Energise

How to survive and prosper in the Age of Scarcity

EDDIE HOBBS

PENGUIN IRELAND

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First published 2010

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ISBN: 978-1-84-488231-1

Figures

6.1.	Oil and gas production profiles – 2008 base case
6.2.	The growing gap between past and estimated future discoveries
6.3.	The growing gap between capacity and demand
6.4.	The price of oil, 1999–2009
6.5.	Two very different consumption trends for oil
6.6.	The Strait of Hormuz

Tables

3.1.	The top oil players, 2007
3.2.	Top fifteen natural gas proven reserves, 2009
3.3.	Top ten gold reserves
3.4.	Gold purity
4.1.	Stocks in Canada, Russia, Australia and Brazil captured by ETF
A.1.	Example profit-and-loss account
A.2.	Example balance sheet
A.3.	Example cash-flow statement

Abbreviations

AMEX	American Stock Exchange
API	American Petroleum Institute
ASPO	Association for the Study of Peak Oil and Gas
BRIC	Brazil, Russia, India and China
CIBC	Canadian Imperial Banking Corporation
CME	Chicago Mercantile Exchange
CPI	consumer price index
CRAB	Canada, Russia, Australia and Brazil
EIA	Energy Information Administration (US)
EROEI	energy return on energy invested
ETC	exchange-traded commodity
ETF	exchange-traded fund
GDP	gross domestic product
IEA	International Energy Agency
IPO	initial public offering
mbpd	million barrels per day
NASDAQ	National Association of Securities Dealers Automated Quotations (US)
NDP	National Development Plan
NYMEX	New York Mercantile Exchange
NYSE	New York Stock Exchange
OECD	Organisation for Economic Co-operation and Development
OPEC	Organisation of Petroleum Exporting Countries
P/E ratio	profit/earnings ratio
PLC	public limited company
UCITS	Undertaking for Collective Investment in Transferable Securities
UN IPCC	United Nations Intergovernmental Panel on Climate Change
UNFCCC	United Nations Framework Convention on Climate Change

Introduction

The natural resources of the planet, especially oil, are depleting. This depletion is happening on our watch and it is the single most important economic change since industrialisation. This conclusion rolled across me like a series of thunderclaps four years ago. Like many people, I’d come to accept conventional thinking that oil scarcity was just another scare story exaggerated by oddballs determined to send us back to an Amish lifestyle abundant in self-sufficiency and social cohesion, but with no electricity. My way of thinking was very cosy – it was also pretty stupid and it was very wrong.

Think about it. Just about everything we do is based on oil. Through the use of mechanisation, earth is used to turn oil into food to feed 6.5 billion people. The quadrupling of the world’s population since 1900 directly correlates to increased oil production throughout the twentieth century. Oil is the lifeblood for our transport, pharmaceuticals and plastics industries, and just about every other product and service you care to think about. It is the world’s most efficient, scalable, transportable source of energy, as well as being the safest.

A temporary disruption in oil supply can have game-changing economic consequences, as we learned during the oil crisis in the 1970s. A permanent depletion in oil supply – created by the rising gap between falling production and rising energy demand – won’t just change economics, it will change society and how we live for ever.

The world endowment of recoverable oil has a limit. Individual oil fields have natural lifetimes from discovery to exhaustion, which is measured in decades. Peaking occurs when half the world’s recoverable oil has been produced and depletion sets in. World peaking occurs when, even allowing for the addition of new fields, the overall production of oil still begins to decline. Supplies become scarcer and prices rise. In a society as dependent on oil as ours, that’s a serious situation, and one that could be just around the corner.

You might, then, expect peak oil to be in the news every day. There are many reasons it isn’t. The experts who estimate oil reserves use a range of technical tools, overlaid with a great deal of personal judgement, in their calculations and, even though they are using the same data, they arrive at different estimates for peak oil. Politics and commercial self-interest also play a role with oil-field owners exaggerating their reserves to gain business advantage and national governments relying almost exclusively on reports from the International Energy Agency (IEA) as a base for their national development strategies.

