Nicole Foss

Dec 142012
 December 14, 2012  Posted by at 8:11 pm Finance Comments Off on Impotence, Leverage and Central Banking

Chaplin – "Modern Times": A story of industry, of individual enterprise – humanity crusading in the pursuit of happiness

Some of our readers have been wondering why we spend so much time covering the situation in Europe. The relevance of the European situation is not perhaps immediately obvious to those geographically far removed, with a temptation to ascribe the problems of the European periphery to locally-specific conditions.

However, the global economy is exceptionally integrated, and what happens in one location all too readily leads to financial contagion – the spread of fear, from one asset class to another, or from one country to another in the case of sovereign debt risk.

Europe is the epicentre of phase II of the credit crunch, from which waves of financial contagion can be expected to emanate for the next several years. Several member states are effectively at, or near, sovereign debt default, with the potential to trigger credit events in the credit default swap market. Banks are over-leveraged, often highly disproportionate in comparison with their host economies and intertwined with the sovereign debt issue.

In many EU member states there are housing bubbles far larger than the American one that began to burst in phase I of the credit crunch (October 2007-March 2009). Bubbles in some states have already burst, while in other countries, housing markets are going illiquid and prices are beginning to decline. As the value of collateral falls, and economies slide deeper into recession and high unemployment, the leveraged debt will be unsupportable. Personal debt is often sky-high, even in countries which are currently considered wealthy and stable.

What is unfolding in Europe is highly relevant to the future of the whole global financial system, and where Europe is leading – into debt deflation, liquidity crunch and depression – many other countries will follow over the next few years. We are in the process of crashing our global operating system, as we did on a smaller scale in the 1930s. Our global credit bubble has peaked, and the debt created in the expansion years – excess claims to underlying real wealth – will not be able to be repaid.

The gargantuan pile of interlocking human promises will become nothing more than dashed expectations. The resulting credit collapse will crash both the money supply and the velocity at which the remaining money circulates in the economy, leaving too little money in circulation to support much economic activity. Credit bubbles bring forward demand by artificially stimulating it, but when they burst, the demand borrowed from the future must be repaid.

Under such circumstances, economic systems, both public and private, seize up. This is what we have been predicting at The Automatic Earth since its inception, and we are now watching it unfold. As we wrote back in June, we are already seeing what a liquidity crunch looks like in practice in places like Greece, where the creeping paralysis in essential services continues to spread:

In every one of Thessaloniki’s 13 hospitals, in Greece’s second largest city, doctors are “playing God,” as Leta Zotaki, head of the radiology service of Kilkis Hospital in the north of the city, puts it. "When we start running out of x-ray films, we have to decide who needs to be examined first; we trade with other hospitals or ask the patients to pay for the film,” explains this trade unionist, who saw her 4,000 euro salary cut by half, and whose night shift hours have not been paid since May.

Some nurses have put up a note on the door of one of the hospital rooms: "When visiting your relatives, don’t bring chocolates, buy them toilet paper,” the note reads. There is a shortage of everything: latex gloves, cold pads, reagents for blood tests and catheters. The only upshot is the fact that public hospital workers have not yet been laid off yet – like they have in other public service sectors. But the doctors who are leaving – who have either retired, or left for private hospitals or abroad – are not being replaced: in Kilkis, the number of doctors has gone from 160 to 125.

The single currency has acted as a straight-jacket, binding disparate economies together and treating them as equivalent from a risk perspective. Bond spreads reflected this perception from shortly after the introduction of the euro until the financial crisis of 2008, but the fiction of equivalence has since come under increasing pressure.


Internal tensions have been building as the disparities between centre and periphery become increasingly apparent, and national interests increasingly diverge – not just between centre and periphery, but also between core states France and Germany. Germany preaches austerity for the periphery and suggests it for France, which resents the interference and makes a last futile attempt at stimulating growth in an era of deleveraging.

When national interests are paramount, there is no real defence of the collective, and when the pie is shrinking, rancorous internecine conflicts become increasingly probable. We are already seeing the blame game begin in earnest in Europe, notably on the European Day of Action on November 14th. The rest of the world does not appear to realize either how serious the situation in Europe is becoming, or that a similar dynamic will take hold in many other places.


November 14, European Day of Action, Madrid, Spain


November 14, European Day of Action, Rome, Italy (AFP Photo/Filippo Monteforte)


November 14, European Day of Action, Lyon, France (AFP Photo/Jeff Pachoud)


November 14, European Day of Action, Lisbon, Portugal (AFP Photo/Miguiel Riopa)


November 14, European Day of Action, Athens, Greece (AFP Photo/Louisa Gouliamaki)


November 14, European Day of Action, Madrid, Spain (AFP Photo/Javier Soriano)


The immutable centralizing force that the single currency represents has allowed tensions to build as disparities have grown. Its rigidity prevents accommodating those disparities with devaluation, while the leverage and interconnectedness of the banking system preclude restructuring the unrepayable debt. Austerity appears to be the only remaining option, and yet by forcing economic contraction, it hastens, rather than avoids, default.

The fundamental problem is the debt exceeds the capacity for either repayment or for bailout by prospective lenders of last resort. This is the issue that much of the rest of the world is also facing. European attempts to deal with it by generating ever greater amounts of debt foreshadow the failure that other governments will face as the same situation engulfs them.

Following a long series of limited and ineffective bailouts, the ECB has promised unlimited bond buying to support sovereign debtors (in exchange for a major hand over of sovereignty). Promises of unlimited intervention issue a challenge to markets to call the bluff, leaving a substantial vulnerability with no back up plan. In the not too distant future, the markets will be trying to discover where the real limits of intervention lie. Other countries, notably the US, which have made similar 'unlimited' promises, should take note. Nothing is ever truly limitless.

The long countertrend rally has been relatively kind to governments and central banks. US-style quantitative easing and European stability funds have appeared to make a difference thanks to the temporary suspension of disbelief. Resurgent optimism – the primary driver of the rally – has reached a crescendo rivalling previous market peaks. Previously bearish commentators are capitulating to the erstwhile uptrend and thanking central authorities for saving the global financial system. This irrational euphoria is typical of market tops, and provides a good contrarian indicator that the rally in the last holdouts is finally over.

Governments and central banks are actually powerless to prevent an epic deleveraging. They may appear omnipotent during expansions and rallies, but this is an illusion. The lesson of history is that once a very large bubble has developed, generating excess claims to underlying real wealth for many years, those excess claims will be rapidly and messily extinguished in a period of deflation. Smaller bubbles may not exceed the capacity of a lender of last resort, but this one – the largest in human history – most certainly does. The fall, when it comes, will be one for the record books, as contractions are typically proportionate to the scale of the excesses in the preceding bubble era.

Congratulations given to central authorities are highly premature, and their reputations are set to take a very large beating over the next few years. It is dangerous to encourage people to think one all-powerful and in control. It may be a confidence booster in the short term, but in the longer term it only leads to people thinking one could and should have done more, when in fact there are no solutions to deleveraging running its natural course following a bubble of this magnitude.

One look at the unedifying spectacle unfolding in the US in response to the looming fiscal cliff is enough to illustrate the petty powerlessness of governments. To review for non-Americans, the fiscal cliff refers to the expiration on January 1st 2013 of a $500 billion package of tax cuts and emergency spending measures amounting to perhaps 4% of GDP. A bipartisan agreement is necessary if the can is to be kicked further down the road. Another would be necessary to raise the debt ceiling again shortly afterwards. Of course achieving an agreement would amount to a temporary stop-gap measure rather than a solution, but it appears a highly polarized group of legislators might even be incapable of that.

The division between parties, and increasingly within, in the US is reminiscent of the divisions at the national level in Europe. When the pie is shrinking, the larger picture, and the interests of the larger group are lost. Functional entities are smaller than before, with narrower scope of interests and therefore much less overlap with each other. The Republican Party in particular is tearing itself apart over its recent election loss, and retreating into factionalism. Bipartisan compromise is rapidly becoming impossible in a highly charged political environment where compromise is seen as betrayal of partisan interests.

Fiscal tightening is inevitable this coming year in the US whether or not a deal is reached at the federal level. States and municipalities are also reaching limits, as we covered early last year, and many are on the verge of bankruptcy. They have made too many promises, and now those promises that cannot be kept, will not be kept. A wave of both public and private debt default at all scales is coming, and the US will be following Europe as liquidity crunch morphs into depression.

This is not what recovery looks like, either in the US or in Europe. Recovery will only be possible once deleveraging has run its course, and at this point it has barely begun. Quantitative easing has never made a meaningful difference to the real economy. The numbers, large as they appeared, were not significant in comparison with the outstanding debt, and funds were not being lent out. The fear has been that 'money printing' would lead to hyperinflation, but deleveraging can occur much more quickly than any central bank can monetize debt.


When bubbles burst, there is always an undershoot. 2008 was nothing more than a warning shot across the bow. The main deflationary event is underway, but has not yet reached a tipping point and substantial pick-up of momentum. It will do, and when it does, markets and economies could find themselves in freefall. Europe is leading the way this time. Others would do well to be forewarned.


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Nov 122012
 November 12, 2012  Posted by at 12:46 pm Life Boat Comments Off on Sandy : Lessons From The Wake Of The Storm

Disaster and Preparedness: How Well Are We Doing?

Superstorm Sandy has been a devastating experience for many, and will continue to be so for a long time to come. Much of the damage will take weeks or months to repair, and some may take years. A myriad long battles with insurance companies are a given, as the available funds are unlikely to match the damage and there will be many arguments as to what is covered. The impacts are widespread, but unevenly distributed, as the repairs will be. Like Katrina before it, Sandy will be a defining event in the lives of many people.

Sandy illustrates a number of important points – how fundamentally dependent modern society is on centralized life-support networks, how interconnected different dependencies are, how crucial the role of energy really is, how disruption in one system can cascade into impacts in many others, and how unprepared people typically are to withstand even relatively short disruptions of essential services. Sandy provides a very useful case study in what we can do to prepare for challenging times, whether those occur due to hurricanes, ice-storms, earthquakes, financial collapse or other possible eventualities.

Most people do not realize that their government expects them to look after themselves for several days in the event of a disaster. Here in Ontario, people are expected to cover for themselves for 72 hours before any external assistance can be provided, but this has not been effectively communicated. Most people are not aware, and many with acute dependencies of various kinds could easily be in trouble long before that, especially in a climate that can be very unforgiving. Emergency preparedness has been given far too little attention, meaning that people are far more vulnerable than they should be. Even a small amount of individual preparedness can go a long way, preparation at a family or community level is even more valuable, and well-communicated municipal emergency preparedness plans can make a major difference.

Sandy hit with high winds, rainfall and a major storm surge at an unusually high tide, causing enormous damage to local infrastructure, particularly along the coast and where the surge was funnelled into inlets. Overhead powerlines were downed by wind, falling trees and flying debris, while underground infrastructure was flooded with salt water, transformers exploded and fires (that could not be reached due to flooding) devastated some communities. Power outages affected millions of homes, and also other essential services such as gas stations, food outlets, hospitals, water supply, and communications. People charging mobile devices in public places with power became a common sight, underlining the critical role of electronic communications.

Transport was crippled in many places by loss of vehicles, closure of flooded subways, blocking of routes for overland travel, debris blocking the harbour to tanker deliveries, and lack of pumping capacity at gas stations. Gas stations with power were overwhelmed by demand, so that lines hours long formed, stations began to run out and tempers flared. Demand for gas was compounded by people filling additional canisters in order to have a supply cushion for vehicles, but also to run generators compensating for the lack of mains power. Gas rationing was instituted in New Jersey and New York City, limiting even numbered licence plates to even days and odd numbered plates to odd days, in an attempt to ease waiting times.

Without adequate transport, providing relief to immobile and vulnerable people is very much more difficult. These people may already have been without food, water, power, heat and medicines for many days before public services can even begin to assess their needs. What we are seeing in affected areas is the extent to which people must look after themselves and each other in times of acute crisis, and what is possible in this regard when push comes to shove. Private initiatives of all scales have been a major part of the immediate disaster relief effort, from individual households with power providing extension cords outside to passersby, families offering to take in others, restaurants providing free meals and gathering places, and big businesses supplying generators and other emergency equipment.

Where such measures are offered, they can make a very significant difference, especially in the immediate aftermath where rapid response time can be achieved. In other less fortunate areas – often outer areas where damage is extreme – people are already beginning to feel abandoned in the wake of Sandy. Increasingly worried about looting or other forms of crime, they are arming themselves and posting warning signs amid the debris. The potential for unfortunate incidents is rapidly escalating, and it could be a long time before the public service response makes much difference. Ironically, however, there are indications that crime rates have actually fallen with people relatively immobilized.

As useful as private efforts are in terms of rapid response, over time they can develop into a disaster capitalism scenario if left unchecked. Private capital may be able to deliver quicker rebuilding, but if this involves scrapping regulatory frameworks and converting public infrastructure into a private for-profit version, the benefit may not be worth the cost to the public good. The risk is that rebuilding could lead to further scaling up, greater centralization in the hands of the few, erosion of local control and local supply chains. A response weighted towards private initiatives could easily end up providing rapid and comprehensive rebuilding in wealthy areas, while neglecting repairs in poorer neighbourhoods. Getting the balance right between mobilizing all appropriate efforts to rebuild, while providing evenly distributed repairs and not ceding too much control over the results, can be very difficult.

The initial attempt to go ahead with the New York marathon did not help matters, as people saw resources such as large generator trucks mobilized to service with event venues that could have been deployed to help suffering locals. Cancelling the race was clearly advisable, but much public relations damage was already done. Angering people under such circumstances increases the potential for antisocial responses that can have cascading effects.

A second punch in the form of a powerful, and unusually early, nor'easter has caused significant setbacks for recovery efforts. Many people whose power had been restored have now lost it again. Those without heat are suffering even more in cold temperatures, high winds are threatening further damage to weakened structures, and several inches of snow are adding to transportation woes.

Restoring some services is going to be a long term process. Flooded tunnels must be pumped out, but that is only the first step. The salt water will have penetrated any damaged areas and will cause rapid corrosion. This is likely to have a significant impact on the 108 year old subway system for years, until all the affected equipment has been replaced. Powerlines have been downed and must be rebuilt, often in areas that are very heavily damaged in other ways. This too will take a long time.

There have been suggestions that powerlines should have been built underground, and there may be pressure to rebuild them this way. This is actually not the panacea one might imagine, and might not have protected the infrastructure entirely from storm damage. Building underground transmission lines is approximately twenty times as expensive as overhead. It involves costly insulated cable instead of simple wires. It sterilizes a much larger land corridor. Faults can be difficult to find and very expensive to repair. Taking this approach would add greatly to the cost and timeframe of restoration efforts.

Gasoline supplies should be slowly normalizing, as tankers are now able to bring in supplies. Fuel distribution could be tricky in some places for quite a while though. When people are put into a mindset that supplies might be unreliable, they increase demand in the short term in order to purchase and hoard a supply cushion. This dynamic can persist for some time, meaning that stretched infrastructure and supplies may have to service higher than normal demand while not yet fully restored. Given that gas supplies may be necessary for both transport and generator fuel, increased demand is even more likely. Fuel storage at home can be dangerous, meaning that many people may be running significantly increased fire risk at a time when the ability to deal with fires may be still impacted by storm damage.

Supply chains for many goods have been disrupted and may remain so for some time, as supply chains are often very long and complex, and can be broken in many different ways. The effects of shortages of one thing can then rapidly impact on the supply of others. Our just in time supply system, with little inventory to act as a cushion, is particularly vulnerable to cascading system impacts. In the name of economic efficiency, we have created a very brittle system, when it is resilience we need in order to be able to withstand system shocks. Resilience requires safety margins and supply cushions, but these represent a cost that we have been increasingly unwilling to bear. In whittling them away, we have left ourselves far more vulnerable than we once were.

Personal emergency preparedness can often take much of the pressure off when disaster strikes. In general terms, it is advisable where possible to have at least two weeks worth of supplies of food, water and medicine on hand, and preferably a month's worth, although this may be very difficult for those with limited means or limited storage space. People unable to prepare much individually may be able to do so to some extent by pooling resources. For high-rise dwellers, a power outage will also mean no water above the third floor, so water supplies can be particularly important.

Having emergency cash on hand is also highly advisable, as transport and power problems, both personal and institutional, can prevent people from accessing funds. Carrying no debt beforehand can make a major difference, as getting out of debt removes a drain on resources that could suddenly become much scarcer, rapidly amplifying the burden of debt servicing. In addition, debt servicing may become physically difficult due to lack of energy and transport options. This may lead to financial penalties that add insult to injury. In the case of Sandy, it appears that some financial penalties for late payments are to be waived, but there is no guarantee that this would always be the case.

Not everyone will be able to provide a cushion for themselves and others, but the more people do, the fewer will require what overstretched public assistance may be available, meaning that public assistance may be able to get to the more acutely needy more quickly. It is in everyone's interest that those who can implement an emergency preparedness plan do so. Our societies have become too complacent in terms of assuming public systems capable of assisting all in a timely fashion actually exist. This leads to responsibility being passed upwards and largely forgotten, leaving people vulnerable when disaster strikes, and that which had been taken for granted turns out to have been an illusion.

Having a supply cushion can make a very large difference to how acute situations play out, especially if a critical mass of people have such a cushion. People without one typically find themselves pitched abruptly into a state of short term crisis management, quite possibly escalating into panic quite quickly. The odds of a constructive and cool-headed response go down when too many people are afraid, and even more so if they are also angry. Both fear and anger are highly catching, and their spread can change the entire way the impact of a disaster unfolds. The human over-reaction, or unconstructive reaction, to events has the potential to cause the majority of the impact in some disaster scenarios.

Encouraging people to make simple personal preparations, as some regions and religions already do, can greatly reduce the potential for something like this to occur. If municipalities would inform people well in advance of difficulties of the need to be self-reliant for at least two weeks, and then explained to them how to go about this, much suffering could be averted. There is a misguided notion that doing anything to encourage preparation will cause people to panic and hoard. While it is true that issuing warnings in the immediate run-up to something like a major storm about to make landfall could have this effect, issuing instructions in a calm and measured way when no disaster is actually looming should not cause a collective psychology problem. It can be difficult to strike a balance between motivating people to act and causing fear, but the answer is not to avoid the issue by failing to motivate people at all.

Aside from the obvious food, water, medicines and cash, there are many pieces of equipment that could be very useful, most of which are not terribly expensive. Wind-up or solar powered radios can keep people informed of what has happened in their area and what is being done to reach and help affected people. Given that mobile electronic communications are so central to people's lives, solar chargers and small battery back ups could allow people to stay connected.

Ordinary batteries and solar chargers for them could keep other equipment functioning. Solar cookers, or coleman stoves with fuel supplies, allow people to cook or heat water without access to normal energy sources. Water filters or purification tablets can provide drinkable water supplies when regular supplies cannot be trusted. Hand tools, work gloves, spare blankets or sleeping bags, candles, matches, flashlights, a first aid kit, bicycles and other basics could be very helpful.

Community connections can allow available equipment to be shared, so that many more people may benefit. Establishing a list of residents, noting vulnerable people, would be useful, particularly in highrise buildings where isolation is all too common. The planning process for such a community initiative would be useful in terms of building relationships of trust prior to any kind of disaster, and those relationships would help people to function together later under challenging circumstances. Established local time banks can be a very valuable part of an emergency response capability, as they can serve as a local skills inventory that can be mobilized very quickly. This was demonstrated following the Christchurch earthquake in New Zealand in February 2011.

Preparations at a neighbourhood or municipal level also make sense, particularly where there may be large numbers of people unable to prepare themselves. For instance, specific public buildings could be designated in advance as mustering areas in the event of disaster, and these could be equipped with emergency supplies. If people knew to come to a particular community space, and knew that space would be equipped to receive them if necessary, they would feel far more secure. As always, creating a resilience cushion takes resources. An emergency supply inventory and maintaining the space to house it would be no exception, but the expense could make a very large difference in times of crisis.

