Early in 2009, I wrote an article about how financial planners (and people generally) need to incorporate the high likelihood of unlikely events into their worldview. The past few days have struck me by their confirmation that all our assumptions will be challenged, and we cannot afford to be complacent about living in a “normal” world or rely on “business as usual” in our planning.

ONE. Late in April an explosion on the Deepwater Horizon 50 miles south of the mouth of the Mississippi River marked the start of the biggest offshore drilling accident in over two decades. We still don’t know what happened, but the result was an oil spill first reported as 1000 barrels per day, then upgraded to 5000 bpd, with current estimates as much as 50,000 bpd – an amount equal to 1% of the nation’s entire oil output. The pressures involved are amazing. One expert estimates that 5000 barrels per day could be leaked by a one-fourth-inch hole in the main pipe, with a stream that would cut your arm off if you somehow got in the way.

The first attempt to cap the leak failed, and BP (and every expert they can hire, I’m sure, plus all the government folks) is looking for strategies that promise a solution in less than a few months. Remember that the site of the leak – and where any relief well must be drilled – is right in the path of a number of large hurricanes in the past decade.

Aside from the immediate problem, which could be huge, deepwater drilling has been the main hope for additional oil supplies for the coming decade. Experts have casually talked about deepwater wells – wells in 5000 to 12,000 feet of water followed by 3-6 miles of drilling through rock and salt — providing an increasing share of the world’s oil. These wells are very expensive (the drilling ship now at the bottom of the Gulf cost $600 million), and the environment is very hostile. Only about one-fifth to one-third of exploratory wells (like this one) are successful, and the cost is about $100 million per well. If there is a find, though, the volume of oil may be substantial, so the potential rewards are great. There is a strong focus on operational safety, and up to now the record has been pretty good, but the risks and conditions are extreme, with pressures beyond what anyone is used to. This was not the first subsea blowout, only the biggest in two decades. Forecasts for future oil supplies all include growing quantities from the deep waters of the Gulf, as well as deep water off Brazil and Africa. Most of the oil sought by the “Drill, Baby, Drill” advocates is off shore, in the Arctic, or similarly difficult locations.

The United States and the entire world face the imminent arrival of Peak Oil. The Deepwater Horizon is becoming the Three Mile Island or Challenger disaster of oil production. Before extending our reach further into the unknown and dangerous, we will pause to review our knowledge, techniques, and regulations. We stopped Space Shuttle flights after each disaster, and we’ll probably slow the pace of development here as well. When we restart, the process will be better but more expensive, and the chances of avoiding an early date for Peak Oil will have been pretty much lost.

How will this affect us? Supplies of oil will be smaller (and less reliable) than they otherwise would have been, and production costs will be greater. The need for capital will be greater, which will reduce the capital available for other needs. (The money that BP is spending to clean up the mess is money that won’t go into new production.) Fuel prices will probably be higher, and the ability of the economy to grow will therefore be reduced, as money going to oil, gasoline, diesel, and jet fuel is money that can’t be used for other needs. We’ll have to be resilient, and do with less.

The blowout and spill will affect us in other ways. The coastal wetlands of the Gulf are some of the most productive acres in America, but they have been disappearing for decades. The spill will hurt those who rely on the area for fishing (think Bubba Gump), and those of us who will have to rely on farmed and imported shrimp instead of the fresh-caught kind. New Orleans restaurants, and tourism, will be hurt, as will others relying on clean water and white sand beaches from Louisiana to Florida. Some of the loss can be quantified (and may be reimbursed), but the spill, if it persists, will remind all of us of additional costs of the American reliance on oil. Further, it now appears that much of the spilled oil remains in the water but below the surface, affecting a much wider area than first believed, with a long-term impact that we can barely guess at, potentially extending to the Florida Keys and up the Atlantic Coast.