The IEA is a Paris-based organisation that advises most of the world’s leading industrialised economies on energy use. Until 2008, IEA data was based on estimates supplied from markets rather than from an audit of world oil. However, in November of that year, following a detailed study of oil fields, the IEA dramatically shifted its position from being sceptical that a world peak would soon be reached to admitting that it could occur within the next two decades. In a report that shattered many of the myths about oil, the IEA doubled its estimate of decline rates from 3.7% per year to 6.7% per year, and now estimates that another four Saudi Arabias would be needed to plug the depletion rate in oil production over the next twenty years just to meet current energy demand. It would take six Saudi Arabias to meet demand if growth were to continue at its present rate.

In a landmark report to the US Department of Energy in October 2005, Robert Hirsch, a noted senior energy programme advisor who directed the US fusion energy project in the 1970s and who has managed technology programmes across most aspects of energy technology, warned that waiting until world peak oil occurred before taking action would lead to two decades of significant deficits in liquid fuels. He further estimated that even if a crash programme were initiated ten years before the peak was reached, there would still be a decade of fuel shortages. Only a crash programme that was begun twenty years before peak would avoid a world liquid fuel shortfall.

Peak oil for individual fields rarely becomes obvious until well after it has physically occurred, and it is then usually followed by rapid depletion. Global peak oil has been variously forecast by independent experts to occur sometime between 2005 and 2011. The IEA estimates that it will occur around 2030, but that estimate relies on dubious growth estimates of oil production from non-conventional sources such as Canadian oil sands and natural gas liquids. It also assumes there will be a huge investment in new infrastructure and that there will be continued co-operation from the oil-producing nations, many of whom are facing domestic peak oil and increasing domestic demand. By contrast, the Energy Watch Group, a Berlin-based independent scientific organisation, estimates peak oil occurred in 2006 and it challenges the IEA estimates of conventional world oil reserves being at 1.255 trillion barrels, instead placing them 32% lower at 854 billion barrels. Energy Watch Group says the biggest disparity is in the Middle East, where it estimates oil reserves are some 46% lower than the IEA figures. On Friday 13 November 2009 the Guardian newspaper reported on a senior IEA official spilling the beans about US pressure on the IEA to underplay the looming oil shortage in order to prevent panic buying. The official claimed that the IEA was understating the rate of decline and overstating the likelihood of new discoveries.

The economic crisis in 2008 pulled oil prices down to a little over $30 a barrel, providing temporary relief from the sky-high prices that had touched $147 a barrel a couple of months before the crash. But even as the global economy grappled with the impact of the banking crisis, oil prices began to rise again and crept past $60 a barrel in May 2009. While we may continue to experience shocks and reversals before real recovery begins, the recession doesn’t change the underlying mismatch between oil production and growth in demand embedded in the global economy. The current recession has merely delayed the inevitable. At the time of writing in late 2009, it still isn’t clear if emerging economic growth is going to be sustainable, especially in the USA, or if it is merely a stimulus-driven burst before another leg down into a multi-year depression. Such is the level of debt carried over from at least two decades of excessive borrowing for consumption purposes across the US consumer sector that government supports and incentives, such as cash for clunkers (a scrappage allowance for old, inefficient cars), may not prove to be adequate counter measures.

The real possibility remains of a long-term trend among US consumers to save and repair debt rather than to return to past consumption patterns, while inflation is exacerbated by the dollar going into freefall because of the yawning US deficit. What will happen to the world’s leading economy, which accounts for 30% of global GDP and is 70% dependent on consumer spending, is anybody’s guess. But the real story of oil is being driven by factors elsewhere, especially red-hot demand from fast-growing, non-OECD countries. (In simple terms the OECD is Europe, Japan and North America, and the non-OECD is just about everywhere else.)

A major global recession was avoided during the dotcom bubble burst from 2001 to 2003 because the Bush administration flooded the US economy with cash through a tax scheme and sharply lowered interest rates. However, arguably all this did was help fuel a credit bubble and buy time before the end of the long economic cycle that started in the early 1980s, bookending the high inflation of the 1970s, which was characterised by low interest rates, low inflation and largely uninterrupted growth. The big by-product of the age that started with Reaganomics was the creation of a globalised economy that put non-OECD economies on an unstoppable growth path and led to a scramble for the limited natural resources of the planet.