Larger scale relief coordination agencies, such as FEMA, also have a role to play. Well thought out contingency plans, backed up with reserves of supplies, equipment and skilled personnel can help tremendously, although response times for larger, more complex entities are likely to be longer. In an ideal world there would be a top down/bottom up partnership between emergency preparedness plans at different scales, and plans would mesh seamlessly with each other. The reality on the ground is always likely to be rather more chaotic in practice, however.

As devastating as storms like Katrina and Sandy can be, there are other possible disaster scenarios that could have longer lasting or more far-reaching consequences. Storms and earthquakes are relatively localized physical events. If they take place at a time when the surrounding areas are functioning normally, then resources can flow in from undamaged areas and recovery in a reasonable timeframe should be feasible, depending on the scale and cost of the damage. In extreme cases like hurricane Katrina, some areas will probably never be rebuilt due to cost and on-going risk of levee failure.

Not all disasters are physical and localized. A major financial crash, while not directly physically destructive, can nevertheless be devastating, and can affect whole countries or supranational aggregations at once. Finance is the operating system, and crashing the operating system has significant consequences in a short period of time. Witness Argentina in 2001 for an example on a small, localized scale, and then imagine something similar unfolding across the developed world within a matter of months.

The odds of experiencing something of this nature over the next few years are uncomfortably high. Where many, or even most, regions are dealing with acute disruption, resource flow from one area to another is considerably less likely. The need for community preparedness is even greater where larger scale formal arrangements could be completely over-stretched and unable to respond effectively. Independent municipal and community systems would be the fallback, hence the need to develop functional preparedness plans at this level, with the intention of covering a longer period of time than that associated with physical disasters.

At the Automatic Earth, our prescription for such an eventuality remains: hold no debt, hold cash on hand, gain some control over the essentials of your own existence and maintain a supply cushion if you can. Think of essential functions (such as cooking or heating your home) and see if there is more than one way to provide for that function. Redundancy confers resilience because it expands the range of potential input scenarios that can be coped with. Anything you can do at the community rather than the individual level would be more useful for more people. Pooling resources not only makes them stretch further, but also builds critical relationships of trust that are the foundation of society.

There will probably be a period of time over the next few years when we need to look after ourselves with little or no top down assistance, and for longer than we can currently imagine. We will probably be limited to the local resource base and supply chains far more than we are used to, meaning that we need to become far more aware of what we actually have and do not have where we happen to find ourselves.

Building preparedness requires civic engagement at a human scale. It requires working together, compromise and the human skills necessary to achieve it, and above all realistic expectations. It provides an empowering sense of purpose that is the best antidote to depression. That in itself can help to keep people focused on the constructive actions they can achieve, rather than on destructive fear and anger.

We need to look at the lessons provided by disasters like superstorm Sandy, hurricane Katrina and the Christchurch earthquake, to name but a few recent examples. Now is the time to learn from these tragedies, so that we can be better prepared to face an uncertain future where limits to growth, and the full range of our modern dependencies, are becoming clearer by the day.


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Oct 272012
 October 27, 2012  Posted by at 10:09 pm Energy 111 Responses »

In recent years, there has been more and more talk of a transition to renewable energy on the grounds of climate change, and an increasing range of public policies designed to move in this direction. Not only do advocates envisage, and suggest to custodians of the public purse, a future of 100% renewable energy, but they suggest that this can be achieved very rapidly, in perhaps a decade or two, if sufficient political will can be summoned. See for instance this 2009 Plan to Power 100 Percent of the Planet with Renewables:

A year ago former vice president Al Gore threw down a gauntlet: to repower America with 100 percent carbon-free electricity within 10 years. As the two of us started to evaluate the feasibility of such a change, we took on an even larger challenge: to determine how 100 percent of the world’s energy, for all purposes, could be supplied by wind, water and solar resources, by as early as 2030.

See also, as an example, the Zero Carbon Australia Stationary Energy Plan proposed by Beyond Zero Emissions:

The world stands on the precipice of significant change. Climate scientists predict severe impacts from even the lowest estimates of global warming. Atmospheric CO2 already exceeds safe levels. A rational response to the problem demands a rapid shift to a zero-fossil-fuel, zero-emissions future. The Zero Carbon Australia 2020 Stationary Energy Plan (the ZCA 2020 Plan) outlines a technically feasible and economically attractive way for Australia to transition to a 100% renewable energy within ten years. Social and political leadership are now required in order for the transition to begin.


The Vision and a Dose of Reality

These plans amount to a complete fantasy. For a start, the timescale for such a monumental shift is utterly unrealistic:

Perhaps the most misunderstood aspect of energy transitions is their speed. Substituting one form of energy for another takes a long time….The comparison to a giant oil tanker, uncomfortable as it is, fits perfectly: Turning it around takes lots of time.

And turning around the world’s fossil-fuel-based energy system is a truly gargantuan task. That system now has an annual throughput of more than 7 billion metric tons of hard coal and lignite, about 4 billion metric tons of crude oil, and more than 3 trillion cubic meters of natural gas. And its infrastructure—coal mines, oil and gas fields, refineries, pipelines, trains, trucks, tankers, filling stations, power plants, transformers, transmission and distribution lines, and hundreds of millions of gasoline, kerosene, diesel, and fuel oil engines—constitutes the costliest and most extensive set of installations, networks, and machines that the world has ever built, one that has taken generations and tens of trillions of dollars to put in place.

It is impossible to displace this supersystem in a decade or two—or five, for that matter. Replacing it with an equally extensive and reliable alternative based on renewable energy flows is a task that will require decades of expensive commitment. It is the work of generations of engineers.

Even if we were not facing a long period of financial crisis and economic contraction, it would not be possible to engineer such a rapid change. In a contractionary context, it is simply inconceivable. The necessary funds will not be available, and in the coming period of deleveraging, deflation and economic depression, much-reduced demand will not justify investment. Demand is not what we want, but what we can pay for, and under such circumstances, that amount will be much less than we can currently afford. With very little money in circulation, it will be difficult enough for us to maintain the infrastructure we already have, and keep future supply from collapsing for lack of investment.

Timescale and lack of funds are by no means the only possible critique of current renewable energy plans, however. It is not just a matter of taking longer, or waiting for more auspicious financial circumstances. It will never be possible to deliver what we consider business as usual, or anything remotely resembling it, on renewable energy alone. We can, of course, live in a world of renewable energy only, as we have done through out most of history, but it is not going to resemble the True Believers’ techno-utopia. Living on an energy income, as opposed to an energy inheritance, will mean living within our energy means, and this is something we have not done since the industrial revolution.

Technologically harnessable renewable energy is largely a myth. While the sun will continue to shine and the wind will continue to blow, the components of the infrastructure necessary for converting these forms of energy into usable electricity, and distributing that electricity to where it is needed, are not renewable. Affordable fossil fuels are required to extract the raw materials, produce the components, and to build and maintain the infrastructure. In other words, renewables do not replace fossil fuels, nor remove the need for them. They may not even reduce that need by much, and they create additional dependencies on rare materials.

Renewable energy sounds so much more natural and believable than a perpetual-motion machine, but there’s one big problem: Unless you’re planning to live without electricity and motorized transportation, you need more than just wind, water, sunlight, and plants for energy. You need raw materials, real estate, and other things that will run out one day. You need stuff that has to be mined, drilled, transported, and bulldozed — not simply harvested or farmed. You need non-renewable resources:

• Solar power. While sunlight is renewable — for at least another four billion years — photovoltaic panels are not. Nor is desert groundwater, used in steam turbines at some solar-thermal installations. Even after being redesigned to use air-cooled condensers that will reduce its water consumption by 90 percent, California’s Blythe Solar Power Project, which will be the world’s largest when it opens in 2013, will require an estimated 600 acre-feet of groundwater annually for washing mirrors, replenishing feedwater, and cooling auxiliary equipment.

• Geothermal power. These projects also depend on groundwater — replenished by rain, yes, but not as quickly as it boils off in turbines. At the world’s largest geothermal power plant, the Geysers in California, for example, production peaked in the late 1980s and then the project literally began running out of steam.

• Wind power. According to the American Wind Energy Association, the 5,700 turbines installed in the United States in 2009 required approximately 36,000 miles of steel rebar and 1.7 million cubic yards of concrete (enough to pave a four-foot-wide, 7,630-mile-long sidewalk). The gearbox of a two-megawatt wind turbine contains about 800 pounds of neodymium and 130 pounds of dysprosium — rare earth metals that are rare because they’re found in scattered deposits, rather than in concentrated ores, and are difficult to extract.

• Biomass. In developed countries, biomass is envisioned as a win-win way to produce energy while thinning wildfire-prone forests or anchoring soil with perennial switchgrass plantings. But expanding energy crops will mean less land for food production, recreation, and wildlife habitat. In many parts of the world where biomass is already used extensively to heat homes and cook meals, this renewable energy is responsible for severe deforestation and air pollution.

• Hydropower. Using currents, waves, and tidal energy to produce electricity is still experimental, but hydroelectric power from dams is a proved technology. It already supplies about 16 percent of the world’s electricity, far more than all other renewable sources combined….The amount of concrete and steel in a wind-tower foundation is nothing compared with Grand Coulee or Three Gorges, and dams have an unfortunate habit of hoarding sediment and making fish, well, non-renewable.

All of these technologies also require electricity transmission from rural areas to population centers…. And while proponents would have you believe that a renewable energy project churns out free electricity forever, the life expectancy of a solar panel or wind turbine is actually shorter than that of a conventional power plant. Even dams are typically designed to last only about 50 years. So what, exactly, makes renewable energy different from coal, oil, natural gas, and nuclear power?

Renewable technologies are often less damaging to the climate and create fewer toxic wastes than conventional energy sources. But meeting the world’s total energy demands in 2030 with renewable energy alone would take an estimated 3.8 million wind turbines (each with twice the capacity of today’s largest machines), 720,000 wave devices, 5,350 geothermal plants, 900 hydroelectric plants, 490,000 tidal turbines, 1.7 billion rooftop photovoltaic systems, 40,000 solar photovoltaic plants, and 49,000 concentrated solar power systems. That’s a heckuva lot of neodymium.

In addition, renewables generally have a much lower energy returned on energy invested (EROEI), or energy profit ratio, than we have become accustomed to in the hydrocarbon era. Since the achievable, and maintainable, level of socioeconomic complexity is very closely tied to available energy supply, moving from high EROEI energy source to much lower ones will have significant implications for the level of complexity we can sustain. Exploiting low EROEI energy sources (whether renewables or the unconventional fossil fuels left to us on the downslope of Hubbert’s curve) is often a highly complex, energy-intensive activity.

As we have pointed out before at TAE, it is highly doubtful whether low EROEI energy sources can sustain the level of socioeconomic complexity required to produce them. What allows us to maintain that complexity is high EROEI conventional fossil fuels – our energy inheritance.

Power systems are one of the most complex manifestations of our complex society, and therefore likely to be among the most vulnerable aspects in a future which will be contractionary, initially in economic terms, and later in terms of energy supply. As we leave behind the era of cheap and readily available fossil fuels with a high energy profit ratio, and far more of the energy we produce must be reinvested in energy production, the surplus remaining to serve all society’s other purposes will be greatly reduced. Preserving power systems in their current form for very much longer will be a very difficult task.

It is ironic then, that much of the vision for exploiting renewable energy relies on expanding power systems. In fact it involves greatly increasing their interconnectedness and complexity in the process, for instance through the use of ‘smart grid’ technologies, in order to compensate for the problems of intermittency and non-dispatchability. These difficulties are frequently dismissed as inconsequential in the envisioned future context of super grids and smart grids.


The goal of modern power systems is to balance supply and demand in real time over a whole AC grid, which is effectively a single enormous machine operating in synchrony. North America, for instance, is served by only four grids – the east, the west, Texas and Quebec. System operators, who have little or no control over demand, rely on being able to control sources of supply in order to achieve the necessary balance and maintain the stability of the system.

Power systems have been designed on a central station model, with large-scale generation in relatively few places and large flows of power carried over long distances to where demand is located, via transmission and distribution networks. Generation must come on and off at the instruction of system operators. Plants that run continuously provide baseload, while other plants run only when demand is higher, and some run only at relatively rare demand peaks. There must always be excess capacity available to come on at a moment’s notice to cover eventualities. Flexibility varies between forms of generation, with inflexible plants (like nuclear) better suited to baseload and more flexible ones (like open-cycle gas plants) to load-following.

The temptation when attempting to fit renewables into the central station model is to develop them on a scale as similar as possible to that of traditional generating stations, connecting relatively few large installations, in particularly well-endowed locations, with distant demand via high voltage transmission. Renewables are ideally smaller-scale and distributed – not a good match for a central station model designed for one-way power flow from a few producers to many consumers. Grid-connected distributed generation involves effectively running power ‘backwards’ along low-voltage lines, in a way which often maximizes power losses (because low voltage means high current, and losses are proportional to the square of the current).

This is really an abuse of the true potential of renewable power, which is to provide small-scale, distributed supply directly adjacent to demand, as negative load. Minimizing the infrastructure requirement maximizes the EROEI, which is extremely important for low EROEI energy sources. It would also minimize the grid-management headache renewable energy wheeled around the grid can give power system operators. Nevertheless, most plans for renewable build-out are very infrastructure-heavy, and therefore energy and capital intensive to create.

Both wind and solar are only available intermittently, and when that will be is only probabilistically predictable. They are not dispatchable by system operators. Neither matches the existing load profile in most places particularly well. Other generation, or energy storage, must compensate for intermittency and non-dispatchability with the flexibility necessary to balance supply and demand. Hence, for a renewables-heavy power system to meet demand peaks, either expensive excess capacity (which may stand idle for much of the time) or expensive energy storage would generally be required. To some extent, extensive reliance on power wheeling, in order to allow one region to compensate for another, can help, but this is a substantial grid management challenge.

Little storage currently exists in most places, although in locations where hydro is plentiful, it can easily serve the purpose. Where there is little storage potential, relatively inflexible existing plants may be required to load-follow, which would involve cycling them up and down with the vagaries of intermittent generation. This would greatly reduce their efficiency, and that of the system as a whole, reducing, or even eliminating, the energy saving providable by the intermittent renewables.

Not all renewables are intermittent of course. Biomass and biogas can be dispatchable, and can play a very useful role at an appropriate scale. EROEI will be relatively low given the added complexity and energy input requirement of transporting and/or processing fuel, and also installing, maintaining and replacing equipment such as engines.

Biogas is best viewed as a means to prevent high energy through-put by reclaiming energy from high-energy waste streams, rather than as a primary energy source. This will be useful for as long as high energy waste streams continue to exist, but as these are characteristic of our energy-wasteful fossil fuel society, they cannot be expected to be plentiful in an energy-constrained future. The alternative – feeding anaerobic digesters with energy crops – is heavily dependent on very energy intensive industrial agriculture, which translates into a very low EROEI, and will not be possible in an energy-limited future scenario.

Smart grid technology, large and small scale energy storage, smart metering with time-of-day pricing for load-shifting, metering feedback for consumption control (active instead of passive consumption), demand-based techniques such as interruptible supply, and demand management programmes with incentives to change consumption behaviour could all facilitate the power system supply/demand balancing act. This would be much more complicated than traditional grid management as it would involve many more simultaneously variable quantities of all scales, on both the supply and demand sides, only some of which are controllable. It would require time and money, both in large quantities, and also a change of mindset towards the acceptability of interruptible power supply. The latter is likely to be required in any case.

Greater complexity implies greater risk of outages, and potentially more substantial impact of outages as well, as one would expect structural dependency on power to increase enormously under a smart-grid scenario. If many more of society’s functions were to be subsumed into the electrical system – transport (like electric cars) for instance – as the techno-utopian model presumes, then dependency could not help but be far more deeply entrenched. In this direction lie even larger technology traps than we have already created.

In Europe, where indigenous fossil fuel sources are largely depleted, there has been a concerted move into renewables in a number of countries, notably Germany and Spain, since the 1990s. The justification is generally climate change, but security of supply plays a significant role. Avoiding energy dependence on Russia, and other potentially unstable or unreliable suppliers, by developing whatever domestic energy resources may exist, is an attractive prospect. Public policy has directed large subsidies into the renewable energy sector in the intervening years.

Feed-in tariffs, offering premium prices for renewable power put on to the grid, were introduced, with different tariffs offered for different technologies and different project sizes, in order to incentivize construction and grid connection of all sources and sizes of renewable power. In addition, in a number of jurisdictions, grid access processes have been streamlined for renewables, and renewable power has preferential access to the grid when the intermittent energy source is available. Other power sources can be constrained off if insufficient grid capacity is available.

The European Dash for Off-Shore Wind – Germany


Middelgrunden wind farm – Kim Hansen, Wikimedia

Recently emphasis has been placed on developing large-scale off-shore wind resources in countries, such as Germany and the UK, where these are available. The advantages are that it is a stronger and more consistent resource than on-shore wind, and that planning hurdles can be avoided. Germany, which has decided to phase out nuclear power by 2022, has been particularly interested in taking this route, and plans to build 10GW of off-shore wind installations by 2020 and 26GW by 2030. It has been more challenging than expected, however, particularly in relation to the exceptionally expensive grid connections and extensions required to bring power from a different direction than the grid had been designed for:

Germany’s power-transmission companies have tabled plans to build four electricity Autobahns to link wind turbines off the north coast with manufacturing centres in the south … Tennet, Amprion, 50 Hertz and Transnet BW said that building 3,800km high-voltage electricity lines – at a cost of around €20-billion – over the next decade was possible if politicians and public rallied behind the so-called energy transformation…

…In a first blueprint for the government, the companies proposed 2,100km of direct-current power lines – similar to those used for undersea links like that between the U.K. to the European continent – to connect the North Sea and the Baltic coasts to the south. On top of that, 1,700km of traditional alternating-current lines would have to be built, they said. These would complement 1,400km of this type of line already planned or being built – at a cost of €7-billion – under the government’s decade-old network plan.

Since Ms. Merkel closed eight of the country’s 17 nuclear reactors last summer and brought forward the phase-out of the energy source to 2022 from 2036, her biggest headache has proved the stability of the electricity network, which was designed to pipe nuclear electricity from south to north, not renewable electricity from the coast.

The cost and financial risk associated with building off-shore grid connections is so high that power companies are struggling to fund them. They are liable to wind farm developers if the latter are unable to sell their electricity for want of a grid connection. Significant connection delays are occurring, described by the German wind industry as “dramatically problematic”. Delays could potentially leave completed wind installations unable to deliver power to the mainland, and worse, requiring fossil fuel to run them in the meantime:

The generation of electricity from wind is usually a completely odorless affair. After all, the avoidance of emissions is one of the unique charms of this particular energy source. But when work is completed on the Nordsee Ost wind farm, some 30 kilometers (19 miles) north of the island of Helgoland in the North Sea, the sea air will be filled with a strong smell of fumes: diesel fumes.

The reason is as simple as it is surprising. The wind farm operator, German utility RWE, has to keep the sensitive equipment — the drives, hubs and rotor blades — in constant motion, and for now that requires diesel-powered generators. Because although the wind farm will soon be ready to generate electricity, it won’t be able to start doing so because of a lack of infrastructure to transport the electricity to the mainland and feed it into the grid. The necessary connections and cabling won’t be ready on time and the delay could last up to a year.

In other words, before Germany can launch itself into the renewable energy era Environment Minister Norbert Röttgen so frequently hails, the country must first burn massive amounts of fossil fuels out in the middle of the North Sea — a paradox as the country embarks on its energy revolution.

The situation has since worsened since:

What started out as a bit of a joke – last December Der Spiegel noted how RWE’s Nordsee Ost wind farm, far from delivering clean energy, was burning diesel to keep its turbines in working order – has rapidly turned serious. Siemens, the contractor for Germany’s offshore transformer stations, has booked almost €500 million in charges, according to Dow Jones. RWE is set to lose more than €100 million at Nordsee Ost. And E.ON’s head of Climate and Renewables, Mike Winkel, is on record as saying that no one, at E.ON or anywhere else, will be investing if the network connection is uncertain.

