or White thinking is called "primitive" by psychologists. Adults under stress can easily backslide (regress) into mutually exclusive dualities typical of childhood.

When small children are learning to use words and organize their thoughts, it is normal and expected for them to see and express their world in very black and white terms. When a young child feels they are not loved, they feel they must be hated. When a child feels his or her parents don't pay enough attention to them, that child will say, "You never pay attention to me." Developmental psychologists call this primitive thinking.

Unfortunately, under duress, adults often regress to primitive thinking. Adults are most prone to regressing to primitive thinking when they are having a hard time and feel overwhelmed by their own emotions. A regression, in psychoanalytic parlance, is a backsliding from mature functioning and thinking to immature ways of functioning and thinking. For that one moment, when the adult starts relying on the words "always" or "never," and seeing the world in black and white terms, they are slipping back to the way they saw the world as a child.

It is perfectly understandable why we might feel freaked out in 21st century America. Everything is really screwed up—our cliff-diving economy, our unrepentant, bailed-out financial oligarchy, our overwhelming debt, our paralyzed political system, our impoverished state governments, you name it. Writing a diatribe blaming all the world's ills on Goldman Sachs is better than a headlong flight from reality, which is the preferred solution of most Americans. I largely agree with Taibbi: if America is now circling the drain, Goldman Sachs has found a way to be that drain. But Goldman Sachs is not our only problem, not by a long shot.

If we are to have any chance^{note 2} of working our way out of this mess, we must avoid regressive thinking, stay calm, appreciate complexity, and think clearly about the right course of action. I'm going to take a proper look at speculation in the oil market to see what the problems are and what we might actually do about them. It's one big problem among many, I know, but you've got to start somewhere.

Not Everything That Can Be Traded Should Be Traded

Let's start with a mature approach to price distortions in the oil markets. The quote and Figure 2 are from Jeffrey Korzenik's Crude Oil Trading Regulation: A Terrible Idea Whose Time Has Come. He's talking about index speculation made possible by the swaps loophole.^{note 3}

If we’re going to trade crude oil like a currency, we should regulate it like a currency, too.

I hold an apparently quaint and obsolete belief: Not everything that can be traded should be traded. Specifically, there’s great danger in using long-term, long-only commodity futures positions as an investment asset class. The same is true of the derivative baskets of commodities that replicate such futures positions. Please note that I’m not talking about futures funds (which trade both sides of the market and are generally in positions only for the short term), but rather the way that commodities are increasingly being used by pensions, endowments and hedge funds as investments rather than short term speculations; this has sometimes been called index speculation, to distinguish it from the traditional variety.

Investment flows into the futures market can distort the pricing that should instead be determined by producers and users of commodities. Price distortions of this type cause enormous economic inefficiencies, are deeply injurious to the world’s poorest, and create significant structural risk in the markets. The chart below is a good illustration of just how “financialized” energy prices have become... [Figure 2, and I've included a recent snapshot taken June 17th of oil prices in 2009. Click on the image to see a larger version.]

[My note: Long traders are betting on a longer term price rise, whereas those "going short" are betting the price will fall.]

Figure 2 — The trade-weighted U.S. Dollar index (the dashed line) versus the DJ-UBSCI Energy Spot index^{note 4} (the solid line) since the beginning of the year. Korzenik says "as emphasized by the arbitrarily drawn horizontal line, these plots are virtually mirror images of each other (running a regression results in a correlation of -0.88). This corresponds to the type of linked price action we saw during the buildup to the commodity frenzy last year. It’s interesting to note that commodities like gold show nowhere near the correlation (-0.177) with the dollar over this same period. Clearly, the pricing of crude oil and energy products have become dominated by financial, not commercial interests."

