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Yumbo breaks down energy and trade part I of II
The Energy Cliff as a Diagnostic Tool in Trade Wars – Part I
- The Trojan Horse Revisited
Axiom: Complex civilizations tend to accelerate the use of resources, while diminishing the quantity of resources available for the civilization’s continued expansion — because they are continually being invested in solving the new problems generated by increasing complexity
There is a general belief that a market economy depends on the exchange of goods and services – which are defined as the end products of commodity and consumption trading. Consumer demand appears to be what defines the function of markets and how they react, respond and mirror this demand and forms the basis for driving the economic well-being of a nation. This is common perception - and the ultimate misdirection away from the real driver of an economy that is intentionally hidden away in plain sight.
All economic activity is a function of the ability to harness Energy – everything else depends on Energy to create both supply and demand. Energy is the hidden driver behind consumer markets, the economy and true independence. The greatest power any country can have against its survival is the access to any viable and proven energy source at any time, any place or under any natural or man-made circumstance.
This is the fundamental reality of nations - wherever or whatever they may be. Without a proven and lasting access to energy, any other resource or commodity cannot be produced or traded for long or a population kept fed and clothed. Cut off the energy access and any empire – no matter how large or how strong - quickly falls before it realises the problem exists.
The Energy trade will therefore form the catalyst in the change to a Multipolar World Order from the Unipolar Hegemony over the next few years. Let us look at how this will unfold.
- Energy Returned On Invested (or EROI)
People tend to be amazed at how relatively small agricultural or industrial operations can produce - at first look – what appears as a significantly larger output than otherwise possible with just the help of high-quality equipment over physical labour or rudimentary processes. While these operations seem very efficient at first-glance, our perceptions are quite the opposite of reality.
How efficient the production of a particular good or service is, truly correlates with the amount of energy expended on its development. The EROI – Energy Returned on Invested— is an excellent indicator of the true nature of our efficiency in producing and using energy. The measure of Energy as a tradable commodity is based loosely on EROI as well. It is a fundamental assessment of the markets in terms of energy rather than goods and services, which often intentionally mislead on the gains in the outputs compared to an arbitrary set of inputs.
EROI is the energy taken to produce a certain product or service, as a fraction (or multiple) of the total input energy needed to extract, transport, refine and distribute the output energy for consumption.
Whether it is reflected in human-animal labour outputs or found in one of the various energy sources that we may tap into every day to produce goods and services, such as oil, coal, gas, etc, the EROI of a particular process is by definition measuring the same parameter across the entire spectrum of production. This term has also been labelled as the EROEI (Energy Returned on Energy Invested). Both terms describe the same principle.
As an example, the modern food production and distribution system now consumes ten times more energy than it provides (EROI = 1/10 = 0.1). The ‘Panic of 1884’ is related to the inception of tractors over conventional farm labour in the United States and accounted for 5% loss of employment and the third largest recession in US history while output remained relatively constant. This is a good example of what a falling EROI can do in a limited economic environment.
Industrial processes are relatively more efficient but this efficiency is declining asymptotically.. The EROI of oil and gas, (especially in the U.S.), has been falling since the early 1930’s, which has now begun inflicting severe pressure on all sectors and industries in the economy. In 1930, the oil and gas industry could produce 100 barrels of oil for market for every barrel of energy cost (or an EROI ratio of 100/1). By 1970, production fell to a ratio of 30/1, and by 2000 it stood at just 11/1.
The EROI in another way is a measure of inefficiency and it can be seen that as society becomes more complex, the more inefficient our energy consumption becomes – not the other way around!
Basically, the falling EROI of oil & gas provides less nett energy for the market. Thus, as nett energy declines, prices rise due to the increased production costs found throughout the economy. The EROI cannot be measured independent from inflationary bias. The nett effect of the two (when inflationary pressures become significant) provides a speeding up of the EROI attrition process.
- EROI Fundamentals
Axiom: Aggregating historical data reveals that the world’s fossil fuels overall experienced their maximum cumulative EROI of approximately 44:1 in the early 1960s. Even coal, the only fossil fuel resource with a EROI that is not yet maxed out, is forecast to undergo an EROI peak sometime between 2020 and 2045. This means that while coal might still have significant production potential in some parts of the world, rising costs of production are making it increasingly uneconomical.