But what if the recessions of 2001–3 and 2007–9 are part of the same major adjustment, heralding the end of the latest economic era, whose death has been avoided artificially by a massive credit bubble? What if this latest adjustment announces the beginning of a new economic age? What if most of the wealth built up in the intervening years is no more than an illusion fuelled by excessive credit, and we’re going back to where we were, just with less credit and tighter regulation? Or, worse, what if bigger forces are at play and we are entering an entirely new economic age: the Age of Scarcity?

I wrote Energise as a way of finding answers to these questions for myself and also as a warning to Irish, European and international readers. If my line of thinking is accurate, whether we face ruin or prosperity depends on how well we’re prepared for the major structural shift that is already underway.

Let me tell you what I have found. In 2005, in the challenging Irish television series Rip Off Republic, I explored how energy operates in Ireland and why prices, interlinked with inflated property values, were so high. In the aftermath of Rip Off Republic, I set out to disprove the theory on peak oil, because I reckoned it couldn’t stack up.

Peak anything is that theoretical point where half the easy-to-reach and cheap natural resources, like oil, have been consumed. It doesn’t mean the end of supply, but it does mean the beginning of scarcity pricing as supply plateaus and demand rises above it. What I have learned from my research has not only alarmed me, but has changed my entire thinking about personal investment planning, about the global economy and about the environment. This journey took me through the pros and cons of what was then a narrow theoretical debate: that oil prices were set to escalate rapidly to well over $100 per barrel, that the fundamental value of oil was more likely to be as high as $500 a barrel and that a prolonged period of boom and bust linked to volatile price spikes in energy seemed unavoidable. The information was out there, and there was lots of it; all it needed was a willingness to look around the corner – and no great intellectual insights on my behalf because I have none.

In March 2006 I told a Progressive Democrats party gathering in Limerick to buy gold because the biggest risk to the Irish economy was a credit-bubble burst in the US. The audience pretty much ignored my advice and a Sunday newspaper sneered. The next year I urged the Green Party’s pre-election conference in Galway to enter government but to switch their emphasis from climate change to oil scarcity. But even the Green Party, whose senior members know the energy story, stuck with CO₂ emissions and carbon taxes as the main course, despite the fact that the Irish economy is at an elevated risk of collapse until the country becomes energy independent.

In 2008 the government, which at this stage included the Green Party, issued two key reports on oil: one dealing with the security of supply and the other with the national plan to deal with shortages. Although more than forty risks, such as labour strikes, terrorist attacks, etc., were examined, neither report dealt with the most important national risk – a permanent decline in oil supply. In fact, in neither report was there even one sentence mentioning peak oil, despite the fact that, in the same year, the IEA, of which Ireland is a member, was conducting a game-changing audit on world oil reserves.

In the meantime, important events have intervened. In 2009 Spirit of Ireland – a private initiative by Irish entrepreneurs, academics and engineers – was launched in a series of national ads with the aim of making Ireland largely energy independent by utilising Ireland’s unique Atlantic-facing topography and weather patterns to generate electricity from wind and hydropower. The organisation’s exciting plan has been a breath of fresh air and has helped match Ireland’s ephemeral and limited energy ambitions with a solid solution. At the very least, this plan has accelerated the important debate on Irish energy and, at best, it may play a pivotal role in the country’s energy solution. Any ambition to transform the Irish economy into a net energy exporter and a beacon for foreign direct investment, attracted by long-term, reliable, low-carbon energy and price security, is worth pursuing.

Globally, the single most important event of recent years has been Barack Obama’s election to the US presidency. Obama’s chief medium-term goal is to wean the world’s largest economy off Middle Eastern oil imports by 2020, a staggering ambition and one set to transform the USA. Listen closely to him and the US president puts energy as his top priority ahead of healthcare and education. Clearly, Obama gets it – and his leadership at this crossover may yet prove to be critical in raising energy to the top of the global economic agenda.

Between 2005 and the downturn in 2008, oil prices increased nearly threefold – and that is just the beginning. By mid-2008, the price of oil had raced past $100 per barrel and was touching $147. Then came the credit-bubble burst. In simple terms, the burst has eliminated most of the wealth accumulated during the five years since the dotcom bubble. But what it hasn’t eliminated is the long-term mismatch between the growth in demand for energy and other natural resources and the level of production at current prices.

