The Perfect (Financial) Storm

Perfect Storm: a critical or disastrous situation created by a powerful concurrence of factors. [Mirriam-Webster's Online Dictionary]

Storm Clouds by CoreBurn / © Some rights reserved.
Licensed under a Creative Commons Attribution-NonCommercial-NoDerivatives license

---

Many people had given dire warnings about the serious problems the economy would be facing. Some even knew it would extend far beyond the United States. But few predicted the severity, scope and timing simultaneously, because of the complex commingling of the events. With hindsight, things become that much clearer.

Three factors--all of which were major contributions--were the reason why the world economy is now facing a global economic downturn of this level of severity. Any of the three occurring on their own would not have caused as much damage as we will now see in the coming months. All three are of course interconnected, but few specialists knew enough about one, let alone three to accurately predict the damage that this storm would cause.

The Road: Questionable Lending Practices
There was of course, Fannie, Freddie and the irresponsible lending practices promoted by government coalitions with free markets. This built a road that led to the edge of a cliff had been construction for decades only to be completed by about 2005. Warren Buffet who is often lauded as the World's best value-oriented investor, divested his entire position in both Fannie and Freddie all the way back in 2000. Buffet said he felt "uncomfortable with certain aspects of the business." It's also clear that many Washington insiders knew a problem was brewing here. In 2006, several Republicans (including John McCain) sent a letter to the majority leader which warned that "if regulatory reform for housing-finance government sponsored enterprises (GSEs) is not enacted this year, American taxpayers will continue to be exposed to the enormous risk that Fannie Mae and Freddie Mac pose to the housing market, the overall financial system, and the economy as a whole." The list doesn't end there, many others knew about fundamental flaws and an inappropriate risk profile for these quasi-government enterprises.

The Vehicle: Energy Price Shocks
Then there was the lack of a stable and sufficient energy supply (particularly oil), which served as the vehicle that had also been assembled over the course of several decades. Peter Tertzakian had some very impressive and accurate foresight with regards to oil 'breaking' the economy. In his 2005 book, he says that the world economy would stop, "'firing on all cylinders' in 2007," and in 2008, "a confluence of events [would force] the public and our nations' leaders to finally realize how vulnerable [the economy] had become [to oil prices]." He goes on to predict a plunge in SUV sales and automaker mergers, acquisitions and consolidations we are now seeing (his forecast calls for Toyota partnering with or buying GM). What he didn't foresee is how high gas prices would catalyze a collapse in suburban home values. With this, the assumption which was held by so many now troubled financial institutions--that home prices always go up--also failed.

The Fuel: Monetary Policy
Lastly, there was the fuel: credit money. Because markets are based on a fiat currency (based on a perceived value) rather than the gold standard (based on intrinsic value), the system is subject to bubbles, sometimes resulting very large corrections (the gold standard has its own drawbacks of course, which is why the two standards have been swapped many times throughout history).

Instead of going into too much into detail about how the world moved from the gold standard to a system of credit, I'll give a brief synopsis here (google it if you want to know more). Following the World Wars, the United States was in a very strong economic position (much like China today), as it was spared widespread damage on its own shores while Europe's infrastructure had been devastated. The country was extremely productive relative to other countries and awash in natural resources. Because they were in a position to lend money for the rebuilding of Europe, they formed the Bretton Woods Agreements (1944/1945). Essentially, the U.S. pledged to maintain a stable dollar by pegging its currency to gold, and all other currencies were in turn pegged to the United States Dollar. Several decades later, when the U.S. started to become a borrower rather than a lender as well as overextending itself with several wars, the hybrid gold standard to become incredibly unstable. It was officially abolished in 1971 and all major currencies were subsequently unpegged from the USD by 1976. No politicians in any of the major economic power had the political leverage to go back to the gold standard because fiat money allows for inflation and inflation makes the economy look good. Instead, national banks pledged to control inflation using imperfect price inflationary indicators, such as CPI and later core inflation.

It's not hard to see from the chart that soon after the gold standard was abandoned, the bubble era had begun. Deflation is considered political suicide and therefore the market corrections are always artificially stopped by government (meaning the problems simply build upon themselves). Former 2008 Republican presidential candidate Congressman Ron Paul can offer more on this subject, but the point is it hasn't worked.



