THINKING ABOUT OIL AND SECURITY

Here's some thinking for the weekend. Let's begin:

The financial carnage -- hedge fund failures, bank runs, credit tightening, and potentially a recession -- due to the current mortgage crisis demonstrates (yet again) that very smart people can do incredibly stupid things. For all of the insight, experience, and knowledge we gained through previous financial failures, we still walked blithely into the gaping maw of the delinquencies, defaults, and outsized bailouts that characterize a financial black swan (a black swan is an event that defies prediction, but it is usually obvious in hindsight).

Bad Assumptions

This should lead everyone to contemplate what other dangers are out there, undetected by the very same people that led us into the last crisis. One good way to find these hidden black swans is to sniff out bad assumptions -- particularly those that are only held aloft by boundless optimism, despite growing evidence that they've gone bad. For example, there is a widely embraced assumption that we will always be able to produce enough oil/gas at a reasonable price to meet global needs. Despite this, the oil market is currently characterized by:

• Rapidly increasing prices (on the way to $100 a barrel) that indicate supply stress. Why the stress? Why haven't we had a production increase since 2005?
• Geopolitical maneuvering by the great powers to lock-up sources of energy -- from the Sudan to Iran to Iraq to Russia. If the market was working correctly and future supplies were going to be driven by the magic of economics in combination with technological innovation, why the effort to secure national supplies?
• The peaking/failure of three (and potentially all four) of the world's major oil fields. If these fields are the foundational producers of the global energy system, how can we make up the loss?

Peak Oil?

If the current assumptions and the theories that are derived from them aren't very good at explaining current events (let alone predictive), then it is smart to look for alternative theories. One alternative (perhaps better) explanation for the conditions we currently see in the oil market can be found in the thinking being done on peak oil. This theory's foundational assumption is that we have already pumped almost all of the easy to produce oil out of the ground and that the complexity of extracting the remaining oil will advance along a exponential curve of difficulty and expense. According to this analysis, we will see:

• Steadily increasing prices as demand outstrips supply.
• An inability to maintain production levels.
• Eventually, a steady and inexorable slide in production as sources of easy/bountiful oil deplete and fall off-line (the rate of this decline, given our relative unpreparedness, will radically outstrip the development of alternative sources of energy).

Top Level Thoughts On Security

Here's a quick round-up of some of the security consequences for this theory (there's much more to do on this):

• An increasing number of wars and conflicts in oil producing areas (Iraq, Iran, KSA, Sudan, Nigeria, etc.). Perversely: 1) the very military force we will likely use in these conflicts is extremely energy dependent and those costs will skyrocket, and 2) terrorists/guerrillas will find that the damage they can inflict with systems disruption rises at a multiple to every decrease in production/supply.
• State failures in the developing world where the costs of energy outstrip the means to pay for it. Hollow states will proliferate.
• Economic dislocation due to a string of recessions and persistent inflation in the developed world as increasing energy costs percolate through the global economy. Global guerrillas in the US?

NOTE: I'm going to list some good books and resources on the topic of peak oil soon.

Comments

[NietzschesGhost]

How can they not be aware of it? The CIA published a report in March 1977 entitled "The Impending Soviet Oil Crisis" (ER 77-10147) in which they outlined the importance a nation's energy security. In fact, some have speculated that the increase in Saudi production in 1985 from 2Mb/d to 5Mb/d was part of a concerted effort to bankrupt the Soviet economy.

Further, Congressman Ron Paul has been giving speeches giving speeches before the house on this very subject for over 2 years. It's hardly a secret.

From this, I'm forced to draw one of 2 conclusions: Either institutional amnesia at the CIA is far worse than anyone could imagine, or you have been deliberately lied to.

[John Robb]

First, that was a mechanism that did bankrupt the Soviets, although it has been heavily discounted by history. Second, rightly or wrongly, Ron Paul and others that talk about peak oil are considered by many to be cranks, out of step with America. Third, most government analysts/decision makers in the security infrastructure don't think in terms of economics.

I think it makes good sense to think/plan about possibilities that could radically impact our future for the worse and then take steps to mitigate their potential impact. Unfortunately, this shock, like many of the others we are facing, will be difficult to mitigate at the national level. It will require decentralized action.

