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Why 95% of Traders Fail

IMF Recycle Peak Oil Theory

Commodities / Crude Oil Jun 03, 2013 - 12:39 PM GMT

By: Andrew_McKillop

Commodities

OIL AT $750 PER BARREL
Since late 2012, on several occasions, the deputy chief of financial modeling at the IMF (International Monetary Fund), Michael Kumhof, has said in interview that: "Ignoring the peak oil issue would be highly unscientific, even irresponsible".

While the IMF remains officially neutral on the subject, Kumhof and his colleagues claim to be certain that the scientific basis of their concern, which includes the thermodynamic theory of entropic energy dissipation, is inexorable. In a certain timespan - which they do not define - oil prices could rise by "up to 800%" compared with current prices. To the extent that Kumhof sets timeframes, this process of rising oil prices might begin by 2017 and, Kumhof claims, will go on "for ever".


Possibly not unrelated to IMF concern in Peak Oil. Goldman Sachs has on several occasions, since late 2012, issued statements on oil which signal the same "scientific" concern.

Quoted in the London 'Daily Telegraph', 26 August 2012:

"Goldman Sachs said the (oil) industry is chronically incapable of meeting global needs (adding that) it is only a matter of time before inventories and OPEC spare capacity become effectively exhausted, requiring higher oil prices to restrain demand. Economists, politicians and the public will continue to deny and ignore the facts, pointing to other factors as the root causes of the state of the economy. Now more than ever, countries like the USA need leaders that are capable of understanding our predicament and lead onto a new path forward".

For GS, we can surmise, talking up oil asset values along with the oil price is normal practice, but in late August 2012, Goldman Sachs was arguing that oil prices would drop!

CONVENTIONAL VERSUS SHALE

Kumhof brushes aside the US shale gas boom, and rapid-growing shale oil output as a flash in the pan. In his words: "....you have the new US oil shale play going on. I think it's going to help a little bit, but not that much". He claims that geological depletion of conventional oil resources will outstrip unconventional hydrocarbon resource output growth, and will drive prices to extreme highs.

Nevertheless, while Kumhof re-stokes interest in Peak Oil, nowhere in his modeling does Peak Gas figure - for easily understood reasons. Peak Gas is already a lost cause, due to the stranded gas boom, featuring deep offshore conventional and unconventional gas resources, and the shale gas boom. Even taken separately, these two "new gas resources" hold mindboggling quantities of gas for potential future gas supply.  Global shale energy resources are geologically located in the world's Hercynian-Variscan orogenic zones. These also include deep coal, and therefore coalbed methane potential. As one single example, there is the Rhenohercynian Basin stretching from Cornwall and South Wales, in the west, to Belgium, Germany and Poland in the east. This contains massive amounts of deep coal which is presently not recoverable, and linked coalbed methane resources, which probably are. Fear and anguish about world gas resources "running out" is mightily difficult, these days.

For Kumhof and his team at the IMF, however, they are rock-solid certain that oil production will decline - but oil demand will not - leading to permanent and extreme high oil prices. Their theory on oil production declining, which is "classic Peak Oil theory" is based on two key arguments:

* Since late 2005 the growth rate of world conventional crude oil output has been close to zero.

* Unconventional oil, not including shale oil until 2009, but including gas liquids, has been the only source of global hydrocarbon liquids output growth.

The financial and economic read-out from this, Kumhof says, can be summarized in his words as: "maybe we are already at the historic maximum level of world production", meaning that any growth in world oil demand can only drive prices up. Regarding the subject of oil demand growth, Kumhof cites the International Energy Agency, the IMF's linked agency treating energy issues, which continues to claim that world oil demand can only, and will only grow. As we know, on a very regular basis, the IEA downwardly revises its previous or most-recent oil demand growth forecasts.

