and Money Part I: Too Little Oil or Too Much Money?
not only determined by the supply of goods available relative to the
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
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
wood. The rest is from trees cut down from my neighbor's
Six logs take 20 minutes to split by hand with an axe, wedge
sledge. That was yesterday. Here in New England we
energy used in this ritual "burning it twice." All the wood
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
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
said that prices were due to moderate and decline over time.
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
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
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
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
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.
Greenspan claims that changes in the balance of oil supply and demand
are causing the price of oil to rise. The defining
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
fine a point on it, that's a 620% increase. Greenspan claims
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
All manner of oil supply
interruptions—hurricanes, strikes, revolutions, militant
attacks—have been going on for decades without causing the
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.
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
supply nor demand shocks yet the price increased in line with
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.
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.
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
rising oil price were largely a
supply and demand
oil and other petroleum-based commodities would have also increased in
price by a similar margin when priced in other currencies.
these commodities did not increase in price nearly as much
priced in currencies other than the dollar, at least not at
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
other commodities have been rising in terms of other currencies besides
the dollar. The most logical explanation is that all
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.
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
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
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
made life easier, but required less energy to get to the fuel
where it's burned. The switch to oil from coal made
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.
and Money Part II: Can We Repeal the Laws of Thermodynamics?
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.
is sophistry. Instead, the world will soon be forced back to
time when a lot more work, in a thermodynamic sense, was required to
heat homes and fuel transport.
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.
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.
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.
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!
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.
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
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 Machine (It
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
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
“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
“…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
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
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
not in my
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
“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
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.
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.
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
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.
|Recent Weekly Commentaries |
- Hedge Funds Still in the Dark
3/15/06 - iTulip.com
3/22/06 - Frankenstein
3/29/06 - Housing Bubble Correction Update
- Financial Markets are Poluted with Risk
- China vs U.S.A.
- The Modern Depression