Energy and Money

Part I:  Too Little Oil or Too Much Money?
Part II: We Can't Repeal the Laws of Thermodynamics

Weekly Commentary: May 4, 2006

Energy and Money Part I: Too Little Oil or Too Much Money?

Inflation is not only determined by the supply of goods available relative to the supply of money to buy them, but also the demand for the currency in which goods are priced relative to the supply of that currency.  It can be hard to tell which factor is primarily driving prices.

Sunday morning.  The air is crisp.  The floor of the woods around my home is orange and red with a thick bed of sweet brown pine needles.  A cord of split firewood tumbles out of Jimmy's dump truck into a heap at the end of the driveway.  This is the easy wood.  The rest is from trees cut down from my neighbor's woods.  Six logs take 20 minutes to split by hand with an axe, wedge and sledge.  That was yesterday.  Here in New England we call energy used in this ritual "burning it twice."  All the wood will burn in the fireplace in the living room and in the antique wood stove in the family room, and
the wood stove in my wife's studio beside our house where wood is the only source of heat.

One 100 lb. wheelbarrow load rolls down the gravel road to the wood shed.  Stack it.  Then another.  Then another.  One cord of wood weighs about 2,000 lbs.  Takes 20 round trips, 15 minutes each.  Gives me plenty of time to think back on Alan Greenspan's tranquilizing speech on oil and energy back in October 2004.  

The price for a barrel of oil had increased from $25 to $45 over the previous year when he made those comments, clearly intended to calm markets that were becoming increasingly alarmed by the steady price rise.  He said that prices were due to moderate and decline over time.  A year and half later oil prices are nearly 40% higher.

Greenspan's speech is a well written, academic survey of the history of oil prices over the past century.  In it, he points out that experts have cried wolf along the lines of "We're running out of oil!"
several times in the past.  We didn't run out then and we aren't about to now either, he says, pointing out that the oil industry has suffered price volatility for over 100 years, especially in the early days.  Periods of high oil prices driven by supply interruptions and demand spikes have been a standard feature of the oil price landscape since the days of Standard Oil.

Greenspan acknowledges that short-term geopolitical challenges pose serious risks of supply disruptions, and that rising demand from China and India contributes significantly to current capacity shortages and thus price volatility.  But, he concludes, supply and demand will reach a harmonious balance and stable prices shall return, just as they always have.  Market forces will see to it.  The feel-good ending to the story: "If history is any guide, oil will eventually be overtaken by less-costly alternatives well before conventional oil reserves run out.  Indeed, oil replaced coal despite still vast untapped reserves of coal, and coal displaced wood without denuding our forest lands."

I enjoy a utopian, free market purist's interpretation of energy price history as much as the next guy, but Greenspan misses at least two important lessons of energy history.  In Part I, I'll talk about the money supply factor he does not bring up, for obvious reasons.  Part II covers explains that his key assertion that "
oil will eventually be overtaken by less-costly alternatives" can't possibly be true unless the laws of thermodynamics are repealed.

Oil Price 1988 to 2006

Greenspan claims that changes in the balance of oil supply and demand are causing the price of oil to rise.  The defining characteristic of oil prices in the past several years has been a steep rise from around $10 per barrel in 1999 to over $72 today.  Not to put too fine a point on it, that's a 620% increase.  Greenspan claims that the relentless rise in prices is largely the result of supply disruptions coincident with rising demand in China and India and factors he alludes to with typical political circumspection as "geopolitical challenges."

All manner of oil supply interruptions—hurricanes, strikes, revolutions, militant attacks—have been going on for decades without causing the price of oil to relentlessly rise as it has for the past seven years with only one significant pullback in 2002.  It used to be—ever since OPEC's supply-induced price shock in the 1970s—that events that disrupted the oil supply temporarily caused oil prices to spike, then decline nearly as rapidly.  For example, as you can see in the chart above, in 1990 during the start of Gulf War oil prices jumped at the beginning of the conflict then dropped back down a few months later.  