NOT FORGETTING ENTROPY THEORY

 Kumhof adds entropy theory - citing Nicholas Georgescu-Roegen -  to what he calls the scientific bases of his Peak Oil theory. He cites the thermodynamic law of energy states always tending towards dissipated states from cencentrated states, then goes on to muse that our present economic infrastructures, adapted to and based on highly concentrated, low entropy fossil fuels are threatened with "falling apart after a few decades". Among the many amazing features of Kumhof's theories (whether IMF-approved or only IMF-tolerated), he ignores renewable and alternate energies except shale oil. Taking solar photovoltaics (and also photosynthetic pigments in plants and algae), these operate through totally non-theromdynamic processes, with zero thermochemical action, and therefore zero increase in entropy. As we also know, for wind and solar power, these have marginal "fuel" costs of zero meaning it is impossible for the next kilowatthour output to cost more than the present one.

Kumhof's main thesis is couched in squeakily neo-science terminology, very similar to the "scientific" forecasts of climate apocalypse "just around the corner". His "Petro Apocalypse" is dated as about 2030, starting about 2017, but there is plenty of leeway in the dating. In fact, Kumhof states his theory as firstly being sure world oil production will decline. but not being certain when the decline of production might start. He immediately shifts on - like Goldman Sachs - to saying the implications of this possible decline would be so grave that he is forced to treat the issue "very seriously".

Very surprising, even astounding for an outsider, this new IMF-tolerated/approved Peak Oil theory is mostly focused on geological depletion of oil resources - not on the decline of economic and financial resources used to maintain, or used to try increasing world total oil output. Kumhof makes short shrift of the facts that world "unconventional" oil output is growing fast, "conventional" oil output is at best stagnant or declining, new oil is highly different from old oil, and world oil demand is at best very weakly growing. He counters with the claim there is only a certain leeway in the time frame "between the most pessimistic and the most optimistic scenarios, before the decline starts".

The theory of "entropic decline", which was first popularized in the 1930s on the back of then-recent atomic science, is comparable with "global warming apocalypse", now mutated to the fear of "anthropogenic weather disruption". The common thread is these are imagined to be events and processes which humans may or may not have caused themselves, but will certainly and surely suffer from. As already noted however, Peak Gas was a co-equal doomster theme about 2006, but has come and gone due to the shale and stranded gas resource booms. With Peak Oil however, an opportunity window still remains - - for trying to prevent oil prices and oil-related assets declining too fast. Bolstering oil prices and helping oil-related equities to "fly", can benefit from IMF-level musings on the Petro Apocalypse, warnings about the claimed-as-possible imminent decline of world oil production, and its claimed-as-certain sombre financial and economic impacts.

OIL HAS TO RUN OUT ONE DAY

The wait-and-see component of Kumhof's oil theory can be summarized as above, but even this isn't sure. Oil energy can be replaced and subsituted. It can also be not used at all - by energy conservation. Decline of world oil demand from around present-day levels (about 89.8 million barrels/day), despite what the IEA might say, is totally possible. To not use Kumhof's neo-science terminology, the decline of oil energy in world energy is a lot better bet than waiting for oil to run out.

It is all very well for Kumhof to say the IMF relies (possibly exclusively) on IEA oil demand data and forecasts. Taking only the "2008-2009 oil sequence", any IEA forecasts on oil demand and oil prices before early 2008, were totally different from its oil demand and oil price forecasts of late 2008 and throughout 2009. The reason was simple: it was impossible for the IEA to ignore the real world! Oil demand crashed and oil prices crashed.

Kumhof, if he wants, can brush aside shale oil as just a flash in the pan, but the world's potential and theoretical total of "unconventional" oil resources, which as already noted are "new oil" and include condensate or gas liquids and extremely light shale oil, very different from present crudes, are mind boggling. Being in charge of financial modeling at the IMF, it is also amazing, at least to me, that Kumhof does not argue that the breakeven price and recoverability of shale oil sets a new floor price for world oil - as high as $65 or $70 per barrel. But he prefers to talk about $750 per barrel!