Investment in wind farms is drying up on growing risk and uncertainty:

Sales of offshore wind turbines collapsed in the first half, a sign the power industry and its financiers are struggling to meet the ambitions of leaders from Angela Merkel in Germany to Britain’s David Cameron. One unconditional order was made, for 216 megawatts, 75 percent less than in the same period of 2011 and the worst start for a year since at least 2009, according to preliminary data from MAKE Consulting, a Danish wind-energy adviser…

…”The industry in Germany has been frozen for a few months because of grid issues,” said Jerome Guillet, the Paris-based managing director of Green Giraffe Energy Bankers, which advises on offshore wind projects…

…Grid operators and their suppliers in Germany underestimated the challenges of connecting projects, Hermann Albers, head of the BWE wind-energy lobby, said in an interview earlier this year. Albers expects Germany won’t reach its 10- gigawatt goal by 2020, installing not more than 6 gigawatts by then.

Shares of Vestas, the world’s biggest wind turbine maker, have fallen 80 percent in the past year, underperforming the 56 percent decline in the Bloomberg Industries Wind Turbine Pure- Play Index (BIWINDP) tracking 14 companies in the industry. Siemens, which with Vestas dominates the offshore business, dropped 27 percent over the same period.

In order to mitigate the risk and prevent the wind programme from stalling, German power consumers are to be on the hook to compensate wind farm owners for the cost of grid connection delays:

The draft bill endorsed by Chancellor Angela Merkel’s Cabinet of Ministers would make power consumers pay as much as 0.25 euro cents a kilowatt-hour if wind farm owners can’t sell their electricity because of delays in connecting turbines to the grid. The plan is aimed at raising investments after utilities threatened to halt projects and grid operators struggled to raise financing and complete projects on time.

The cost of consumer surcharges to maintain the ‘Energiewende’ (the shift to renewable energy) appears set to become an election issue in Germany:

Germany’s status as a global leader in clean energy technology has often been attributed to the population’s willingness to pay a surcharge on power bills. But now that surcharge for renewable energy is to rise to 5.5 cents per kilowatt hour (kWh) in 2013 from 3.6 in 2012. For an average three-person household using 3,500 kWh a year, the 47 percent increase amounts to an extra €185 on the annual electricity bill.

“For many households, the increased surcharge is affordable,” energy expert Claudia Kemfert from the German Institute for Economic Research told AFP. “But the costs should not be carried solely by private households.” Experts have pointed out that with many energy-intensive major industries either exempt from the tax or paying a reduced rate, the costs of the energy revolution are unfairly distributed.

Meanwhile, the German Federal Association of Renewable Energies (BEE) maintains that not even half the surcharge goes into subsidies for green energy. “The rest is plowed into industry, compensating for falling prices on the stock markets and low revenue from the surcharge this year,” BEE President Dietmar Schütz told the influential weekly newspaper Die Zeit.

Grid instability is of increasing concern in Germany as a result of the rapid shift in the type and location of power generated. The closure of nuclear plants in the south combined with the addition of wind power in the north has aggravated north-south transmission constraints, which are only marginally mitigated by photovoltaic installations in Bavaria.

With a steep growth of power generation from photovoltaic (PV) and wind power and with 8 GW base load capacity suddenly taken out of service the situation in Germany has developed into a nightmare for system operators. The peak demand in Germany is about 80 GW. The variations of wind and PV generation create situations which require long distance transport of huge amounts of power. The grid capacity is far from sufficient for these transports.

As the German grid is effectively the backbone of the European grid, and faults can propagate very quickly, instability is not merely a German problem. Instability can result from a combination of factors, including electricity imports and exports and the availability of fuel for conventional generation. Germany narrowly avoided, causing an international problem in February 2012 due to power flows between Germany and France and a shortage of fuel for gas-fired generation in southern Germany.

Many new coal and gas-fired plants are to be built in the south in order to address the problem. Old coal plants are likely to have their lives extended and emission limits loosened in order to maintain needed generation capacity. Thermal plants are being effectively forced to operate uneconomically, as they must ramp up and down in order to make way for the renewable power that has priority access to the grid. Operating in this manner consumes additional fuel and produces accelerated wear and tear on equipment. Price volatility is increased, making management decision much more difficult.

On days when there is a lot of wind, the sun is shining and consumption is low, market prices on the power exchange can sometimes drop to zero. There is even such a thing as negative costs, when, for example, Austrian pumped-storage hydroelectric plants are paid to take the excess electricity from Germany….

….Germany unfortunately doesn’t have enough storage capacity to offset the fluctuation. And, ironically, the energy turnaround has made it very difficult to operate storage plants at a profit — a predicament similar to that faced by conventional power plants. In the past, storage plant operators used electricity purchased at low nighttime rates to pump water into their reservoirs. At noon, when the price of electricity was high, they released the water to run their turbine. It was a profitable business.

But now prices are sometimes high at night and low at noon, which makes running the plants is no longer profitable. The Swedish utility giant Vattenfall has announced plans to shut down its pumped-storage hydroelectric power station in Niederwartha, in the eastern state of Saxony, in three years. A much-needed renovation would be too expensive. But what is the alternative?

German industry is already taking precautionary measures as the risk of power interruptions is rising rapidly. Even momentary outages due to minor imbalances can result in equipment damage and high costs, and it is unclear who should shoulder the losses:

It was 3 a.m. on a Wednesday when the machines suddenly ground to a halt at Hydro Aluminium in Hamburg. The rolling mill’s highly sensitive monitor stopped production so abruptly that the aluminum belts snagged. They hit the machines and destroyed a piece of the mill. The reason: The voltage off the electricity grid weakened for just a millisecond.

Workers had to free half-finished aluminum rolls from the machines, and several hours passed before they could be restarted. The damage to the machines cost some €10,000 ($12,300). In the following three weeks, the voltage weakened at the Hamburg factory two more times, each time for a fraction of second. Since the machines were on a production break both times, there was no damage. Still, the company invested €150,000 to set up its own emergency power supply, using batteries, to protect itself from future damages….

….A survey of members of the Association of German Industrial Energy Companies (VIK) revealed that the number of short interruptions to the German electricity grid has grown by 29 percent in the past three years. Over the same time period, the number of service failures has grown 31 percent, and almost half of those failures have led to production stoppages. Damages have ranged between €10,000 and hundreds of thousands of euros, according to company information.

Producers of batteries and other emergency energy sources are benefiting most from the disruptions. “Our sales are already 13 percent above where they were last year,” said Manfred Rieks, the head of Jovyatlas, which specializes in industrial energy systems. Sales at APC, one of the world’s leading makers of emergency power technologies, have grown 10 percent a year over the last three years. “Every company — from small businesses to companies listed on the DAX — are buying one from us,” said Michael Schumacher, APC’s lead systems engineer, referring to Germany’s blue chip stock index….

….Although the moves being made by companies are helpful, they don’t solve all the problems. It’s still unclear who is liable when emergency measures fail. So far, grid operators have only been required to shoulder up to €5,000 of related company losses. Hydro Aluminum is demanding that its grid operator pay for incidents in excess of that amount. “The damages have already reached such a magnitude that we won’t be able to bear them in the long term,” the company says.

Given the circumstances, Hydro Aluminum is asking the Federal Network Agency, whose responsibilities include regulating the electricity market, to set up a clearing house to mediate conflicts between companies and grid operators. Like a court, it would decide whether the company or the grid operator is financially liable for material damages and production losses.

For companies like Hydro Aluminium, though, that process will probably take too long. It would just be too expensive for the company to build stand-alone emergency power supplies for all of its nine production sites in Germany, and its losses will be immense if a solution to the liability question cannot be found soon. “In the long run, if we can’t guarantee a stable grid, companies will leave (Germany),” says Pfeiffer, the CDU energy expert. “As a center of industry, we can’t afford that.”

The expectation of uninterruptible power, and the extreme dependency it creates, is the problem. Consumers do not feel they should be required to provide resilience with expensive back up options, yet this is increasingly likely in many, if not most, jurisdictions in the coming years. In emerging markets, it is common for power supply to be intermittent, and for fall-back arrangements to be necessary. We recently covered this situation in detail at The Automatic Earth, using India as a case study.

The European Dash for Off-Shore Wind – The United Kingdom


North Hoyle Offshore Wind Park

The UK’s Renewable Energy Roadmap has plans on a similar scale to Germany, proposing 18GW of wind capacity by 2020 (or some 30,000 turbines). Scotland is particularly keen to emulate, and surpass, Denmark, which generates 30% of its power from wind. Denmark is able to do this because it does not operate in isolation. It is effectively twinned with with Scandinavian hydro power, which provides the energy storage component, albeit at a price. On windy days, Denmark can export its surplus power to its neighbours, which have large enough grids to absorb power surges, but it does so at a low price. When the wind is not blowing, Denmark imports power at a high price. Ownership of the storage component makes a significant difference to the economics.

Unfortunately for Scotland, it currently has no access to a comparable hydro resource, either within it own borders or in the English market where it would be selling surplus power. As things stand, if wind power were developed at the proposed scale, it would have to be twinned with gas plants, but North Sea gas is already in sharp decline. For this reason, Britain and Scandinavia are planning to build NorthConnect, which would join Britain and Norway in the world’s longest subsea interconnector (900km) at an estimated cost of £1 billion (€1.3 billion), supposedly by 2020. This would follow on from the BritNed interconnector linking Britain and the Netherlands as of 2011 – a 260km line developed at a cost of £500 million (US $807.9 million).

“Using state-of-the-art technology, the interconnector will give the UK the fast response we will need to help support the management of intermittent wind energy with clean hydro power from Norway,” Steven Holliday of the National Grid says. “It would also enable us to export renewable energy when we are in surplus. At this very moment a seabed survey is underway in the North Sea, looking at the best way to design and install the cable, which would run through very deep water.”

If the project were completed as projected, it would allow the British, like the Danes, to subsidize the Norwegian power system, as the economic advantage lies with the owner of the storage capacity. The odds of completing such an ambitious project on time, however, and within budget, have to be regarded as low even if we were not facing financial crisis. Given that we are, those odds fall precipitously. The likelihood of having to twin whatever off shore wind is actually built with gas therefore increases. UK gas production is falling and storage is limited.

The shale gas reserves touted to provide affordable gas in the future amount to a mirage, thanks to the very low EROEI and high capital requirement. The UK is facing a future as a gas importer at the wrong end of a long pipeline from Russia. This is not a secure position to be in, especially given the UK’s gas dependence following the 1990s dash for gas. Developing wind power will make little difference if there is no flexible generating plant to provide back up.

The cost of building the turbines, their grid connections, back up gas plants and additional gas storage would be over ten times the amount required to build a fossil fuel alternative. According to a recent report to Britain’s Department of Energy and Climate Change, the cost of the grid connection alone would be greater than the entire cost of the alternative option.

The cost would have to be borne upfront, while the payback would come over a long period of time. This has significant implications for the net present value, and ‘effective EROEI’, of wind energy, especially in a scenario where the applicable discount rate is likely to skyrocket due to growing instability:

When introducing a discount rate of 5%, which can be considered very low both in non-financial and in financial realms, and represents societies with high expectations for long-term stability (such as most OECD countries), the EROI of 19.2 of this particular temporal shape of future inputs and outputs is reduced to and ‘effective’ EROI of 12.4 after discounting.

But discount rates are not the same in all situations and societal circumstances. Investing into the same wind power plant in a relatively unstable environment, for example in an emerging economy, where discount rates of 15% are more likely, total EROI for this technology is reduced to a very low value of 6.4, nearly 1/3 of the original non-discounted value.

Currently stable states are far more likely to resemble developing countries in a future of upheaval.

The investment choice is having to be made at a time when financial crisis is beginning to bite, thanks to Britain’s disastrous financial position as the ponzi fraud capital of the world. While wind is currently the preferred option, it is very likely the decision will be revised over the next few years, with relatively few turbines ever having been built, and perhaps even fewer actually connected to the grid. Neither the turbines nor the gas alternative, if there turns out to be sufficient capital to build either one, would last more than perhaps thirty years, so both represent medium term solutions only.

The CEO of the National Grid, in an interview last year with the Today Programme on BBC Radio 4, informed listeners that they would have to get used to intermittent power supply. No one seemed to be paying attention. It is interesting to note that under the old nationalized and vertically integrated CEGB in Britain, there was a responsibility to keep the lights on. When the CEGB was broken up, the National Grid inherited only the responsibility to balance supply and demand.

The UK power regulator, Ofgem, has also issued stark warnings of blackouts:

Millions of households are at risk of power black-outs within three years because coal stations are being replaced with wind farms, the energy watchdog has said. In its strongest ever warning, Ofgem said there may have to be “controlled disconnections” of homes and businesses in the middle of this decade because Britain has not done enough to make sure it has enough electricity. The regulator’s new analysis reveals the risk of power-cuts is almost 50 per cent in 2015 if a very cold winter causes high demand for electricity. Ofgem believes the lack of spare power generation “could lead to higher bills”, which are already at record high of £1,300 per year.

Whitehall sources said there is very little the Government can now do to avoid the risk of black-outs in the middle of the decade. It will take around three or four years to build any new gas plants and it would be very difficult to build more coal plants under European rules.

Alistair Buchanan, chief executive of Ofgem, said Britain’s energy system is struggling under the pressure of the “unprecedented challenges” of a global financial crisis, tough environmental targets and the closure of ageing power stations. Currently, Britain has 14 per cent more power plant capacity than is strictly necessary to keep the lights on. However, this crucial buffer will fall to just four per cent by the middle of the decade. Its report shows the risk of power-cuts begins to increase sharply from next year onwards.

Given the time scale for changes in generation and in infrastructure, preparations based on joined-up thinking have to be made well in advance of any looming crunch points. We are essentially experimenting with changes in a sporadic and haphazard fashion, and finding we are running risks we had not anticipated due to our failure to understand infrastructure requirements and dependencies. The risks are building rapidly, and it may already be too late to avoid unpleasant consequences.

Essentially, what appears to be happening across Europe is that nations are falling in love with offshore wind, permitting grand projects far out to sea – and then belatedly realizing that it is not so easy to get the energy back to shore. It is a bit like building hotels in the desert and forgetting to put the roads in. How come some of the world’s most advanced and industrialized countries are committing such a colossal oversight?

The problem is one of mindset. Ever since the first days of electricity, there has really only been one model for energy distribution. You build a generating center, more or less wherever you want it, and then create outbound distribution links to whoever needs power. This hub-and-spoke model is deeply ingrained in every aspect of energy distribution, from how utilities and grid operators work to the way regulators and policy makers think. But for renewable energy, it does not work.

You cannot just put a wind farm wherever you want. In fact, in the case of offshore wind, the locations you have could hardly be more inconvenient from an energy transport point of view. That means grid connections almost need to come first in the thinking about offshore wind. How expensive will they be? How feasible? How can the costs and installation timeframes be reduced?

These questions are fairly obvious, and are nothing new. One renewable energy veteran remembers speaking to an oil and gas representative a few years ago, who said that if we were really serious about renewables then the first thing we would have to change is the grid. Needless to say, that has not happened. If the issue is not addressed soon then every offshore market runs the risk of having an experience like Germany’s.

A European Supergrid?


Image: Airtricity

A European supergrid, with many cross-border transmission lines, has long been a European goal. The idea is to share power as widely as possible, evening out disparities in supply and demand across Europe. It is intended to be particularly applicable in terms of evening out the effects of intermittent renewable energy, notably off-shore wind, which could be linked with distant storage capacity. The vision even includes integrating Icelandic geothermal power.

Initial steps are already being contemplated with regard to integrating off-shore wind in north west Europe:

The North Sea Grid Initiative consists of Germany, Denmark, Norway, Sweden, Belgium, France, Luxembourg, and the United Kingdom. These countries signed a memorandum of understanding back in 2011 to help spur offshore wind development and tap into the ideal types of renewable energy in different parts of Europe within the next decade. More than 100 gigawatts (GW) of offshore wind are in the development or planning phases throughout Europe.

Pooling grid connection costs between countries by linking wind farms is projected to bring costs down substantially. Interconnectors are extremely expensive, hence the incentive to reduce costs wherever possible.

To make offshore wind work in northwest Europe, policymakers may have to adopt even more ambitious plans for the technology, gathering individual projects into hubs further offshore to capture more wind and pool connection costs, in a potentially high risk strategy.

The approach could shave 17 percent off an estimated 83 billion euros to connect 126,000 MW of offshore wind by 2030, according to a report produced last year by renewable energy lobby groups, consultancies and university research departments, “OffshoreGrid: Offshore Electricity Infrastructure in Europe”.

Groups such as Friends of the Supergrid envisage an exceptionally ambitious scaling up of power system integration, with a view to transitioning to an electrified economy by 2050:

“Supergrid” is the future electricity system that will enable Europe to undertake a once-off transition to sustainability. The concept of Supergrid was first launched a decade ago and it is defined as “a pan-European transmission network facilitating the integration of large-scale renewable energy and the balancing and transportation of electricity, with the aim of improving the European market”.

Supergrid is not an extension of existing or planned point to point HVDC interconnectors between particular EU states. Even the aggregation of these schemes will not provide the network that will be needed to carry marine renewable power generated in our Northern seas to the load centres of central Europe. Supergrid is a new idea. Unlike point to point connections, Supergrid will involve the creation of “Supernodes” to collect, integrate and route the renewable energy to the best available markets. Supergrid is a trading tool which will enhance the security of supply of all the countries of the EU.

The stated goal is to a achieve a transition to sustainability, while providing for a low-carbon, high-growth scenario. This is an obvious contradiction, given that high growth not sustainable by definition. The plan appears to be the pinnacle of techno-utopia, and a clear example of fashionable energy fantasy. Unfortunately unrealistic dreams can be sold as safe long term investments:

Despite these uncertainties, others believe the supergrid is a smart investment. ‘There are pension funds and many investors looking for safe returns,’ Julian Scola, spokesman for the European Wind Energy Association in Brussels, said to the New York Times. ‘Electricity infrastructure, which is a regulated business with regulated returns, ought to and does provide very safe and very attractive investment.’

Pension funds, while they still exist in their current form, could be lured into backing something too good to be true, as happened so extensively during the initial phase of the credit crunch. Such investments are highly unlikely to pay off.

The Broader European Energy Context


In addition to the problems with off shore wind and grids, knock on effects are anticipated in other energy markets with greater reliance on wind power:

There will be an increase in gas-price volatility across Europe as markets with more wind capacity, such as the U.K., Spain, France, Germany and the Netherlands, are linked to those with less, James Cox and Martin Winter, consultants at Poyry in Oxford, England, said in a research report published today. Wind will be the main source of irregular supply, as output can still fall to zero no matter how much capacity is installed, while solar continues to produce even under cloud cover.

“If it’s cold and still, it’s much more extreme for the gas network because you get the heating demand response to the cold weather and the power response to the still weather,” Cox.

The European Union has reached 100 gigawatts of installed wind-energy capacity, equivalent to the output of 62 coal-fired power stations, the European Wind Energy Association said Sept. 27. In the EU, about 5 percent of electricity came from wind last year.

The winners in this scenario will be owners of so-called fast-cycling gas storage, which can respond rapidly to falling wind generation, and traders who can take advantage of diverging prices at Europe’s trading hubs as weather patterns vary by geography, Cox said.

Once again, ownership of key energy storage components is critical. In our financialized world, it is also small wonder that traders playing an arbitrage game would be expected to enjoy great opportunities for gain. This dynamic has already threatened power supplies and is likely to do so repeatedly:

Germany’s electricity grid came to the brink of blackout last week – not because of the cold, but because traders illegally manipulated the system. They tapped emergency supplies, saving money but putting the system at risk of collapse.

Normal supply is maintained by the dealers acting as go-betweens for the industrial and domestic electricity consumers and the generators so that the latter know how much to supply. The Berliner Zeitung said the dealers were legally obliged to continually order enough electricity to cover what their customers need. But this was not done earlier this month, according to the regulator’s letter. Instead dealers sent estimates which were far too low, meaning the normal supply was almost completely exhausted. Several industry insiders told the Frankfurter Rundschau daily the tactic was deliberately adopted to maximise profits.

The dealers systematically reduced the amount they ordered for their customers, avoiding the expensive supply and forcing the system to open up its emergency supply – the price for which is fixed at €100 a Megawatt hour. This is generally considered very expensive – but compared to what else was on offer at the time, it represented huge savings – yet put the entire electricity supply system on emergency footing for no reason.

