Caught in a Rat Trap: Jevons’ Paradox

Depleted

As natural sources of fuel deplete there is, not unnaturally, a concern to introduce more efficiency, to conserve our resources. The idea is that by producing more efficient cars, heating systems or whatever we’ll decrease fuel use and buy ourselves more time to do whatever it is we need to do: melt the polar icecaps, most likely.

Unfortunately, this is exactly wrong. If we make more efficient use of fuel we will use it faster and probably do more damage than if we stagger along in our current fashion. This is the Jevons’ paradox, a mode of market failure that should make grown environmentalists weep, if they weren’t too busy saving the few remaining penguins by smothering them in oil retardant chemicals.

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Salience is Golden

New Frames

As so often in the past Warren Buffett has stirred up a swarm of annoyed investors, this time by explaining why he thinks gold as an asset class isn’t so much overvalued as irrelevant. He’s done this in a way typical of the man, by changing our frame of reference, to give us an entirely new perspective on the issue.

This gives us an insight not just into gold's current status as an investment class but also into why Buffett is almost unique as an investment guru. He doesn’t rely on the old arguments about what’s important by drawing on existing ideas of what’s salient, but develops new ones, based on his own models. He changes what’s salient, and that’s real gold for investors.

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Economic Value in Aitch-Two-Oh

Odd Water

"The world's supply of fresh water is running out. Already one person in five has no access to safe drinking water. "

Well, so says the BBC. But water’s an odd thing. You can’t live without it but it’s not particularly valuable. In fact the stuff in your faucet is free, it’s just the cost of getting it there that we pay for.

Water is, perhaps, the pre-eminent example of the old truism that price is what you pay but value is what you get. Only thing is, how do you value something that has no market price? Fortunately teams of highly trained thinkers have been working on this, just so we know the price of everything even if we’re not willing to pay it.

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The Case Against Re-Emerging Markets

Brave Punditry

If you’re of a contrarian viewpoint you might cast your eyes across the pundit’s tips for the best performing sectors of 2010 – or, indeed, any year – with a slightly jaundiced eye. This year’s favourite flavour of investment is emerging markets. There are strong and powerful arguments in support of this particular long-term trend but you’ll rarely find the short-term value counterargument.

Counterarguments are critical for sensible value investors, because they force us to consider what could go wrong despite what our deceitful and biased brains are telling us. Any idiot can see what can go right – and, indeed, they spend a lot of time telling us about it – but putting a purely positive spin on any investing situation doesn’t come close to providing a sensible basis for allocating our valuable and scarce capital.

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Peak Oil, The Revenge Of Planet Earth?

Depletion or Destruction?

A recent report from the UK’s Energy Research Council, a body not known for sounding panicky alarms, suggests that under all reasonable scenarios the rate of global oil production will peak by 2030. By their worst case estimates it’s already done so. The reality of a world of depleting oil resources is upon us: green activists would argue that it’s a race between depletion and destruction.

As this is a situation that will affect the vast majority of people alive today it’s something you might think would be at the top of policymakers’ agendas. However, in the dash to save the world from economic collapse this is about the last thing on their minds. So the question is probably whether the market can save ourselves from ourselves. Based on recent experience of oil trading it’ll probably pay not to be too hopeful.

Wanton Irrationality

Oil is no less subject to bizarre and wantonly irrational behaviour by traders than any other market. We certainly saw evidence enough of this in 2008 when oil prices spiked at near $150 a barrel. At this point all sorts of odd behaviour started to appear. There was a bubble in small oil companies with no assets other than a dubious claim on a scrubby bit of land in some far-flung, God-forsaken, hell hole. Well, that’s if they actually had any claims at all.

While all this was going on oil traders spotted that that the futures price of oil had soared, leading to a big gap between it and the actual real ‘spot’ price of a barrel (technically when the future price is greater than the spot price a commodity is said to be in ‘contango’, probably because ancient traders couldn’t spell). This situation led many traders to vigorously engage in arbitrage, selling futures and buying actual oil – which they then needed to store until they had to deliver on their futures contracts.

