Monday, December 29, 2008

Two Greatest Mysteries of the Early 21st Century

When I look back at the almost-complete first decade of the 21st Century, I can make sense of most of it. But there are at least two mysteries which continue to vex me. Although I’ve read a lot about each of these issues, I have not read any truly satisfactory explanations.

1. Why did Saddam Hussein act guilty?

There is no way to describe Saddam Hussein’s behavior in the months and years leading up to the second Iraq war except as that of a man who had something to hide. Even though Hans Blix, the U.N.’s designated inspector, increasingly insisted he was making progress, Hussein never provided the transparency required to make the western world believe he had nothing to hide. Even in the winter of 2003, Hussein had declared all of his Presidential Palaces, which covered 32 square kilometers and possessed hundreds of buildings, completely off-limits to UN inspectors. The only explanation that makes sense is that a violation of his Presidential Palaces was somehow a matter of personal honor and, until the very end, he thought George Bush was bluffing. But it’s hard to imagine that Hussein thought Bush was bluffing in the winter of 2003, when Bush practically started using the word “when” rather than “if” as he spoke about an imminent invasion of Iraq. I suppose the western world had been so wimpy for so long in this respect (remember the UN’s 19 sanctions after the first Iraq War?) that Hussein just couldn’t imagine the cowardly infidels following through with their threats. Considering how he was found living alone in a ratty hole one year later, I’m sure that Hussein rued his faulty judgment to the day he died, swinging from a noose (an Iraqi one!). It is a conundrum which bothers me to this day.

2. Why is OPEC so secretive with its oilfield data?

There is perhaps nothing more important to the well-being of the modern world than energy. So when oil prices began an upward climb in 2003, leading to a peak of $147/barrel in the summer of 2008– an order of magnitude higher than it had been for 20 years – the world sat up and took notice (Indeed, I happen to believe that energy prices might have actually caused the beginnings of the financial crisis which began in 2008 – see here).

In order to figure out what is going on with energy prices at any given time, one is tempted to construct a bottoms-up analysis of both energy supply and energy demand. While the demand side of the equation is relatively easy to figure out given masses of available correlated financial data, the supply side of the equation is an informational black hole. We must simply admit that we don’t know. OPEC spokesmen are no help. At the height of the crisis this summer, they were insisting that supply was plentiful and orders were being filled on an orderly basis, all evidence to the contrary. Supply concerns got so dire, and the spot price of oil got so high, that people were looking to Matthew Simmons and his Peak Oil theories for help. Unfortunately, the only data he had was vague or old. OPEC has no interest in letting the world know what is going on within its tight confines, other than to brashly assert that it can cheaply meet projected demand for 50 years. Meanwhile, the self-declared “fair” price of oil had gone from around $20/barrel to $30-40, to $60, and then to $70-80, all within the space of about five years. And yet we are now hearing that various middle eastern governments don’t work (and appropriate investments will not be made) with the price of oil less than something like $80-90.

With the IEA releasing a decidedly glum report at the end of 2008 (for a summary, read this) which essentially confirmed the major tenets, if not necessarily the exact timing, of Peak Oil, the world has begun an ever increasing clamor for data from OPEC producers. But they remain mum. So my question is: if there is truly no practical limit to the amount of oil which OPEC can supply to the rest of the world, why don’t they show us? Why won’t they provide us with as much rig-level specificity as the oil analysts of the world would require? What, exactly, do they have to lose? The absence of such data will, at the very least, result in continued volatility of energy prices.

OPEC's reticence strikes me as very similar to Saddam Hussein’s in early 2003, and I am extremely uncomfortable with it. More than just about anything else, it makes me think that Peak Oil theories are more correct than not. And if so, then we’re all in for trouble, because $147 is going to seem cheap.

Thursday, December 25, 2008

Comparative Health Care Disadvantage

At the request of my stepfather-in-law during a Christmas dinner table discussion, I am here taking up the topic of the comparative disadvantage of the U.S. Auto companies (or any other U.S. company, for that matter) in competition with companies from countries with socialized medicine.

I’ll start with my answer first and then work backward.