It was not oil that was in a bubble at $147; it was the entire economy that was overvalued (homes, cars, equities, etc.). It was not price manipulators, speculators pushing oil prices upward but merely investors moving money from U.S. dollars into commodities to hedge against global inflation. This is why neither gas prices nor equities rooted in these commodities increased by nearly the same amount. Ironically, we now call this a "credit crisis".


In The End: A Terrible Concoction
As I've said, any one on its own, the flawed road, the vehicle or the fuel, doesn't really present instantaneous systemic danger. Had gas prices stayed low, consumer sentiment may have stayed high and home prices may not have plunged with Americans reconsidering the value of homes situated in very distant suburbs. Had monetary policy been better managed, oil prices would have increased more linearly rather than exponential volatility shocking markets (unlike the oil shocks of the 1970's, 2008 had no major supply squeeze). All three would still have presented a very serious threat individually of course, but the "perfect storm" as Bernanke puts it, is why the economy has weakened far more than many of the partitionary experts had predicted. I would caution that conditions are likely to continue to get worse even if global financial markets can be stabilized. Political instability has become one of the spillover effects and history has shown it is very difficult to maintain peace in the case of poor countries (or bankrupt ones). And yet I remain optimistic for the future, because after the storm, nature always rights itself. Always.

The Black Gold Sands

Image: Terry Bain [cc]

Barring a complete catastrophic collapse of the global economy and credit markets (which happens not to be overly improbable), the Canadian oilsands will remain in a relatively strong position despite correcting oil prices.

In the absence of a breakthrough scientific discovery like cold fusion, there exists neither a viable alternative fuel source for oil, nor a likely prospective one in the near future. It certainly isn't impossible, but a cold-fusion type of discovery is highly improbable. The Manhattan programme and Apollo project are often cited as major scientific investments yielding results; but neither one required the kind of infrastructure overhaul that would be required to reduce demand for fossil fuels. With rising energy costs, nuclear, wind, solar and the other alternatives to fossil fuels will all become more competitive with oil. In fact, from a price-energy perspective, $100/bbl crude oil is already fiscally disadvantaged compared to its alternatives. One joule of oil priced at $100/bbl is even more expensive than the same amount of energy produced from wind energy. Residents of Hawaii paid 24 cents per kilowatt hour for their electricity because oil is the primary fuel used for electricity generation in the state (the cost of electricity produced from wind is on the order of 14 cents/kWh). The only reason oil remains so prominent is that it happens to be convenient (batteries are not well-suited to power cars) and current infrastructure, which will take decades to update, necessitates it.

A common mistake people make is to think that the rate of change of the consumer electronics industry can be replicated in the energy industry. The reason consumer electronics can evolve so quickly is mass (or lack thereof). Replacing a 20 ounce cell phone requires considerably less work than replacing a quarter-ton vehicle. This is because a cell phone has relatively little total intrinsic value in the materials used, which is in part why many electronics become cheaper as the become smaller (for example, a 1 GB flash card now costs less to make than a 1 GB magnetic hard drive).

How Long Will It Take?
In terms of energy substitutions, the change from wood to coal took 75 years. The change from coal to oil took 100 years. Natural gas took even longer because of the extensive pipeline infrastructure that was needed to accommodate it--in fact, over 28 trillion cubic feet of natural gas associated with oil wells has been discarded in the U.S. alone since 1936 (U.S. Department of Energy). The gas is simply burned at the wellhead or vented to atmosphere without capturing its useful energy because the pipeline infrastructure would cost more than the potential revenues from selling the gas. This does not happen much anymore in North America, but continues in places that have no market for natural gas such as deep offshore production and some middle eastern oil producing nations. Liquification of natural gas (LNG) and gas hydrates are emerging alternatives to pipelines, but both are expensive because of the energy inputs involved.

Transportation Industry
The transportation industry uses about 50% of the world's oil. The United States has about 250 million automobiles. Even if automobiles that didn't use fossil fuels were available today at a competitive price, it would take 9 years to replace most of them (9 years is the mean age of these vehicles, according to the Bureau of Transportation Statistics.