An increase in demand from China and India combined with war in the Middle East, nationalization of energy supplies in Latin America and other geopolitical issues are plausible explanations for a steady rise if not for the parallel rise in the price of everything else, regardless of supply.  For example, there have been neither silver supply nor demand shocks yet the price increased in line with the price of oil from 2003 to 2004, and has been playing catch-up with the price of oil from 2005 to date.  This analysis by a publication in China concludes that high oil prices arise not from their demand for oil but U.S. printing too much money.

Oil vs Silver 

Another place to look for correlation between sustained oil price increases and price drivers is the dollar money supply.  


Money stock, as measured by Money at Zero Maturity (MZM) -- a more reliable measure of money in circulation than M1, M2, and the now defunct M3 -- has grown in four distinct periods since 1995.  (A) is the period leading up to the stock market bubble, (B) the period of the stock market bubble when the market was producing its own money, (C) the period when the Fed flooded the system with liquidity in response to the collapse of the stock market bubble, and (D) the period of Fed "tightening" during which foreign central bank purchases of U.S. treasury and agency debt kept long term rates low, allowing the housing bubble to form and grow, and commodity prices especially, increase by in some cases several hundred percent.  

If the rising oil price were largely a commodity supply and demand issue, then oil and other petroleum-based commodities would have also increased in price by a similar margin when priced in other currencies.  But these commodities did not increase in price nearly as much when priced in currencies other than the dollar, at least not at first.  If you live in Europe, between 2002 and Greenspan's piece in 2004, you experienced an oil price increase from EU$22 to EU$35 when the dollar price of oil in the U.S.  increased from US$20 to $45, a 63% vs. 125% gain.  Since 2004, however, oil along with all other commodities have been rising in terms of other currencies besides the dollar.  The most logical explanation is that all currencies have been debased in unison, but this is hard to measure.  One indicator is the Dabchick Gold Index.  This index is intended to show how gold is valued throughout the world independently of the value of any country's individual currency.  While the gold price increase from 2001 until November 2005 was greater in dollars than in other currencies, since November 2005 the price rise has been more or less the same in all currencies.

Gold in all Currencies

While it's hard to separate money supply and demand from commodity supply and demand factors, a continuously rising price of oil along with other commodities over an extended period of money growth implies that expensive oil may be due at least as much to an excess of money as to an tight oil supply. Of course, it's not a central banker's job to tell you that.  It's his job to tell you that everything's going to work out just fine.  

No one can say for sure how much the rise in the prices of oil and other commodities are related to the money supply, to the risk premium added by the world's first "pre-emptive war," to nationalization of oil and gas production in Latin American countries.  One thing is certain: if central banks significantly reduce the money supply to contain the rise in assets prices, signficant deflationary forces are likely to be released that the Fed may find difficult to control.  This is why I believe the Fed's stated effort to withdraw liquidity will either not be followed by serious action to achieve it, or will be followed by an even more extreme reflation campaign than followed the brief period of deflation that resulted from the collapse of the stock market bubble in 2000.

Cutting and hauling wood is a lot of work. The switch to coal from wood not only made life  easier, but required less energy to get to the fuel to where it's burned.  The switch to oil from coal made that even easier; oil doesn't have to be chopped up and hauled around; vast quantities can be conveyed cheaply through pipes.  In Part II, I question Greenspan's assertion that "...oil will eventually be overtaken by less costly alternatives..." In fact, the switch to oil alternatives will be a step backwards to an era when you had to expend a lot of energy just to get the fuel to the point where you can burn it.

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Energy and Money Part II: Can We Repeal the Laws of Thermodynamics?

We have plenty of oil.  But we're running out of cheap oil and there are no cheap alternatives.

In Greenspan's view, market forces will manage a smooth transition from oil to new sources of energy, just as they did for the transition from wood to coal and from coal to oil.  This is sophistry.  Instead, the world will soon be forced back to a time when a lot more work, in a thermodynamic sense, was required to heat homes and fuel transport.