The Global Clean Tech Bubble


Those who advocate for a complete shift to renewables often state that it would be possible if only the political will to fund the transition were available. In fact, funding programmes have been introduced in many jurisdictions, often on a very large scale. Capital grants and long term Feed-In Tariff (FIT) contracts have been introduced in many European countries and in other regions. Feed-In Tariffs, which typically offer a twenty year guaranteed income stream in order to overcome the investment risk, have often been the economic tool of choice. Some of these have been very generous, and the subsidy regimes have driven large investments in renewables for many years. The costs have been in the hundreds of billions of dollars, with projections for many times that much in the future, both for generation capacity and for the necessary infrastructure to service it:

In 2005, VC investment in clean tech measured in the hundreds of millions of dollars. The following year, it ballooned to $1.75 billion, according to the National Venture Capital Association. By 2008….it had leaped to $4.1 billion. And the [US] federal government followed. Through a mix of loans, subsidies, and tax breaks, it directed roughly $44.5 billion into the sector between late 2009 and late 2011. Avarice, altruism, and policy had aligned to fuel a spectacular boom….

I….Investors were drawn to clean tech by the same factors that had led them to the web, says Ricardo Reyes, vice president of communications at Tesla Motors. “You look at all disruptive technology in general, and there are some things that are common across the board,” Reyes says. “A new technology is introduced in a staid industry where things are being done in a sort of cookie-cutter way.” Just as the Internet transformed the media landscape and iTunes killed the record store, Silicon Valley electric car factories and solar companies were going to remake the energy sector. That was the theory, anyway.

With the much of the risk safely lodged elsewhere, at least apparently, a sense that one could not lose became increasingly entrenched. This is dangerous, because this is the psychological underpinning of a speculative mania. When investors begin to throw money at something regardless of cost, believing that the investment can only go up, a self-reinforcing spiral leading into an epidemic of poor decision making tends to be the result. The sector over-reaches itself and the boom ends in bust, trashing the economic reputation of the sector for many years.

Productive capacity that had been built out in order to service the artificially-stimulated demand is then abandoned, often without having recovered its costs. Demand suffers an undershoot as the stimulus is withdrawn, typically for long enough that productive capacity has degraded to unusability before demand can recover. In this way, bubbles encourage the conversion of capital to waste.

Bubbles are inherently self-limiting and do not require a trigger to burst. They simply reach the maximum expansion, run out funds to tap to keep the expansion going, and implode. In the case of cleantech, the day of reckoning has been aggravated by lack of infrastructure, specifically grid capacity, as we have see above. Projects in some jurisdictions were facing years or more of delay for want of the physical ability to move the power from where it was proposed to be generated to where it could possibly be used.

For instance, the available grid capacity in Ontario (Canada) was oversubscribed in the launch period the the FIT programme. Ambitious grid expansion plans are planned, but over a period of decades. Even if we were not facing financial crisis, the financing for specific projects would have long since disappeared before the projects could expect to receive at FIT contract. Similarly in Europe, the grid connections necessary to build out off-shore wind on a large scale simply do not exist, and cannot be brought into existence in less than several decades time. Time is a major factor for high tech investors used to a rapid, or even explosive pace of development:

There was an additional factor at work: impatience. Venture capitalists tend to work on three- to five-year horizons. As they were quickly finding out, energy companies don’t operate on those timelines. Consider a recent analysis by Matthew Nordan, a venture capitalist who specializes in energy and environmental technology. Of all the energy startups that received their first VC funds between 1995 and 2007, only 1.8 percent achieved what he calls “unambiguous success,” meaning an initial public offering on a major exchange. The average time from founding to IPO was 8.3 years. “If you’re signing up to build a clean-tech winner,” Nordan wrote in a blog post, “reserve a decade of your life.”

The truth is that starting a company on the supply side of the energy business requires an investment in heavy industry that the VC firms didn’t fully reckon with. The only way to find out if a new idea in this sector will work at scale is to build a factory and see what happens. Ethan Zindler, head of policy analysis for Bloomberg New Energy Finance, says the VC community simply assumed that the formula for success in the Internet world would translate to the clean-tech arena. “What a lot of them didn’t bargain for, and, frankly, didn’t really understand,” he says, “is that it’s almost never going to be five guys in a garage. You need a heck of a lot of money to prove that you can do your technology at scale.”

The bubble is now bursting, especially for solar, which had benefited from the largest subsidies, but increasingly for wind as well. Investments in renewable energy companies, formerly seen as a no-lose bet, have often been failing to live up to expectations, to put it mildly. Early entrants did very well, but late comers are the empty bag holders, as with any structure grounded in ponzi dynamics:

Renewable energy is the future, say environmentalists. But for green and ethical investors it has turned into a nightmare, with makers of wind and solar power systems among the worst-performing stocks in recent years. Take Vestas, the Danish wind turbine maker. Early investors enjoyed sparkling returns, with shares leaping from 34 Danish kroner in 2003 to 698 in 2008 – a 20-fold rise. But since then, beset by the loss of government subsidies, cost overruns, production delays and competition from China, the price has collapsed. Today it is trading at 35 kroner – so someone investing in 2008 will have lost nearly 95% of their money. In August Vestas revealed it had slumped into losses and shed another 1,400 jobs, bringing total redundancies for the year to more than 3,700. It had planned to construct a plant at Sheerness docks in Kent to supply turbines for expected deep-water North Sea wind farms, but this was axed in June.

Solar panel manufacturers have also burnt a hole in investors’ pockets. Look at SunTech, the world’s biggest maker of PV (photovoltaic) panels, based in Wuxi, China. Its private equity backers (notably Goldman Sachs) made a fortune when it listed on the New York Stock Exchange in 2005, making well over 10 times their original investment. So did the people who bought at the initial share launch, with the shares shooting from $20 to $79 in late 2007. And today? They are changing hands at just 92 cents. First Solar, another one-time darling of Nasdaq, collapsed from $308 in April 2008 to $23 last week. Solar is an industry awash with overcapacity in China, falling prices and declining government subsidies.

Solar is particularly expensive in comparison with currently available alternatives. Grid parity – cost competitiveness with other sources – is a distant dream, hence the requirement for disproportionately large subsidies:

“Today, you’d need to charge $375 per megawatt hour to justify investment in new solar equipment—nearly four times the average US retail price of electricity,” writes Catherine Wood of AllianceBernstein….And these calculations don’t include the cost of backup power or energy storage to supply power when the sun isn’t shining. A backup power system or battery would add roughly 25% to the electricity price required to justify new investment in solar power.

“Finally, these calculations ignore the cost of the real estate upon which a solar panel sits, because most smaller scale installations are on a rooftop that would otherwise go unused. For utility-scale installations, however, ignoring real estate costs is not fair. The cost basis for what will be the largest utility-scale solar power installation in Japan more than doubles if you take into account the value of the real estate that the solar panels will occupy.


China has made a very large investment in renewables and energy storage technologies, and their productive capacity has expanded so quickly that companies in other countries have struggled to compete, particularly in photovoltaics. The sharp fall in panel prices has been very hard on non-Chinese solar manufacturer, dropping capacity significantly. The Chinese developmental state has been building out infrastructure of all kinds for many years, hence this determined move is no exception. Subsidies at the national level were vastly larger than those given by western states, and a national feed-in tariff was introduced. Additional support was given at the provincial and local levels in the form of tax incentives and access to real estate at subsidized cost.

Even in China, however, huge losses are now being incurred:

China in recent years established global dominance in renewable energy, its solar panel and wind turbine factories forcing many foreign rivals out of business and its policy makers hailed by environmentalists around the world as visionaries.

But now China’s strategy is in disarray. Though worldwide demand for solar panels and wind turbines has grown rapidly over the last five years, China’s manufacturing capacity has soared even faster, creating enormous oversupply and a ferocious price war. The result is a looming financial disaster, not only for manufacturers but for state-owned banks that financed factories with approximately $18 billion in low-rate loans and for municipal and provincial governments that provided loan guarantees and sold manufacturers valuable land at deeply discounted prices.

China’s biggest solar panel makers are suffering losses of up to $1 for every $3 of sales this year, as panel prices have fallen by three-fourths since 2008. Even though the cost of solar power has fallen, it still remains triple the price of coal-generated power in China, requiring substantial subsidies through a tax imposed on industrial users of electricity to cover the higher cost of renewable energy. The outcome has left even the architects of China’s renewable energy strategy feeling frustrated and eager to see many businesses shut down, so the most efficient companies may be salvageable financially.

Even as costs fall on a bursting bubble, renewables have not achieved grid parity. That quest has been greatly aggravated, particularly in North America, by the shale gas mirage, which promises so much gas for the foreseeable future that it has crashed the price of gas in the meantime:

The price of natural gas peaked at nearly $13 per thousand cubic feet in 2008. It now stands at around $3. A decade ago, shale gas accounted for less than 2 percent of America’s natural gas supply; it is now approaching one-third, and industry officials predict that the total reserves will last a century. Because 24 percent of electricity comes from power plants that run on natural gas, that has helped keep costs down to just 10 cents per kilowatt-hour—and from a source that creates only half the CO2 pollution of coal. Put all that together and you’ve undone some of the financial models that say it makes sense to shift to wind and solar. And in a time of economic uncertainty, the relatively modest carbon footprint of natural gas gets close enough on the environmental front for a lot of people to feel just fine turning up the air-conditioning.

Unconventional fossil fuels (shale gas, coal bed methane, tight formation gas, shale oil and oil-shale etc) are well entrenched in their own bubble, as we have repeatedly documented at TAE (see for instance Shale Gas reality Begins to Dawn and Unconventional Oil is NOT a Game-Changer).

People are currently believing the hype, and perception is what moves prices. The current perception is of glut, when in fact the unconventional fossil fuel boom is likely to be short-lived thanks to very low EROEI, a high capital requirement and huge amounts of leverage. The artificially low price of natural gas is on the verge of putting over-leveraged gas producers out of business en masse, at which point the North America will be set up for a supply crunch and price spike. By the time that scenario plays out, there will no longer be the time or the money to shift back to investment in renewables.

Fracking is getting underway in many other jurisdictions as well, and will very likely be similarly disappointing. In Europe, the mirage offers the hope of gas independence from Russia, but this potential is likely to be illusory. Ironically from an environmental point of view, given that gas is perceived to be acceptable from a carbon emission perspective, gas produced by fracking is very much more carbon intensive than conventional production – likely worse than coal.

The boom and bust dynamic is, for the time being, alive and well in the energy sector. Any part of the real economy which has become heavily financialized will be subject to the rapid speculative swings of finance. Such swings can devastate vital economic sectors. The bust which is coming courtesy of the bursting the largest financial bubble in human history will be one for the record books.

Austerity and the Future of Renewable Energy Subsidies


The feed-In tariffs that stimulated so much investment in renewable energy for sale to the grid have been suffering cutbacks in many, if not most, jurisdictions that introduced them. Solar tariffs in particular have been deemed too generous, especially in an era of increasing austerity. We covered this dynamic at TAE back in early 2011 in The Receding Horizons of Renewable Energy.

The financial benefit of a feed-in tariff accrues to a few relatively wealthy renewable energy entrepreneurs, while the cost of the subsidy is borne by electricity consumers. It will become increasingly difficult to justify high levels of private payments as times get harder and electricity bills become less affordable for the masses. The costs, for tariff payments, for back up generation capacity, and for infrastructure build out, have escalated rapidly on increasing installed capacity in early adopter countries. Cutting feed-in tariffs, or whole programmes, is likely to become a means of scoring easy political points once we move from general support for green initiatives towards a greater focus on a shrinking economy. Environmental concern peaks with the economy, in that people who do not have immediate worries of scarcity place more importance on wider issues with a longer timeframe. Once an economy is in contraction, however, societal discount rates skyrocket and the focus on broader issues rapidly disappears. Considering what the future holds economically, a loss of concern for the environment is sadly highly likely.

Ironically, installing renewable generation under a feed-in tariff often does little or nothing in terms of energy security for the person installing it. All power is typically loaded on to the grid and paid for, and all power consumed is purchased from the grid. Separate storage systems are often explicitly disallowed, meaning the the owner of the renewable energy system is as vulnerable to blackouts as anyone else. Generation installed in this way is effectively a money generating system from the point of view of the installer, rather than an energy generating system.

One group of countries aggressively cutting renewable energy subsidies is the European periphery. Both Greece and Spain, for instance, championed renewable energy regardless of cost, but are now being forced to retreat from the sector. In both countries, subsidy uptake exceeded expectations, hence the future costs are projected to be far larger than had been anticipated.

In Greece, a lack of funding and a substantial regulatory burden has delayed much of the mass of applications to the point where they are unlikely ever to be built, but substantial investments, mostly in wind power, have already been made and the projects commissioned.

Since George Papandreou came to power in the October 2009 elections in Greece, a central policy priority has been the promotion of “green energy.” As part of this policy, between EUR 10-15 billion in renewable energy (RE) projects have been licensed. These include large, industrial-scale wind and photovoltaic projects, as well as smaller installations of up to 1-5 MW…

….Unfortunately, there has been no prior control over either the number or location of the applications permitted, nor has there been a cap on the energy generation capacity licensed. As a result, investors have responded in far greater numbers than imagined.

The process has not been without its political clientilism. In an effort to appease farmers, for instance, the Ministry of Agriculture made extraordinary efforts to get farmers to apply for RE production licenses, with many public assurances that their applications would be approved. As a result, thousands of farmers responded, with the result that the number of applications is at least double the original forecast. These farmers already benefit excessively from EU Common Agricultural Policy subsidies, and will soon increase their reliance on the state through renewable energy generation.

Reliance on payments from the state is not a good position to be in, in a country where the economy is seizing up, as it currently is in Greece. Greece is experiencing a liquidity crunch, and we covered what that really means several months ago at TAE in Crashing the Operating System – Liquidity Crunch In Practice. The power system is no exception. Back in June, in the run-up to the general election, the financial crisis became acute:

Greece’s debt crisis threatened to turn into an energy crunch on Friday, with the power regulator calling an emergency meeting next week to avert a collapse of the country’s electricity and natural gas system. Regulator RAE called the emergency meeting after receiving a letter from Greece’s natural gas company DEPA, dated May 31 and seen by Reuters, threatening to cut supplies to electricity producers if they failed to settle their arrears with the company….

….According to an energy industry source who declined to be named, DEPA has no cash to settle gas supply bills worth a total 120-million euros (US$148.4-million) with Italian gas firm Eni , Turkey’s Botas and Russia’s Gazprom, which fall due this month. DEPA CEO Haris Sahinis declined to comment on the company’s cash position but told Reuters: “DEPA is taking every action to avoid owing anything to its suppliers.”

If DEPA cuts off supplies, Greece’s independent power producers such as Elpedison, Mytilineos, Heron and Corinth Power — which cover about 30 percent of the country’s power demand — would be forced to stop operations. Greece’s grid operator ADMIE would then have to proceed to rotating power cuts to avoid a general blackout, just as the country’s summer tourism season, a rare foreign exchange earner for the country’s uncompetitive economy, goes into full swing.

These producers use natural gas, much of it supplied by DEPA, to produce about 70% of their electricity output. Greece’s dominant electricity company PPC uses natural gas to a much lesser extent than the other producers, but PPC’s coal and hydro units would not be able to cover the shortfall. Power companies have failed to pay their bills to DEPA because they, in turn, have not been reimbursed by LAGHE, a state-run clearing account for the nation’s energy transactions.

In recent months RAE has repeatedly urged the government to shore up the accounts of LAGHE, which is sitting on a deficit of more than 300-million euros. The account went into deficit because its receipts have not matched the generous subsidies it pays out to renewable energy producers, particularly for solar panels. LAGHE’s deficit deteriorated earlier this year when two electricity retailers, PPC’s biggest rivals, went bust without honoring their obligations to the account, leaving authorities scrambling to find cash….

….Greece could also boost the LAGHE account by using about 100-million euros sitting in the accounts of the two power retailers that went bust earlier this year, Zervos said. But energy authorities have no access to that money because it has been frozen as part of a criminal investigation into the bust. “It’s absolutely crazy. This is money that power consumers paid into the energy system,” the source said.

In a highly interconnected system, the potential for knock-on effects is very significant. The system is only as strong as its weakest link, and when there is little money to go around to settle accounts, there are many weak links are exposed. The risk is cascading system failure.

By September, Greece was responding to the threat by, among other factors, axing the feed-in tariff programme and targeting previously favoured renewable energy producers:

Greece, aiming to stave off a fresh energy crisis, plans to support its main electricity market operator through a temporary tax on renewable power producers and by extending an emergency loan, a senior official said on Friday. Deputy energy minister Asimakis Papageorgiou told Reuters that Greece’s international lenders had dropped their opposition to the loan plan [previously seen as illegal state aid] in view of the country’s critical energy situation.

The electricity system came close to collapse in June when market operator LAGHE was overwhelmed by subsidies it pays to green power producers as part of efforts to bolster solar energy. LAGHE was already suffering in Greece’s debt crisis as bills were left unpaid by consumers protesting against the collection of an unpopular property tax via the bills of PPC, the country’s sole electricity retailer.

Papageorgiou also said that Greece would unveil by the end of 2012 plans for a market-based retail electricity network. He said PPC, due to be privatized under a massive government sell-off plan to ease Greece’s budget crisis, will probably spin off some power stations and distribution lines to create one or two rival companies. PPC itself would find a strategic partner.

The state-run Loans and Consignments Fund, a key lifeline for the country’s energy system, will give LAGHE a one-year loan of 140 million euros ($180 million), Papageorgiou said. “The troika (EU, IMF and ECB) approved it because they realized that these actions are necessary for the market to survive and return to a normal state,” he said.

Earlier this year the fund extended 100 million euros to state-owned natural gas supplier DEPA and another 110 million to dominant state-controlled utility PPC (DEHr.AT).

The temporary charge on renewable energy producers was a further measure to plug LAGHE’s deficit of more than 300 million euros. “I’d call it a solidarity levy,” Papageorgiou said. “It will be in force over a very specific period… and set at such a level that will allow them to operate normally with satisfactory returns.”

Greece has slashed the guaranteed feed-in prices it pays to some solar operators and is no longer approving permits for their installation.

Greek consumers, who can ill-afford to pay more for anything as unemployment skyrockets, are being asked to cover a 19% hike in electricity prices. The power system framework is a byzantine mess, and the last few years of attempted transition have added enormously to the complexity of the predicament. It is unclear in what form the system may ultimately survive, but in the meantime, the population is very likely to have to get used to interruptible supply at best.

When feed-in payments are cut, and windfall taxes imposed instead, those who took on loans to build projects will not be able to service the debts they incurred. Their eventual default will add to the illiquidity of the system. Further investments in renewables will dry up on risk of so many kinds at once. A twenty year guaranteed payment, meant to overcome that risk and stimulate investment, is a promise too good to be true. When governments make reckless promises they cannot keep they will simply repudiate the contracts unilaterally. There are no risk free investments, but many people have acted as if there were and have structured their investments, or even their lives, around promises destined to be broken:

The Spanish and Germans are doing it. So are the French. The British might have to do it. Austerity-whacked Europe is rolling back subsidies for renewable energy as economic sanity makes a tentative comeback. Green energy is becoming unaffordable and may cost as many jobs as it creates. But the real victims are the investors who bought into the dream of endless, clean energy financed by the taxpayer. They forgot that governments often change their minds….

….The austerity programs have piled on additional difficulties in the form of subsidy reductions. No government would announce “temporary” subsidies, for fear of scaring off investment in renewable energy. Still, that’s exactly what the subsidies are turning out to be. Investors everywhere are going to get slaughtered as debt-swamped governments trim or eliminate the freebies.

The renewable energy bubble was inflated by government subsidies. Those same governments are now deflating them. Turns out the subsidies were too good to be true.