The comparative disadvantage that US companies face in a global world is equal to the difference in average per capita health care spending by the company in question versus the per capita healthcare tax burden of the competing nation in question.

First, let’s recognize that health care is not free in countries with socialized medicine. The money must come from somewhere. In fact, it comes from workers, too, just not directly in the form of health care compensation, but indirectly through taxation.

All other things being equal, a company in a country with socialized medicine must pay a worker a higher wage so that he can afford the incremental tax associated with socialized medicine.

For simplicity’s sake, let’s look at workers in two countries. Let’s assume that the economies of the two countries are roughly similar, so that those workers are going to demand the same net disposable income for their labor. Let’s further assume that the two countries spend roughly the same amount of money on healthcare. Let’s also ignore administrative costs.




The company ends up paying the same total compensation to each of the workers, so there is no comparative advantage to one country or another under these strict assumptions. Socialized medicine alone does not save a company anything.

If there is any comparative advantage then, it has something to do with the assumptions I mentioned above.

This is a topic for another day, as it is simply ginormous in scope.

However, let me point out that Americans are profligate health care spenders. Anyone who has a bad knee or bad hip in the United States just goes out and gets a new one, at a cost of 15 or 20 thousand dollars. We have cancer centers in the United States where the cost of outfitting a single screening room might be several million dollars. I myself have had two knee surgeries in the past three years, trying to get one recalcitrant joint to behave properly so I can ski and play tennis. My similar counterpart in the UK has probably had only one surgery, and possibly none.

In my opinion, the single most compelling benefit of a socialized system of medicine would be to keep the cost of health care down. Such systems are like austerity programs for healthcare spending.

However, such a benefit comes at a tremendous cost of freedom, and I am not yet willing to give that up. I’d rather have Americans spending too much money on healthcare by choice than spending considerably less by necessity. For we can always choose to spend less if we can’t afford it. The converse is not true in a socialized system. I might not be skiing this year if I lived in the UK.

Wednesday, December 24, 2008

Merry Christmas

To all my faithful readers, and to everyone else, too, Merry Christmas.

It's a good thing we're about to get this awful year behind us!

As much as we might gripe, most of us still have much to be thankful for. Let's hope the new year brings hope and joy to everyone.

Tuesday, December 9, 2008

Blagojevich

I can't decide whether this is gut-bustingly hilarious, or just plain old depressing.

I tend toward the former, although the mirth it provides can be muted at times by the thought that someone like Blagojevich could actually be elected to the governorship of a relatively large state. Are there no barriers at all to elected office? Shouldn't we have some? Maybe make them take a civics test or something?

Thursday, December 4, 2008

Oily Chickens and Eggs

Sitting at lunch today, I had some rather profound thoughts regarding the financial crisis which has been unfolding around the world. It was in thinking about the validity of Peak Oil theories that these thoughts occurred to me.

Please bear with me, because I am just starting to work this out, and will use these pages to record my thoughts as they occur to me.

The question is this: is it possible that the beginnings of Peak Oil actually caused much of the financial distress we are encountering today?

The Cost of Energy in Layman’s Terms

Before I get to the main argument, let me go through some quick calculations.

In the United States, we consume about 20 million barrels of crude oil per day. Multiply by 365, and you get about 7.3 billion barrels of oil per year.

For the fifteen years just prior to about 2003, a barrel of oil traded at a price of just under $40 in real dollars (i.e. adjusted for inflation). In that year, the price of a barrel started climbing rather dramatically, as shown below:






The price of oil peaked just shy of $150 per barrel in the summer of 2008. That’s a rise of about $100 per barrel. Well, if we multiply that increase by the number of barrels we consume in a year, 7.3 billion, we understand that there was an economic cost to consumers of oil products in the United States of at least $730 billion per year if the price of oil were to remain at that level. These increases would be both direct (cost of auto fuel or heating oil) and indirect (increase in the cost of eggs which are transported to market with fuel).

Does that number, $730 billion, sound familiar? Doesn’t it sound like the amount of money that Hank Paulson requested from the Treasury to bail out the world financial system?