Originally dismissed as cranks, those few writing on these themes some years ago foresaw what was to come. I was a late convert. I admit I don’t know how high oil prices will go or if some of the more extreme forecasts, like economic collapse, will come to pass, but I am now convinced that the old conventions of safe investment in traditional assets are going to prove very wrong and will destroy wealth as we enter a long period of high inflation. I am also convinced that the combination of peak oil and the need to transform the way we live and measure economic growth, coming at a time when human beings have created a global communications revolution, will spark a new revolution in invention and innovation in clean energy, in energy efficiency and in new sciences which will lead, after a period of turbulence, to a new age in human development in which we finally learn to switch from measuring progress narrowly by GDP to measuring progress by pricing it against the theft of resources from our children and their children.

However, for the moment, Ireland still sleeps. The destruction of tax revenues, which is crippling public finances, is not, as is commonly thought, the greatest challenge to Ireland’s economic wellbeing. Far more serious is its energy dependence on imported fossil fuels. Even if the long-term target of 40% green energy is achieved, Ireland will still depend on imports for 60% of its energy. Sitting on the western edge of the European energy grid, with practically no energy sources of its own, Ireland has one of the most exposed economies to turbulence in oil and gas pricing in the world.

Even if the renewable energy targets set by the government are achieved, they will not be enough to stave off an energy drought and a sharp economic reversal caused by competitive advantage shifting to favour nations with the greatest energy independence. Don’t expect Intel to stay when the Irish national grid becomes unstable. We are in a race to leave oil as fast as possible but there is not yet enough urgency or public debate on the hard choices that lie ahead, like fast-tracking new, strategic energy projects and considering nuclear electricity interconnectors – whether the voters like it or not. If Ireland is to complete a northwest European energy grid, combining with France and Britain, multiple interconnections will be required. So far, there is one interconnector in development to Wales. It is a simple statement of fact that fanciful notions of generating 40% of our electricity from the wind are not viable without the ability to offload seasonal excess, for example on windy summer nights; without interconnection, turbines will need to be shut down with huge losses to investors.

That Ireland’s energy policy is confused is an understatement. The Irish Department of Communications, Energy and Natural Resources is stuck in the past relying on outdated and discredited IEA reports not just for energy supplies but for the entire foundation of Ireland’s national development plan. Ireland is not alone: most other countries have based their national economic plans on discredited and outdated IEA assumptions about the future of affordable oil. That’s why, for Irish readers, I suggest a course of action you can take to elevate energy-related investment from a personal to a national priority. At least you won’t be toiling on entirely barren ground or on ground hogged by weak Green initiatives. On the opposition side, the Fine Gael policy think tank has a multifaceted strategy, labelled NewERA, to develop a national recovery agency by a reform and refocus of state companies. It includes important thinking on renewable energy and removing Irish dependence on imported fossil fuels.

Despite occasional breakouts in the mass media, the peak oil message has been swamped by shorter-term issues like collapsing property prices and economic reversal. Predictably, it will only be as rising oil prices hit ever higher psychological barriers – first there was $50 per barrel, then $100, next $200 – that the scale of the emergency facing us will be grasped. The climate change debate followed a similar pattern – as forecasts were replaced by evidence, the argument was more widely accepted. The next question is, can we react in time?

The slowness in realising the truth that is emerging from the tyranny of facts that dominate the peak oil debate is easy to understand; there is an overwhelming array of vested interests promoting disbelief about the depletion in fossil fuels. Enormous sums of money are invested on the notion that there is an abundance of cheap fossil-fuel energy, especially oil, available on the planet. These vested interests range from the military and infrastructure industries through to automobile manufacturers and airlines and the governments that they hold captive in mutually binding economic relationships that have existed for generations. Collectively, a doctrine of rejection has been established that will crumble only as oil hits super-high prices.

In Ireland, the get-out-of-jail card has been the National Development Plan. But it’s a sham – the NDP is based on the falsehood that oil will be $100 per barrel by 2020, as enshrined in the government’s 2006 energy policy. That, in turn, is based on an earlier IEA assumption that has already been proved wrong and which is challenged by the IEA’s more recent reports (covered in Chapter 5). Ireland is building an infrastructure for an age – the cheap oil age – that has passed and is pricing the cost of the commodities and energy needed to implement the NDP on assumptions that are recklessly wrong.