In Spain, renewable subsidies were generous and achieved a huge increase in installed capacity, at a consumer cost of 6 billion euros a year by 2009 (compared to 5.6 billion in Germany where the economy is four times the size). Approximately half the subsidies went to solar, which produced 2% of the power. However, when financial crisis began to bite, cuts were inevitable. Initially, tariffs on new projects were reduced 45%, and later a new decree retroactively limited the number of production hours qualifying for subsidies for existing projects with feed-in tariff contracts:

Spain’s solar industry lobby group, the Asociacion Empresarial Fotovoltaica, estimated that the second decree would effectively reduce tariffs received by PV plants by 30 per cent, forcing many of the PV companies to default on their debt. Infrastructure Investor magazine called the second decree “the Christmas Eve massacre.”

Investment began to dry up almost immediately on greatly increased regulatory risk, and companies were left with no domestic market for their products:

Spanish renewable-energy companies that once got Europe’s biggest subsidies are deserting the nation after the government shut off aid, pushing project developers and equipment-makers to work abroad or perish. From wind-turbine maker Gamesa Corp. Tecnologica SA (GAM) to solar park developer T-Solar Global SA, companies are locked out of their home market for new business. These are the same suppliers that spearheaded more than $69 billion of wind and solar projects since 2004 that today supply more than 50 percent of Spain’s power demand on the most breezy and sunny days….

….”They destroyed the Spanish market overnight with the moratorium,” European Wind Energy Association Chief Executive Officer Christian Kjaer said in an interview. “The wider implication of this is that if Spanish politicians can do that, probably most European politicians can do that.”….

Industry Minister Jose Manuel Soria, who is preparing a wholesale redesign of the pricing for Spain’s regulated energy industry, described the January move as a “first step.” The nation’s energy regulator in March suggested scaling back incentives for solar thermal plants. The government also may impose temporary taxes or caps on renewable plants, Standard & Poor’s said in February….

….T-Solar, which became the world’s biggest solar-farm operator by leveraging its Spanish business, currently has more than 40 running in Spain, Italy and India. While it still makes solar panels in Orense, Spain, they’re bound for Peru. “We have an important pipeline of projects, and it’s 100 percent outside Spain right now,” T-Solar Managing Director Juan Laso, who also heads the country’s photovoltaic power association, said in a telephone interview. “If you take such a brutal measure, what you do is oblige the industry to move out,” he said of the January moratorium.

For the time being, there are still other markets to be served, but as financial crisis spreads, that will be less and less the case. Many other jurisdictions are cutting, or contemplating cutting, subsidies. The remaining market is set to shrink relentlessly, squeezing overcapacity of supply.

A Decentralized Renewable Reality?

Renewable energy is never going to be a strategy for continuing on our present expansionist path. It is not a good fit for the central station model of modern power systems, and threatens to destabilize them, limiting rather than extending our ability to sustain business as usual. The current plans attempt to develop it in the most technologically complex, capital and infrastructure dependent manner, mostly dependent on government largesse that is about to disappear. It is being deployed in a way that minimizes a low energy profit ratio, when that ratio is already likely too low to sustain a society complex enough to produce energy in this fashion.

Renewable electricity is not truly renewable, thanks to non-renewable integral components. It can be deployed for a period of time in such a way as to cushion the inevitable transition to a lower energy society. To do this, it makes sense to capitalize on renewable energy’s inherent advantages while minimizing its disadvantages. Minimizing the infrastructure requirement, by producing power adjacent to demand, and therefore moving power as little distance as possible, will make the most of the energy profit ratio. The simplest strategy is generally the most robust, but all the big plans for renewables have gone in the opposite direction. In moving towards hugely complex mechanisms for wheeling gargantuan quantities of power over long distances, we create a system that is highly brittle and prone to cascading system failure.

In a period of sharp economic contraction, we will not be able to afford expensive complexity. Having set up a very vulnerable system, we are going to have to accept that the the lights are not necessarily going to come on every time we flick a switch. Our demand will be much lower for a while, as economic depression deepens, and that may buy the system some time by lowering some of the stresses upon it. The lack of investment will take its toll over time however.

While a grid can function at some level even under very challenging conditions – witness India – it is living on borrowed time. We would do well to learn from the actions, and daily frustrations, of those who live under grid-challenged conditions, and do what we can to build resilience at a community level. Governments and large institutions will not be able to do this at a large scale, so we must act locally.

As with many aspects of society navigating a crunch period, decentralization can be the most appropriate response. The difficulty is that there will be little time or money to build micro-grids based on local generation. It may work in a few places blessed with resources such as a local hydro station, but likely not elsewhere in the time available. The next best solution will be minimizing demand in advance, and obtaining back up generators and local storage capacity, as they use in India and many other places with unstable grids. These are relatively affordable and currently readily available solutions, but do require some thought, such as fuel storage or determining which are essential loads that should be connected to batteries and inverters with a limited capacity. Later on, such solutions are much less likely to be available, so acting quickly is important.

Minimizing demand in a planned manner greatly reduces dependency, so that limited supply can serve the most essential purposes. It is much better than reducing demand haphazardly through deprivation in the depths of a crisis. Providing a storage component can cover grid downtime, so that one no longer has to worry so much when the power will be available, so long as it is there for some time each day. Given that even degraded systems starved of investment for years can deliver something, storage can provide a degree of peace of mind. It is typically safer than storing generator fuel.

Some will be able to install renewable generation, but it will not make sense to do this with debt on the promise of a feed-in tariff contract that stands to be repudiated. Those who can afford it will be those who can do it with no debt and no income stream, in other words those who do it for the energy security rather than for the money, and do not over-stretch themselves in the process. Sadly this will be very few people. Pooling resources in order to act at a community scale can increase the possibilities, although it may be difficult to convince enough people to participate.

It is difficult to say what power grids might look like following an economic depression, or what it will be possible to restore in the years to come. The answers are likely to vary widely with location and local circumstances. Depression years are very hard on vital economic sectors such as energy supply. Falling demand undercuts price support, and prices fall more quickly than the cost of production, so that margins are brutally squeezed. Even as prices fall, purchasing power falls faster, so that affordability gets worse. Consumers are squeezed, leading to further demand destruction in a positive feedback loop.

Under these circumstances, the energy sector is likely to be starved of investment for many years. When the economy tries to recover, it is likely to find itself hitting a hard ceiling at a much lower level of energy supply. With less energy available, society will not be able to climb the heights of complexity again, and therefore many former energy sources dependent on complex means of production will not longer be available to simpler future societies. Widespread electrification may well be a casualty of the complexity crash.

We are likely to realize at that point just how unusual the era of high energy profit ratio fossil fuels really was, and what incredible benefits we had in our hands. Sadly we squandered much of this inheritance before realizing its unique and irreplaceable value. The future will look very different.


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Oct 232012
 October 23, 2012  Posted by at 9:38 pm Finance Comments Off on Japan Is Not A Good Example Of How Deflation Typically Plays Out

Kükator Sumo wrestlers performing dohyo-iri Wikimedia Commons

Japan is not a good example of how deflation typically plays out. As Ilargi points out, they were an exporting powerhouse exporting into the biggest consumption boom the world has ever seen. They also had a very large pile of money to burn through building their four lane highways from nowhere to nowhere, since they were the world's largest creditor when their bubble burst in 1989. This is clearly not our situation.

No one will be exporting their way out of a global economic depression. In contrast, exporters are going to feel the pain big time as their markets dry up. We can expect trade wars and protectionism to abound. Take note Germany, Scandinavia, Australia, New Zealand etc etc.

We have had the inflation, only instead of a currency hyperinflation, we experienced a 30 year credit hyper-expansion. Either one amounts to an expansion of money plus credit compared to available goods and services, and is therefore inflation. Credit is equivalent to money on the way up, but not on the way down. Credit loses 'moneyness' and credit instruments are massively devalued in a great deleveraging. This is deflation by definition and it is already underway. Debt monetization is nothing in comparison with the scale of the excess claims to underlying real wealth that stand to be eliminated.

I agree that the currency of a deflating nation strengthens. This is exactly why we have been writing about the value of the US dollar increasing, which it has done. The bottom came in a long time ago, and despite the set backs that are an integral part of a fractal market, the trend is up, and will be for some time. That's not to say it will be for the long term – far from it in fact – but for now that is the case. We have made it clear that cash is a short term bet (of the order of a few years), and that the longer term strategy is to move into hard goods at the point when one can reasonably afford to do so with no debt.

Some could do so now, while others would have to wait for prices to fall, as they inevitably do in a deflation, but not immediately. Price movements follow changes in the money supply. We have been in a counter-trend reflation since 2009, and prices have risen as a result. They may continue to do so for a while after the reflation is clearly over, but then the trend will reverse.

Prices will fall, but purchasing power will fall faster, meaning that prices will rise in real terms for most people. Those who have preserved capital as liquidity will find their purchasing power enormously increased, but most others will lose purchasing power because they will have no access to credit, highly unfavourable employment circumstances, rising property taxes and very little actual money.

The fiat currency regime will eventually descend into chaos as beggar-thy-neighbour devaluations become the norm, but not everyone can devalue at will or at once. The market will decide relative values for the next while.

Money will go from where the fear is to where the fear is not. It will be leaving the European periphery, and increasingly the entire eurozone, and flooding into currencies like the USD, the Swiss franc, the Swedish krona, and temporarily the British pound. It doesn't matter if the US is downgraded. Market participants will ignore the ratings agencies and vote with their feet on a kneejerk flight to safety.

You might think that the US indicators are much closer to the hyperinflation set-up than to deflation. I would disagree of course, for reasons Ilargi has explained (plummeting velocity of money for instance). I would also point out that people extrapolate the trend of the last three years forward, but fail to anticipate trend changes. We are in one. Many markets have topped already (gold, silver, commodities, oil etc), and the rolling top of the last year or so is about to claim the American stock market as well.

The rollover in the markets will drag the real economy down with it, with a time lag, since the time constant for changes in the real economy is much longer than for the financial world where value is virtual. We are headed into the teeth of the Greatest Depression, or at least the most significant one since the fourteenth century.

Hyperinflation is simply not on the cards any time soon. The depression will proceed for many years before that becomes a serious risk, unless you live in the European periphery that is, where currency reissue is a very real risk in the relatively short term.

In those currencies, loss of faith in New Drachmas, New Pesetas or New Lira is very likely, and the periphery countries will be cut off from international debt financing, with hyperinflationary results. That is not the situation in the US at all, and won't be for quite a long time. Eventually, when international debt financing is dead and buried, then printing will be a risk and a loss of faith in the erstwhile reserve currency could be expected.

In the meantime, debts defaults are going to skyrocket, each one doing its bit to destroy the value of credit instruments, and subtract from the effective money supply. This is already underway, and the great asset grab has begun as a result. Witness the asset stripping of Greece for instance.

In Europe, endless bailouts of sovereigns and the well-connected are doing nothing to increase the money supply or the velocity of money. In contrast, the ineffectuality of governments is doing nothing more than feeding the cycle of fear by demonstrating their impotence time after time. They are trying to overcome contraction, but are fighting an irresistible headwind. It is not going to work. Europe is already in contraction, and as fear will be increasingly in the ascendancy, that will only get worse.

Government obligations will be shed right, left and centre (by governments of the right, left and centre) because they will have no choice. Yes, this will lead to anarchical unrest, and yes, this will be met with a heavy-handed repressive response. Social polarization is very much on the cards – governments vs people, haves vs have-nots, natives vs immigrants, employers vs workers, unionized vs non-unionized, Us vs Them in general terms. This will not be pretty, to say the least. Just because it is a bad thing does not mean that it cannot happen, or that government, by their actions, can make any difference to the outcome.

Bailouts are never for the little guy. The creditors hold the political power and write the rules. They will not allow debtors off the hook. Instead of repayment in money, they will take people's freedom instead, making debt slavery much more real than it is today. Debts will not be forgiven, but sold on to more aggressive debt collectors. This is already happening in the US, where debt collection is becoming increasingly unconscionable.

Debts will only be effectively forgiven when people have nothing useful to repay, not even their labour. By then the middle classes will probably be living in latter day Hoovervilles, like the Villas Miserias populated by the formerly middle class Argentines.

Savers will have all the buying power, IF they have managed to get their savings away from dependence on the solvency of middle men. Otherwise they will likely disappear in a giant black hole of credit destruction, as yet more excess claims to underlying real wealth.


Continue reading »

Jul 272012
 July 27, 2012  Posted by at 10:36 pm Finance Comments Off on Bubbles and the Titanic Betrayal of Public Trust

Robert Shiller, co-creator of the Case-Shiller index for US housing and author of Irrational Exuberance, has an interesting perspective on markets. Unlike the vast majority of economists, he recognizes both the role of speculative fervour in driving prices to over-reach themselves as a bubble develops and the fact that bubbles and their aftermath are swings of positive feedback inherently grounded in ponzi dynamics. As such, his position has considerable overlap with ours at The Automatic Earth:

Markets and the Lemming Factor (2008)

Some trends are persistent enough that they eventually attract a very wide pool of participants, as apparent gains amongst one's peers eventually overcome the caution even of many inherently skeptical people. When they last long enough to overcome the caution of bankers, the result is easy credit to fuel the fire, and a blatant disregard for systemic risk. This is how the largest speculative bandwagons are formed – the ones that become manias and eventually lead to ruin for a large percentage of the population.

Prices are continually pushed up, irrespective of any reasonable objective measure of value, by those who think that it does not matter how much they pay for something if there will always be a Greater Fool who will pay even more. The evidence of pyramid dynamics where insiders and early movers benefit at the expense of later generations destined to become empty-bag holders – should be abundantly clear. The pool of Greater Fools is not limitless.

In our view, major bubbles, of which there are many examples in history, represent a highly contagious collective taking leave of the senses. Over time, as they develop, the largest bubbles come to encompass and to drive much of the way in which a given society functions. The trend that takes hold, and which is destined to over-reach itself, becomes the defining the zeitgeist of an era, before reversing sharply with devastating effect.

The best known examples can be clearly seen in financial charts that allow the progression of the phenomenon to be quantified. This is possible when the infectious idea manifests as a parabolic increase, and subsequent implosion, in value of something that has become a focus of speculation.


However, speculative bubbles that manifest financially, and therefore lend themselves to quantification, represent only a subset of socioeconomic or sociopolitical swings that can spread exponentially within societies and come to define certain periods of their history. This broader category of transformative social movements that come to capture the collective imagination, and often later deliver the reigns of power into the hands of extremists, is also subject to over-reach and reversal.

The fundamental point is that Ponzi dynamics do not have to be quantifiable for their essential nature to drive cycles of expansion and retrenchment. Mr Shiller recognizes this point, and recently wrote a piece comparing what he calls "social epidemics" that occur within the context of market economies with those that do not.

Bubbles Without Markets

A speculative bubble is a social epidemic whose contagion is mediated by price movements. News of price increase enriches the early investors, creating word-of-mouth stories about their successes, which stir envy and interest. The excitement then lures more and more people into the market, which causes prices to increase further, attracting yet more people and fuelling “new era” stories, and so on, in successive feedback loops as the bubble grows. After the bubble bursts, the same contagion fuels a precipitous collapse, as falling prices cause more and more people to exit the market, and to magnify negative stories about the economy.

But, before we conclude that we should now, after the crisis, pursue policies to rein in the markets, we need to consider the alternative. In fact, speculative bubbles are just one example of social epidemics, which can be even worse in the absence of financial markets. In a speculative bubble, the contagion is amplified by people’s reaction to price movements, but social epidemics do not need markets or prices to get public attention and spread quickly.

Some examples of social epidemics unsupported by any speculative markets can be found in Charles MacKay’s 1841 best seller Memoirs of Extraordinary Popular Delusions and the Madness of Crowds. The book made some historical bubbles famous: the Mississippi bubble 1719-20, the South Sea Company Bubble 1711-20, and the tulip mania of the 1630’s. But the book contained other, non-market, examples as well.

MacKay gave examples, over the centuries, of social epidemics involving belief in alchemists, prophets of Judgment Day, fortune tellers, astrologers, physicians employing magnets, witch hunters, and crusaders. Some of these epidemics had profound economic consequences.

Mr Shiller asserts that, in the absence of quantitative feedback mechanisms, "social epidemics" can carry further into over-reach and therefore lead to worse consequences when the trend reverses.

There was no way, of course, for anyone either to invest in or to bet against the success of any of the activities promoted by the social epidemics – no professional opinion or outlet for analysts’ reports on these activities. So there was nothing to stop these social epidemics from attaining ridiculous proportions …

… China’s Great Leap Forward in 1958-61 was a market-less investment bubble. The plan involved both agricultural collectivization and aggressive promotion of industry. There were no market prices, no published profit-and-loss statements, and no independent analyses. At first, there was a lot of uninformed enthusiasm for the new plan. Steel production was promoted by primitive backyard furnaces that industry analysts would consider laughable, but people who understood that had no influence in China then. Of course, there was no way to short the Great Leap Forward. The result was that agricultural labor and resources were rapidly diverted to industry, resulting in a famine that killed tens of millions.

The Great Leap Forward had aspects of a Ponzi scheme, an investment fraud which attempts to draw in successive rounds of investors through word-of-mouth tales of outsize returns. Ponzi schemes have managed to produce great profits for their promoters, at least for a while, by encouraging a social contagion of enthusiasm.

Mao Zedong, on visiting and talking to experts at a modern steel plant in Manchuria, is reported to have lost confidence that the backyard furnaces were a good idea after all, but feared the effects of a loss of momentum. He appears to have been worried, like the manager of a Ponzi scheme, that any hint of doubt could cause the whole movement to crash. The Great Leap Forward, and the Cultural Revolution that followed it, was a calculated effort to create a social contagion of ideas.

There are many similar historical examples. While they are often known as periods of top down control, this is misleading, as Mr Shiller points out in relation to the Maoist example.

Some might object that these events were not really social epidemics like speculative bubbles, because a totalitarian government ordered them, and the resulting deaths reflect government mismanagement more than investment error. Still, they do have aspects of bubbles: collectivization was indeed a plan for prosperity with a contagion of popular excitement, however misguided it looks in retrospect.

Societal transformation is much more comprehensive when galvanizing change catches on from the bottom up, delivering an effective mandate for consolidating power around an idea into the hands of whomever can give a mass movement a focus that fits the collective mood. The personality cult of Mao Zedong was a very clear example of an idea that gripped, and temporally consumed, the social fabric of a nation (for a superb description of the era and its underpinnings in social mood contagion see Wild Swans: Three Daughters of China by Jung Chang).

Witness, for an additional historical example, the Stakhanovite movement in the early days of the former Soviet Union (1935), which celebrated heroic (and mythical) achievements in worker productivity. This initiative spread across many industries and initially inspired greater (and greater) effort over longer (and longer) working hours, leading to substantial productivity improvements 'for the glory of the socialist workers' paradise' that people felt they were engaged in building.

Unfortunately, bottom-up idealism did not deliver any such thing. Instead, people's commitment was used to set ever higher quotas that everyone was then expected to live up to, codifying these at a societal level in national five year plans. Effort initially freely given was later institutionalized as formal expectation to which bonuses and penalties were attached.

Given that the foundational claims of superhuman productivity were almost certainly fictitious, and that subsequent 'achievements' became more exaggerated over time, the burden on ordinary people increased substantially. Unachievable goals combined with strong incentives led to major divisions and resentment within the workplace, particularly between workers and managers.

This destabilization of relationships in the factory environment facilitated a divide and rule approach from the top down that played a role in the consolidation of central power under Stalin. As with Mao's China, an economic initiative for expanding prosperity based on a popular movement backfired as empowerment morphed into disempowerment, and very unpleasant consequences followed.

Greater emphasis on interpreting the historical record in terms of cycles, whether or not they can be quantified in market terms, makes greater sense of the rise and fall of imperial structures as well as the smaller scale cycles within cycles that these examples represent. Ponzi dynamics are the underlying commonality at all degrees of trend for a fractal system based on swings of positive feedback in both directions:

From the Top of the Great Pyramid (2008)

At the largest scale, empires are also grounded in pyramid dynamics, which is why they too have a limited lifespan. They grow by assuming control, either politically or economically, of new territories, positioning themselves to cream off surpluses from an ever-expanding geographical area in a form of involuntary buy-in …

… Wealth conveyors in favour of the economic centre, at the expense of the hinterland, are the very heart of empire, but without continual expansion to feed rapidly developing central complexity, they eventually fail, leaving the centre unable to sustain its existing complexity level. As with economic bubbles, empires hollow out in the latter stages, consuming their own substance in a catabolic manner in order to compensate for the inability to strengthen wealth conveyors sufficiently quickly to keep pace with the expanding requirements of the centre.