[Nils Gilman]

I think this is a total misreading of the current mortgage situation. In fact, many people over the last few years have observed -- often in the same breath -- that (1) the relaxation of credit terms for the poor invariably winds up in a credit crisis, and (2) the global housing market was exhibiting every sign of a bubble. The only thing that might arguably have been a surprise is how badly people had priced the CDOs, and how illiquid the markets for these vehicles were. (Even that was pretty obvious to the folks involved in creating those products.) That's the triple play that led to this summer's financial crisis: lax credit terms for the poor, a housing bubble, and untested financialization. Anyone could have -- and a lot of people did -- predict that this mix was unlikely to have a happy ending. So, let's not call it a black swan when what we have here instead is the classic American mix of privatization of profit and socialization of costs. The charade of acting like all this was unpredictable is simply a ruse to make the bailout of bankers politically palatable.

What other future alleged Black Swans can we debunk in advance? Let me put on the record some other big, bad events that we can already see coming, and that no one ought to get away with acting shocked about when they do:
* A rapid, messy collapse in the US dollar
* A major inflationary episode in China
* A major global recession that, deepened by populist anti-trade reactions
* The detonation of a nuclear device in a major global port
* All four of the above simultaneously....

When these things happen, some people will be tempted to call them Black Swans. They will base that claim narrowly, citing the particular way the event was precipitated, and the fact that certain smart were caught with their pants down, as "proof" that the event in question was "unpredictable."

But as overall categories of happening, I think these -- like the long-predicted popping of the housing bubble -- are not black swans, but more like "inevitable surprises." The particular way in which the event will come about will be unpredictable and revealing of mass complacency, but the chance that at least one of these events will take place in the next decade strikes me as better than even. In fact, the wonder with all of those events is that they haven't happened already. Of course they'll take people by surprise when they happen, but that doesn't mean they are surprising in the stricter epistemological sense that Taleb uses the term "Black Swan."

Bottom line: Just because the public or some individual is complacent, doesn't mean that the bad stuff that happens to them was a Black Swan.

[chainlinq]

The best introductory book I have read on this is Deffeyes Hubbert's Peak: The Impending World Oil Shortage
http://www.amazon.com/Hubberts-Peak-Impending-World-Shortage/dp/0691116253/

I have been tracking and discussing peak oil (and investing accordingly) for several years. Even among people who have been following and profiting from peak oil, there is a new growing realization of how politically explosive this is. The recent moves by the Canadian government in Alberta to raise the royalty rates on oil production is just the beginning. Oil companies profits will soar even though they are producing less oil. Imagine the fire storm when Exxon reports yet another in a string of record profits for a quarter with gas prices at $10.00 a gallon.

You covered this some at the end of your book but imagine what a 21st century Huey Long with access to 4GW systems could do with the kind of unrest high gas prices would cause. I am not talking open warfare, but a domestic political campaign based on the Internet and fueled by dissatisfaction with the status quo. The real black swan, the true unknown, is the individual or group who leverage 4GW systems to exploit a major event like peak oil. At the very least, we are talking about changes to domestic political and economic systems that we have not seen since the Great Depression and the New Deal

[Bob Morris]

One excellent source of info on peak oil that any governmental or military official would probably pay attention to is Matthew Simmons of Simmons & Company. They are a major investment bank in Houston to the oil business. Simmons has been talking about peak oil for years.

Text of speeches
http://www.simmonsco-intl.com/research.aspx?Type=msspeeches

[Fabius Maximus]

Some of this is just bad data.

1. Oil production data

a. Anyone familar with developed world economic statistics knows how frequently and to what degree they are revised -- and still have large uncertainties (error bars). Global data is of course worse. Oil production data is of esp low quality.

Real global gdp of +5%/year is about oil demand up 1.5% -- an tiny number, easily lost in the noise.

Worse are inventory shifts. We have good data on primary storage (refiners) from developed nations, almost nothing useful from the rest of the world -- and nothing on secondary (distributors) and teritary (end users) storage. These swings can be very large.

As best can be determined (not much), oil production has been flat since early 2006. Nor a surprise. OECD crude inventories were large at that time. OPEC officially cut production by 1 million barrels/day in October. The actual cuts were probably less, and done earlier in the year.

2. Peak Oil

Most experts on both sides agree that there is a flood of new high quality oil production coming on stream in the next five years (CERA, Chris Skrebowski's Megaprojects survey).

We do not know how much of that will be offset by declines of existing fields, by conservation resulting from price increases of the past few years (US gas demand is decreasing), and possible global economic slowing.

The data to accurately forecast peak oil is not in the public domain. Ask the Gulf and FSU rulers. Hence estimates run from 2006 to 2026. We just do not know.

But the adaptation process to peak oil will take at least 20 years, so we need to get started NOW.

Note that many of the books about Peak Oil were written by people with long histories of proven false predictions. A word to the wise.