In a fiat currency environment EROI achieves process disruption far quicker and for far longer than in systems functioning with real money. The premise that in an Austrian monetary system a similar EROI degradation does not occur is false – rather, the market self-corrects and reaches energy balance before the anomaly reaches a structural (or systemic) collapse. Fiat currency systems have no such safeguards since the market is never really in control of the price discovery mechanism – this necessity was destroyed by Central Banks in 1973.
Several other studies suggest that this ongoing decline in the overall value of the energy extracted from global fossil fuels has played a fundamental role in the slowdown of global economic growth in recent years. In this sense, the 2008 financial crash did not represent a singular event, but rather one key event in an unfolding process.
If current projections come to pass, then over the next few decades the comparative costs of fossil fuel energy production to the market value of fossil fuel energy will approach each other. The total net energy yield available to fuel continued economic growth will inexorably decline. This will, in turn, squeeze the extent to which the economy can afford to buy fossil fuel energy that is increasingly expensive to produce.
Generally the following holds for EROI
EROI 3/1 and lesser
Transportation system: i.e. roads, bridges & trucks to move people and goods.
Transportation, agriculture, minimal health care, education.
Transportation, agriculture, basic living, health care, education, basic consumer goods
EROI 30/1 and greater
Transportation, agriculture, good living, heath care, education, advanced consumer goods.
As EROI falls below 30/1, the extraction process is inefficient and debt needs to be added to finance the energy extraction process to make it appear economically viable.
It is impractical to think that the system will automatically collapse when and because the net energy of the oil production process becomes negative (or the EROEI smaller than 1). No, it will crash much earlier because of factors correlated to the control system that we call "the economy". Complex systems always kick back earlier than the numbers expect. The EROI value currently accepted as the low threshold is between 5/1 – 7/1.
By using real money to produce energy, deficit spending cannot occur to continually debt-fund the energy renewal process - and therefore the EROI ratio cannot practically achieve a number less than 5/1 for very long (although market corrections do tend to overcompensate so a short period of EROI activity below 5 is possible but is fundamentally not sustainable).
Civilisation is literally expending more energy than it consumes or needs at an alarming rate, one result of our profit-at-all-costs approach to economic ‘success’ and reliance on a currency system since the late 1800’s that is not also a store of value.
As SRSRocco observes, this is the Trojan Horse of economic engineering that the debt-funded market system will never see coming until it is absolutely too late. The loss of viable energy production as a result of the inability of the public (the spender of last resort) to meet spiralling costs of production will decimate any country without access to cheap energy resources, means of refinement and infrastructure for distribution.
- To Trade Or Not To Trade (in Dollars) – That Is The Question
The trade in energy has always in the past been carried out in gold or a de-facto gold standard – using the inherent value linked to the gold price as the basis for a monetary unit of exchange. This meant the energy supply is kept in parity with other commodities and market cost could never be more expensive than demand price. The laws of a free market and sound money would never allow such a level of debt-fuelled purchases without adequate backing collateral – unfortunately we are very far from such a monetary utopia.
Since 1971, most nations of the world have become caught in the grip of Washington for access to energy. The US Federal Reserve Note since then has been directly and deliberately linked to the global purchase of energy and energy related products, and universally coined as the petrodollar. Nations requiring energy needed to purchase petrodollars in exchange for production of real goods and services in order to buy energy – which led to the cycle for further production.
The agreement between Saudi Arabia and Washington to buy oil energy with petrodollars had two consequences – one, the linking of world production of goods and services to the consumption activity of the United States exporting US inflation to the rest of the world; two, the rise of national Central Banks to control energy trade through issue of local currencies to keep liquidity in US dollars alive or risk national bankruptcy.
The second enabled globally linked banking systems to bypass open market operations to fund energy production directly by buying the petrodollar with their own debt-based bonds leveraged on ‘safe’ investments by their depositors and in their local currencies. This made banks able to control trade through the manipulation of energy purchases. Think Venezuela or North Korea and you will see how powerful this control can be.
However note that bond yields from Central Banks and corporations are based on growth in energy production. That's correct... bond returns are based on NETT GROWITH IN ENERGY SUPPLIES. With falling energy supplies from EROI depreciation, bonds just don't work all that well – these are propped up in the interim by inflationary practices of Central Banks which is not sustainable for the longer term. The market always self corrects to fair value - no matter how long this may seem to take.
By extension, the petrodollar became the de-facto international monetary unit for settlements on trade between countries. About 62% of world trade is settled by clearing houses in New York, London, Paris and Tokyo carrying out purchases in petrodollars and necessary conversions to other currencies. The transactions flow through the SWIFT interbank currency transfer protocol based in Brussels. There is therefore a direct relationship between trade, energy and the petrodollar.
