As many readers will know, I am an enthusiastic advocate of a new way of looking at the economy, something which I call “surplus energy economics” (“SEE”). In support of this, I’ve developed something known as “SEEDS”, or Surplus Energy Economics Data System.
With the finishing touches being put to the 2016 version, what I aim to do here is to outline some of its principal conclusions. This will also serve as something of a primer for those not familiar with SEE.
SEEDS-16 confirms that, despite a price-war in oil markets and a weakening in demand resulting from economic slowdowns (most significantly in China), the underlying trend in the “energy cost of energy” remains strongly upwards. Energy market surpluses do not change the fundamental point, which is that depletion continues to make replacement sources of fossil fuels increasingly expensive.
Rapid expansion in shale output doesn’t change this, because the big weakness with shales is the very rapid rate at which production from individual wells declines. The future clearly lies with renewables (and principally with solar), but, as discussed later, these are unlikely to change the dynamics of an increasingly-costly energy supply mix.
What this means is that, after a hiatus, there will be a resumption of “energy sprawl”, meaning that the resource and financial requirements of energy supply will continue to absorb a rising proportion of economic output. This in turn means that the real measure of prosperity – that is, output net of the economic rent attributable to the imperative of energy access – will come under increasing pressure, despite the assumption that economic efficiency will improve.
As the first chart shows, the world’s real economy – that is, the economy of goods and services, rather than their “financial economy” proxy – can be expected, first, to stagnate, and then to enter gradual decline.
Some of the world’s most vibrant economies, such as India and China, may buck this trend for as much as a decade. With few exceptions, the outlook for the mature developed economies is bleak, with Britain and Japan set to suffer the worst declines, in both cases for quite specific reasons.
At the same time, continued expansion in the “financial” economy of money and credit – which have value only as “claims” on the real economy – has created a very dangerous situation. Essentially, the financial economy has created far more claims than the real one can ever satisfy, and SEEDS-16 quantifies these “excess claims” at $67 trillion.
The basics – the surplus energy economy
Essentially, SEE argues that we need to think in terms of two economies, not one. The first of these – the “real economy” – consists of goods and services, labour and resources.
This real economy is a function of energy, not money. After all, money has no intrinsic value, and can be (and has been) created at will, without adding anything to the real output of the goods and services that we need. Energy, as the basis of the real economy, needs to be defined broadly, to include labour and nutrition as well as the more familiar forms of energy such as fossil fuels and renewables.
Since it has no intrinsic worth, money possesses value only as a “claim” on the output of the underlying – real – economy. Money, then, has only “claim value”, whilst debt, as a “claim on future money”, is in reality a claim on the future output of the real economy.
Together, money and credit comprise the second or “financial” economy. This is the economy of monetary data (such as GDP, incomes, spending and debt) with which everyone is familiar, but in reality it is nothing more than a convenient proxy for the real economy of goods and services.
The financial economy, consisting entirely of created claims on real output, can in principle help us to manage the real one to best effect. But an obvious danger exists where we create claims that exceed what the real economy can deliver. Where this happens, the difference is known in SEE as “excess claims”, meaning “financial claims on economic output that the real economy cannot satisfy”.
And this is exactly what has happened over the last decade and more. The financial system has created credit (money and debt) at a much faster rate than growth in the real economy. “Excess claims” show up primarily as escalating debt which we know can never be repaid.
SEEDS-16 quantifies a global aggregate of “excess claims” of $67 trillion as of the end of 2014. Put simply, these “excess claims” are “value” within the financial system that, one way or another, has to be destroyed, because it cannot be satisfied.
This $67 trillion number is not analogous to global debt, which is very much larger (around $200 trillion). Rather, the excess claims figure is indicative of the scale of debt and other claims that cannot be met, and will therefore have to be written-off in one way or another.
On this basis, it is a permissible simplification to say that about one-third of all global debt can never be repaid.
This creation of “excess claims” has happened for two main reasons. The first is simple recklessness. The second is a miss-match between what the financial system expects the real economy to produce, on the one hand, and, on the other, what the real economy has actually delivered. This “anticipatory error” reflects a tendency to assume that the future will be an extrapolation of the recent past. The trouble with this is that it has been derailed by the disappearance of the rates of economic growth that had become familiar in the past.