Now, please don’t get confused that these numbers have anything to do with each other – they are different things. But I mention the relationship so that you reader have some sense of the scale of the increase in the cost of oil.

In the summer of 2008, compared to all previous years, consumers in the United States were sending an additional $730 billion of annualized costs to producers of crude oil. That’s $730 billion less money that those consumers had for other things, like mortgages, car payments, tuition or earrings from Tiffany. There are about 110 million households in the United States. Do the math, and it turns out that this number is $6,636 per household per year.

That is an enormous number. The 2005 US Census estimated that median household income in the United States was just over $46,000 per year. So the increase in oil prices, by the summer of 2008, was consuming just shy of 15% of the entire income of the median American family.

Now, please also note that the American family is quite leveraged. A vast majority of the American family’s income is already pledged to other things, including mortgages, car payments, food and other such necessities. Where the heck is such a family going to get an extra $6,000?

When economists calculate the effects of increases in the cost of energy, they generally do their analyses on a net basis. In some sense, this is entirely appropriate, because the money which is spent on energy doesn’t actually disappear, it just gets rearranged. It goes from the consumers of energy to the producers of energy. It is not a surprise that Abu Dabi and Dubai are pretty fancy places these days; money has been flowing there in a torrent in recent years.

The point is that, when money flows to producers of oil, it is then invested back into the various world economies, promoting economic growth in one place or another. So the net effect of these increases in energy costs may not be that dramatic in terms of measuring global GDP growth.

However, getting back to our median household and that $6,000, I am beginning to think that the word of economists on global GDP growth may not mean much in the current context. As consumers in the United States have gotten more and more leveraged in the new century, I think that extra $6,000 of expense has become more and more dear.

In fact, I am beginning to believe that such an expense would create enough distress at the margin to increase, say, mortgage default rates up to the current level of 5.5%. And as you know (largely from my post here), that increase in mortgage default rates has rippled through our economy, creating further distress. That distress has unfolded in such a dramatic fashion as to cause the demise of the entire investment banking industry. We are in the midst of an unprecedented situation. I woke up yesterday to hear that the US government now had to bail out Citibank, to the tune of $306 billion of federal loan guarantees!

[ Side Note (don’t read this part if you don’t like economics): Another reason that economists may have underestimated the devastating effect of higher energy prices is that they generally perform their analyses taking into account inflation, as measured by a broad index like the CPI. Well, inflation tends to help consumers insofar as it makes their fixed obligations (mortgages, rents, car payments, etc.) easier to meet as prices & wages increase, but those fixed obligations stay the same. In this case, however, any inflation we’ve had is specifically tilted toward an increase in the price of energy costs, and it has not been accompanied by corresponding rise in wages. Therefore, the increased costs have imposed a true burden on consumers.]

So, I have come to the conclusion that, based on the sheer scale of the increase in the cost of energy, it is quite possible that the chain of events which has led to our current economic catastrophe could very well have started with energy costs.

A Connection to Peak Oil?

Peak Oilers were nodding their heads as the price of oil started to really skyrocket in 2006, saying “I told you so!” Conversely, however, as the price of a barrel has come back down to just over $50 per barrel in November, 2008, others have been reiterating their contention that the unprecedented run on the price of oil was due to the exploding existence of financial speculators in the marketplace, and as the asset bubble has burst and these speculators have disappeared, the price of oil has come back down to normal market prices.

I don’t know which of these two scenarios is correct. But anyone who knows me knows that I am intrigued, if not completely convinced, by the theories of Matthew Simmons and his fellow Peak Oilers.

As such, I have a competing theory for what has been going on in the world markets lately, given that it’s possible that the current financial crisis was set in motion by the spike in energy prices. And the conclusion is not pretty.

Let me explain.

It has been thought for some time that demand for oil is generally quite price inelastic. It has been shown in several studies with extensive historical data that the consumption of oil is highly insensitive to changes in price. The price of oil can go up fairly dramatically without really affecting people’s demand for it. This seems to comport with reality; in the United States, until about midway through 2008, even though the price of oil was rising fairly dramatically, people’s consumption patterns did not really change all that much. We still need our gasoline to get to work.