Nowhere in his arguments is there any discussion of oil energy substitution, for example shifting road, rail and marine transport to run on natural gas and "squeezing oil out of the energy mix".

Just as astounding, the collapse of oil demand growth in nearly all OECD countries, and the halving of demand growth rates since 2008 in the Emerging economies figures nowhere in IMF Peak Oil lore. In the case of almost all EU countries or Japan, it is necessary to go back as far as 7 - 15 years to find any significant oil demand growth in their energy economies.

Very very arbitrarily as we wouldn't expect from IMF studies, Kumhof and colleagues scenarize that world oil output will decline by 2% every year "for a number of years", from various start dates which they deliberately badly define, but can or may include 2017. This generates a "mechanical" fall in the growth rate of GDP of about 1 percentage point per year in the US, the Euro area, Japan and Korea.

FINANCIAL AND ECONOMIC ARMAGEDDON

Also like climate crisis researchers, calling themselves "scientific", this 1% a year clip off GDP growth is extended ahead for 20 years just like that (previously, we can note, this was described as "for a number of years"). The result is that that OECD regional GDP, around one-half world economic output, ends up about 20% below its previous growth trend, after 20 years. This in fact - if it had any chance of becoming real - would be equivalent to approximately doubling the current worst ever OECD debt-and-deficit crisis, by its financial and economic impact. This would be Financial Armageddon.

As already mentioned it is possible the real goal of this scenarizing is to keep up oil prices and oil asset values. No serious oil substitution is modeled by Kumhof, from the start of oil prices rising "for ever" , enabling oil prices in his words:  "to rise to very high levels, in fact almost 800%". This would equate to prices in constant-value 2013 dollars around or above $750 per barrel!

Kumhof concedes that from certain price levels for oil, say $200 per barrel, the effect of oil prices on the economy and GDP will be "non-linear". More precisely, beyond price levels of say $200 per barrel a lot of businesses will not be able to cope. Especially vulnerable sectors cited by Kumhof would include road, air and bulk marine transport. The world car industry would be dealt a death blow.  Agriculture would be heavily hit and food prices would rise. At least as amazing, this would continue with nobody thinking to use less oil and substituting oil energy - as they have been doing, in OECD countries, for over 35 years!

Oil prices would, in Kumhof's theory, be able to effortlessly rise far above $500 a barrel - and nothing happens in the economy, except doom, and some boom for Goldman and the Parasite League! The oil will not be substituted (for example by champagne or biodiesel made from caviar). Consumers will dumbly and desperately go on buying the stuff, whatever the price.

Making this extra-lucid E.T. economics even more laughable, Kumhof and his team claim that they firstly model "a relatively smooth adjustment" path where industries simply re-allocate what they can to other energy sources before, sadly of course, the economy "goes non-linear". They also admit that an oil price of even $200 a barrel "is a world we have never been in", especially if these high prices were to last not for a few months, "but basically for ever".

AND WHAT ABOUT GOLD?

Oil prices - even in very low triple digits - are unsustainable. When they struggle, or more often are pushed into that extreme range, they fall. When they fall this time, in 2013, the collateral financial damage is going to be large. This real world outlook will not be found in Kumhof's musings.

Claiming that if we entered the new peak-oil world "with never ending high oil prices", there would not be massive energy substitution - and almost certain new oil wars in the Middle East - is juvenile bordering on educated idiocy, but Kumhof and his IMF colleagues can do it. Their only factual basis, we should carefully note, is that conventional oil production has been on a plateau since about 2005, and this occurred despite oil prices constantly rising from 2005 to 2008.

Gold mine output, and gold prices did exactly the same.