Climate change and the damage caused by CO₂ emissions from fossil fuels are no longer regarded as quaint theories put forward by suit-and-sandal environmentalists, rather they are seen as very serious, real and current issues, as evidenced by the melting of the Greenland ice-cap and large ice fields in Antarctica. Oil depletion is following the same trajectory in terms of gaining widespread understanding but there’s still a long way to go before the truth is accepted by the majority.

But you can act now. You can divest yourself of assets that will be hit hard by prolonged energy-led inflation and switch to assets that are positioned to create wealth during what will be the longest and largest commodity bull market in modern history. Energise will show you how to benefit. But you can also invest now in energy-efficient technologies ranging from basic cavity-wall injection to state-of-the-art smart meters and you can move from companies that make big-engined gas guzzlers to those pioneering smaller hybrid engines. There’s a lot you can do to prepare.

While I am confident that human ingenuity, resources and technology will arrive to plug the gap between depleting oil and gas resources and rising demand, I’ve no confidence that these will arrive on time or at sufficient velocity to avoid a prolonged period, lasting between ten and twenty years, when we will experience a period of high inflation in both energy and commodity prices.

Not only does this pose significant problems to economies that, like Ireland’s, are more exposed towards energy as an input cost, but it has the potential to devastate the balance sheets of those who are unwilling to prepare (for this reason Chapter 1 deals with the effects of the 1970s oil crisis). The best-case scenario is a turbulent few decades as we wean ourselves off oil while struggling with the gap between rising energy demand and affordable supply. The worst-case scenario is an economic collapse as we return to pre-oil age standards of living. Because this is a possible outcome if we reach a tipping point, having failed to make sufficient progress in reducing our dependency on fossil fuels, Energise will explore it.

Energise is delivered as a conversation, identifying along the way businesses that are interesting and appear, at least on a cursory glance, to be well positioned to benefit from the commodity bull market we are about to experience. But, be warned, I am not an expert in analysing individual companies and their share prices. I can identify economic trends and shifts and suggest how to allocate assets, especially into funds, but stock picking is a matter best conducted by experts. You will need to undertake more current research and, if necessary, take advice from suitably qualified stockbrokers and analysts who’ve freshly researched these companies, before investing. I have neither the skill, the experience nor the resources to do this. Instead, what I have done is select funds and exchange-traded funds (ETFs) as well as shares mostly in sector-dominant companies. Recent developments in ETFs and in exchange-traded commodities in Europe, especially by the investment group ETF Securities, provide a vast scope to play these markets without resorting to pure stock picking. This book will also introduce you to wild cards, more volatile embryonic companies that could have far higher upside potential, albeit with higher risks, to add some sizzle to your portfolio. You’ll find these companies predominantly in the emerging green-energy sector, which still remains a minnow when measured against the breadth and scale of quoted stock markets.

The trick with any investing is to strike a balance that suits you. If you’re uncomfortable with stocks, stick to funds. A well-managed fund or ETF will beat a poorly constructed stock portfolio hands down. However, if you like stocks, load up on sector-dominant players, but, at the same time, don’t ignore the vast potential from emerging companies in green energy and, especially, in energy efficiency. Most Irish balance sheets are 50% to 70% dominated by Irish property and by Irish shares, whether directly held or through pension and investment funds. The common-or-garden variety mixed fund in Ireland has very little positive exposure to the mega-trends outlined in this book. This is why I’ve been urging diversification. There’s no optimum mix of assets, but if your balance sheet ends up dotted with gold, energy, commodities and energy-efficiency investments added to index-linked Eurobonds and commercial property with rents linked to the consumer price index (CPI), to hedge against inflation, you’ll have got the message and you’ll be prepared for what is ahead.