Part II of Energy and Money is an ode to the lowly liquid, petroleum.  Unappreciated and misunderstood by the average consumer.  Exploited by politicians.  Maligned by environmentalists.  Gasoline by the gallon, petrol by the pint, diesel by the drum.  Smelly and explosive, refined from crude -- a disparaging term -- we cheerfully pour the stuff into our cars, trucks, trains and planes and burn it as carelessly as dormatory furniture at a frat party bon fire.  But what a marvel these fluids are, as they go up in smoke, these sloshing chemical batteries, packing an unimaginable energy punch in a small convenient liquid manufactured and packaged by mother nature.

Liquid solar energy, collected over millions of years, converted by photosynthesis into the carbohydrates we know as plants, and then by physical and chemical forces over millennia into the hydrocarbon fluid we call petroleum.  Sweet and sour, but only in refiners’ parlance.  None suitable for drinking.  Unlike ethanol, good for politicians and martinis, together, but like all manufactured oil alternatives – so-called “renewable” energy – a poor substitute for the real thing, like a blind date for a long lost love, and nearly useless for reducing dependence on our fossil fuel friends.

First of all, we use a lot of oil.  Mother nature spent hundreds of millions of years to nurture liquid fossil fuels into the liquid batteries we burn but it’s only taken us a little over a century to use about half of them up.  The best half.  The asparagus tips.  The ice cream off the cone before the rest drips into your hand on a hot summer day.  The first ten minutes of Thanksgiving with the in-laws. 

It’s all down hill from here. 

Oil Consumption

We burn oil at the rate of 921,000,000 gallons per day in the USA.  Just to drive our cars we use 320,500,000 gallons of gasoline from sunrise to sunset, vroom through 3,700 gallons a minute, coast to coast.

Peak Oil.  Whether you believe that an End of the World crisis is coming or not, there’s general consensus among experts that all the oil that nature provided us that was easy and thus cheap to dig out of the ground, no matter how clever we get at doing it, has already been dug up.  There is plenty of coal and uranium to generate electricity for a good long while, to run factories and heat buildings and houses.  Lots of compelling alternative electricity generation techniques, too, such as wind and solar.  Energy for transportation is the challenge. 

Inefficient Use of Fossil Fuels

Maybe some day we’ll be driving a Prius (rhymes with “pious” – a brief, offensive rant will be appended to this commentary shortly), powered by a tiny pebble bed nuke running an argon gas turbine.  Sweet!  Coming to a Toyota dealership near you… in 2023 for $4,000,000 in 2006 dollars or $24,000 New American Dollars, issued in 2013.  Or maybe we can shovel coal into the boiler in the back of a Humvee that’s been converted to steam power.  That’ll keep the kids busy… no more whining about the stale DVD collection.

Only 5% of petroleum production is used for heating buildings, manufacturing or other fixed use applications, the rest is used for transportation.  There’s a reason for that.  Oil is too expensive to use for heating, and the other fossil fuels need to be converted into a fluid before they can be used for transportation.

Not to worry, say the energy optimists.  Soon enough we’re going to stop using these many million year old pre-charged liquid chemical batteries and start to make our own.  Who needs mother nature.  To hell with Her!

Efficient but Limited Use of Quadruped Power

Ethanol from corn and grass.  Biodiesel from the back of the local KFC.  Liquefied natural gas (LNG) from methane.  Liquid hydrogen from hydrogen gas from hydrolyzed water.  Gasoline from coal. 

All of these substitutes for petroleum remind me of the joke about a miracle product: dehydrated water.

Just add water. 

All you need to make fossil fuel alternatives is energy, including a lot of fossil fuels.  And water.  And land.  And time.

The main challenge in our energy future is not the limitations of alternative sources of energy but in the unique and under appreciated characteristics of petroleum that we have come to rely on for economical transportation and for petroleum based products.  The plastic in your shower curtain.  The fertilizer to grow the corn you eat or, if you've got the pols in your pocket, convert to ethanol.