TWO. Another startling experience was seeing the New York Stock Exchange lose 6% of its value in seven minutes on May 6, then have almost all of the drop erased as quickly. It’s alarming that several days later we still don’t know what triggered the drop, or why it wasn’t contained. With memories of the crisis of 2007-09 still fresh in our minds, coupled with SEC suits and criminal investigations of Goldman Sachs, confidence in the fairness and stability of investing has taken another big hit. There are second-by-second records of everything that happens with these markets, so it should be possible to reconstruct the course of the crash and rebound. However, some investigations into prior problems have not resulted in public reports of exactly what happened. Maybe “they” never figured it out, or maybe “we” aren’t supposed to know. We can hope that this was a one-time problem, but we’ll be looking over our shoulders from now on. Since one of the suggested culprits is the electronic systems involved with high frequency trading that suck profits from the markets without providing liquidity when it was needed, many folks will need to be assured that the investment process is not rigged against them before feeling it is safe to participate again.

This event, of course, is merely one more in a series of disruptive events over the last three years that has led to the bankruptcy or collapse of major companies (Bear Sterns, General Motors, Lehman Brothers, Freddie Mac, Fannie Mae, Merrill Lynch, AIG, Chrysler), the near paralysis of the entire global financial system, massive actions by the Federal Reserve, the US Treasury, and their peers around the globe, and a massive transfer of debt from the private sector to governments.

How will this affect us? Congress is still debating major reforms, and instability persists. Each crisis reveals additional problems and systems that do more to manipulate and take advantage of markets than they contribute to the efficient mobilization of capital that has helped drive American prosperity. If the rules aren’t changed sufficiently, there could be an “Investors strike.” Capital will cost more. Social divisions – the distrust of “Wall Street” and all that implies – could increase.

THREE. A third surprise of the early days of May was record rainfall in Nashville, Tenessee. The weekend storm of April 30 to May 2 included the rainiest day and the third rainiest day in the city’s history, and areas of downtown (and much of central and western parts of the state) saw record flood levels. While this was unprecedented in the city’s history (and extremely rare anywhere in the US outside of a tropical storm), it was only the latest in a series of extreme weather events including record snows (and rains) on almost a weekly basis from December to March along the Eastern Seaboard from Richmond to Boston. Globally, this winter has seen persisting storms or droughts across the Northern Hemisphere from the US to Europe to China. There was a previously unseen wind pattern in the Arctic, possibly following from decreasing ice coverage there, and Canada had a year without a winter. These persistent, often slow-moving, storms have the potential to redefine “normal” weather. The Weather Channel described Nashville’s rain as a 1000-year flood. Based on history, they were probably correct, just as this winter was the snowiest on record in many Eastern cities. I wouldn’t be surprised, however, to see this becoming a common pattern in the future. One signal of what could be coming soon is the report that the water temperatures in the region of the Atlantic where most big storms form has been at record levels for the last three months. The previous record was in 2005, the year of Katrina and Rita.

A related problem is in Venezuela. Over 2/3 of that country’s electricity comes from the giant Guri dam, once the largest power plant in the world. Unfortunately, the country has experienced such a drought this year (and last) that the level of the lake behind the dam is falling rapidly. The dam’s power output is dropping, and could be eliminated in the fall if the rains aren’t much above average during this rainy season. Without this electricity, the government (led, of course, by the divisive Hugo Chavez) may have to redirect the power used in the oil industry toward more essential public services. Without electricity, the country could stop or reduce exporting oil to the US – 800,000 barrels per day, or 4% of our total use. This would be a terrible choice for them, and a potential crisis for us. There’s a similar drought affecting the power dams in industrial regions of southern China, leading that country to increase coal imports to keep the lights on and factories running.

Then there’s the volcano in Iceland, back in the news blocking air traffic across the Atlantic and within Europe again. The specific battle between airlines, businesses, governments, and scientists over how dangerous the ash clouds really are and who should decide on whether flying is too risky is a new one. (How do you balance the risk of a plane crash or extra wear on engines against the risk of additional deaths from people driving on crowded roads because they can’t fly, and the costs to business and people generally from the shutdown of air freight?) The volcano next to the one with the long name could be the next to go, and it is potentially much larger. The story of earthquakes (Haiti, Chile, and Indonesia) and tropical storms (from Florida to Bangladesh and Burma) over the past few years is similar, but on a broader scale.

