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Sunday, September 14, 2014

Book Review: The End Of Growth

Jeff Rubin's book The End Of Growth is a good introduction to the impact of Peak Oil on the economy and markets. It was published in 2012, and the Kindle version has been updated since then (note that I did not read the updated version). Although the book is not perfect, I think it has some advantages over other analyses of Peak Oil. Although Peak Oil has been proclaimed to be dead, I explain the advantages of starting to analyse it now - you want to understand the concept before it rises again from the grave.

Jeff Rubin was the Chief Economist at CIBC world markets, and wrote the earlier book, Why Your World Is About To Get A Whole Lot Smaller, I was familiar with his analysis based on his visits to my previous employer. This is why I picked out his book for a review, even though there may be more recent publications. Since Peak Oil is a fairly slow-moving process, I am not too concerned that the book is out of date.

Book Description

The book is 259 pages, excluding the 12 pages of notes and the index. It is aimed at a wide audience, without excessive technical detail nor detailed investment recommendations.

The book is divided into two parts, with the first part explaining why he argues that economic growth depends upon cheap oil, and the second part explains what the economy will look like in a no-growth world.

Why Read About Peak Oil Now?

It may appear to be a fairly strange time to review a  book on Peak Oil. It has been declared to be dead in various articles. Moreover, there is a reasonable chance that oil prices could markedly slide over the coming months in response to cooling of growth in China. (I do not follow the Chinese economy enough to judge the probability of that outcome.) Lower energy prices could cause mayhem amongst high-cost, over-leveraged North American shale producers, and so high energy costs may be last thing investors will be worried about.

However, if you are new to the concept, that is the best time to look into Peak Oil. It is a slow-moving structural framework, and oil price cycles will come and go within that framework. If you start paying attention to Peak Oil when oil prices are shooting higher, you are very likely to panic and over-extrapolate the trend. This happened to a lot of people in 2008, and that probably provides a partial explanation for why enthusiasm for Peak Oil has waned. (The hype about the North American shale energy bonanza is presumably another important factor.) And it should be noted that some of Jeff Rubin's calls in 2008 did not turn out too well, and those could be traced to embracing Peak Oil too tightly. Although I may discuss that topic elsewhere, I would underline that what happened in 2008 provides a good example of why enthusiasm for Peak Oil needs to be tempered.

Investors and analysts need to learn from their own mistakes, but it is a lot less expensive to learn from others' mistakes.

Will Growth Really End?

I have some reservations regarding various parts of his analysis. One key area is the question whether "growth" can continue. In Sustained Growth On A Finite Planet,  I gave a somewhat theoretical explanation of why real GDP growth can continue despite the finite-ness of the Earth and the Earth's resources. To summarise, energy can shrink as a percentage of GDP, and there are biases in the construction of GDP to allow it grow, even though the "standard of living" is not really improving.

A supporter of Jeff Rubin's analyses could argue that my stance is unrealistic. In practice, energy price spikes are associated with recessions in the United States. And given the importance for U.S. consumers for foreign exporters, when the U.S. economy catches a cold, the rest of the world tends to get pneumonia. Although I recognise that the historical relationship is strong, energy prices are not the only factor driving the economy. For example, the U.S. economy entered recession in December 2007, before the price of oil shot up. Although the rise in oil prices did not help the U.S. consumer, the credit markets were already in disarray, and the convulsion around the bankruptcy of Lehman Brothers would probably have happened regardless.

But if you think of "economic growth" as a rise in a standard of living, there are less reasons to dispute the view that Peak Oil is synonymous with the "end of growth".

What Is Peak Oil?

The most useful parts of the book are the description of what Peak Oil is, and how it impacts the economy. As a former sell side Chief Economist, Jeff Rubin has a lot of experience in summarising why technical subjects matter to investors. This is the key advantage this book has over a book written by someone like a physicist or geologist, at least for someone new to the subject.