Timing is everything and you should consider this book as a starting point for assembling a portfolio of investments that will help you benefit from the forces now unleashed. The downturn has compressed prices and earnings across all sectors, including energy, representing an opportunity to get into energy-related assets at values not seen for several years. In many instances prices by mid-2009 were at half their levels before the sharp downturn in equity markets, which represents a great opportunity to buy into some of the biggest energy and commodity companies in the world, companies that are sitting on a vast swathe of assets set to go sharply higher as demand growth regains momentum. In simple terms, for many fine companies 2001 prices are available in 2009. That doesn’t make 2009 the ideal year to invest – far from it. By mid-year, it was already clear that very substantial risks remain to investors and that, as government-sponsored economic stimuli wear out, the global economy could go into another tail spin – in other words, a W-shaped recession. Remember, while the first shock to the banking system was delivered principally from sub-prime debt default, other shock waves lie ahead: for example, to refinance the credit market, large numbers of US borrowers will have to switch from their deeply discounted, adjustable-rate mortgages to higher-priced mortgages. Simultaneously, batches of commercial mortgages, which typically rollover every five years, are coming up for refinance in a difficult lending market as US commercial real-estate values continue to fall.

The rising cost of borrowing and lower property prices, combined with higher unemployment and bankruptcies, will act, at best, as a drag on US economic recovery, so vital to recovery elsewhere. The only good news about a protracted recovery is that it will give you time to prepare for what will happen afterwards when the global appetite for energy picks up pace again. But as the recovery begins, whether V-shaped, U-shaped or W-shaped, don’t make the mistake of consigning the 2008–9 recession to history, filing it away as a banking crisis. Ask yourself, what fundamental conditions caused the crisis? Was it really just about sloppy regulation and greedy bankers chasing bonuses? Low oil prices and low inflation create low interest rates. Cheap borrowing accelerates credit expansion and pumps up speculative bubbles. Keep going for long enough and asset prices inflate across the board as credit becomes addictive – the only way to wealth is to leverage bank finance on those ever rising asset values as servicing the finance becomes easy because interest rates are so low.

But what happens when interest rates begin to rise as asset prices get red hot? What causes rates to go up? Take a close look at the recent history of recessions and most of them coincide with spikes in oil prices. In the run-up to the most recent recession, oil prices shot up sevenfold from a cosy $20 per barrel in 2000 to nearly $150 per barrel by 2008. By 2007, US inflation, touching 6%, was being tracked by rising interest rates. The speculative bubble was about to burst and did so in dramatic fashion in 2008 when top US investment bank Lehman Bros collapsed under a mountain of debt. By 2009 interest rates had been cut to historic lows and governments had stepped in with massive stimulus packages. The evidence, by mid-2009, was that these steps had begun to stabilise the global economy, but even in the depths of the downturn, take a look at oil prices. After hitting a low just under $40 a barrel, prices had nearly doubled by the summer of 2009. What do you think will happen as the real recovery kicks in and oil demand rises? That’s right, much higher prices and inflation. Oil isn’t the only commodity to begin to race back, copper prices had also doubled by mid-year.

The first half of the book will take you through a basic understanding of commodities before presenting the evidence about why rising oil prices are not just a temporary glitch driven by speculation but rather a fundamental switch as the world moves past peak oil. If you’re unfamiliar with the techniques needed to look under the bonnet of the financial data produced by PLCs, don’t worry, I’ve transported and updated sections from my previous general investment book published in 2006 to help you prepare. Don’t be put off by being introduced to new companies or the thought of buying shares directly. It’s really quite simple, good companies exist all over the world, well positioned to grow while others fade. It’s just a question of digging them out like truffles – and Energise provides a start for you.

Be prepared, you will be introduced to new lines of thinking that may significantly challenge your existing beliefs. Fund managers, life companies, major international investment houses and national governments continue to deny officially that there is an immediate and substantial problem with energy supplies at affordable prices. The reason is simple. Accepting the problem would mean having to do something about it and face very substantial write-offs in the wealth buried in assets that are negatively exposed to the forces now at loose in the global economy.

That’s why the book contains a full chapter on fresher information from the IEA released in November 2008 – and missed almost entirely by the media. The IEA report, and its interim warning that underinvestment in infrastructure during the downturn will lead to an imminent oil spike, is an early warning that these forces are already in play. So how can you prosper and avoid ruin in the coming Age of Scarcity? Well, let’s start with what happened in the 1970s, a rough template for what’s to come.