How will all these natural events affect us? Fortunately, our forecasting systems are often good enough (except with earthquakes) to minimize the direct loss of life, but they can’t eliminate all the deaths. The cost of cleanup and recovery is often paid by the taxpayers of already stretched governments at all levels, leaving less money for schools, health care, and other priorities. Plans are disrupted, businesses lose money, environments are altered – things change. If the events are relatively small in scale, we gradually forget about them. If they are large enough (as in Venezuela, New Orleans, and Haiti), disasters can potentially lead to the downfall of governments and widespread dislocations of people. We plan as though nature and climate are stable and reliable, but the reality is quite different. Bigger events require more capital for rescue and reconstruction, money that we assumed would be available for other things. We seem never to budget for emergencies, or consider how they’ll affect the future of the broader society.

CONCLUSION. In the course of my work as a financial planner, I read commentary and forecasts from a number of fund companies and economists. I always listen for any mention that real resource constraints are something they take into account. When I get the chance, I ask about it. The answer, except for people who focus on the issues (like Jeff Rubin, formerly of CIBC, or the writers on The Oil Drum blog) is almost uniformly negative. Yet events like major oil spills, market instabilities, and violent or extreme acts from natural systems continue, and play out against a global society that is highly stressed, with fewer reserves and resiliency.

One example of the apparent attitude of the “managing class” is the recent Secular Forum of PIMCO, as reported by Mohanel El-Erian last week. PIMCO develops a “secular outlook” each year, outlining the world it sees itself operating in for the next five years. Last year they announced the “New Normal,” a phrase which has been widely adopted, for a world with little growth as debt issues are worked through. Other firms probably prepare similar studies, but PIMCO publicizes their more than most, and it is the basis for their investment strategy. http://www.allianzinvestors.com/documentLibrary/mutualFunds/supportingLi…

The report is interesting and worthwhile to read. One thing that is striking, though, is the almost total omission of any reference to events in the “real” world. Their focus is on debt levels and growth rates, on the battle between inflation and deflation, and the role of developed versus emerging economies. However, evens like those discussed above are limited to one sentence in one paragraph on page 7 (of 8), discussing reasons why their general forecast may be too optimistic:

“Second, some of the super-secular issues (such as climate change, demographics and the atomization of societies) could play out in secular time, significantly increasing the structural headwinds facing the global economy.”

Shortages of natural resources, starting with Peak Oil and exemplified by the Gulf oil disaster (and why we have to be drilling there for oil in the first place), increasingly extreme weather events as predicted by global climate change projections, and fragile, overstressed, and dehumanized financial markets – these are all possibilities that PIMCO (and most of its peers, from what I can see) do not take into account. I believe, by contrast, that they will be crucial in shaping the economy and social change over the coming years.

The production of oil will be more costly, require more capital, and will soon start to decline overall. Rescue, repair, and reconstruction work following natural disasters will require lots of money, energy, and other resources, straining governments, insurance companies, and ordinary people alike. An unreliable financial system will make it harder to mobilize capital, the basic purpose of the money market system. The ability of major institutions to operate and provide financial backstopping to all these challenges when already in debt cannot be relied upon. Certainly any planning strategy, whether for individuals, investors, or society at large, must incorporate these challenges in its worldview.

(notes to first paragraph)
“Fat Tails, Black Swans, and Serial Crises: Planning for a Volatile World,” Journal of Financial Planning, March 2009, page 44-46. http://www.spireip.com/advisors/vodra_articles.asp
This article does not repeat the arguments for Peak Oil or Global Climate Change. To read my views on these subjects, follow this link from my website: http://spireip.com/advisors/vodra_articles.asp