Electric vehicles can't be competitively priced today without making significant infrastructure changes. Batteries that meet the range requirements for American automobiles are simply too expensive. Also, too many steps in the electrical conversion process make it an intrinsically inefficient way to turn wheels. The figure above shows potential paths to turning the wheels of motorized land-based transportation. Each step loses energy due to thermodynamic constraints (the fewest number of steps are often the best route). Ethanol and other biofuels have a lower energy density than hydrocarbons as well as other significant challenges (discussed below). Heavy trucks are nowhere close to using alternative fuel sources and the aviation industry does not even know of a potential alternative to jet fuel.



1970's Lessons Learned?

Those who are old enough to remember the oil shocks of the 1970's and early 1980's can recall long lineups at gas stations and the economic chaos it caused. It prompted everyone to rethink the dependency of crude oil because of the economic impacts it had on oil importing economies around the globe. The first crisis occurred in 1973 when the Arabic members of OPEC imposed an oil embargo aimed at countries that gave military and political support to Israel. A resolution was reached between OPEC members and the United States in early 1974, but the shortages it created would leave prices elevated for several years. In 1979 another crisis occurred the Shah of Iran was exiled. Oil production from Iran would fall 75% in the next two years as a result of political instability and the resultant war with Iraq. Over the next several years however, other countries were able to fill the supply gap as a result of higher prices. Virtually every oil consuming nation devised an energy strategy in light of these price shocks. It would be left up to the policymakers to see these strategies through to completion as an oil glut ensued and very cheap energy prices left the general public unconcerned about energy independence for the rest of the 20th century.

United States Strategy
Project Independence was a vision of President Nixon which never got much traction because of extensive costs. Another reason American politicians did not to want to reduce oil consumption was that at that time, the United States was the largest producer of crude oil in the world, meaning that oil production was a very large part of the domestic economy (U.S. oil production peaked just a couple years earlier in 1970). Instead, strategic political measures were favoured such as a strategic alliance with the Saudi's as well as military efforts to ensure unimpeded flow of oil from the producer nations.

France's Strategy
In response to the same crisis, France decided to invest heavily in nuclear energy over a period of 15 years. Today, France leads the world in Nuclear Energy production, and even exports electricity from its nuclear plants to surrounding nations such as Germany. This now leaves them in an economically advantaged position compared to its European counterparts; however, oil consumption per capita only decreased by about 35%. This is because the substitution was only made for electrical power generation and they did not attempt to replace oil the transportation industry (this would have taken much longer and have been much costlier).

Brazil's Strategy
Brazil actually did decide substitute foreign oil in its transportation industry following the oil shocks of the seventies. They used sugarcane ethanol to do it and this conversion took them 30 years to reach a degree of energy autonomy. Flex fuel vehicles are mandated to use the E25 blend of 25% ethanol, 75% gasoline; some can even use E100 (almost pure ethanol). The United States tried recently to model Brazil's strategy, but it is failing for two reasons:

1. Brazil is a developing nation and its average citizen consumes 1/5^th of the liquid fuel that the average American does. It can't be scaled up in an overpopulated world without creating serious food shortages, as we've already started to see.


2. Brazil intersects the equator, meaning considerably more energy is available for the process photosynthesis that ultimately creates the energy used in the biofuels. This is why sugarcane ethanol yields about 8 times the energy required to produce it, while corn ethanol in the continental U.S. hovers around breaking even (optimistic scientists say 1.5 while pessimistic ones say 0.7). This means that for every gallon of diesel a farmer uses to cultivate corn, the amount of ethanol can be processed from the crop contains no more energy than a gallon of diesel--but the farmer can still make money provided subsidies are paid by the government.

Where Prices Will Go From Here
Now it's quite possible (but not probable) that oil could return to $40 a barrel depending on the depth of the global recession (some have even forecasted $10 oil). Even if prices did fall below $40 a barrel, such low prices will not stick once the recession has ended. Sector-specific inflation has increased the cost of production quite dramatically. Production and labour costs are out of control and the cost of production for new oilsands projects now sits between $80 and $120 a barrel. This is far too high for receding demand, and it may need to deflate and correct itself along with the rest of the global economy. This will present short-term challenges and if oil did fall to $10 or $20/bbl, this unlikely scenario would certainly mean layoffs; but even so, long-term supply will remain under pressure. The other supply issue surrounds peaking production in the worlds largest oil fields as I discussed in the past. Saudi Arabia's spare capacity (oil it can produce during shortages) is now limited to sour heavy crude, which only a few refineries in the world can handle.

