In their own words

“The world is caught in a dangerous feedback loop – higher oil prices and climate disruptions lead to higher food prices, higher food prices lead to more instability, more instability leads to higher oil prices.  That loop is shaking the foundations of politics everywhere.”

-Thomas Friedman

 

“Fortunately, we are not doomed to eternal punishment, as Prometheus was for stealing fire for humankind.  Nor does the dwindling of the old fire of fossil fuels mean a return to the Dark Ages.  Instead, we can create a safer, stronger, fossil-free world by tapping into a far greater resource than fossil hydrocarbons.  The real underlying fuel of America and of modern civilization is innovation and ingenuity.”

-Amory Lovins

The Balance of Power

Few things effect international relations more than the balance of power.  Whether it be water or oil, the first societies to harness the potential of these commodities enjoy the creation of wealth and goods such as cropland in the case of water and industry in the case of oil.  Eventually each sector is going to grow and the demand for the input will outgrow the supply, leading to price hikes that make that commodity even more desired.  Problems exist when the source of these commodities are located outside of that nations borders.  The balance of power is then transferred from the first-mover user to the upstream producer of that commodity.  This is where it gets interesting.  The choice then becomes whether to use soft power (such as diplomacy, aid, or economic development) to gain influence over the producer or hard power (military action, sanctions) to force them to act.  Only by reducing demand for the commodity in question can the consumer nation wrestle back control from the producer nation.  This could include finding a substitute, developing new technology, or learning to use that resource more efficiently.  In the case of water, there is no substitute.  Downstream nations must learn to make the most out of every drop that they have.  This includes studying what crops to plant domestically and supplementing others through trade.  New technology such as desalination plants could also help secure access to clean water, but it will take an economic toll.  In the case of oil, there are several substitutes such as biofuel, natural gas, and plug-in hybrid cars, but while we further explore these technologies, squeezing the most out of every drop seems to make the most financial sense.

From OPEC to CHAOS: How Petro-Dollars Fueled the Arab Spring

Alright, let’s get back to the economics associated with climate change here.  More specifically, the economics of oil and how the accumulation of petro-dollars by oil-producing nations (almost in some cases, did in others) bring about their downfall.  Most everyone remembers the “Arab Spring” that began in December 2010 when a 26-year-old street vendor named Mohamed Bouazizi set himself on fire to protest his continued harassment by the authorities.  As the protest spread among the arab world, the grievances highlighted the lack of opportunity for the youth, state corruption, economic decline, human rights violations, censorship, and other wrong doings on behalf of the ruling party or dictators of these countries .  By March 2011, protest had erupted in 17 countries in the region. 

(Black = Government Overthrown; Dark Blue = Sustained Civil Disorder and Governmental Changes; Light Blue = Protests and Governmental Changes; Red = Major Protests; Beige = Minor Protests)

Now we know the reasons for the protests and the scale of the uprisings, lets take a look behind the scenes at the conditions that set the stage for this upheaval. 

Current Account
In Economics, the Current Account is the broadest accounting of a country’s trade and investment with the rest of the world.  The Current Account measures 4 areas of trade – Merchandise Trade (goods), Services, Investment Income Flows, and Unilateral Transfers such as foreign aid or remittances from workers sending money back home.  The Current Account provides a snapshot on the financial health of the country, and of how much the country is importing and exporting of each area measured.  While there is no direct impact on the stock or bond markets, the Current Account does show how much money is coming in (surplus) or leaving (deficit).  Consistent and increasing deficits could impact the value of the dollar if creditor nations begin to doubt our ability to pay back the borrowing.  If other countries balk at our debt levels, the dollar will depreciate.  Below is a graph of our current account since 1980.

Now when you think of the America’s current account deficit, you probably think of China’s account surplus.  Images of container ships filled with cheap, disposable goods probably came to mind.  But in fact, the largest creditors of America’s current account deficit have been oil-producing nations.  I was recently brushing up on some economic terminology and this theory was confirmed by my Macroeconomics textbook from 2008.  Amazing that the problem was identifiable even back then.  Recently, The Economist published an article called Petrodollar Profusion that contained the graph outlining the current account surpluses as a percentage of GDP for these oil-producing countries.