The first key point is that Peak Oil does not mean that "we are running out of oil". What matters is the rate of extraction, and the energy costs associated with that extraction. As an extreme example, there is presumably enough Uranium in my back yard to power a nuclear reactor for some fraction of a second. However, the energy needed to extract that Uranium is larger than would be generated by that reactor, and so it is safe to say that this Uranium would never be mined. (It will decay, but that's another issue.) Therefore, one could say that Uranium supplies will never "run out" - since there will always be some in my back yard - but that is a completely pointless observation. What matters is how much there is that can be profitably extracted.

If we turn to a more reasonable example, take North American shale hydrocarbon production. In order to extract oil or natural gas from that shale, high pressure water and toxic chemicals are injected into the rock to fracture the rock formation (hence the nickname "fracking"). The characteristics of these wells are different from conventional wells - there is an initial burst of flow, which tails off relatively rapidly (being uneconomic after about 5 years).

Let's assume that such wells stop producing after 5 years (for simplicity; I am uncertain what the exact decline rates are). What happens if that if we keeping drilling the same number of (non-dry) wells each year, we will end up in a steady state where producing wells number 5 times the number of (non-dry) wells drilled each year. In order to double production (in the short term), all you need to do is double the number of wells you drill each year, and the amount of producing wells will double in 5 years. Roughly speaking, that is what has happened with North American shale production. (Note:this assumes that the number of dry wells drilled, and the average flow rate per well are constant.)

Why did I add the qualifier "short-term" above?  It is because of  "Peak Oil": the flow rates of new wells are presumably lower than older wells. This happens as a result of the presumed competence of oil and gas drillers - they drill the "sweet spots" first, and then they are forced to go after more marginal sites. Over time, for the same amount of drilling activity, the flow rate will drop. Within the Peak Oil community, the feeling is that this fate will hit shale oil production within North America within a few years. (Natural gas output has plateaued as there is already more supply than demand. Drilling for gas could be ramped up again.) Please note that although those forecasts look plausible to me, I am not an expert. Unfortunately, oil production forecasts are an important part of the valuation of oil and gas companies, and so the forecasts can be affected by the Wall Street hype machine.

Rubin emphasises that this factor will lead to what is now referred to as an "undulating plateau" of production, rather than a smooth bell curve shaped peak. Too much time was wasted in the Peak Oil community fitting mathematical curves to production data, and too much emphasis was paid to what would happen when the peak would be reached. Production rates depend upon the economics of demand, and not just geophysical constraints.

Increasing Cost Of Production

In addition to rates of production dropping, cost of production rises as more marginal sources are tapped, Sources like the Tar Sands were known about for a long time, but they were unable to be profitably tapped.

Whether or not it is economic to extract an energy source is a slippery concept. At any point in time, this is determined by the monetary costs. But since energy prices are expected to rise, won't those sources become economical? The problem is that this is not necessarily true. The cost of production may still rise more than the rise of the output. The reason is that the energy inputs are greater than the energy value extracted. For example, corn ethanol is an economic disaster as the net energy from the ethanol is less than the energy needed to harvest the corn. The business is only viable as the result of a government mandate and subsidies. This analysis is known as the Energy Return On Investment.

These increasing costs affect almost all energy sources. Rubin discusses the situation for coal. Although increasing tonnages of coal are being extracted in the United States, the quality of the ores are dropping. Rubin notes that in terms of the output energy value, coal production in the United States peaked in 1998.

Oil - Critical For Transport

The focus on oil is not an accident - liquid fuels are critical for transport and the industrial infrastructure. Other than for trains, diffuse sources of energy are inadequate for transport as the density of energy per unit of mass is too low. Additionally, industrial equipment needed for mining and the maintenance of the electrical grid run on diesel fuel.