So the debt colossus that hangs over the world financial system like the Sword of Damocles has resulted both from the excessive creation of debt and from the poor performance of the global economy.
The real economy
Why, then, has the real economy become so weak?
That it has indeed weakened is underlined by performance since the 2008 slump. Generally, a recession tends to be followed by catch-up growth, as businesses and households alike carry out spending deferred during the down-turn. This time, however, here has been no such catch-up rebound.
The explanation for the weak performance of the global economy lies in the rising trend cost of energy.
To understand this, it must be appreciated that energy cannot be accessed at zero cost. Capital and operating expenses, though usually considered as money amounts, need to be assessed in energy terms to make sense of this equation.
The critical equation here is EROEI, meaning the Energy Return On Energy Invested. An EROEI of 30:1 means that, within 31 units of energy accessed, 1 unit is the energy cost incurred, and the remaining 30 units are available for use.
The SEEDS system uses the inverse of EROEI, which is ECOE, or the Energy Cost Of Energy. If the EROEI of a given source is 30:1, the ECOE of that source is 3.2%, which is 1 divided by 31.
Like EROEI itself, the ECOE progression is non-linear. If EROEI falls from 60:1 to 30:1, ECOE rises from 1.6% (1/61) to 3.2% (1/31), a relatively small increase in cost for a halving of EROEI. Reduce the EROEI to 15:1, however, and ECOE rises to 6.25% (1/16), a very material increase in cost. At EROEIs of 10:1 and 5:1, ECOE is 9.1% and 16.7%.
What this in turn means is that the overall EROEI of the economy can move a long way before its effects become apparent. Critical territory is entered, however, once EROEIs fall below about 15:1.
Conceptually, the “energy cost of energy” can be thought of as the economic rent which the resource set imposes on the economy. Historically, unfortunately, it has not be accounted for in this way.
Rather, it has tended to be overlooked altogether.
Of course, the actual cost of energy in any given year is determined by factors only tangentially linked to underlying trends. Political factors, such as wars, revolutions and OPEC policies can drive prices sharply upwards, as they have on many occasions.
Conversely, a slump in activity – and hence in demand – can undermine prices very significantly, particularly if they follow a period in which sustained high energy prices have led to a spike in investment.
The latter describes the current situation. Until 2014, growth in demand for energy was pretty robust, and was expected to remain so. High prices encouraged big investment in supply, most notably in the production of oil and gas from shale formations in the United States. At the same time, high prices stimulated investment in renewable energy sources such as wind and solar power.
Latterly, with the slowdown in Chinese expansion, the global economy has all but lost what previously had been almost its only engine of growth.
This has come as something of a shock to the system, mainly because of a widespread failure to recognise that China, like the West before it, had been delivering growth primarily on the back of enormous incremental borrowing. At the same time, hefty capital investment had resulted in big increases in supply, principally from US shales.
What we have now is, to all intents and purposes, a price-war, between US shale producers on the one hand, and, on the other, Saudi Arabia and its fellow Gulf exporters.
Both sides are suffering severe financial pain from this price-war. The Gulf countries have experienced drastic falls in their export revenues, which have in turned created enormous fiscal deficits. In the United States, companies specialising in shales have suffered carnage, reporting sharply lower cash flows and profitability, and rapidly increasing debts. Much of this debt is deeply into “junk” territory, and equity value has slumped, all but cutting off the shale sector from access to new capital.
This has extremely important implications for the future production outlook. Though the sheer scale of oversupply suggests that the price-war may prove protracted, the tactical weakness of shale lies in rapid depletion rates. It is by no means uncommon for production to decline by as much as 75% in the first year of a shale well’s operation. This means that, to maintain or increase output, operators need to carry out an on-going drilling programme, something that has been likened to a “drilling treadmill”. As a result, the drying up of investment funds is likely to result, relatively quickly, in declines in production. The Gulf producers appear likeliest to win the price-war, though that can be by no means a certainty.
The critical equation – the trend cost of energy
Whatever the outcome of the oil price-war, the salient point is that energy prices are extremely volatile, whereas what is needed for purposes of economic analysis is a trend rate of changes in ECOEs.
This is shown in the next chart. Between the first oil crisis in 1973 and around 1990, actual energy prices were well ahead of trend. They were again above-trend between 2004 and 2013, but have now fallen back to below-trend levels.
