Peak Oil Economics
& Money - What Underwrites our Dollar?
David Ford
December 20, 2004
A topic that is surprisingly never linked and analysed these
days is that of the monetary & economic impact of peak oil.
Most gold bugs would be well aware of the classic arguments of
inflationists and deflationists as they relate to the fate of
our fiat monetary systems, but none I have read have really mused
on the impact of oil shortage on our monetary system's fundamentals
and operation. This is due mainly to group denial of coming oil
scarcity, or as James Kunsler puts it "consensus trance"
of the belief in the longevity of our current living arrangements.
Most discussions of monetary backing have focused on the history
of gold and silver in this role, and the dilution of this backing
through monetary inflation, which I tend to think is a part diversion
from the point at this stage of the dollar's evolution.
I say this in light of the fact that gold and silver were supplanted
by oil some time ago as the primary, most valuable commodity,
and underwriter of the value of the dollar and the assets given
their high value in dollars (such as but not limited to Western
Real Estate). I make this point remembering that it is the dollar
that currently purchases us incredibly large volumes of cheap
energy that makes the living arrangement and utility of the real
estate and other assets we own a proposition and hence assigns
them high value.
So what happens when due to depletion and supply constraints
the dollar no longer purchases us huge volumes of cheap energy?
Part of the answer is obvious and spells high initial commodity
inflation - but would this stabilise and translate to higher
asset prices (such as real estate) as we experienced in the aftermath
of the inflationary period of the 70s? If we consider that in
the long term demand for energy will never now decline, but in
fact accelerate due to population factors, and this combined
with energy supply always falling for geological reasons, then
the only way for supply and demand to balance in this market
is for UNENDING rises in energy prices. This is a very different
kettle of fish to the 70s when there were swing producers to
counter the OPEC scourge.
Matt Simmons in a recent presentation to the Harvard business
School said that "There is no clear ceiling for when oil
is too expensive." This implies an ever increasing
inflation of oil and its energy derivatives going forward, including
all consumer products that are derived from it directly or indirectly,
or have their distribution facilitated by it.
So is Hyperinflation the end game? Perhaps. If what Matt Savinar
of Life
after the oil crash implies is true in that the dollar is nothing
but a proxy for energy availability - then the monetary system
may well be headed for chronic deflation, not hyperinflation.
So where does the truth lie? If deflation is the true specter
then what impact will Bernake and his helicopter money bring
to bear to solve the problem? Perhaps that will enable us to
continue to grow the money supply so that I can one day pay my
debts - even though cheap energy is becoming scarcer? This is
the point where I believe the equation gets very interesting.
I tend to be of the view that not enough focus is given to what
will likely happen to INCOME during the years of post peak oil
and limited energy availability. Similarly the impact of expensive
energy on the utility of most assets whose value is underpinned
by the availability of cheap energy is virtually never considered.
Take for example a $US500,000 home 70km from the city that is
affordable as a living arrangement as long as you only have to
spend US$50 a week on gas. What happens if you all of a sudden
have to spend US$200-300 on gas? These dots are easily connected.
Much higher living costs, higher borrowing costs, less job opportunity
due to investment limitations of expensive energy - all point
to much lower housing prices. Though the argument is complicated
by the inflationary pressures of rising base building costs and
population driven consumer demand, is it possible that housing
is over-capitalised in light of future living costs?
In the post peak oil world I tend to think that income cannot
rise to cover both existing debts, and rises in the cost of the
products we purchase to live. My belief in this is based on the
capital available at the time for development, what this will
be able to purchase in light of massive commodity inflation,
and the will to invest it in businesses that will create new
employment at current wage levels.
I see disposable income for both business and families dropping
and the cost of inputs increasing to the point that for a business
or family in debt, profit margins and saving respectively must
go negative and never recover due to the unending rise in energy
prices. At some point those businesses or families will liquidate
stock, assets and anything else to pay off debts whilst income
is falling or indeed failing. The impact of this would be a sharp
decrease of the money supply as debts are extinguished en masse.
If one considers ramping up Bernake's electronic printing press
in this scenario I fear that the price of commodities in limited
supply will only rise faster that will crimp income/profits even
further that would merely exacerbate the race to liquidate debt
given income growth may be at best static or probably negative.
Fundamentally the business environment would be getting worse
as time progressed as energy/commodity costs spiraled upward
whilst customers spending power lowered. There is therefore only
limited possibility that this newly injected Bernanke helicopter
cash would find its way into business investment that would create
jobs and wealth. For those jobs that remain an increasing supply
of willing labour via population growth and unemployment would
only further put downward pressure on income levels.
Crikey!
So we potentially have massive commodity and product price inflation
combined with chronic asset deflation as debts are liquidated.What
happens to Silver and Gold in this scenario - well from a pure
input cost to produce these costs must rise. This implies an
increase in its price assuming there is not liquidation of these
assets to pay debts.
Jason Hommel gave Richard Russell a serve a while back for claiming
the possibility of metal deflation - astutely making the claim
that there is nowhere near enough metal to sell to extinguish
even the tiniest fraction of current dollar debts. Equally with
current poster asset classes being taken to the cleaners it makes
sense that many will seek to own a tangible asset whose value
is not linked to debt or required cheap oil for utility.
Gold and silver are indeed these best candidates as they also
exhibit investment grade qualities (ie small quantity/weight
- high worth ratios and fungibility) that are vital for fulfilling
this function. I recall reading a snippet that reminded us that
an average house in LA sold for a bag of silver coin (717 ounces)
during the height of the 70s oil shock panic. Another analysed
the capital value of a house in Silver based on historical rents
prior to the establishment of the FED. It claimed a range of
500 ounces to 1000 ounces of silver for the price of a house.
If average houses in LA are now worth $500,000 then at what price
will the 717 ounces of silver and the house meet? $500,000 or
$100,000 - does it matter?. Not really. But I tend to think that
with energy becoming more scarce, and the existing utility of
suburban houses becoming further challenged the other article
I saw suggesting a tenfold decrease is not that unimaginable.
This would also align to current reserve requirements for our
fractional banking.
The silver part of the metal equation is more interesting than
gold. Ted Butler estimates in the 1999 piece that there is only
3.5-4 times more above ground silver than gold on the planet,
whilst we mine Silver at a rate of 7.5 times that of gold. A
vast majority of mined Silver volume is also inelastic and directly
related to base commodity production.
In the above scenario of collapsing business investment and debt
liquidation there is no doubt that base commodity production
would shrink significantly as demand contracted, vastly affecting
the already stretched supply demand fundamentals of silver whilst
monetary demand for the metal would be just starting to increase.
Add to this an energy starved population demanding alternative
energy security from solar alternatives will likely maintain
silver demand at current or higher levels in spite of base metal
production collapse.
It is an interesting thought, but given the above likely wholesale
move into hard assets not linked to debt or cheap oil for utility,
and the fundamentals of the silver supply and demand structure
- it is likely that silver will one day in the near future be
priced at a ratio to gold of less than 3.5:1 and perhaps even
parity.
Got any?
December 19. 2004
David Ford
email: dford2@bigpond.net.au
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321gold Inc
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