Taibbi fixated on price speculation in the run-up to $147/barrel in 2007-2008. Better he should have focused his attention on—he does mention it—the recent rise from an average monthly price of $39.16 for crude oil in February to about $68.00 now during the worst economic downturn since the Great Depression. While some of the price rise might be due to OPEC cuts and stockpiling in China, no data I'm aware of show an increase in demand, or even a definite stabilization of the recent downward trajectory in global oil consumption.

Therefore we must conclude, and it's no secret, that the recent price rise has been due to long-term, long-only community futures positions taken by index traders (e.g. pensions, endowments, hedge funds) using the avenues available to them. Conveniently, the means are furnished by Goldman Sachs, among others. Here is economist James Hamilton writing about how the speculation works on May 17, 2008.

An important recent trend in management of pension and hedge funds is the increasing allocation of investment dollars to commodity speculation. There are lots of ways you can do this. Perhaps the simplest is to purchase, say, the July NYMEX oil futures contract. If you'd bought that contract Friday, it would enable you to take delivery of oil in Cushing, Oklahoma some time in July for $126/barrel. As a pension fund, you don't actually want to receive that oil, so in early June you'd plan on selling that contract to someone else and using the proceeds to buy the August contract. If oil prices go up and you can sell the contract for more than $126/barrel next month, you will have made a profit. By rolling over near-term futures contracts in this way, your "investment" will earn a return that follows the path of oil prices.

The Goldman Sachs Commodity Index is essentially a mechanical calculation of how much money you'd have each day if you followed a strategy like this for each of the major commodity contracts, with energy prices comprising about 70% of that index. There are a number of firms [like Goldman Sachs] that offer products that could implement such strategies on your behalf, such that the dollar value of your investment will essentially follow the GSCI (or similar index) less trading costs and management fees.

Long-only index traders are now said to be hedging against expectations of future inflation, which manifests as a hedge against a falling dollar as shown in Figure 2. Wall Street bankers, who know that short-term inflation expectations are nonsense, are no doubt driving & riding the long wave, as I described in Mr. Market Gets It Wrong Again. Thus Goldman Sachs issues bogus oil price forecasts to keep the ball rolling (like the one in our opening quote at the top).

Taibbi approvingly quotes hedge-fund operator Michael Masters, who believes the influx of index speculators into the oil market has been the sole factor driving up prices since 2003, and was the biggest factor in the price rise from end-2007 until July, 2008 (Figure 3).

Figure 3 — The open-interest (contracts) in oil rose steadily until the end of 2008. The rise was largely due to the influx of index (pensions, endowments, hedge fund) traders. This graph is taken from the Air Transport Association's Energy Matters presentation dated June, 2009. The airline industry is understandably upset about index speculators. Some airlines took a bath when they tried to hedge their risk by locking in forward (6-month) prices at $120/barrel or more. At the time, few foresaw the crash in September. Some airlines were thus stuck with exorbitant oil prices long after the price had fallen below $50.

Masters' position is a caricature of reality. If it's Black Or White, let's call his view the "Black" alternative. He can explain Figure 2 (recent speculation) but he can not explain Figure 1 (the supply & demand imbalance). Nevertheless, the recent price rise strongly suggests that there was speculative froth over and above what the "fundamentals" price should have been in 2008:H1. This premium might have been somewhere in the $25-35 range, as it is today. That would suggest that the "real" price at the top should have been somewhere between $100 and $110/barrel, as I argued in Mr. Market.

The "White" position ascribes the entire upward price movement in 2007-2008 to supply & demand fundamentals. From the June 17, 2009 CNN Money story Obama vs. the Oil Bubble—

Scott Irwin, an agricultural economist at the University of Illinois, says there is little evidence to support the notion that index fund buying is playing a substantial role in the level of commodity prices. "The academic work to date finds no evidence that the massive run-up of commodity prices can be traced to the index funds," he said.

Irwin said a recent study of dynamics in the corn market, where prices spiked last year as well, shows that the rise in futures buying by index funds and other long hedgers was met with increased selling by large commercial interests—the entities that these markets were created to serve.