[Cody]

I read that there's oil in Alaska. Maybe that is some of the inconvenient oil. PBS seems to argue that solar power might become affordable soon. Germany is financing some solar energy, but that doesn't mean that they'll continue to afford it.

[NietzschesGhost]

"I read that there's oil in Alaska."

When people talk about oil in Alaska these days, they invariably mean the oil within ANWR (Since north slope production has been in decline for decades).

The problem with ANWR is that there are only 10 billion barrels there. Sure, it sounds like a lot until you realize that the US consumes approximately 8.76 billion barrels in 1 year. That means that all of ANWR's oil is worth 416 days of consumption. That's it.

And even if the project were approved tomorrow, it would still be almost 10 years before a drop of ANWR oil showed up. But even the most generous estimates (CERA and USGS, interestingly enough) don't think ANWR could produce faster than a 0.9Mb/d peak, approximately 15-20 years from now.

And let's not forget the security threat presented by *yet another* 1000 miles of unguarded pipeline traversing isolated terrain.

[Duncan Kinder]

Several points:

1) According to Paul Krugman, in his latest column, "A Catastophe Foretold", the current mortgage crisis not only is not a black swan but actually was predicted in 2004:

"“Increased subprime lending has been associated with higher levels of delinquency, foreclosure and, in some cases, abusive lending practices.” So declared Edward M. Gramlich, a Federal Reserve official.

These days a lot of people are saying things like that about subprime loans — mortgages issued to buyers who don’t meet the normal financial criteria for a home loan. But here’s the thing: Mr. Gramlich said those words in May 2004."
http://www.nytimes.com/2007/10/26/opinion/26krugman.html?em&ex=1193630400&en=f2dd4c0c93cbbe01&ei=5087%0A

2) As many, if not most, readers of this blog already know, The Oil Drum is an excellent source of information about Peak Oil and related topics.
http://www.theoildrum.com/

3) As the Oil Drum points out, there's still lot's of oil left; its just getting harder and harder actually to get. To me, we could draw several conclusions from this:
a) The time spent getting oil shall increase in relation to the time saved from using the oil thereby obtained.
b) The effort spent getting the oil shall increase relative to the ease achieved from using oil.

These conclusions in turn suggest that something resembling the labor theory of value shall become more and more meaningful when discussing energy policy. When Peak Oil kicks in it shall become necessary, when discussing fossil fuels, to consider the labor that has been embedded into them in the process of obtaining them.

4) I sat in Deffeyes' geology class in the 1970's, when he was then predicting that oil would peak. Sooner or later, the guy will be right.

[adam]

John,

All good points. I'd hesitate to get involved in the "peak oil" question but I'm reasonably certain that the Club of Rome group in 1967 or so pointed out that we'd have this issue sooner or later in their seminal work Limits to Growth. Unless we gain another planet we cannot grow forever.

Now lets look at the security issue with specific cases of Iran and Dubai.

Iran, a nation that the people in charge of the US want to go to war with, makes a lot of money from high oil prices. In 2004, with oil prices low, Iran made around $36bn in oil sales. This year it is likely to go towards $70bn. This money is being used in Iraq (to do things like build a major airport terminal at Najaf, and support the Iraqi government). Even with that spending that's a lot left for military kit that they can buy to defend themselves, and spend on their current 5-year economic programme.

Now lets look at Dubai, on the tail end of their oil reserves. Dubai has been attempted to remodel themselves as an international place to do business, like Lebanon was and London is. We might recall that Dubai attempted to buy P&O last year, only to be brutally rebuffed by the US government (they see this as the fact that they are too Muslim or too dark-skinned, to spend money or own things in America. Dubai and the United Arab Emirates have long been a close US ally, so this was a major "fuck you" from the American government).

This was, broadly, similar to the way that Saudi was treated in the 1980s (allowed to buy US treasury bills, and not allowed to purchase US companies) but the times had moved on - the US has used all of its good will in the Middle East in the last few years.

Dubai were not happy about the treatment that the US gave them, and are now looking for opportunities in places like India and Europe. I was recently over at a meeting / conference / booze-up (London doesn't float on a sea of alcohol, it wallows) where the UK government attitude to Dubai's money was, to be blunt, promiscuous, and rightly so - Dubai are our allies too. Dubai recently picked up UK engineers Doncaster for around £700m. They've also announced a gradual pullout from US assets into more stable European ones (Euros, rather than Pounds, but we'll get some wedge too). Overall a lot of money is moving into Europe, much of it from Middle Eastern holdings in America. We're expecting a lot more of it in the future, and our attitude to their cash will continue to be somewhere beyond "yes please" (more like "oh baby, yes")

This means that the Gulf will be looking to give America less cash in future, at a time when the US credit crunch means that it needs a lot more. Overall this cannot be good for America, and this causes me some concern (although Schadenfraude is still a part of the emotions here).