So what is the problem?  The problem is that the oil exporting countries have been hoarding these dollars instead of spending them.  They could either spend them on imported goods from oil importing countries (machinery from USA for example) or they could put them to use by investing in their own economies and building out infrastructure, improving education, healthcare, housing, or agriculture, thereby creating jobs and building a middle class.  Spending on imports from other countries would grease the wheels of the global economy and balance out the payments.  After all, that is what keeps the world trading.  Instead, most of this wealth was transferred to sovereign wealth funds who further line the pockets of the ruling class.  For more info on sovereign wealth funds and the rise of state capitalism, please see the book The End of the Free Market by Ian Bremmer.  The point is that building the middle class was not what they chose to do, and the protests continued.  

Unemployment
One of the most prominent cries coming out the protests was the lack of opportunities for the young population.  In many of these countries there is a young (age 15-24) and growing population but a disproportionate lack of jobs for them.  Throughout the Middle East, the unemployment has historically hovered around 12% overall, but the unemployment rate for the youth is averaging 27%.  Aside from the high unemployment rate, there is the mysterious fact that there is an inverse relationship between education level and employment.  This means that the most highly educated young people are also the most likely to be unemployed.  Of those with jobs, many find themselves working in the public sector instead of the private sector where market forces would spur innovation and growth and thus create more jobs.  Across the region, the labor force participation rate is at 48%, compare that to 63.6% in the US, our lowest level since 1981.  

Over a year later we have seen significant changes in the mid-east (except Syria where the fighting continues) but only time will tell what results the arab spring ushered in.  One thing is certain, the oil keeps pumping and the money keeps flowing.

I know it is horrible to think about, but every time we fill up at the pump, we are sending our dollars overseas to strengthen these regimes and prolong the behavior that has kept them in power for so long.  It is a brutal reality, but it is the world we live in.  Until we develop a clean and renewable source of power, our money is going to chase the fossil fuels that power our lives.  But when you follow the money to the source, it isn’t a very pretty picture at all.

In His Own Words . . .

Near the polar cap, waterways are opening that we could not have imagined a few years ago, rewriting the geopolitical map of the world.  Rising sea levels could lead to mass migrations similar to what we have seen in Pakistan’s recent flooding.  Climate shifts could drastically reduce the arable land [available that is] needed to feed a burgeoning population as we have seen in parts of Africa.  As glaciers melt and shrink at a faster rate, crucial water supplies may diminish further in parts of Asia.  This impending scarcity of resources compounded by an influx of refugees if coastal lands disappear not only could produce a humanitarian crisis, but also could generate conditions that could lead to failed states and make populations more vulnerable to radicalization.  These troubling challenges highlight the systemic implications – and multiple-order effects – inherent in energy security and climate change.

Admiral Mike Mullen
Chairman of the Joint Chiefs of Staff
Joint Forces Quarterly, January 2011