The First Law of Thermodynamics: Conservation of Energy.  If you had a window seat in high school physics class, the law says that there’s no free lunch when it comes to chemical processes that use heat to do work.  You can’t get more energy out of a system than you put into it.  This is relevant to this discussion because while petroleum is a pre-charged chemical battery, all substitutes for petroleum, such as liquid hydrogen and bio fuels like ethanol and bio diesel, have to be manufactured by humans.  Manufacturing substitutes for petroleum takes energy and limited and expensive resources like land and water, not to mention fertilizers made from petroleum. 

Perpetual Motion

Perpetual Motion Machine (It Didn't Work)

Some processes, such as making ethanol from corn, require more energy to manufacture than is stored in the resulting liquid battery.  More importantly, they take more money to make than they produce.

The following Statement of Senator John McCain on Amendment to Prohibit Extension of Ethanol Subsidies Mar 11, 1998:

“Mr. President, enough is enough.  The American taxpayers have subsidized the ethanol industry, with guaranteed loans and tax credits, for more than 20 years.  Since 1980, government subsidies for ethanol have totaled more than $10 billion.  The Finance Committee amendment to ISTEA, if not stricken, would give another $3.2 billion in tax breaks to ethanol producers.

“Current law provides tax credits for ethanol producers which are estimated to cost the Treasury $770 million a year in lost revenue, and the Congressional Research Service estimates that loss may increase to $1 billion by the year 2000.  These huge tax credits effectively increase the tax burden on other businesses and individual taxpayers.

“…the Department of Energy has provided statistics showing that it takes more energy to produce a gallon of ethanol than the amount of energy that gallon of ethanol contains.

“Finally, let me quote Stephen Moore, of the CATO Institute, who puts it very succinctly in a recent paper: ‘...[V]irtually every independent assessment--by the U.S. Department of Agriculture, the General Accounting Office, the Congressional Budget Office, NBC News and several academic journals--has concluded that ethanol subsidies have been a costly boondoggle with almost no public benefit.’ 

“So why do we continue to subsidize the ethanol industry?  I think James Bovard of the CATO Institute put it best in a 1995 policy paper: ‘...[O]ne would be hard-pressed to find another industry as artificially sustained as the ethanol industry.  The economics of ethanol are such that, for the industry to survive at all, massive trade protection, tax loopholes, contrived mandates for use, and production subsidies are vitally necessary.’”

Economical Use of Ethanol

Hydrogen is another promising human charged energy battery.   Using nuclear energy to generate electricity for hydrolysis to create hydrogen, or to heat water to get hard to reach petroleum out of the ground, uses more energy than it creates, a net energy loss.  That doesn’t make it a bad idea.  Converting an abundant form of energy that cannot be used for transportation into a scarce form that can is not only a good idea but one what we’ll come dependent on, even if there’s a net energy loss.  But it still implies a higher net cost of Btu’s (British Thermal Units) per person for transport. 

Hydrolysis produces hydrogen gas that must then be compressed into a liquid; this process consumes energy.  The resulting liquid hydrogen is not nearly as efficient as oil by volume, although it is competitive by weight.  It takes 366 standard cubic feet of hydrogen gas to match the energy in one gallon of gasoline.  After liquid hydrogen is produced, it's hard to transport because unlike gasoline it has to be kept at a very low temperature, near absolute zero, to prevent it from turning back into a very explosive gas.


Hydrogen: not in my garage

In addition to manufacturing, transport, and storage costs, liquid hydrogen has one third of the energy density of gasoline by volume.  The 18-wheeler that brought that orange you're eating to the local supermarket market burns diesel fuel with a power density of 1 million Btu per cubic foot, versus 270 thousand Btu for liquid hydrogen. That 18-wheeler can travel 1000 miles on the diesel fuel in two 84-gallon tanks that take up 23 cubic feet of space under the rear of the cab.  Two 1,100-gallon liquid hydrogen tanks that use 316 cubic feet of space in the trailer are needed to get the same range, never mind the added space for the batteries that are needed to convert the hydrogen into usable energy.