We need to be very well aware that the current weakness in prices is caused in large part by the price-war, so we most certainly can not assume that we have moved back into an era of cheap energy.
Indeed, the overwhelming burden of evidence indicates that the upward trend in real prices (and ECOEs) remains very much in place. This doesn’t reflect any assumption that global economic growth will improve, since this actually looks unlikely. Rather, indications from the supply side of the equation strongly suggest a continuing uptrend in costs
Starting with oil, the cost of developing and producing new sources of oil has risen relentlessly for at least two decades, and arguably even longer. The world’s biggest, most cost-effective fields were developed first, and the fields which replace them are ever smaller, ever more remote and ever more costly to produce.
It has, indeed, been argued that the production of conventional oil peaked in 2005, and that subsequent net increases in supply have come from unconventional sources (which may be why influential publications now talk about “liquids” rather than “oil”). The most important unconventional source of liquids is shale, but this suffers from very rapid rates of depletion. High investment can cope with this, of course, but not if returns diminish because the best locations have – quite logically – been used first.
Though conventional natural gas has yet to peak, gas is otherwise in much the same situation as oil, with the most cost-effective fields already depleted, and costs rising as ever more marginal resources are developed.
Reserves of coal are relatively abundant, but the calorific value of the production slate is declining, because the best coal (such as anthracite) has been extracted first. Furthermore, environmental considerations strongly militate against expanded use of coal, something which might be difficult to do anyway, given the decline in calorific content. The role of nuclear will clearly increase, but nuclear fuel supplies are by no means abundant, and dealing with spent fuels remains extremely difficult.
What all of this means is that renewables will account for a rising share of the energy slate in the future. This said, renewables only accounted for about 2.5% of primary energy supply last year, and increasing this proportion will be expensive. Within the mix of renewables, the most promising (by a very wide margin) is solar power. The track-record of wind-power is somewhat mixed, and its economics seem to rely on heroic assumptions for the longevity of plant. Biofuels are of limited scope, not least because a lot of liquid energy is used up in planting, harvesting, processing and distribution. Moreover, a big increase in biofuels output would pose a clear threat to food production, a critical issue which may already be at serious risk due to water depletion, the declining nutrient content of land, the high (energy) cost of inputs, and the implications of climate change.
There are two other points to note about renewables. First, and before the outbreak of the oil price-war, the best renewables (principally solar) had showed that they can compete reasonably well with fossil fuels in price terms. But their pricing, and their cost-effectiveness, only looks solid when they are compared with the oil and gas production mix of today, and more specifically with the high-cost sources that are increasingly being accessed.
To put it another way, renewables may be able to compete with an oil and gas slate whose costs have already risen sharply, but they cannot replace the world’s rapidly-dwindling (but still significant) legacy of large, long-established and very low-cost fields.
Second, renewables cannot match the energy density – the quantity of calories-per-kilo – offered by fossil fuels, especially oil. Propelling a Boeing 747 with electricity is not remotely possible today and, despite rapid progress in battery technology, may be prevented by the laws of physics from ever becoming possible.
The energy/economy relationship
Though the day-to-day relationship is subject to huge volatility, the underlying trend in the ECOE – the energy cost of energy – is emphatically an upwards one. Even with a price war in full swing, the “economic rent” which energy imposes on the economy remains far higher today than it was ten years ago.
Though it may take several years to happen, the likelihood is that energy prices will in due course move back into higher territory, partly in response to big cuts in capital investment. This is to some extent a cyclical phenomenon, but the cycles behave in sine-wave formation around a secularly-rising trend. This is termed the “oscillating trend”, and is shown conceptually in the next chart.
The secular rise in trend energy costs is already taking its toll on the real economy. The energy cost drain has resulted in escalating indebtedness, because the world has gone on acting as if the “economic rent” exacted by the energy resource set does not exist. The cost of household essentials has soared, undermining discretionary spending capacity in ways not measured by conventional calculations of inflation.
The weakening real economy has already forced us to cut returns on capital to levels which deter investment. What this really means is the pressure on the real economy is forcing us to prioritise consumption.
The next stage of the ECOE squeeze will involve economic deterioration that can no longer be disguised. In future articles, I will look in more detail and how and where this is likely to happen.