In short the oil price hike is having some interesting security implications outside of the usual run of things.

[MattShultz]

The world's been twenty years from running out of oil ever since it started using it. Continual advances in exploration and extraction technology keep pushing that deadline back, and there's no reason to expect that process to come to a halt anytime soon.

Of course, Peak Oil is useful if you want to justify supply squeezes and price hikes whose origin is more geopolitical than geological. It's also handy for excusing military interventions; after all, if the oil is running out, no one can really blame their governments for rushing to secure what's left of it.

[Nils Gilman]

Another useful tool for thinking about the implications of peak oil, in conjunction with possible alternative fuels, is the concept of "energy return on investment" (EROI). Check out Tad Homer-Dixon's gloss on this: http://www.homerdixon.com/articles/20061129-nytimes-endofingenuity.html
Money:

A better measure of the cost of oil, or any energy source, is the amount of energy required to produce it. Just as we evaluate a financial investment by comparing the size of the return with the size of the original expenditure, we can evaluate any project that generates energy by dividing the amount of energy the project produces by the amount it consumes.

Economists and physicists call this quantity the "energy return on investment" or E.R.O.I. For a modern coal mine, for instance, we divide the useful energy in the coal that the mine produces by the total of all the energy needed to dig the coal from the ground and prepare it for burning - including the energy in the diesel fuel that powers the jackhammers, shovels and off-road dump trucks, the energy in the electricity that runs the machines that crush and sort the coal, as well as all the energy needed to build and maintain these machines.

As the average E.R.O.I. of an economy's energy sources drops toward 1 to 1, an ever-larger fraction of the economy's wealth must go to finding and producing energy. This means less wealth is left over for everything else that needs to be done, from building houses to moving around information to educating children. The energy return on investment for conventional oil, which provides about 40 percent of the world's commercial energy and more than 95 percent of America's transportation energy, has been falling for decades. The trend is most advanced in United States production, where petroleum resources have been exploited the longest and drillers have been forced to look for ever-smaller and ever-deeper pools of oil.

[John Robb]

Nils, in response to your first comment, please reread the first para, particularly this sentence:

"For all of the insight, experience, and knowledge we gained through previous financial failures, we still walked blithely into the gaping maw of the delinquencies, defaults, and outsized bailouts that characterize a financial black swan."

Question: why, with this prior insight, did the market's wisdom fail?

[Mikyo]

Economists have always held that markets fail because of excessive government regulation. Almost every one else has always held that markets fail from the lack of regulation. Could both be wrong? Has finance has become so globalized that governments no longer have much influence over it?

[Marcello]

"The world's been twenty years from running out of oil ever since it started using it. Continual advances in exploration and extraction technology keep pushing that deadline back, and there's no reason to expect that process to come to a halt anytime soon."

Just because the sheperd cried wolf that does not mean that the wolf did not get the sheeps in the end. No matter what tech you throw at it it does not change the fact it's a finished resource.

[Duncan Kinder]

"Could both be wrong?"

Yes.

"Has finance has become so globalized that governments no longer have much influence over it?"

Governments remain capable of screwing things up, as a casual survey of the Bush Administration suggests. One measure of the ability of governments' ability to influence finance is the relative value of paper currency vs. gold. The higher the relative value of gold, the less the ability of governments to control finances. On 9/11, the value of gold was about 270 dollars/euros. Today, it is about 775 dollars or 540 euros. In short, effective regulation remains necessary; however - given the limitations of the current nation state - such regulation is not feasible.

[adam]

"Has finance has become so globalized that governments no longer have much influence over it?"

No. Globalisation relies on there being somewhere else that a company can go to, in order to achieve the same objective. This is emphatically not the current situation with oil, we need everything coming out of the ground.

Actually I opened my email box this morning and my sleep-drugged eyes popped open (painful, I don't recommend it).

http://in.reuters.com/article/businessNews/idINIndia-30192220071027?rpc=401&

If true, and its from Venezuela so it may not be although it was announced on a Saturday when something true and disturbing is normally slipped out, OPEC are actually going to have on the agenda using something other than dollars for the sale of oil. Bear in mind that one of the current major issues that the US has with Iran is the fact that they are increasingly using Euros for major oil sales, with other nations looking onto the discussion with some interest - especially the Europeans and the rest of OPEC. Some commentators over the years have argued that the US invasion of Iraq was partially over their use of the Euro in oil sales - I personally doubt if anything so complicated got discussed in the White House in 2001-7 (although to be fair its more that they're still looking for a coherent, sane explanation for the Iraq adventure than an actual conspiracy theory).