- The Triffin Dilemma and EROI
There is a fundamental incompatibility between the attainment of global economic stability and having a single national currency perform the role of the world’s reserve currency. Belgian born American economist Robert Triffin first highlighted this incompatibility in the 1960s. He observed that having the US dollar perform the role of the world’s reserve currency created fundamental conflicts of interest between domestic and international economic objectives.
On the one hand, the international economy needed dollars for liquidity purposes and to satisfy demand for reserve assets. But this forced, or at least made it easy, for the US to run consistently large current account deficits. The Triffin Dilemma, therefore, argued that the demands on an international currency meant that excess supply would undermine its value.
After WWII the Bretton Woods international monetary system came into being. This was a fixed rate currency regime with the dollar as the global reserve currency. But to ensure stability and financial discipline, the major currencies were fixed to the dollar and the dollar was fixed to gold at the rate of US$35 an ounce.
This is where the Triffin Dilemma kicked in. The various nations then attempted to preserve the Bretton Woods system by maintaining a two-tiered gold market; one operating at the official $35 an ounce price while another traded gold at the market price, which was well above $35. Of course such a policy was completely unsustainable and it too failed.
Bretton Woods was on its last legs. President Nixon ended the system once and for all when in August 1971 he suspended the convertibility of dollars into gold. From that point on, the dollar was without an anchor and the global monetary system went from a fixed to floating regime. The dollar became the petrodollar in 1973, when a trade deal created between the United States and OPEC (Saudi Arabia) required energy purchases to be made only in US dollars.
As a direct result of this deal, the US benefitted by paying for imports with essentially costless dollars. The huge deficits brought about by excess US consumption produced a massive amount of liquidity throughout the global economy. While Triffin’s Dilemma would have predicted a collapse of the dollar because of the glut of dollars in the system, such an outcome didn’t eventuate.
This was primarily because the beneficiaries of US consumption didn’t have the means to buy energy without the petrodollar. So they reinvested their excess dollars back into US asset markets, notably US Government debt. Such actions supported the dollar, kept interest rates low in the United States , and perpetuated the imbalances in trade and energy production.
EROI is a declining ratio over time, while the value of the petrodollar decreases from debt creation. Energy costs keep increasing due to modernising processes that consume more and more energy.
At some point it will not be practical or possible for a country to continue buying petrodollars with more and more goods to purchase lesser and lesser usable energy – rather they will have to borrow the currency at an interest rate that they usually cannot repay. This is why emerging markets that are not also oil producers are unable to break out of the petrodollar debt trap.
This debt trap has imbalanced the financial system to create an energy-driven supply chain (based on Wall Street) that over time will be more expensive than the demand for the energy that the chain produces. As the system breaks down further, at some point countries will face energy starvation.
The EROI process linked to the petrodollar is an unsustainable and lethal combination. The following charts explain the problem of EROI applied to US energy conglomerates. Note that cash flow is a measure of energy invested against energy returned.
The cash flow for production vs cash fkw for demand
LoLLong term debt increased 100% in four years for the top three oil companies.
The hypothesis of falling EROI was indirectly linked to GDP by Professors Kenneth Rogoff (Professor of Public Policy and Professor of Economics at Harvard University) and Carmen Reinhardt (Professor of International Financial Systems at Harvard Kennedy School). Their findings supported the premise that too much debt (approx. 60% - 90% of GDP) would negatively impact growth.
This GDP figure of between 60% - 90% can be shown to equate to an EROI of between 20/1 – 10/1. The USA currently has a government debt of close to 105% of GDP and total financial obligations close to 250% of GDP. It is a fact that energy growth for the largest economy on the planet has been negative for a long time, and the EROI in the range of 5/1 is already seen in US Shale production - even without help from ZIRP of the Federal Reserve.
As there was no interest penalty for borrowing from the US Treasury between 2008 – 2016 (primarily due to the economic ZIRP of the Greenspan-and-Bernanke Fed strategy), the energy debt trap was able to be extended past the point of a natural systemic EROI collapse arising from debt defaults by energy conglomerates. This Energy crash will still happen if the Federal Reserve continues with QT and interest rate hikes, but can be delayed by further QE and a return to ZIRP.
Until the cost penalties increase past the point where nations (or conglomerates that hold proxy control of a nation’s energy assets) cannot repay their energy obligations, the system will still be functional but with an ever –increasing debt load to repay, this is snowballing the problem the longer the debt is rolled over.