Where The Automatic Earth parts company with the views of Mr Shiller is in his opinion of the prospects for the bursting of our current bubble. He believes that systems which do appear to be quantifiable through market mechanisms contain sufficient control mechanisms to limit the downside:

Bubbles Without Markets (cont’d)

Modern economies have free markets, along with business analysts with their recommendations, ratings agencies with their classifications of securities, and accountants with their balance sheets and income statements. And then, too, there are auditors, lawyers and regulators.

All of these groups have their respective professional associations, which hold regular meetings and establish certification standards that keep the information up-to-date and the practitioners ethical in their work. The full development of these institutions renders really serious economic catastrophes – the kind that dwarf the 2008 crisis – virtually impossible.

From our perspective this view seems incredibly naive, especially coming from someone who sees bubbles as Ponzi schemes and should therefore understand the implications. It appears that Mr Shiller lacks an appreciation of just how large a bubble we have actually blown in the era of globalization, not to mention an understanding of just how badly the putative control mechanisms have devolved into pervasive blindness and corruption. We need only look at the extremely permissive financial regulatory framework – a result of comprehensive regulatory capture – to see where the power lies in the financial world. Most of betrayals of public trust we have seen in recent years are legal.

In our era of catabolic casino capitalism, the financial system has been hollowed out. Huge risks have been taken with other people's money for short term private profit. Reserve requirements have been whittled away to almost nothing in an attempt to maintain monetary expansion, and now there is virtually no cushion against financial crisis. The lack of capital adequacy requirements in the derivatives market has left a large construct of virtual value with toxic levels of counterparty risk, and a built-in meltdown mechanism thanks to perverse incentives to burn things down for profit.

It has been legal in places to rehypothecate collateral infinitely, meaning it is permissible to employ a small amount of collateral to underpin a vast quantity of loans, again leaving no margin for error. We have seen complex financial instruments mis-sold to municipalities all over the world, and 'assets' sold to customers then shorted by the financial institutions that sold them.

We have seen loans made to people, companies and governments that could not possibly repay them, because the sellers were able to collect their fees upfront, while selling the huge risk on to investors through securitization. Due diligence was virtually non-existent for many years, while systemic risk grew unchecked. In the USA, the mortgage securitization process broke the chain of title for property, and the banking system attempted to cover this up through fraudulent reconstruction of paperwork after the fact. Naked shorting has been used to create artificial selling pressure.

The benchmark LIBOR rate has been fiddled since its inception, creating enormous private profits at public expense. As crisis has developed as a result of these, and many other, abuses, the response has been austerity for the masses while the insiders, who should have know better, have been able to walk away from the consequences of their recklessness. The public sector is being asset-stripped as the great collateral grab gets underway.

The formal 'control' mechanisms have done nothing of substance to reign in the development of a global Ponzi structure, in fact they have more often acted to facilitate it. In reality they do little beyond lulling us into a false sense of security. The existence of an institutional framework is no guarantee of effective function. The substance is long gone, and what we are left with is a shell. The appearance of a large, robust structure is an illusion, and the risk we are facing is one of implosion. This is how all bubbles come to an end.

By way of analogy, not only has the Titanic already hit the iceberg, but most of the regulatory response constitutes rearranging the deckchairs. Most of society is still obliviously listening to the band, while the few are busy locking the third class passengers below decks. There are not enough lifeboats …..

Image top: M.C. Escher Hand with Reflecting Sphere 1935


Jul 182012
 July 18, 2012  Posted by at 2:18 pm Finance Comments Off on Jeff Rubin and Oil Prices Revisited

Harris & Ewing Hot Air 1938
"Goodyear Blimp at Washington Air Post, Washington, D.C."

Jeff Rubin, former chief economist with Canadian bank CIBC, is very well known for his predictions of exponentially increasing oil prices (see for instance this 2009 lecture). Mr Rubin’s position was that prices would continue their rise due to a confluence of circumstances – that conventional supplies have peaked, that unconventional sources are expensive to produce and that demand would continue to grow with the energy requirement inherent in expanding global trade.

According to Mr Rubin, the assumption that transport costs would remain marginal led to the 2008 oil price spike, causing a global recession. In his opinion, high oil prices, not the sub-prime mortgage crisis, were the primary driver of financial crisis. This opinion is shared by many commentators. The simplistic approach of prediction by trend extrapolation is similarly common. In contrast, anticipation of trend changes is rare.

Mr Rubin’s price prediction was for oil first to pass $100/barrel and then reach $225/barrel by 2012, with continued growth and general price rises in an era of resource scarcity.

This was restated at the ASPO conference in November 2010, where Mr Rubin and I (both plenary speakers) ended up on opposite sides of the argument as to the prospects for growth, the trajectory for oil prices, the dynamics of the causative relationship between energy and finance, the nature of speculative bubbles, the importance of credit and debt, the probability of a major liquidity crunch, the basis for market prices, the applicability of positive versus negative feedback loops, whether or not equilibrium exists in economics, and almost every other important aspect of the way the world works.

We were, however, in agreement that resources are finite and that this will have very significant consequences in the future.

The position I espoused at the conference was that the oil price recovery from 2008/09 was close to peaking, and that, rather than the huge price spike Mr Rubin was predicting, we would see oil prices fall substantially over the next few years, as a result of financial crisis. The bursting of a thirty year financial bubble would be the primary driver of changes in the real economy, including the energy sector.

My explanation of the 2008 price spike and collapse, and also the manner in which next few years will play out, was (and continues to be) based on the context of the largest speculative bubble in human history. This has been a period of enormous inflation – a drastic increase in the supply of money and credit relative to available goods and services. Specifically we have seen a huge credit expansion, and, in the process, have accumulated a massive amount of debt on a global scale.

As we have explained many times at TAE before, credit hyper-expansions create excess claims to underlying real wealth through ever-increasing leverage. The additional purchasing power leads to the bidding up of assets prices, and, over time, to the expectation that prices can only continue to appreciate. The real economy becomes subsumed into a speculative mania.

Such periods have always resolved themselves with the extinguishing of these excess claims (deleveraging), which, being a contraction in the supply of money and credit relative to available goods and services, is deflation by definition. Investors wake up to the fact that asset price appreciation is over and that there is nowhere near enough collateral to back all the outstanding debt. The great grab for over-subscribed collateral begins. The resulting free-for-all picks up momentum as it proceeds and does not play out as a slow squeeze. The effective money supply collapses, and the impact of this is compounded by a very large fall in the velocity of money, leading into an economic seizure, or period of Great Depression. Prices follow the money supply to the downside, as speculation goes into reverse.

Naturally, such a period would be characterized by very weak demand for a long period of time. Economic activity would be greatly reduced, and a lack of purchasing power, thanks to monetary collapse, would leave money, not energy, as the limiting factor, probably for several years. While energy is the primary driver of expansion, finance is the primary driver of contraction, as the time constant for changes in finance is simply much shorter than for changes in supply or demand in the real economy. Finance is the operating system. When that crashes, resource availability becomes temporarily secondary.

One only has to look at the Great Depression of the 1930s to see the effect of a bursting credit bubble, even in the midst of plentiful resources. As the people who lived through it at the time said, they had plenty of everything except money. Our bubble will follow the same pattern, but as it is very much larger than the bubble of the Roaring Twenties, we can also expect the aftermath to be much larger. Resource limitations will bite in the end of course, but financial crisis extends the timeframe (at the price of making it worse later by sucking investment out of the sector for years, thereby setting us up for a later supply crunch).

Into 2008, increasing liquidity had been driving up asset prices across the board. A combination of liquidity and the perception of imminent scarcity led commodity prices to be bid up greatly in excess of what the fundamentals would justify at the time. The story of oil in 2008 is one of exaggerated boom leading to exaggerated bust as liquidity was rapidly evaporating, and the perception of scarcity became a perception of relative glut. The price collapse on speculative reversal (78% in five months) had very little to do with actual supply and demand, neither of which change so quickly. Financial crisis was clearly in the driving seat. At TAE we pointed out, as oil was reaching for the sky in early 2008, that the price would peak and then crash. Anticipating trend changes is a large part of what we do.

The resurgence of confidence, and therefore liquidity, from 2009 led to the beginning of the second price cycle of boom and bust. I was arguing in my 2010 ASPO talk, that oil would not regain the 2008 peak, but that price would once again overshoot the fundamentals on a perception of scarcity, and we would thereafter see prices fall again, probably to below the 2008/09 bottom – in other words to a level at or below that of the lowest price producer.

When Mr Rubin was asked his opinion of my ASPO lecture at our shared podium, his response was to call my boom and bust model “a bastardized form of monetarism that could only have been derived by a non-economist”. The audience was encouraged to laugh at the concept. I was not given an opportunity to respond at the conference, so I posted my thoughts at TAE and expressed them to Jim Puplava at Financial Sense Newshour. I posed a rhetorical question to Jim, asking if, given the generally dismal predictive abilities of economists, non-economists could possibly do any worse.

If we fast-forward to 2012, we find ourselves in the thick of a sovereign debt crisis in Europe, substantial deleveraging, spreading financial contagion, ineffective bailouts, widening credit spreads, tightening credit availability, deepening financial scandal and falling oil prices. It is absolutely clear that finance is in the driving seat once again.

Rubin acknowledges that his price forecast has not been realized, but he continues to argue, as he did in 2008, that high oil prices are causing the financial crisis.

Whatever happened to $200 oil?

If a mea culpa is in order, its roots can be found in the decision to underplay the demand side of the equation. Oil prices plunged to $40 a barrel after economic growth collapsed, taking global oil demand along for the ride. And that same movie is about to play out again. Recessions are already rolling across Europe. Economic growth in North America is lackluster, at best. Meanwhile, the spectre of sovereign debt defaults in the euro zone continues to hang over global financial markets. Added up, it spells another sharp drop for oil prices not because fuel is abundant, but because once again the world can’t afford to stay out of a recession. What happened to my forecast for $200 oil? Quite simply, the end of growth.

The inexorable build up to financial crisis has been measured in decades, with a smooth exponential rise in the money supply (i.e. inflationary credit expansion) in the post WWII period, while oil prices have been all over the map in that time. Did oil cause Europe to introduce a single currency with a highly flawed architecture for instance? Or cause a long period of negative real interest rates to bait a debt trap (leading, among other things, to huge housing bubbles)? Or allow banking to be deregulated so it could become too big to fail? I think not, at least not directly.

Energy is not the sole driver of events, at least not in the highly simplistic manner Mr Rubin suggests. Energy and human systems interact in far more complex and non-linear ways. Time constants for different kinds of change vary. Sometimes one factor is the key driver and sometimes it is another. The role of finance as a driver clearly cannot be ignored. Operating systems can take on a life of their own, in the sense that their own internal dynamics become a major factor in their own right.

Underplaying the demand side of the equation was indeed an error, but not in the sense that Mr Rubin mentions. The change in demand in 2008 was nowhere near large enough or rapid enough to trigger the price collapse at that time.

The crisis was entirely predictable to those who understand ponzi dynamics, however. Major bubbles act to bring demand forward during the expansion phase, at the expense of crashing it thereafter. In the last three decades of catabolic ponzi growth, we have probably burned our way through a century of demand. Leverage allowed us to borrow from the future, but deleveraging is now going to crash demand and asset prices.

In the case of oil, the effects of phase II of the financial crisis, and the coming demand crash, on oil prices will be exacerbated by a major shift in the perception of supply – from scarcity to glut, as a result of the unconventional oil fantasy. We covered this additional aspect in detail here at TAE not long ago in Unconventional Oil is NOT a Game Changer and in Peak Oil: A Dialogue With George Monbiot.

As we pointed out, unconventional fossil fuels and other low EROEI energy sources are caught in a paradox – they are unable to sustain a society complex enough to produce them. The additional supply will be minor and temporary, but the perception that we are suddenly swimming in oil will act to undermine oil prices further, to the point where such sources rapidly become uneconomic, which is exactly what we have already seen in natural gas.

Mr Rubin’s $225 price prediction for 2012 will be looking far more off-base in the relatively near future than it does today. If we do see that kind of price in the future, it will have to wait for the peak of the third boom and bust cycle, which likely will not even begin for several years (once massive deleveraging has run its course).

Mr Rubin’s view of the future remains at highly odds with our view here at TAE, although he has in some ways moved closer to our position. His view of energy driving finance suggests that once oil prices have fallen far enough, the economy will recover, until demand pushes up price once again and the cycle repeats. We, on the other hand, see no prospect of demand recovering for years, despite what should turn out to be historically low oil prices in nominal terms. Financial crisis is the driver, and will continue to be so for a long time.

Jeff Rubin has recently written a second book, in which he maintains that a lack of economic growth will be good for the environment, and that it will lead to a stable non-growing economy. To put it mildly, this is not our view at TAE. There is no such thing as a stable, non-growing society.

Stasis simply does not exist. It is not a mere lack of growth we are facing, but a very strong and prolonged period of economic contraction, as the demand borrowed from the future during the expansion years must be repaid. To say that this would be good for society or the environment is a bit of a stretch. True, we will emit less CO2, but financial crisis invites and entrenches escalating conflict, which is exceptionally hard on both the environment and society. Mr Rubin still appears to have little idea what we are truly facing in the coming years.

I find myself inclined to agree with the late 2010 assessment of Mr Rubin by Dan Gardner for the Ottawa Citizen:

Jeff Rubin is a guru you shouldn’t listen to

Jeff Rubin is an almost eerily perfect example of the sort of expert people should not listen to — but do anyway.

The foundation of Rubin’s fame is a correct call he made a decade ago. At the time, oil prices were low and stable. Most experts were sure they would stay that way. But Rubin became convinced the world was approaching “peak oil” — the point at which oil production would cease to grow and the price of oil would soar.

As Rubin predicted, oil prices started to climb in 2003. Up and up they went, to previously unimaginable highs. In the first half of 2008, oil topped $140 a barrel. Rubin and the few others who called the surge became media darlings.

… In November 2008, Rubin told a reporter that high oil prices killed the economy. Of course, this was well after the crash of the financial system, the global economy and the price of oil. I can find no record of him saying this beforehand.

The story he has told since then about oil prices yo-yoing the economy is — whether correct or not — an explanation he came up with only after the fact.

Not that any of this has humbled Rubin. Throughout 2009 and 2010, he forecast the return of triple-digit oil prices. It didn’t happen. But these flops, too, made no difference to Rubin’s confidence. He is as sure of himself as ever. And just as persuasive. How could he not be? He is supremely confident. He has a simple analytical story. And he is a superb communicator, in print and in person.

This is the stuff that satisfies the psychology of the audience. It is the stuff of which gurus are made.

Unfortunately, seminal research by University of California psychologist Philip Tetlock shows it is precisely this sort of expert whose predictions are most likely to fail.

Caveat emptor.


Jul 082012
 July 8, 2012  Posted by at 8:22 pm Energy Comments Off on Peak Oil: A Dialogue with George Monbiot

George Monbiot recently made a major about-face on his peak oil stance, on the grounds that unconventional oil represents a new reality. The basis of his u-turn is a recent report on unconventional oil by Leonardo Maugeri, (former) oil executive at Italy's Eni, published at Harvard University, where Maugeri's a Senior Fellow at the John Kennedy School, Belfer Center, which we discussed here at TAE in Unconventional Oil is NOT a Game Changer.

George Monbiot:

We were wrong on peak oil. There's enough to fry us all

Peak oil hasn't happened, and it's unlikely to happen for a very long time.

A report by the oil executive Leonardo Maugeri, published by Harvard University, provides compelling evidence that a new oil boom has begun. The constraints on oil supply over the past 10 years appear to have had more to do with money than geology. The low prices before 2003 had discouraged investors from developing difficult fields. The high prices of the past few years have changed that.

Maugeri's analysis of projects in 23 countries suggests that global oil supplies are likely to rise by a net 17m barrels per day (to 110m) by 2020. This, he says, is "the largest potential addition to the world's oil supply capacity since the 1980s". The investments required to make this boom happen depend on a long-term price of $70 a barrel – the current cost of Brent crude is $95. Money is now flooding into new oil: a trillion dollars has been spent in the past two years; a record $600bn is lined up for 2012.

I sent George a short response to his article, by way of opening a dialogue:

What we are facing is a demand and price collapse that will render unconventional supplies uneconomic. Natural gas is leading the way over the next few years. The high cost and low EROEI are fatal flaws.

And received this reply:

If there's a collapse in demand, peak oil is not an issue, right? If there's a resurgence of demand, unconventionals become economic again. As for EROEI being a constraint, try telling that to the tar sands producers in Alberta.

With best wishes,


The debate continues. Here is my next installment:


A demand collapse will certainly put peak oil on the backburner for a number of years. The next few years will be remembered for financial crisis as we move into what will be at least as bad as the Great Depression (and very likely worse, since the bubble was much larger this time). Peak oil will not have gone away, however.

We have used the cheap and accessible oil (and other fossil fuels) and what remains will be exceptionally, and increasingly, expensive in both financial and energy terms. Predictable consequences will follow from this, but in a complex interaction with many other factors, notably the context of the huge credit bubble bursting. This amounts to crashing the operating system. For a while, resource constraints will be relieved due to economic seizure (i.e. the collapse of both the money supply and the velocity of money).

During the period of financial crisis, deflation and deleveraging, weak demand will buy us some time, but at the cost of setting us up for a supply crunch later. The period of sharply falling prices will kill investment in the energy sector, because the cost of production will fall less quickly than prices, meaning margins will be squeezed. Both physical and financial risks will be much higher. A lack of economic visibility will be anathema to what are inherently long term projects.

In addition, trade collapses during periods of economic depression, as for instance letters of credit become impossible to obtain, and the lack of funds for maintenance compromises the integrity of distribution infrastructure. Infrastructure may also be deliberately targeted during the inevitable upheaval. All of these factors act to reduce supply, and would be difficult, or impossible, to reverse quickly if demand were to rise.

When supply and demand become tight, what transpires is not a simple price spike, but an exaggerated boom and bust dynamic. This has been underway since 2005/06. The first full cycle unfolded from 2005/06 to 2008. The second began in 2008/09 and will probably end with a price bottom relatively early in this depression with a resurgence of military demand, given that oil is liquid hegemonic power.

That should feed into the third cycle, which should send prices sharply higher in real terms, if not to a new high in nominal terms. This price volatility, against a backdrop of severe economic contraction, upheaval and fear is leading towards a profound societal change, most likely a significant period of involuntary loss of socioeconomic complexity.

You mention the tar sands, and they are indeed an interesting case – an arbitrage between cheap natural gas and expensive syncrude that can continue while the price disparity is maintained. They are able to make money, even though they are not producing much net energy. Unfortunately for the tar sands producers, the price disparity is set to reverse.

The hype surrounding shale gas has crashed the price to the point where it is on the verge of putting producers out of business. Natural gas in North America appears to have bottomed, while the perception of glut in unconventional oil, combined with weak demand and a lack of appropriate infrastructure for internal North American sources, is set to undermine oil prices considerably.

Tar sands projects will be under acute threat under those circumstances – not imminently, but over the next five years or so. Once one cannot make money from some combination of artificial input/output price disparity, public subsidy and the ability to socialize externalities, then EROEI becomes the defining factor, and the EROEI for tar sands is pathetic.

While I agree that oil men do not base decisions on EROEI, ultimately EROEI will determine their ability to make money, and that is their driving motivation. Finance can only temporarily allow people to ignore thermodynamics.

EROEI effectively determines what is and is not an energy source for a given society (ie to maintain a given level of socioeconomic complexity). Unconventional fossil fuels are caught in a paradox – that their EROEI is too low for them to sustain a society complex enough to produced them.

