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Commentary: Oil and the economy

(Note: Commentaries do not necessarily represent the position of ASPO-USA.)

By itself, the concept of having to get by on just a little bit less oil each year seems to be manageable enough. Some think that a steadily, or even sharply, rising price will merely reduce demand and promote exploration and that everything will more or less normally work itself out through well understood market mechanisms. Perhaps it will, but I think the odds are stacked against a smooth transition to a future of less net energy.

The critical fact is this: Because all money is loaned into existence, our economy requires perpetual growth to function. The purpose of this article is not to opine on whether this is a good or a bad system, but merely to describe it and the risks it carries by virtue of its design.

With constant economic growth, our money system is relatively happy; without growth, it becomes utterly despondent. Without constant economic growth, preferably in the range of 3% (or more!), the collective pile of debts cannot be serviced out of new growth and so they begin to default.

This is exactly the dynamic that has been exposed and now is in play in Europe and, if my guesses are correct, will soon visit the very core of the thin-air money machine, the US itself.

That’s the difference between growth and shrinkage in our world economy. Night and day. Life and death. If this strikes you as a rather fragile and unsustainable way to construct an economy, then you are not alone. After all, how can anything grow forever?

The key takeaway here is this: Our economy must grow in order to function.

Oil & the Economy

When I have the opportunity to present to and interact with people who are on the economic/financial side of the equation, they very rarely understand - truly understand - the energy side of the equation. You know, the not-so-subtle difference between total energy and net energy, and the fact that the first and second laws of thermodynamics have never been broken.

And in reverse, I often find that people in the energy camp do not really appreciate how the economy functions, and that it is really a complex system with multiple nested feedback loops predicated upon growth. In my view, each camp would benefit from spending a little bit more time in the other camp because both are really making some very profound assumptions.

The economic folks are assuming that energy will somehow be found and brought to market and the energy folks are assuming that the economy will be there to support their capital and technology-intensive efforts. Neither of these assumptions are very helpful if they help us overlook the potential disruption that declining net energy could unleash within our economy.

To return to the idea of our economy as a complex system for a minute. The field of complexity research is pretty robust and understands the basic principles of the coupling between energy flows and complexity. Whether the complex system being studied is a wave encountering the shore, a pile of sand, or an economy; the same fundamental rules seem to apply. Maintaining complexity requires energy while increasing complexity requires more energy.

At this point I have to confess that my earlier description of the economy was woefully narrow. Yes, it is a nested system with multiple feedback loops, but those in turn are interconnected with political, social and cultural systems, each of which are themselves complex systems. It is in the largest sense that we must consider the impact of declining net energy on the complexity and behaviors of our most critical systems.

To make things even more uncertain, another feature of complex systems is that they are inherently unpredictable. When an event might occur, or how big that event might be, are both unknowable, whether it is the size and timing next earthquake on an overdue fault or the vigor and demands of the social uprising we are talking about. Complex systems are frequently tightly coupled and little events cascade and become larger events; the so-called butterfly effect.

My view here is that a decline in net energy will disrupt the economy, and other interlocking systems, in ways that are both unknowable and larger than expected by most.

Six Inches Thick

Recently there was a revealing AP story about coal seams in Kentucky being chased that were only six inches thick. Revealing because it tells us a lot about where we are in the net energy story.

Those managing pensions with 30 year investment horizons should be thinking really hard about those six inch coal seams. They should ponder what it means that half of all the oil ever burned has been burned over the past 22 years and wonder about where the supplies will come from to fund the next 22 years.

In fact all of us should; what we assume to be the way the world works, and the way all of those interlocking complex systems function, is a very, very recent development historically speaking and can continue if, and only If, the amount of available surplus energy continues to grow.

This is not an idle concern, but one that will shape our futures by shaking our monetary and economic systems to the core. Such is the nature of complex systems starved of the requisite amount of energy required to both maintain and advance the current level of complexity.

(Source - http://www.multpl.com/s-p-500-dividend-yield/)(Source - http://www.multpl.com/s-p-500-dividend-yield/)

To make things just a little bit darker for equities today is the fact that from a historical perspective dividend yields are quite unattractive and reversion to the mean is the better bet:

Historically, truly compelling equity yields are in the vicinity of 10% but even the long term average is more than double the current yield. The two ways to bring the dividend yield back into the historical fold are for prices to fall by half or dividends to be doubled.

Unless a massive earnings binge is expected, which rising energy costs render difficult if not impossible, the ‘fall by half’ option is the more likely outcome. How could equities fall by half? One way would be to keep the dollar constant and let the prices fall. This is the more obvious method. The other way is to debase the currency and let the purchasing power of stocks erode by half while holding their nominal prices constant.

If that sounds tricky, it is exactly what has happened over the prior thirteen years where the S&P is now trading at the exact same level it was back then. Inflation has been anything but absent over that same period and this is how printing money in the face of declining net energy (and an enormous credit bubble popping) will deliver to us smaller returns even as the tried and formerly true monetary levers are pulled and pulled again in search of a response we can recognize.

The bottom line here is that everything we think we know about investing and how the world works is challenged by the pesky reality of energy sources that are dwindling in both quantity and quality. The days of pulling magic monetary and fiscal levers and then having the resources magically appear are over. A new and more complex future has arrived.

Unfortunately the experience set of practically everyone currently with their hands on these levers does not extend to energy, physics, the laws of thermodynamics, or anything outside of the tidy but woefully incomplete world of economics.

Our job, then, is to assess for ourselves what the nature, duration, and size of the economic disruptions might be that result from steadily squeezing the available amount of net energy that all these complex systems are supported by.

Whatever the answer each person or entity arrives at, whether that is “there’s nothing to worry about,” or something dire, is perfectly fine as long as a comprehensive, data rich conversation and/or debate is held. The time for holding assumptions and beliefs is over. It is time to broaden our views, wander into the neighboring camps, and see what we can learn from each other.

Chris Martenson (@chrismartenson) speaks twice at the 2011 ASPO-USA Conference. First, Thursday Nov. 3 at the Congressional Auditorium inside the U.S. Capitol. Then later that afternoon in a session titled “Of Wells and Wall Street.” Dr. Martenson is the author of a “The Crash Course: The Unsustainable Future of Our Economy, Energy and Environment” published by Wiley and now available in bookstores. His website, Chrismartenson.com, reaches a wide and growing audience of individuals interested in how to navigate the coming times with an eye towards preserving capital and mitigating risks.

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