Back on September, 2008, Hamilton published Scott Irwin takes down Michael Masters at Econbrowser.

My purpose in writing this post is to show that Mr. Masters' bubble argument does not withstand close scrutiny. He first makes the non-controversial observation that a very large pool of speculative money [Figure 3] has been invested in different types of commodity derivatives over the last several years. The controversial part is that Mr. Masters concludes that money flows of this size must have resulted in significant upward pressure on commodity prices, which in turn drove up energy and food prices to consumers throughout the world. This argument is conceptually flawed and reflects a fundamental and basic misunderstanding of how commodity futures and related derivatives markets actually work. It is important to refute Mr. Masters' argument since a number of bills have been introduced in the U.S. Congress with the purpose of prohibiting or limiting index fund speculation in commodity futures and OTC derivative markets.

The first and most fundamental error Mr. Masters makes is to equate money inflows into futures and derivatives markets with demand, at least as economists define the term. Investment dollars flowing into either the long or short side of futures or derivative markets is not the same thing as demand for physical commodities. My esteemed predecessor at the University of Illinois, Tom Hieronymus , put it this way, "for every long there is a short, for everyone who thinks the price is going up there is someone who thinks it is going down, and for everyone who trades with the flow of the market, there is someone trading against it." These are zero-sum markets where all money flows must by definition net to zero. It makes as much logical sense to call the long positions of index funds new "demand" as it does to call the positions of the short side of the same contracts new "supply." 

[My note: Irwin presents other economic fundamentalist arguments in this vein.]

I wonder how Irwin explains away the recent rise in oil prices, an increase which apparently reflects a "financialized" market that does not serve the interests of oil end-users and is almost entirely divorced from supply & demand fundamentals. Given his recent remarks to CNN Money quoted above, I guess he thinks everything is OK and there is nothing to explain. Worse still, his argument that the commodities markets are always in (or only temporarily out of) equilibrium—this is his "zero sum" game—seems to imply that bubbles are impossible in principle!

The key word here is "temporarily." In the longer run, the tail (speculation) does not wag the dog (fundamentals). Bubbles are temporary by definition—they must all collapse sooner or later. But while they are going on—they go on for months at a time—a lot of damage is done to the commercial interests the market is supposed to serve. Why should buyers & sellers of commodities be put at such risk? If you doubt this, just ask Delta Airlines.

The upshot of Irwin's argument is that the skyrocketing price in 2008:H1, the precipitous fall in 2008:H2, and the recent rise in 2009:H1 were all due entirely to supply & demand fundamentals. Like Masters' view, Irwin's position is a caricature which ignores the human—you know, crazy—element in economics, now properly modified to be behavioral economics. See Scientific American's recent article The Science of Bubbles and Busts (July 9, 2009).

It's not Black Or White. But let's go to the heart of the matter. Why speculate in energy (oil)? Why is oil being treated like a currency?

If you've been paying any attention to events in the oil markets over the last 5 or 6 years, you probably "know" four things: 1) economic growth always seems to be accompanied by growing oil consumption; 2) thus, growing emerging economies like China and India are using more and more of the stuff; 3) the price got really high in 2008 and rose for 5 years before that; and 4) there's a persistent rumor about something called "peak oil"—even if you're not quite sure what that actually means. (Does it mean oil production starts declining when half the reserves are gone? or are we Running Out Of Oil?, or some other nonsense?)

If you are a pension fund or an endowment armed with this "knowledge" that oil is really precious stuff, betting that oil prices will rise in the future looks like a sure thing. So we see that Figure 1 and Figure 2 really do fit together, despite what Taibbi, Masters and Irwin say, and despite the mistake index traders are making by going long on oil far too early.