They can only be produced for the relatively short period of time that the complex society built on conventional sources continues to maintain its current capacities, but as the conventional sources disappear, and that society can no longer support itself, the ability to undertake all the activities required for unconventional production will be lost. The hype has no foundation.

We have been living in a major departure from reality in many ways, as always occurs during bubble times, but those times are coming to an end. Instead of overshoot, we are headed for undershoot, and we are not going to like it.

Note the critical paradox of unconventional supplies. That is where the cornucopian view of energy, where Monbiot now seems to have landed, breaks down.

The same argument applies to renewable power as it is currently practiced. Without affordable conventional fossil fuels, the increasingly complex alternatives cannot be developed and exploited.

We find ourselves in a world of receding horizons.

Unconventional supplies are always priced at conventional energy plus a premium, thanks to their crucial dependency on conventional supplies.

What high Energy Return On Energy Investment makes possible, low EROEI will eventually take away, following a brief boom that constitutes the last gasp of our modern energy bubble era.

Image: Raúl Ilargi Meijer: Data source: David Murphy



Jul 032012
 July 3, 2012  Posted by at 2:17 pm Energy Comments Off on Unconventional Oil is NOT a Game Changer


National Photo Co. Fossil Fuel 1920
Washington, D.C. "Penn Oil and truck."

Oil prices have been falling.


This is no surprise to us here at The Automatic Earth, as our position is that the 2008 price peak will stand for a very long time, and that the rise from the 2009 low has been a counter-trend rally. Prices of many assets have been moving with the ebb and flow of confidence, and therefore of liquidity, in this era of extreme financialization, and commodities are no exception.

As we have pointed out many times, prices do not reflect the fundamentals of supply and demand in any particular industry. If they did so, equities and different commodities would not move in relative sychrony, yet they have often done so.


Instead, prices reflect a combination of general confidence (or lack thereof) and the perception of future scarcity or glut, whether or not that perception is, in fact, accurate. Commodities top on fear of shortages. When there is a perception of scarcity, speculators bid up the price in advance of what the fundamentals would justify at that time, as they did in the run up to the 2008 price peak.

When the speculative bubble bursts, the sector is dumped and the price collapses as speculation goes into reverse. In 2008, commodities in general fell 58%, and oil prices plunged 78% in five months as the financial crisis sucked liquidity out of the system and the perception of imminent scarcity disappeared.


With the temporary resurgence of confidence from the 2009 bottom, liquidity returned, and, increasingly, so did the perception of scarcity for commodities in general and for oil specifically. Prices were bid up again, although not to the previous high, even though analysts extrapolating the trend forward were calling for a much larger commodity price spike than 2008.


Commodity prices in general peaked in May 2011 and continue their retreat.


Confidence is ebbing as the scope of the financial crisis centred in Europe becomes increasingly evident, and vulnerabilities in other regions and sectors of the economy emerge. Even the Chinese juggernaut (the primary driver of commodity demand) is visibly faltering.

Retreating liquidity and persistent economic weakness act to undermine comodity prices further. This process is far closer to its beginning than its end. As the global credit bubble of the last thirty years implodes, we will be heading right in to the teeth of liquidity crunch, economic seizure and another deflationary Great Depression. Under such circumstances, we can expect demand to be weak for many years, and with falling demand will come falling price support.

At the same time, in the case of oil, we are seeing a sharp reversal of perception – from one of scarcity to one of glut – as pundits discuss how technological innovations, including horizontal drilling and hydraulic fracturing, will increase global supply dramatically. De-conventionalization of oil supply is touted as the solution to peak oil for the foreseeable future.

Euphoria particularly surrounds the projections for US production, with talk of the country becoming both energy independent and an exporting powerhouse – a New Middle East.

Leonardo Maugeri:

Oil: The Next Revolution – the Unprecedented Upsurge of Oil Production Capacity and What it Means for the World

Thanks to the technological revolution brought about by the combined use of horizontal drilling and hydraulic fracturing, the U.S. is now exploiting its huge and virtually untouched shale and tight oil fields, whose production although still in its infancy is already skyrocketing in North Dakota and Texas.

The U.S. shale/tight oil could be a paradigm-shifter for the oil world, because it could alter its features by allowing not only for the development of the worlds still virgin shale/tight oil formations, but also for recovering more oil from conventional, established oilfields whose average recovery rate is currently no higher than 35 percent.

The natural endowment of the initial American shale play, Bakken/Three Forks (a tight oil formation) in North Dakota and Montana, could become a big Persian Gulf producing country within the United States. But the country has more than twenty big shale oil formations, especially the Eagle Ford Shale, where the recent boom is revealing a hydrocarbon endowment comparable to that of the Bakken Shale. Most of U.S. shale and tight oil are profitable at a price of oil (WTI) ranging from $50 to $65 per barrel, thus making them sufficiently resilient to a significant downturn of oil prices.


World oil production capacity to 2020 (Crude oil and NGLs, excluding biofuels)
From: Maugeri, Leonardo. “Oil: The Next Revolution” Discussion Paper 2012-10, Belfer Center for Science and International Affairs, Harvard Kennedy School, June 2012.

The difficulty is that an analogous scenario has unfolded before, in the natural gas industry. Out of sync with other commodities, the boom and bust in natural gas is giving us a glimpse of the future for unconventional oil. The extraction techniques are the same ones that have generated tremendous hype, while simultaneously setting up a ponzi scheme in flipping land leases, creating the perception of supply glut, crashing the price of natural gas in North America to far below break-even, amplifying financial risk for increasingly indebted producers, and threatening to put those same producers out of business.

This is the dynamic that is set to lead North America into a natural gas supply crunch over the next few years, as we discussed recently in Shale Gas Reality Begins to Dawn.Those involved in unconventional oil would do well to take note.

The drilling costs are high, as are the decline rates ("While some have been able to yield as much as 1,000 barrels a day, the rate then falls off to 65 percent the first year, 35 percent the second, and 15 percent the third"), and the EROEI is very low in comparison with conventional oil. As with unconventional gas, which suffers from the same obstacles, the industry is set on an accelerating drilling treadmill in an attempt to grow equity by expanding the reserve base with the cash flow generated.

Continued expansion is necessary to maintain the perception of company value. In other words, the industry is based on ponzi dynamics. So long as prices hold up, we can expect it to continue, but if we look at the broader economic context in conjunction with the lessons derived from unconventional gas, there is every reason to expect that the production boom is temporary, precisely because these circumstances will generate a price collapse.

Estimates of the price required for the new supplies to be economic vary. The consensus appears to be that there is a sufficient price cushion to withstand a fall, but producers are not anticipating a major one. Unfortunately for them, we can expect the perception of glut, combined with deepening economic depression, to force prices down to the cost of the lowest price producer, and quite possibly lower, at least temporarily. Companies on the unforgiving drilling treadmill will be facing increasing financial risk, and over the next few years, as over-extended and over-indebted companies go out of business, we can expect a supply crunch to develop.

The timescale is difficult to predict, as there are many factors with different timeframes to consider. Large scale deleveraging, which is set to unfold over the next few years, will have a tremendous impact on project capital availability, on demand, and on the affordability of operating and maintaining existing infrastructure. It will also be very difficult to build out new oil transport infrastructure to cope with changing energy supply patterns. The infrastructure mismatch will put continued downward price pressure on North American oil in comparison with international supplies, reducing the fungibility of oil.

Marin Katusa:

Oil Price Differentials: Caught Between Sands And Pipelines

North America has a long history of oil production and processing. Decades of producing oil and consuming lots of petroleum products have left the continent with a pretty good system of pipelines and refineries but pipelines are annoyingly stagnant things that tend to stay where you build them. And it turns out that the pipelines of yesterday are in the wrong places to serve the oil fields and refineries of today.

America's oil infrastructure was built around two inputs some domestic production and large volumes of imports. You see, while the Middle East may be the biggest producer of crude oil in the world, most of the refining occurs in the United States, Europe, and Asia. There are two reasons for this. The first is that it's easier to ship massive volumes of one product (crude oil) than smaller volumes of multiple products (gasoline, diesel, jet fuel, and so on). The second reason is that refineries are generally built within the regions they serve, so that each facility can be tailored to produce the right kinds and amounts of petroleum products for its customers…

…Remember how the US's oil pipelines were designed primarily to move refined products from the Gulf region and the coastal refineries to inland customers? Well, those pipelines of yesterday now run the wrong way.

The production boom in shale oil has momentum, and that is likely to carry on for some time, even in the face of sharply falling prices, as has been the case for natural gas. The rig count in shale oil production is skyrocketing, even as the rig count for natural gas falls, and production lags rig count.

The quantity of recoverable oil has been considerably hyped, and this resource is not going to represent a game-changer. In fact it would not even if we were not facing economic circumstances set to crash production.

Robert Rapier:

Does the U.S. Really Have More Oil than Saudi Arabia?

The estimated amount of oil in place (the resource) varies widely, with some suggesting that there could be 400 billion barrels of oil in the Bakken. Because of advances in fracking technology, some of the resource has now been classified as reserves (the amount that can be technically and economically produced). However, the reserve is a very low fraction of the resource at 2 to 4 billion barrels (although some industry estimates put the recoverable amount as high as 20 billion barrels or so). For reference, the U.S. consumes a billion barrels of oil in about 52 days, and the world consumes a billion barrels in about 11 days.

In addition, the enormous number of expensive wells required would takes decades to drill with the rigs available, even if considerable efforts were made to increase their number, meaning that the oil that is there would be produced very slowly.

Beyond the shale oil of the Bakken in North Dakota or the Eagle Ford in Texas, there are other forms of unconventional oil that form part of the North American production boom hype.

Robert Rapier again:

When some people speak of hundreds of billions or trillions of barrels of U.S. oil, they are most likely talking about the oil shale in the Green River Formation in Colorado, Utah, and Wyoming. Since the shale in North Dakota and Texas is producing oil, some have assumed that the Green River Formation and its roughly 2 trillion barrels of oil resources will be developed next because they think it is a similar type of resource. But it is not.

The prospects for some of these are significantly worse than for shale oil, especially where the EROEI is even lower. Colorados oil shale in particular is unlikely ever to amount to much. While shale oil is a liquid hydrocarbon trapped in low permeability source rock, which can be liberated through fracking, oil shale is not a liquid at all, but solid kerogen that requires tremendous energy inputs to be separated from the source rock. Those required energy inputs mean a rock-bottom EROEI. Costs in monetary terms are sky-high as well.

Elliott Gue:

The Difference Between Oil Shale and Shale Oil

To generate liquid oil synthetically from oil shale, the kerogen-rich rock is heated to as high as 950 degrees Fahrenheit (500 degrees Celsius) in the absence of oxygen, a process known as retorting.

There are several competing technologies for producing oil shale. Exxon Mobil has developed a process for creating underground fractures in oil shale, filling these cracks with a material that conducts electricity, and then passing currents through the shale to gradually convert the kerogen into producible oil. Royal Dutch Shell Plc buries electric heaters underground to heat the oil shale.

Although estimates of the cost to produce oil shale vary widely, the process is more expensive and energy-intensive than extracting crude from Canada's oil sands. Producers would require oil prices of roughly $100 a barrel before this capital-intensive process would be feasible on a commercial scale.

Shale oil may have an EROEI of approximately 4, while tar sands would come in at 3 and oil shale would be 2 or less.


Cutler J. Cleveland and Peter O’Connor – A comparison of estimates of the energy return on investment (EROI) at the wellhead for conventional crude oil, or for crude product prior to refining for oil shale

Humans are prone to grasp at straws and believe in fantasies rather than face unpleasant realities. Believing that unconventional fossil fuels can maintain business as usual is a fantasy. We cannot run our current complex society on low EROEI energy sources.

We are still facing peak oil, and, on the downslope of Hubberts Curve, we will be running faster and faster on our accelerating treadmill just to slow the decline in supply. Unconventional supplies with lower and lower EROEI are not going to change that picture, and the crash of prices that will happen thanks to economic depression will aggravate the situation considerably in the short term. We can expect prices to fall faster than the cost of production, and many corporate casualties to emerge as boom turns to bust, as it always does.

The next few years will be remembered for financial crisis, where it will be money in short supply rather than energy. As economic contraction proceeds, and purchasing power falls substantially due to the collapse of the money supply, demand for energy will – temporarily – fall a long way. Beyond that, as the deleverging comes to an end and the economy begins to stabilize somewhat (probably between five and ten years down the line), we are likely to see a supply crunch develop.

With that we are likely to see a major price spike, and the potential for resource wars will grow dramatically. Oil is liquid hegemonic power, and conflict can be expected to develop when it is perceived to be scarce. Thats not where we find ourselves today, but it is where the future is taking us.


Jun 242012
 June 24, 2012  Posted by at 1:30 pm Finance Comments Off on Shale Gas Reality Begins to Dawn

It has long been our position at The Automatic Earth that North America is collectively dreaming with regard to unconventional natural gas. While gas is undeniably there, the Energy Returned On Energy Invested (EROEI) is dramatically lower than for conventional supplies. The critical nature of EROEI has been widely ignored, but will ultimately determine what is and is not an energy source, and shale gas is going to fail the test.

As we pointed out in Get Ready for the North American Gas Shock in July 2011, the natural gas situation is not what it seems at all:

The shale gas bubble is a perfect example of the irrationality of markets, the power of perverse short-term incentives, the driving force of momentum-chasing, the dominance of perception over reality in determining prices, and the determination for a herd to stampede over a cliff all at once.

The perception of a gas glut has driven prices so low that none of the participants are making money (at least not by producing gas) or creating value. We see a familiar story of excessive debt, and the hollowing out of productive companies dead set on pursuing a mirage.

Many industry insiders know perfectly well that the prospects for recovering substantial amounts of gas are poor, and that the industry is structured as a ponzi scheme. Still, there has been money to be made in the short term by flipping land leases and building infrastructure to handle gas.

The hype is so extreme that those who fall for it contemplate, in all seriousness, North America becoming a natural gas exporting powerhouse, and a threat to Australian LNG producers, or to Russia's Gazprom.

This concept, constructed from a mixture of greed and desperation (at the lack of conventional gas prospects), is entirely divorced from reality. (See here for Dimitri Orlovs excellent piece on why Gazprom has nothing to worry about.)

Nevertheless, euphoric hype is extremely catching. Given that prices are driven by perception, not by reality, hype has the power to change the dynamics of an industry, exaggerating boom and bust cycles in practice. The hype has resulted in the perception of glut – that North America is drowning in natural gas. The inconvenient fact that this peception is completely wrong does not alter its power in relation to prices.

Natural gas companies gambling on shale gas have been facing prices so low – far below the cost of production – that all of them have been producing gas unprofitably. The financial risk has been increasing dramatically as the companies have been drowning in debt trying to ride out the rock bottom prices that have been the result of people believing the fantasy. Finally, casualties of the financial shenanigans involved are emerging. It is very likely that there will be many more, as companies that have tried to ride out the low prices go under.

Wolf Richter:

Natural Gas: Where Endless Money Went To Die

Alas, thanks to the Feds zero-interest-rate policy and the trillions it has handed over to its cronies since late 2008, the sweeps of creative destruction have broken down. Instead, boundless sums of money have been searching for a place to go, and they're chasing yield when there is none, and so theyre taking risks, any kind of risks, in their vain battle to come out ahead.

The result is a stunning misallocation of capital to the tune of tens of billions of dollars to an economic activity drilling for dry natural gas that has been highly unprofitable for years. It's where money has gone to die. What's left is debt, and wells that will never produce enough to make their investors whole.

But the money has dried up. And drilling for natural gas is collapsing. Last week, there were only 562 rigs drilling for dry natural gas, the lowest number since September 1999…


…At $2.53 per million Btu at the Henry Hub, the price of natural gas is up 33% from the April low of $1.90 per million Btu, a number not seen in a decade.

.But even if it doubled, it would still be below the cost of production. And if it tripled, it might still be below the cost of production for most producers. That's how mispriced the commodity has become.

More from Wolf Richter:

Dirt Cheap Natural Gas Is Tearing Up The Very Industry That's Producing It

The economics of fracking are horrid. All wells have decline rates where production drops over time. But instead of decades for traditional wells, decline rates in horizontal fracking are measured in weeks and months: production falls off a cliff from day one and continues for a year or so until it levels out at about 10% of initial production. To be in the black over its life under these circumstances, a well in the Barnett Shale would have to sell its production for about $8 per million Btu, pricing models have shown.

…Drilling is destroying capital at an astonishing rate, and drillers are left with a mountain of debt just when decline rates are starting to wreak their havoc. To keep the decline rates from mucking up income statements, companies had to drill more and more, with new wells making up for the declining production of old wells. Alas, the scheme hit a wall, namely reality…

…The natural gas business is brutal. The peak in drilling occurred in September 2008 with 1,606 rigs. Then the financial crisis threw it into a vertigo-inducing plunge. After last years mini-peak, the plunge continued…

Production lags behind rig count, and while rig count for gas wells has been setting new decade lows, production has been rising month after month to new record highs. But lagging doesn't mean decoupled. And someday…. Oops, it already happened. It has started. Production has turned the corner, and not just in one field, but across the US.


Its still just a little notch in the curve. But its a sign that the collapse in rig count is translating into lower production numbers. And when the steep decline rates are beginning to overlap the drop in rig count, production will head south in a dizzying trajectory.

Money has been thrown at the industry, but the notion is dawning that the game is up and that returns will never materialize. The ponzi scheme has reached its natural limit, and investors are waking up to the realization that they have been chasing a fantasy.

Ironically, just as the washout begins, natural gas prices may have bottomed. Conventional natural gas in North America peaked in 2001. Coal bed methane and now shale gas have been revealed to be massively overblown as an energy source. Producers are reaping the consequences of malinvestment and will be going out of business. Demand has been building with the transition from coal to natural gas for power generation. This is an ideal set up for a supply collapse and subsequent price spike.

North America is poised for a huge natural gas shock. Far from being an exporter, North America is going to experience a natural gas supply crunch. Prices will be rising at the same time as peoples purchasing power falls precipitously, thanks to deflation. The structural dependency on natural gas that has been cemented in recent years is going to guarantee maximum pain as prices reconnect with reality.

Jun 182012
 June 18, 2012  Posted by at 8:16 pm Finance Comments Off on Capital Flight, Capital Controls, Capital Fear

Ben Shahn Nickel Inn August 1938
"Quick lunch stand in Plain City, Ohio"

The ending of extend-and-pretend is ushering in a new era of fear and uncertainty which is rapidly evolving into the next phase of the on-going credit crunch.

It is becoming clearer to many that the problems run much deeper than they had perceived, and more people all the time are realizing the systemic nature of the risks we are facing. Fear leads to knee-jerk reactions. In financial markets, it leads to volatility and self-fulfilling prophecies to the downside. It leads to capital flight, and then to capital controls.

Capital controls were an integral part of the Bretton Woods regime, but went out of favour in the expansionist Washington Consensus era that followed. They remain controversial.

Douglas Rediker, a senior fellow of the New America Foundation and until recently a member of the executive board of the IMF, says:"There are no winners in capital controls. But if banks and your economy are losing capital, you may use them to stem the tide. It’s not winning, but it’s not losing as bad as you might otherwise.

Capital controls appear to have limited contagion and economic damage in the Asian Financial Crisis in 1997/98. In later cases of relatively isolated financial crises, notably Iceland, they have also been credited with limiting the scope of krona currency crisis.

Capital controls are rapidly returning to official favour, but the likelihood of being able to employ them to contain a crisis orders of magnitude larger in scope is very small. Under such conditions, the risk is that capital controls will amplify the fear that is the driving force for capital flight.

The spread of financial contagion – fear by another name – is increasingly evident in Europe at the moment. Interest rates are one measure of fear, representing the perceived risk of default and thus a risk premium. As this perceived risk rises, interest rates go up, but this has the effect of making the debt harder to repay, leading to a further increase in the perceived risk of default, and therefore higher interest rates yet again.

Once a country is trapped in this vicious circle, collective psychology tells us where it will lead – to default. Similarly, austerity programmes force default by making it more difficult to repay loans by forcing economic contraction. Positive feedback loops have an inexorable progression that picks up momentum as they proceed.