The implication is that if there is a shift towards other energy sources (renewables, nuclear), some energy will need to be inefficiently converted into liquids that support transport,

Oil Producers Are Where Consumption Growth Is

A significant part of the book discusses the situation within oil-producing countries. Within OPEC in particular, the authorities offer subsidised food and energy in order to keep their hold on power. For example, gasoline in Saudi Arabia costs 13 cents a litre. Additionally, the country is a prodigious consumer of water, which is increasingly being generated by fossil fuel powered desalinisation. As a result, there are projections that Saudi Arabia would consume all of its production by 2030.

This factor needs to be kept in mind when at more optimistic global oil production growth projections. The production growth may occur, it just will not available for the developed world. (Note that although there has been great excitement about the United States producing more oil than it imports, that just means that is just importing slightly less than 50% of its consumption.)

Muddling Through

Although Rubin does not highlight the issue, there is reason to believe that the industrialised economies can continue to muddle through for a considerable time before energy constraints kill growth completely - possibly decades.

  • Demand destruction. A long-term rising trend in energy prices will force substitution and conservation efforts.He also notes that taxing energy - such as the steep taxes imposed in Denmark - could force conservation as well. Although it appears unlikely within the United States, it may be that strategic considerations may force a change of direction.
  • Lower energy usage does not entail a lower standard of living. Europeans have a higher standard of living with a much lower average level of energy consumption. People may embrace things like bike riding.
  • Neoliberal Degrowth Policies. Rubin notes that the last recession did a very good job of reducing carbon emissions. He was rather polite, blaming this on the recession and not policy. Somewhat ironically, free market oriented policies throughout the developed world have done a rather spectacular job at reducing consumption amongst the middle and lower classes. For example, deregulating financial sectors to allow housing bubbles and busts, structural reforms to labour markets, and austerity have done a good job of reducing full-time employment amongst youth. Unfortunately, since the neoliberal policies were supposed to be promoting growth, Green parties have not given the conservative parties credit for their ecological achievements.

Weak Points Of The Book

The book is not perfect. It is fairly introductory, which does limit its usefulness for researchers. The data was often presented within the text, while I would prefer charts to put data in historical context. And as I note above, the relationship between growth and energy consumption should have been examined more closely.

I also depart with his analysis at various points. He still has a tendency to connect too many factors to energy; economies have cyclical behaviour that is independent of the cost of energy. In particular, I gave up reading his analysis in Chapter 2 - "Debt Is Energy Intensive". I have serious doubts about conventional fiscal policy analysis as it is; forcing a linkage to energy costs makes it even worse. All the developed economies were hit by higher energy prices, but it was only the euro area that had a sovereign melt down. That is because energy prices have little to do with the dubious pseudo Gold Standard the euro area nations forced upon themselves.

Not A Doomer Book

Another advantage of this book over other sources of information about Peak Oil - in particular, web sites - is that he does not wallow in pessimism. Being a "doomer" is a widespread problem in internet debates. But as I note above, the developed economies should be able to avoid catastrophes for a long period of time (although European policymakers are flirting with disaster as I write). As I discussed here, the markets and economic policy makers are unable to focus on the long-term risks posed by Peak Oil, and so the markets will not discount such outcomes. However, an individual has to plan for the long term within their personal financial plans, and so one eye should be kept on the subject.

If you want to express the situation metaphorically, peak oil is not a cliff face that industrial civilisation will fall over, rather that it a noose that is imperceptibly tightening around its neck.

Concluding Remarks

The book is imperfect, but it provides a good introduction to the subject while avoiding various psychological pitfalls. The subject of Peak Oil may not appear timely, but it needs to be in the back of the mind of fixed income analysts. In order to be bearish on bonds, you have to project a steady multi-year tightening cycle. It remains to be seen whether the business cycle could last that long before triggering the oil price spike that would bring it to its end.

Final Note: The book appears to be out of print, but the updated Kindle version is available at Amazon (affiliate link to hardcover version).

(c) Brian Romanchuk 2014

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