Doesn't leave much room for oranges.

Another promising fossil fuel substitute is biofuel.  The best case, biofuel from switch grass. The following comes from John Duetch, director of energy research and undersecretary of Energy in the Carter administration, and director of the CIA and deputy secretary of Defense in the first Clinton administration, is a professor of chemistry at MIT.  Writing in last week's Wall Street Journal:

“As for the land required to support significant biofuel production from a dedicated energy crop, switch grass offers a basis for estimation. It grows rapidly, with an expected harvest one or two years after planting. Ignoring crop rotation, an acre under cultivation will produce five to 10 tons of switch grass annually, which in turn provides 50 to 100 gallons of ethanol per ton of biomass. Thus the land requirement needed to displace one million barrels of oil per day (about 10% of U.S. oil imports projected by 2025), is 25 million acres (or 39,000 square miles). This is roughly 3% of the crop, range and pasture land that the Department of Agriculture classifies as available in the U.S.  I conclude that we can produce ethanol from cellulosic biomass sufficient to displace one to two million barrels of oil per day in the next couple of decades, but not much more. This is a significant contribution, but not a long-term solution to our oil problem.”

This brings us back to our friend, gasoline.  In terms of the net energy, cost and power density, there’s the pre-charged petroleum battery that we’ve been digging out of the ground cheaply but increasingly expensively.  And then there’s everything else, that has to be manufactured. 

Back to Greenspan's speech.  In his view, market forces will manage a smooth transition from oil to new sources of energy, just as they did the transition from wood to coal and from coal to oil.  This is sophistry.   The transition from wood to coal was smooth due to a key advantage of coal over wood—by volume the former has much higher power density.  Similarly, the transition from coal to oil was lubricated not only by oil's improved power density over coal, but also because oil is liquid and is therefore cheaper to transport than coal.  It can be piped long distances at wide range of naturally occurring temperatures.

Nothing comes close diesel or gasoline for power density by volume.  This is where Greenspan gets the dunce cap for his "wood-to-coal, coal-to-oil, oil-to-something new" replacement argument.  Coal was adopted over wood, and oil over coal, because each new energy form had better power density and was more efficient to extract, transport, and burn than the previous form.  Sooner or later the economy will be forced—for the first time in history—to adapt to an inherently thermodynamically and economically less efficient source of energy than the previous one used.

 Rising Commuting Costs will Cut Real Estate Values in Rural Areas

One result of our oil-based transportation system is cities with concentrated populations surrounded by far-flung suburbs, all connected by highways.  The highways are used by autos propelled by highly inefficient gasoline engines, and trucks with slightly more efficient diesel engines.  This population and real estate distribution is predicated on an oil transportation and combustion infrastructure that has evolved over the past century.

Our transportation infrastructure depends on the availability of large quantities of an inexpensive combustible fluid that packs a lot of Btu's into a small space.  Oil is a unique, high power density fluid.  It can be pumped right out of the ground, refined, conveyed through pipes and into tanks, and then be burned in engines.


We are not running out of oil.  We are running out of cheap oil.  Alternatives are several times more expensive than oil, even at $70 per barrel.  The last oil price crisis resulted from an increase of $16 to $100/bbl (in 2006 dollars) over six years. Imagine an era—over the next 20 years or so—during which oil prices increase by a factor of five to ten or more, leading to prices of $350 to $700/bbl or higher.  That's  the reality of oil economics.

The utopian dream is thousands of wind mills offshore generating electricity for hydrolysis of sea water into hydrogen gas, and miles of solar cells all over the desert churning out billions of watts of electricity to power our cities over the next twenty years or so.

Maybe.  But we still have to get around and transport stuff from where we get it to where we need it. 

More ideas on that in our next installment in this series.

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