Perception of risk drives capital flows – away from problem states and toward safe havens. What happens is that spreads rise. Perception of high risk leads to much higher rates, whereas perception of lower risk leads to falling rates, at least in the early stages of a financial crisis. Safe haven status does not require objective measures of safety or sounds fundamentals. All one has to be is the least worst option. Money goes from where the fear is to where the fear is not, pushing some over the edge, while buying time for others. In either case, large capital flows are destabilizing, and governments will try to use capital controls to prevent them.

The situation with the erstwhile European single currency is the epicentre of financial crisis this time. It is creating multiple risk distinctions – periphery versus core within the eurozone, long term versus short term, and also an increasing disparity between the euro countries and those outside the single currency. Clearly the interest rates are rising in the countries of the European periphery, to the point where these countries are effectively being shut out of international credit markets, and the businesses, local authorities and individuals within them are experiencing knock-on drying up of liquidity.

Funds are leaving these countries and moving towards the core states, but this move reflects only risk disparity within the eurozone. Some parties remain comfortable with the euro as a concept and are content seeking the relative security of the stronger states within it. Others take a broader view and have already lost trust in the single currency. For them, an acceptable level of risk begins with holding no euro-denominated assets at all.

Interest rate spreads are broadening within the eurozone, but core country rates are also beginning to rise, albeit from a very low level. To some this appears confusing.

Robin Wigglesworth for the FT:

German yields jump as Spain hits euro-era highs

Borrowing costs for Germany, the UK and France, deemed among the safest sovereigns in Europe, rose sharply on Tuesday as investors took fright at the worsening crisis in Spain.

Yields on Spain’s government bonds soared to their highest level since the launch of the euro. The yield on benchmark 10-year debt increased to more than 6.8 per cent.

However, it was the climb in borrowing costs of the"core" sovereigns, which typically tended to move in the opposite direction of the periphery’s bond yields, that unnerved many investors.

Germany, the UK and France’s 10-year bond yields have risen 25 basis points, 16bp and 47bp to 1.42 per cent, 1.69 per cent and 2.73 per cent respectively since the start of the month.

Spreads can continue to rise within the eurozone while rates for the whole region rise relative to other sovereigns believed to represent a lower risk. All risks are relative, and the risk-averse psychology of a decline magnifies all differences. Attempts by central authorities to fight the psychology of decline with bailouts perversely reinforce it under such circumstances, by convincing investors that there really is something to worry about. The psychology of a rally is supportive of central interventions, making them appear successful, but declines make central authorities look incompetent, no matter what they do.

Each subsequent bailout, meant to be definitive, buys less and less time before the spiral of fear continues upward again. In the case of Spain, yields began to rise again mere days after a $100 billion bailout that was not even contingent on austerity measures, as previous bailouts for other countries had been.

The growing impetus for fear-driven risk avoidance is already causing problems, not just for the countries where capital is leaving, but also for the safe-haven recipients. The US, representing the safe haven of the reserve currency, has seen substantial inflows that are causing problems for the banking system.

Dakin Campbell, Dawn Kopecki and Bradley Keoun for Bloomberg:

U.S. Banks Said To Seek Relief From Regulators As Deposits Swell

Deposits are flooding into the biggest U.S. banks as customers seek shelter from Europe’s debt crisis and falling stock prices. That forces lenders to raise capital for a growing balance sheet and saddles them with the higher deposit insurance payments. With short-term interest rates so low, it’s hard for financial firms to reinvest the new money profitably.

Regulators have asked banks to take the deposits anyway, three people said, with one lender accepting $100 billion. The regulators want lenders to take the deposits because it improves the stability of the financial system, according to one of the people, who said U.S. banks are viewed as places of strength…

…The extra deposits are problematic because they’re subject to withdrawal, so banks have to park the money in low-yielding short-term investments, Litan said. With few other choices available, banks have stashed their excess deposits at the Fed, which means the cash gets counted as assets. This expands their balance sheets and thus pushes down their leverage ratio, which measures Tier 1 capital divided by adjusted average total assets; the lower the ratio, the weaker the bank, at least in theory…

….At least one firm, Bank of New York Mellon Corp. (BK), tried to recoup some of the costs by charging depositors 13 basis points, or 0.13 percent, for holding unusually high balances.

Europe’s financial crisis is also supporting the value of the US dollar. A knee-jerk flight to safety into the reserve currency has been underway for some time already, and shortages of dollars are now increasing demand beyond supply. This dynamic has a lot further to go as dollar denominated debt, of which there is more than any other kind in the world, begins to deflate in earnest. Dollar liquidity will be in increasingly short supply.

Lukanyo Mnyanda, Emma Charlton and Allison Bennett for Bloomberg:

Dollar Shortage Seen in $2 Trillion Gap Says Morgan Stanley

Central banks rebuilding foreign- exchange reserves at the fastest pace since 2004 are crowding out private investors seeking U.S. dollars, boosting demand even as the Federal Reserve considers printing more currency.

After falling to an all-time low of 60.5 percent in the second quarter of last year, the dollar’s share of global reserves rose 1.6 percentage points to 62.1 percent in December, the latest International Monetary Fund figures show. The buying has left the private sector with $2 trillion less than it needs, according to investment-flow data by Morgan Stanley, which sees the dollar gaining 8.2 percent in 2012, the most in seven years.

While the Fed has created more than $2 trillion under its stimulus programs since 2008, the flows signal that there may actually be a shortage of dollars to meet demand as Europe’s debt crisis deepens and the global economy slows. The dollar has risen 3.5 percent since the end of April against a basket of the most-widely traded currencies even amid speculation that the Fed, which meets this week, may undertake the type of stimulus measures that weakened it in the past.

"The market often assumes that people are long dollars, but many of those dollars are held by central banks, which are unlikely to move out," Ian Stannard, head of European currency strategy at Morgan Stanley in London, said in a June 13 interview."That leaves us with the private sector, which is short," meaning they don’t have enough of them, he said."In an environment where we see a global slowdown, the dollar will be well supported."

Safe haven status can lead to negative nominal interest rates, as interest rates are a risk premium. Rather than asking for a return, spooked investors are prepared to pay for the privilege of capital preservation. They are less concerned with the return on capital than the return of capital. In Switzerland, a major safe haven recipient of capital fleeing the eurozone, negative rates already apply. In the US, short term rates are likely to stay low, but longer term rates may well be on the verge of rising.

States are seeking to prevent destabilizing capital flows. We are currently seeing the beginning of a process that has very much further to go. Switzerland responded early on with determination to peg its currency to the euro, in an attempt to prevent its currency appreciating to the point where its export markets would suffer. However, currency pegs merely present a tempting target for speculators. They may stand for a while, but if the underlying condition that gave rise to capital flows is not addressed, currency pegs can prove impossible to maintain, costing sovereign states a lot of money while making a fortune for tenacious speculators with far more ammunition than states can defend against.

Graeme Wearden for the Guardian:

Swiss bid to peg 'safe haven' franc to the euro stuns currency traders

Giles Watts, head of equities at City Index, warned that Switzerland could find itself in a battle with currency speculators to hold the value of its currency down.

"Most interventions in the currency markets by the authorities of late have only helped prices in the short term at best. If the euro crisis intensifies there is every chance the market could test the SNB's resolve to hold the cross rate above the 1.20 level," Watts said.

Last month, the SNB pledged to keep interest rates near zero and increase the supply of Swiss francs available to traders. This move did not succeed in weakening the currency.

The Japanese yen has also been driven higher since the financial crisis began, hurting the country's exporters and prompting Japan's central bank to launch its own interventions.

Louise Cooper, markets analyst at BGC Partners, warned that central banks do not have unlimited power – as the UK learned during Black Wednesday in September 1992. "The Japanese example with yen intervention teaches us that intervention can work in the very short term but changing long-term global currency flows is near impossible – a lesson that the UK learned from George Soros," Cooper said.

The Swiss efforts to hold down the value of their currency, although unlikely to succeed in the long run, may accentuate upward pressure on the currencies of other non-euro safe havens, threatening their export markets in turn.

Simon Kennedy and Emma Charlton for Bloomberg:

Swiss Open Fresh Round In Currency War Ignited By Global Economic Slowdown

The initiative may leave Norway and Sweden vulnerable to unwanted gains in their currencies as countries such as Brazil and Japan fight to limit appreciation amid a flight from the euro debt crisis and near-zero U.S. interest rates. With Group of Seven finance chiefs set to hold talks this week, it also exposes the clash among policy makers counting on exports to offset slumping demand at home.

"We will see a lot more intervention now, we will see manipulation on a grand scale," said Stuart Thomson, who helps oversee about $120 billion as a portfolio manager at Ignis Asset Management in Glasgow."Traditional safe havens are trying to undermine the value of their currencies."

What we are headed for are global currency wars, with rounds of beggar-thy-neighbour currency devaluations, ultimately leading to the end of the fiat currency regime. The every-state-for-itself mentality is a major part of the psychology of contraction. This is the attitude that is tearing at the socioeconomic fabric of not only the eurozone, but ultimately of the European Union as well.

Where national interest become paramount, and the interests of the collective are lost, the endgame has arrived for the supranational entity. Political aggregations are increasingly fissile under such circumstances. For now, it is Europe in the crosshairs, but broader global divisions are on their way.

Capital controls, on both inflows and outflows, will be far more extensive than currency wars, however. We can expect all manner of attempts to control money flows at all scales. The impact will be widely felt by people trying to protect their scarce resources by removing them from the system while that is still possible. This can be difficult, and for ordinary people without the ability to send funds abroad leads there is a need to protect it domestically. Options are limited and increasingly risky.

David Böcking for Der Spiegel:

Desperate Greeks Withdraw Money from Accounts

Many Greeks are emptying their bank accounts out of fear that the country may return to the drachma. But most of the money is not going abroad. Instead, individuals are storing cash in safe deposit boxes or at home — leading to an increase in burglaries…

…There is still little sign of panic in Greece, and there has not been a stampede to the banks. Nevertheless, people are withdrawing hundreds of millions of euros from the banks every day. In May alone, outflows totaled €5 billion. According to official figures, €80 billion has been withdrawn since the start of the crisis…

…Rich Greeks have long been moving billions to countries such as Italy or Switzerland, or buying luxury properties in London. But overall, according to estimates by the Greek central bank, only about one-fifth of the total money withdrawn has gone abroad. Many customers have left their money in the bank itself, Christiana says — but in a safe deposit box rather than in their accounts."It's currently impossible to find a free safe deposit box in a Greek bank," she says.

Those customers clearly don't want to be surprised by a currency reform. There has long been speculation over how that could work. The banks could close over a weekend, take stock of the euro holdings in their accounts and prevent further transfers to foreign accounts. Euro bills which are already in circulation would be marked with stamps. The export of unmarked bills would be prevented at the borders. Within a short time, the drachma could be reintroduced…

…Greeks now have around €50 billion stashed at home, reports the Greek newspaper Ta Nea, citing the Greek Finance Ministry. Burglaries are increasing as a result. In Crete, they have gone up by 700 percent within two years. Burglars recently stole €50,000 in cash from a house of an old couple in Athens.

The crisis may now increase the social divide in Greece, just as it has done many times in recent years. While members of the upper class have long managed to stash their money in safe places, a possible currency reform and the subsequent devaluation would probably hit many low-income earners unprepared.

Safe deposit boxes are not a secure option in the event of a bank run. If the bank’s doors are shut, the likelihood of being able to access a safe deposit box is vanishingly small. The odds of the contents remaining where they were left for long enough for the owners to be reunited with their property are also rather low. Even when there is no threat of an imminent bank run, financially-strapped central authorities may be minded to help themselves to the assets of others.

Elisabeth Leamy for ABC News:

Not-So-Safe-Deposit Boxes: States Seize Citizens' Property to Balance Their Budgets

"They figured the safety-deposit box was safer than keeping it under the mattress. In the case of a lot of citizens, they were wrong, weren't they?"

California law used to say property was unclaimed if the rightful owner had had no contact with the business for 15 years. But during various state budget crises, the waiting period was reduced to seven years, and then five, and then three. Legislators even tried for one year. Why? Because the state wanted to use that free money…

…Some states keep their unclaimed property in a special trust fund and only tap into the interest they earn on it. But California dumps the money into the general fund — and spends it.

Governments may also decide that the contents of safe deposit boxes may constitute evidence of criminal activity, and reserve the right to assess the property stored, making the owners prove legitimacy. In a liquidity crunch, it is quite likely they will regard there being no legitimate reason for holding cash, and private gold ownership may be declared illegal. Both cash and gold could be subject to confiscation.

Richard Edwards for The Telegraph:

Safety deposit box raids yield £1bn of drugs, cash and guns

Scotland Yard said that Met’s Specialist Crime Directorate raided seven properties: three safe depositories, an office and three residential addresses…

…"Operation Rize is a money laundering investigation and is entirely unprecedented, one of the largest of its kind ever undertaken in the UK," he said. "In the past safety deposit boxes have been searched on an individual basis often resulting in the recovery of guns, drugs and cash. We believe that this operation has the potential to impact upon many layers of serious crime."

The investigation has been running for two years and included intensive work with lawyers to ensure they were able to seize all of the boxes.

Members of the public who have innocently and legally stored their valuables were"inevitably" going to get swept up in the disruption, it was predicted.

Legal niceties are very likely to go by the wayside as deleveraging proceeds and the global grab for scarce cash begins in earnest. Those who posses the power to grab assets left in harm’s way are very likely to do so, then possession will be nine tenths of the law.

Simon Black for Sovereign Man:

It starts: the government’s plan to steal your money

European officials yesterday flat out admitted that they were discussing rolling out a series of harsh capital controls across the continent, including bank withdrawal limits and closing down Europe’s borderless Schengen area.

Some of these measures have already been implemented sporadically; customers of Italian bank BNI, for example, were all frozen out of their accounts starting May 31st upon the recommendation and approval of Italy’s bank regulator. No ATM withdrawals, no bill payments, nothing. Just locked out overnight.

In Greece, the government has taken to simply pulling funds directly out of its citizens’ bank accounts; anyone suspected of being a tax cheat (with a very loose interpretation in the sole discretion of the government) is being relieved of their funds without so much as administrative notification.

It’s no wonder why, according to the Greek daily paper Kathimerini, over $125 million per day is fleeing the Greek banking system. European political leaders aim to put a tourniquet on this wound in the worst possible way.

Moving money abroad to a safer haven is not the simple solution one might imagine either. Governments that could not stop the hemorrhage as it was happening are seeking to reverse the capital flight after the fact. Of course, such actions will only further inflame fear, while doing nothing to address the reason for capital flight. They will thus increase the impetus for capital to flee in any way that it can.

Bruce Krasting:

On Capital Flight and Forced Repatriation

All around the globe one can find evidence that money is moving around with the sole purpose of finding someplace"safe". Capital flight is a perfectly logical consequence in today’s world. Barely a day passes where we are not reminded that nothing is safe any more. Not our currencies, not our equities, not our bonds and certainly not our banks/brokers.

In Greece there are many example where capital flight is undermining stability. The most obvious is the capital flight from the Greek banks that has taken place over the past few years. This flow of money is also perfectly logical. There are many risks of leaving money in a Greek bank:

•The Bank could default. The principal in the account is at risk.The guarantee (up to E100k) is from the government. What's that worth?

•The government could default. The chaos that would follow would result in a freeze of all bank balances.

•The government could announce one morning that it was re-establishing the Drachma. This would mean that any Euros in a Greek bank would be automatically converted into Drachmas at the old official rate. The value of those Drachma would be worth half (or less) as a result of the immediate devaluation that would occur…

…A move is being made in Brussels to"force" the Swiss government/banks to transfer all of the assets of Greek citizens back to the Greek banks. For a Greek this means that your money is hostage. It has been functionally expropriated. It will be transferred into a banking system that is fraught with risk. Some portion of the money that goes back to Greece will certainly be lost…

…If this happens (the folks in Brussels are pushing hard) a very dangerous precedent will have been set. Flight capital will have been made illegal.

Capital flight from the periphery is currently being quietly financed by other European central banks, allowing Greeks and other depositors in the periphery to continue withdrawing funds without banks closing their doors. Instead of a bank run, we have seen what has been described by several commentators as a "bank jog".

However, the rest of the eurozone cannot continue such support indefinitely, especially as fear causes the pace of the ‘jog’ to pick up, and contagion spreads the problem to other states. When that support ends, bank insolvency will be revealed.

The kind of capital controls one should expect, and prepare for, include:

•Restrictions on bank withdrawals

•Restrictions on money market fund redemptions

•Greater restrictions on retirement fund liquidations

•Fixing an official exchange rate and criminalizing market rate transactions

•Banning the conversion of domestic currency to foreign currency

•Banning the movement of assets out of the country to foreign financial institutions

•Barriers, restrictions, additional transaction costs imposed on foreigners seeking to deposit funds or make investments in safe havens

•Forcing sovereign debt owners to accept longer maturities rather than principal repayment

•Banning gold ownership

•Reissuing the currency in a new form (an acute risk in Europe obviously)

•Restrictions on the size of cash transactions

Assets held within the grip of the system are at risk. There is a critical dependence on the solvency of middle men, on government guarantees, and on the powerful resisting the temptation to grab what they can in the financial free-for-all of deflation and deleveraging that is picking up momentum. None of these is a good bet. Whatever actions one might plan to take, it is necessary to take those actions before push comes to shove. That way they can be taken under conditions of relative calm.

There are no no-risk solutions, but different options will suit different people, depending on their circumstances. Some may choose to store assets in another jurisdiction or in another currency if those options are available, but losing control over assets abroad is a distinct possibility, as is difficulty in converting the currency chosen as a store of value back into something that will functions as cash at home.

Physical travel may become much more difficult as capital controls lead to border controls of other kinds. Holding assets close to home gives one the greatest degree of control, but with certain obvious risks attached. Typically, he who loses the least in a deflation is the winner, as there are no easy answers.

Once fear is in the ascendancy, it is very difficult to combat. Governments and central banks simply do not have the control they think they do, and they do not understand the nature of battle they are engaged in. It is not a matter of restoring certain objective conditions. Central authorities are trying to fight the inexorable recognition that the magnitude of the debt that has resulted from our 30 year credit expansion dwarfs the wealth of the world, that the $70 trillion in G10 debt underpins some $700 trillion in derivatives.

That realization, and the natural reactions stemming from it, are the problem. As confidence evaporates, so does liquidity. Credit – the vast majority of the effective money supply – ceases to be equivalent to money. The resulting crash of the effective money supply is deflation by definition. This is what we have been predicting since the inception of TAE. This is how credit expansions always end – with the implosion of credit instruments that amount to no more than a pile of human promises that cannot be kept.

Martin Wolf for the FT:

Panic has become all too rational

Finance plays a central role in crises, generating euphoria, over-spending and excessive leverage on the way up and panic, retrenchment and deleveraging on the way down. Doubts about the stability of finance depend on the perceived solvency of debtors. Such doubts reached a peak in late 2008, when loans secured against housing were the focus of concern. What is happening inside the eurozone is now the big worry, with the twist that sovereigns, the actors upon whom investors depend for rescue during systemic crises, are among the troubled debtors. Such doubts are generating a flight to safety towards Germany and, outside the eurozone, towards countries that retain monetary sovereignty, such as the US and even the UK.

It is often forgotten that the failure of Austria’s Creditanstalt in 1931 led to a wave of bank failures across the continent. That turned out to be the beginning of the end of the gold standard and caused a second downward leg of the Great Depression itself. The fear must now be that a wave of banking and sovereign failures might cause a similar meltdown inside the eurozone, the closest thing the world now has to the old gold standard…

…How much pain can the countries under stress endure? Nobody knows. What would happen if a country left the eurozone? Nobody knows. Might even Germany consider exit? Nobody knows. What is the long-run strategy for exit from the crises? Nobody knows. Given such uncertainty, panic is, alas, rational. A fiat currency backed by heterogeneous sovereigns is irremediably fragile…

…Before now, I had never really understood how the 1930s could happen. Now I do. All one needs are fragile economies, a rigid monetary regime, intense debate over what must be done, widespread belief that suffering is good, myopic politicians, an inability to co-operate and failure to stay ahead of events.