Regulation or not has nothing to do with this, just a devil's brew of economics (dead, dead dollar values) and dismal US foreign policy decisions.

[MaYHeM]

Bad assumptions never cease to flow from this site.

Peak oil driving prices up? What a joke. The market is wholly unaware of any peak in production capability. Aside from the fact, that Peak oil is as big a lie as Global Warming being caused by mankind. Stop believing everything CNN tells you to believe, fancy pants Gore lovers.

If you've been around this site long enuf, you may remember I was blasted for calling out the defeatist attitudes that here abide (vetted by time showing I was completely right and most of the chumps of this site wrong). Failing to predict Iraq, you can bury your failure amid a landslide of new bleak theory on how the West is impotent to address the changing political landscapes.

I just came back to gloat.
US Army: All - 1
Global Guerrillas: 0

Get on the bus, go home, and STFU! You lost, we didn't.

[adam]

Mayhem,

Ah... bless. Yes I do remember you. You were the poetry guy who was using Texas based Iraqthemodel as a viewpoint on how Iraq worked.

Still, I remain a little confused by this post.

"Bad assumptions never cease to flow from this site."

Fair enough. Bad asusmptions are always to be challenged. Such as?

"Peak oil driving prices up? What a joke. The market is wholly unaware of any peak in production capability."

Hm. Production capability. Interesting phrase to choose, as its not really one linked to oil production itself, just the capability. Actually refining capability is pretty much tapped out right now, there's no slack left. As for "the market" Goldman Sachs, Simmons International and the Bank of Montreal have all said that we're in Peak Oil. I'm not an expert but I'm willing to bet that these groups are all involved in "the market". Now there is an argument that we're not at peak oil yet, it may be as late as 2013. But it will hit in your lifetime, not that of your kids. The simple observable fact is that we need more oil than the planet can produce, particularly as both China and India demand more and the vast Saudi oil fields head towards their end.

The big caveat to that is that we might find a huge amount of oil in Africa but that's even less stable than the Middle East.

" Aside from the fact, that Peak oil is as big a lie as Global Warming being caused by mankind. Stop believing everything CNN tells you to believe, fancy pants Gore lovers."

Well that told me. Global warming is a myth, apparently. Really. I'd assume that Fox News says so. On the other hand quite a lot of people that know what they are talking about say otherwise. Its very much like Iraq.

"If you've been around this site long enuf, you may remember I was blasted for calling out the defeatist attitudes that here abide (vetted by time showing I was completely right and most of the chumps of this site wrong)."

How so? Iraq is a complete disaster for the US foreign policy in the region, and for the US military. I'm struggling to see what crumbs of comfort you are clinging onto. Could you explain where the good news is? I suppose there is an argument that US casualties have now reduced to the civil war period of 2005, but frankly thats a little like a cow saying that being steak is better than mince, either way the cow's not going to be happy about it. US casualties considered year by year have gone up since 2003 (a mere war year, although the number is skewed by 2003 being only 9 months long as the invasion wasn't in January).

2003 486
2004 849
2005 846
2006 822
2007 857 (to date, with optimistic assumptions we'll assume around 900-ish by the end of the year).

I'm trying very hard to see how you see this set of numbers as good news.

The reality is that at this stage most of the ethnic cleansing has been done, the players are mainly waiting for The Surge (TM)to end in 4 months time, and for the really serious internal fighting to get underway. Politically Iraq remains on hold whilst everyone gets ready for the next round. And yes, you are right, the US remains largely impotent in the area, as it controls none of these things.

"Failing to predict Iraq, you can bury your failure amid a landslide of new bleak theory on how the West is impotent to address the changing political landscapes."

Failing to predict what in Iraq? Complete chaos? John was there well before it happened.

"I just came back to gloat."

Feel free to gloat. I'm not quite sure what you are gloating about.

"US Army: All - 1
Global Guerrillas: 0"

The guerillas won in Iraq. The early guerillas currently form the Iraqi government. Maybe that's a minus sign in front of the US Army score.

"Get on the bus, go home, and STFU! You lost, we didn't."

Who is we? What is the "win" here? What does winning in Iraq look like?