In fact, if one looks at the recent statistics, the theory is pretty much borne out:




The chart above shows supply of crude oil products from the U.S. DOE. It shows that, although the price of oil started to spike starting as early as 2003, consumption patterns were not really affected until sometime in the middle of 2008. This suggests that oil consumption, within some parameters at least, is indeed relatively unaffected by the price.

Here’s where it starts to get tricky, because, like most problems in macroeconomics, we are presented with a bit of a chicken and egg problem.

Most economists would probably contend that the unprecedented rise in oil prices in recent years was an anomaly, and that the reduction to $50 in the second half of 2008 is proof. Although most will admit some connection, they’ve dissociated the vast majority of the decrease in the price of energy from the recent economic distress.

Yikes!

But what if the rise in price was actually caused by real, Peak Oil, demand-curve economics? What if the world demand for oil was actually bumping up against the physical constraints of pumping an additional barrel of oil from the ground, and plain old supply-demand theories could actually explain 100% of the rise to $147/barrel? Certainly there’s plenty of data on the demand side of the equation to support this claim.

We’ve already established that demand for oil is relatively price inelastic. So the increasing price wouldn’t automatically quash demand.

But one thing we do know, with utmost certainty – one thing that all economists would agree upon – is that the demand for oil is highly correlated with economic activity. When economic activity ceases – as it has now – the demand for oil, and energy in general, plummets. Less tankers traverse the seas to deliver goods. People fly on airplanes less. Families stay home for vacations, instead of driving to Vermont. Power plants deliver less juice to manufacturing plants.

Is it possible that economists have gotten the chicken and egg reversed? What if Peak Oil issues actually created most of the increase in energy costs? What if those energy costs increased in unprecedented ways, such that, for the first time in history, they actually became an economic burden on the average American household just when it was most leveraged? That $6,000 per year we calculated at the beginning of the article sure seems like a lot of money, doesn’t it?

What if Peak Oil caused a rise in the price of energy, and because of the inelasticity of demand, that price didn’t come back down until the price of oil itself had caused enough of an economic cycle to cause significant demand destruction?

The implications of this point of view are simply chilling. It suggests that the limits to our future growth, indeed the extent to which we are going to be able to pull ourselves out of this financial mess, are dictated primarily by the supply of cheap energy.

Get growing again, and the price of oil goes up again. Soon enough, the world can’t maintain the economic dislocation from energy costs, and we’re back in an economic cycle.

Furthermore - and this is probably a topic for another day - because of the relative inelasticity of oil demand and the way that such dynamics exhibit themselves in the marketplace, it suggests that we might be in for quite a bit more volatility in our economic cycles than we have ever experienced, at least since the Great Depression. The latest events unfolding around the world seem to confirm at least this part of the theory.

Conclusion
These are cloudy thoughts I am having. If you’ve read this far, I appreciate your patience, as I’m unsure of them myself. I just wanted to get them down in writing so that I could test my thoughts against history as it unfolds over the next several years and decades. Obviously, I will revisit all of these thoughts from time to time and update as appropriate. Please feel free to comment, though save any ad hominem attacks for other blogs.

Monday, December 1, 2008

High Larity in Venezuela

I was listening to NPR on my way to work this morning. They did a short piece on the presence of Russia’s Navy in the Caribbean for the first time since the Cold War. Russia has apparently accepted an invitation from Hugo Chavez to perform naval maneuvers with the Venezuelan Navy. The media is all a-titter about it.

The NPR correspondent attended, and recorded, a brief ceremony at La Guaira, the port city near the capital, Caracas. President Chavez spoke at the ceremony, as did one or more Russian naval officers. During the course of the piece, NPR played various marches performed by the Venezuelan military band whose performance preceded the talks.

The band sounded eerily similar to my son’s middle school band. The horn section, in particular, created a jovial dissonance with its off-key harmonies. I imagined uniforms with buttons missing, hats askew and soldiers wearing two different boots.

If the competence and professionalism of the Venezuelan Navy is at all comparable to that of the Venezuelan Navy Band, I think we don’t have much to worry about. Chavez has got some work to do before their Naval breast-beating is something to take seriously.