Pain at the Pump

Like Method Man, I came to bring the pain hard-core from the brain, but I’m talking about gas for your car, bus, and plane. Unless you walk to work and don’t have a TV or radio, you are probably aware of the rising price of gas the past few weeks. In fact, since January 2012 the average monthly price of gas has increased almost 14% from $3.380 in January to $3.852 per gallon in March. The price per gallon normally goes up during the spring as people drive more, but according to the U.S. Energy Information Administration, this is the highest price level we have seen this early into the driving season. Many commentators have already predicted $5 per gallon by the summer. That would be just the beginning of our troubles as higher gas prices force consumers to cut back on spending thereby jeopardizing our budding recovery.
Point the Finger
So who is to blame? Blame Obama? Blame Bush? Blame Iran? Blame the Democrats? Blame the Republicans?  Blame the oil companies?  Actually, we can only blame ourselves because we continue to choose to pay $4 a gallon. . . and we haven’t learned anything from our mistakes over the last 10 years.  As long as there is demand, companies will charge whatever price the market dictates.  So while we are quick to say “drill baby drill” every time the price per gallon nears $4, we have simply not changed our behavior.  What we should be doing is purchasing higher mpg cars, utilizing public transportation systems, and simply driving less.  We should be investing in and researching natural gas engines.  These steps would diversify our transportation sector away from its reliance on oil as well as free up demand.  It is simple economics – reduce demand and the price will fall. 
Demand from Emerging Markets
The reality is that we live in a truly global marketplace where one country is no longer a market in itself.  This means that even if the US did start drilling everywhere for oil, it would actually only have a small impact on the world markets.  China, India, and Brazil are all energy hungry and have enough clout to move prices ever higher.  A major contributor to the recent spike in oil prices is the tension between Iran, the US, and Israel.  However, Saudi Arabia said it would offset any decrease in Iranian supplies that result from sanctions.  This still creates uncertainty, and therefore a risk premium. 
The Real Reason for Higher Prices
Actually, there are a combination of reasons for higher gas prices.  1) Increased demand from emerging markets; 2) Tensions in Middle East; 3) Lower production levels worldwide and 4) Price spread between Brent and WTI.  The first three reasons listed here are pretty self-explanatory: it is becoming harder and harder to find the black gold at the same time that global demand is rising.  The oil rich region of the Mid East underwent an upheaval with the Arab Spring and production has yet to come back to prior levels.  Basically, the lowest hanging fruit has been picked from the tree and now we must take on ever riskier (i.e. expensive) projects to access our bounty such as deep water drilling, tar sands, etc.  As long as the price per barrel stays high, these projects make financial sense and encourage exploration and production.  
Refinery Problems
Several major refineries in the northeast have shut their doors in the last few months exacerbating the pain at the pump.  The reasoning behind the closings has to do with the price difference between the benchmark for the different grades of crude.  As of 3/30/12, the spot price for Brent is $123 per barrel and the spot price for WTI is $103 per barrel.  Historically, these two benchmarks have traded within a few dollars of each other.  With the spread over $20 per barrel, the refineries outside Philadelphia that process the Brent are simply not profitable.  These refineries were set up years ago when Brent was the standard benchmark.  Now there has been a shift to WTI as the standard, but the refineries in the northeast can not process that type of crude which is typically refined in the midwest or gulf coast.  This means that a lot of refining capability has come off-line and does not look like it is coming back. 
Conclusion
Until we come up with abundant, renewable energy and scale it to meet our needs, we will fall victim to price shocks for our natural resources.  The US has been doing a great job of decreasing its energy usage through efficiency measures, but there is still plenty of room to improve.  Behavior affects markets, and the law of supply and demand always produces equilibrium.  If we want to avoid being in the same predicament next year, 5 years from now, or 20 years from now, we must realize that we need to end our dependence on the same resources that put us here in the first place.  After all, $5 per gallon won’t hurt so bad when you car runs 100 miles per gallon.

On the Right Track

For the first time in more than 60 years, the United States is now a net fuel exporter.  Yes, you heard that right, the US exported 27 million more barrels of petroleum products than it imported in 2011.  Compare that to 2005 when we imported almost 900 million more barrels than we exported.  Needless to say, this by no means declares us “energy independent”, but it does raise some interesting points that deserve mention.

For starters, growth in emerging countries is responsible for driving much of our export demand.  Countries such as Mexico, Argentina, Brazil, Singapore, and the Netherlands are now all net importers of US fuel.  Since 2006, Mexico’s demand for fuel has increased by 2/3 while Singapore’s demand has quadrupled.

Another reason for the shift is due to the recession and fragile recovery in America.  Simple truth is that with 8% unemployment, many drivers are no longer commuting to work everyday.  However, the bright spot here is that many Americans are now driving smaller, more efficient cars rather than the SUV’s that once roamed the freeways.  Add in the fact that automakers have increased the fuel efficiency of their engines from 21.9 MPG in 2000 to 23.8 MPG in 2009 and you begin to see a trend.

The biggest contributor to this turnaround however, is the increased production of petroleum products within the USA.  This includes fuels such as ethanol as well as natural gas.  Recently, it has been stated that the US is sitting on over 100 years worth of natural and shale gas supply.  So large is the supply, that the price of natural gas has plummeted 32% over the course of 2011 leading some companies to flare off the excess gas because their pipelines are full.  Natural gas is a fuel in itself, but also a by-product of drilling for oil. At $100 a barrel of oil, you can imagine how much drilling has been taking place.

What ever the reason, one thing is certain – the US is still a major user of petroleum.  No matter whether we are a net importer or exporter, consumers will still be getting hit hard at the pump due to rising demand from emerging economies.  As far as the glut of natural gas is concerned, approximated half of US households use nat gas for heating, but our industrial and commercial usage is rather limited.  While we might see lower heating bills, the US needs to begin building out a nat gas infrastructure for long haul trucking or even locomotives that are powered by the fuel.  There are several drawbacks to using natural gas that I will highlight in subsequent posts, but the point of this article is to show how recent discoveries and booming production changed an energy trend 6 decades in the making.  This abundant supply of cheap natural gas should add to our energy portfolio and help the US restore it’s economy and create jobs.  What it should not do is switch our demand from one single energy source to another.