You've got it wrong if you believe that only speculation pushed oil prices up from 2003 to 2008 or only fundamentals drove all the price increase—an existing market disequilibrium between available supply & potential demand gave and still gives legs to speculation in oil. Both factors played a role in inflated oil prices, with supply & demand being the underlying cause—that's what the word "fundamentals" means. It's Black And White. Goldman Sachs is merely a morally-challenged facilitator of short-term price bubbles, i.e. they are the drain we're going down.

There's No School Like the Old School

Speculation causing temporary bubbles in the commodity markets is a bad thing. Unwarranted price distortions & volatility cause needless pain for producers and consumers. I don't know enough about the gory details of how the NYMEX currently works to recommend specific solutions, but I do know this: the "swaps loophole" must closed and "bona fide hedging" exemptions should be repealed. The market should probably work as it was set up in 1936. I agree in principle with Taibbi when he writes—

In 1936, however, Congress recognized that there should never be more speculators in the market than real producers and consumers. If that happened, prices would be affected by something other than supply and demand, and price manipulations would ensue. A new law empowered the Commodity Futures Trading Commission – the very same body that would later try and fail to regulate credit swaps – to place limits on speculative trades in commodities. As a result of the CFTC's oversight, peace and harmony reigned in the commodities markets for more than 50 years.

Depression-era regulation has been repealed over and over again in the last 20 years. You can clearly see where that got us. There's no school like the old school. The derivatives industry is against proposed CFTC changes. That's bona facie evidence that something good might be in the works.

Taibbi describes how Goldman Sachs is preparing to blow or take advantage of a new bubble in the Cap & Trade carbon trading market (Bubble #6, Global Warming). Inflated "asset" values (carbon?) are a likely outcome if the legislation passes. A society that can not define and police its markets properly has no chance of fixing the longer term problems (the oil supply, the climate) that underlie them.

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Notes

1 This is a slide from the American Transport Association (see Figure 3).

Investment banks must issue bullish reports to drive the index investor herd (the Goldman Sachs theme song...)

Rollin', Rollin', Rollin'...

Keep Movin', Movin' Movin'
Though they're disaprovin'
Keep them doggies moving,
Rawhide!

Don't try to understand 'em,
Just rope and throw and grab 'em,
Soon we'll be living high and wide.
My heart's calculatin'
My true love will be waitin',
be waiting at the end of my ride...

Rawhide!

2  A few protests in the streets à la Iran might be helpful too. Americans can't afford to hit the snooze button on the alarm clock anymore. Even if the protests wouldn't accomplish anything, they could still demonstrate that we're awake and watching something other than TV.

3  From the Senate testimony of Michael Masters last summer:

When Congress passed the Commodity Exchange Act in 1936, they did so with the understanding that speculators should not be allowed to dominate the commodities futures markets. Unfortunately, the CFTC has taken deliberate steps to allow certain speculators virtually unlimited access to the commodities futures markets. The CFTC has granted Wall Street banks [like Goldman Sachs] an exemption from speculative position limits when these banks hedge over-the-counter swaps transactions. This has effectively opened a loophole for unlimited speculation. When Index Speculators enter into commodity index swaps, which 85-90% of them do, they face no speculative position limits.

The really shocking thing about the Swaps Loophole is that Speculators of all stripes can use it to access the futures markets. So if a hedge fund wants a $500 million position in Wheat, which is way beyond position limits, they can enter into swap with a Wall Street bank and then the bank buys $500 million worth of Wheat futures.

In the CFTC’s classification scheme all Speculators accessing the futures markets through the Swaps Loophole are categorized as “Commercial” rather than “Non-Commercial.” The result is a gross distortion in data that effectively hides the full impact of Index Speculation.

4  About the Dow Jones-UBS Commodity Index: "UBS Securities LLC has acquired AIG Financial Product Corp's commodity business has of May 6, 2009. As such, the Dow Jones-AIG Commodities Indexes have been rebranded as the DJ-UBSCI effective May 7, 2009." I'm not going to make a big deal out of this; I just thought you ought to know.