One problem with projections about the Canadian oilsands ultimate recoverable oil estimates is that they often assume demand for this commodity will remain unchanged through 60 years. Instead, its likely that the oil which is hypothetically recoverable at today's prices will simply be left in the ground. This is analogous to the way many coal reserves remain in the ground from when coal was partially substituted for oil. My best guess is that it will take at least 25-30 years to significantly reduce global dependency on oil. The change is happening though, and Fort McMurray could easily end up being Detroit north if city planners aren't smart about economic development of the future. In the transition period from this now disadvantaged fuel, the oilsands should remain profitable. If not by a windfall, then at least by a small margin.

The White House of Cards

The problem with foreclosures is that often times the pledgor is not cognizant of the severity of the problem until it's too late. It happened with millions of Americans who lost their homes. It happened with large institutions like Bear, Fannie, Freddie, Lehman and Wachovia. Now it is happening with the U.S. government.

Many financial advisers continue their rhetoric about a pending recovery of the U.S. economy, as it 'always does'. As mentioned in earlier posts, the U.S. economy is structured on cheap oil, which despite the crisis, still does not exist right now. In USD terms, oil is still more expensive than it was a year ago. Either the financial advisers don't get it, or they are lying the way Enron executives lied to their shareholders while funnelling their money out the back door. I suspect it is the former. Following weeks of market turmoil, record low auto sales and continuing record high oil prices, Citigroup finally began recommending to investors to sell shares in GM and Ford this week after their shares fell 82% and 67% in the last year. At least they made their statement sound eloquent:

"[W]e believe the risk-reward balance [on automaker stocks] has tilted decidedly negative on both absolute value and relative value versus underperforming suppliers," -Citigroup investment note.

Thanks Citi for the timely advice. Neither Ford nor GM has had a profitable automotive division in over 6 years. Better late than never I suppose.

Many had hoped that swift approval of the bailout plan would restore confidence in the U.S economy. Such an effect has yet to be seen as even the hopeful are growing skeptical. Hank Paulson said it will not prevent all bank failures--which are likely to resume their course now that the short selling ban has ended. Violent and sometimes even more damaging aftershocks continue to ripple worldwide as the USD is still the most widely held currency. The only stable asset right now is gold (it appears moderately unstable because of the gyrations of the currencies in which it is valued). Few signs of a bottom can be seen yet and confidence continues to slide.

Anyone who has been overseas recently knows that the once universal US dollar began to fall out of favour by merchants for other currencies over a decade ago. Unfortunately most Americans have never been overseas and don't even understand what is happening with their 401k's. Even the presidential candidates appear naive (or perhaps it is merely election rhetoric). They appear to think that they can solve the 'crisis' by investing in the economy (cutting taxes, fixing health care, energy independence spending, gas tax holidays, and so on). Unfortunately, it's probably too late for that, as they don't have any more pre-approved credit to invest. They would have to borrow it from foreign investors (or print it and make the USD worthless). The flaw that proved fatal for many of the failed institutions was the assumption that they could always raise more capital, if required.

House prices will always go up, storied institutions can always raise debt, and foreign investors will always buy up U.S. treasuries. The first two cards have already fallen. With foreign investors fleeing, the U.S. government needs to prove to its lenders that it will not default and is serious about paying back its debt rather than running deficits indefinitely. Serious action could take the form of pulling out of Iraq as quickly as humanly possible--this would likely split the country in three and destabilize the region, but the U.S. economy is pretty unstable itself if anyone hasn't already noticed; furthermore, as Alan Greenspan notes, Iraqi oil production has only now recovered to pre-war levels, so staying longer is unlikely to result in significant cheap oil supply anytime soon. It would also be wise to pull out of Afghanistan as soon as possible and negotiate a deal with the Taliban--this may not be in line with offical public policy; but as John McCain said, unofficial policy is often quite different from public policy. Most importantly, they need to sit down with the leaders of economic powerhouses and negotiate a set of terms to repay their debt and stabalize confidence. The first two cards have already fallen, if the third were to fall, it would get ugly. Barack Obama talks about hope and change. Let's all hope someone understands the severity of the problem and is willing to make the change required to avert a catastrophe.