During my usual surfing around the internet I came across an interesting little snippet. “Zero Hedge” is a site I visit quite often, it has regular articles posted from a variety of contributors. Following each article is a series of comments and replies from readers. Generally the reader comments are well thought out and intelligent. Occasionally there are some that really give you pause to think and consider.
I found one of those today and thought it was worth extracting the relevant section for examination.
by trav777 on Mon, 12/28/2009 – 15:39
Energy is the base of this pyramid we call economics as there is not ONE THING ON THIS EARTH that gets done […] without energy.
The profitability of energy production as expressed by EROI (Energy Return On Investment) is declining, therefore all activities based on it are also declining. This is often expressed roughly as a cost-of-energy or entropy. We are sliding toward a situation where there is far less pure profitability to drilling up oil, consequently, there is less net available and all activities based upon use of energy are inherently less profitable.
As profit ratios decline, interest rates that represent “market” lending against them must also decline. If activity cannot satisfy the growth needs of the coupon, the loan isn’t made, and due to supply and demand laws for credit, the coupon must fall. The banker cannot extract more return than the venture will produce.
This also explains why we see increasing leverage ratios. Profitability is so near-zero in so many things that the only way to achieve “returns” is to scale leverage to infinity.
This touches on three very interesting points:
1.) “Peak Oil” isn’t necessarily about oil volume or oil reserves so much as it is about the cost of getting oil to the consumer. When the cost of oil gets too high, due to any number of factors but particularly extraction costs, then the profit available to the rest of the economy (from exploiting that energy) is reduced commensurate. It is a see-saw effect. Unfortunately the equations and relationships of our economy are based on costs remaining within certain bounds. If the costs of energy get too high, the rest of our economy falls in consequence. A very good argument can be made that we are already in the bind of this dilemma, we have an economic model dependent on growth, but our growth has now hit a natural limit – we can’t supply energy at a cost that will support that any longer. We have reached and passed “peak oil”. There is only stasis and decline from here…
2.) In order to to finance future energy (oil) projects there has to be the credit available to pay for it. The oil game has to be profitable enough to pay for the costs of business. If the oil business actually retained sufficient profits in order to self finance its activities then that would be one thing, but the profits are essentially all dispersed as dividends to shareholders, the actual work gets paid for by debt. The upfront costs are borrowed and then paid back from future earnings. That only works if there are sufficient future earning though, there comes a cost point where that system breaks down. Either as Trav777 says, because The banker cannot extract more return than the venture will produce, or because there isn’t the money to put into the venture in the first place. The current financial crisis started off being characterised as a credit crunch, it has expanded into more than that now, but at the heart we are still suffering the same problem, it is getting harder and harder to get credit. Which is where I would quibble with Trav777’s point about interest rates – it all depends upon the availability of capital for lending, if capital is being rapidly destroyed then there is less supply and interest rates will stay high or higher. Either is enough to create serious energy implications. Too high interest rates may mean a venture cannot proceed, but too little capital available also means only a fewer number of projects can proceed. Declining established production and constrained new production equals reduced total production. Reduced total production plus increased cost of production means price increases shocks. None of that needs to come from issues of physical reserves available, global economic and financial conditions are quite sufficient to spike prices.
3.) This is where we can get into the classic economic traps of stagflation, deflation, inflation or whatever other -flation you wish. Basically the problem is that costs go up and yet the ability to service those cost declines. For some the solution to that dilemma is to retrench and rationalise and live within your means, but for others the response is to double the bet to double the return and so maintain the game. ” Profitability is so near-zero in so many things that the only way to achieve “returns” is to scale leverage to infinity “. The financial players have been doing this for a decade now, but it is completely unsustainable of course and it is what has broken the financial system. Borrowing money to gamble only works if you win, and borrowing hugely means that when you lose everyone else falls with you. From there it just turns into a very nasty spiral. No capital, no investment, no production, no profits and now on top of that we can add increasing costs because everything in our economies is dependent on cheap energy.
But energy isn’t cheap any more, we have passed the peak of the supply of cheap oil, from here it just gets more and more expensive. Even if it did get “Cheap” for a time, that just means an oil industry that couldn’t service its costs, the industry contracts, supply gets constricted yet more and prices spike again. There is no way out, our way of live in the rich 1st world is ending. It may take a time for it to die but it is never going back to the way it was. The only questions left are what will we replace it with and how much pain will be entailed in the process.
By the way – if you are interested in all of this and would like to read more on the subject by a genuine expert rather than an amateur commentator, I recommend the book:
Why Your World is About to Get a Whole Lot Smaller ~ by Jeff Rubin. (- oil and the end of globalisation)
It has some kinda scary conclusions and implications. If you can, seriously – read this book.