The similarities do not stop there. Markets for both are intensely manipulated by price, and both are major tradable assets. Gold is a very rare mineral, producing it has "a low EROI", that is to say producing gold is energy and materials intensive and can only cost more with time, as major easier-minable reserves diminish and most forms of energy, certainly oil, rose in price for a decade. Ten years ago, the breakeven cost to produce 1 Troy ounce of gold was at least 45% lower than the current breakeven of around $1000, depending on mine types and local input costs. Oil breakevens have also risen, even doubled in less than 10 years and for US shale oil, if not Canadian tarsand oil, could be as high as $65 a barrel today.

In both cases, continuing with the similarities, it is hard to disentangle whether the production plateaux for oil and gold are exclusively due to geological and technical constraints, or also due to a range of other important factors, especially the financial crisis which can operate on an almost instant-overnight basis.  At this current time (although Kumhof and his colleagues try to sideline this) the reasons why world oil output has been so flat are mostly "not about geology". In the case of gold, geology has got almost nothing at all to do with the current situation, it only sets a rough floor price for the metal and sure and certain rebound potential for mining stocks.

The gold mining industry is very unlikely to significantly expand output - whatever the gold price. The oil industry is decreasingly likely to achieve - or need to achieve - sizeable growth of daily or annual output. In both cases, the world may theoretically "need growth" but the results are simply and basically uneconomic.

ACT OF FAITH - LEAP OF LOGIC

We can easily accuse Kumhof of making a leap in the dark. Making any pretence his theory has more to do with geology than with Goldman Sachs or MF Global is for the least disingenuous, in fact outright stupid. Oil prices in 2008 were firstly manipulated to extreme highs, then crashed to extreme lows, by market "minders" with a heavy hand on the roulette wheel. The reasons why Kumhof's models come to the conclusion that "geology is definitely starting to play a role in our ability to grow output", and that "higher oil prices statistically only have a very small impact on growing the production of oil and on reducing the demand for oil", depend on E.T. economics, or folklore, and are two of the most outrageously non-scientific assertions it is possible to make.

Given the pace of oil substitution and oil saving only in the past 10 years, not 17 years, the potential for serious and outright contraction of world oil demand well before 2030, in the period of about 2020-2025 is increasingly logical and feasible. We can say (unlike Kumhof) there is a significant probability that world oil demand starts regularly contracting quite a few years before 2030 and this will not be a price-driven change.

Kumhof prefers to cite studies and interviews by Robert Hirsch, a Peak Oil doomster-boomster who says that "to cope with peak oil" huge investments must be made, so large there is no equivalent in human history in order to realign, restructure and rebuild world economic infrastructures, and massively change nearly all industries. Hirsch rather naively claims this "would take 10 years at the very least", when the real time lapse would be 25 - 35 years or more. This we can note again, is all based on the logic that oil demand has been very weak since 2008 and oil production has shown almost no growth - from conventional sources - since 2005.

Kumhof bows out with a reference to Nicholas Georgescu-Roegen, but not Herman Daly, and says that inside the IMF there is presently no "official position" on Peak Oil and High Entropy Economics. We we can wish him luck in his missionary quest, which at least has more intellectual content than Strauss Kahn's hotel fun and frolics!

By Andrew McKillop

Contact: xtran9@gmail.com

Former chief policy analyst, Division A Policy, DG XVII Energy, European Commission. Andrew McKillop Biographic Highlights

Co-author 'The Doomsday Machine', Palgrave Macmillan USA, 2012

Andrew McKillop has more than 30 years experience in the energy, economic and finance domains. Trained at London UK’s University College, he has had specially long experience of energy policy, project administration and the development and financing of alternate energy. This included his role of in-house Expert on Policy and Programming at the DG XVII-Energy of the European Commission, Director of Information of the OAPEC technology transfer subsidiary, AREC and researcher for UN agencies including the ILO.

© 2013 Copyright Andrew McKillop - All Rights Reserved Disclaimer: The above is a matter of opinion provided for general information purposes only and is not intended as investment advice. Information and analysis above are derived from sources and utilising methods believed to be reliable, but we cannot accept responsibility for any losses you may incur as a result of this analysis. Individuals should consult with their personal financial advisor.

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