So they started hiring oil tankers to slowly steam around the world carrying the excess oil. Which led to the wonderfully paradoxical situation where the world was awash with the black stuff even as the price climbed to ever more ridiculous levels and everyone started moaning about the price of gas. And, of course, small investors piled into oil and oil stocks.

Fiction and Fact

Then Goldman Sachs suddenly moved their top-of-the-range peak oil price prediction up to $200 a barrel. That, of course, was the cue for a crash even more vertiginous than that of stocks, down nearly 80% at the worst point.

Underpinning all this amusing nonsense, however, are some brutally realistic facts. As the ERC report relates:

“Although there are around 70,000 oil fields in the world, approximately 25 fields account for one quarter of the global production of crude oil, 100 fields account for half of production and up to 500 fields account for two thirds of cumulative discoveries. Most of these ‘giant’ fields are relatively old, many are well past their peak of production, most of the rest will begin to decline within the next decade or so and few new giant fields are expected to be found.”

What had started as a upwards move based on some pretty sensible oil market fundamentals ended up as a behaviourally induced rout when the inflated expectations of emotionally compromised investors were burst by a nasty dose of economic reality. Situation normal, then.

The Impact of Oil Depletion

What’s worse, and makes some of the irrational moves in the market even more explicable, is that the data from these giant fields is often not publically available being both commercially and, in some cases, nationally, sensitive information. As we saw in Ambiguity Aversion uncertainty is a major factor in investor perceptions and in situations characterised by it it’s to be expected that you’ll see emotionally driven swings in prices, often quite sharp ones. In reality the facts about peak oil will emerge only slowly and in hindsight.

Normally we can’t know what impact such an event will have. The world is too complex to make multi-faceted predictions about stuff that lies far in the future. Mostly we don’t have a clue about what will happen next week. Without knowing future economic conditions we can’t even predict energy consumption requirements – the current downturn has reduced oil usage quite sharply, for instance – let alone oil production levels.

So we don’t know what impact new energy sources will have or whether attempts to reduce CO2 emissions will help. We don’t know how quickly oil fields will deplete or whether new giant ones will be found. We don’t know what effect the huge potential growth in China and India will have. We don’t know if the Middle East will go up in flames and Iran will close the oil gateway to the world, the strategically critical Straits of Hormuz. We don’t know whether governments will wake up and actually do something useful.

OK, maybe we can guess the answer to the last one.

Some Certainty in an Uncertain World?

However, we do know a few things with something approaching unusual certainty. We know that the probability is that the window of peak oil production is upon us. We know that investment in alternative energy resources is woefully lacking. We know that people will not easily be weaned off their energy dependency.

At some point there will have to be a sustained attempt by the developed world to develop new energy sources. An increase in nuclear usage is a virtual certainty. Improvements in wind, solar, agri-power and other sources will also come. Significant and sustained increases in energy prices of all kinds is virtually assured: the problem is that replacing oil completely will take a long time. The Hirsch Report commissioned by the US Department of Energy estimates that it’ll take at least 20 years of sustained investment before the peak to avoid serious energy dislocation. It may already be too late to achieve that.

Pascal’s Ultimate Wager
 
It’s impossible to discuss energy issues without addressing global warming. We know that it’s happening, we just don’t know what effect it will have. Applying Pascal’s Wager suggests that the worst-case downside of allowing it to continue unchecked – the death of most of humanity – is probably worse than the worst-case downside of stopping it – a significant reduction in global economic growth. Of course, Planet Earth would continue without us, no doubt vowing to never repeat that particular experiment.

The way forward in a world in which oil is hideously expensive is not clear-cut. One route leads to a vast increase in global coal consumption, a path that will do nothing to save the polar bear, the other to a more sustainable future but at the cost of much reduced economic growth. As that famed economist Woody Allen opined:

“Today we are at a crossroads. One road leads to hopelessness and despair; the other, to total extinction. Let us pray we choose wisely.”

Our past unwillingness to plan properly for the future means that energy is going to become a lot more expensive, at least in the medium term. Everyone should prepare themselves accordingly, we all need to choose which price we prefer to pay.


Related Articles: The Malthusian Prophesy, The Tragedy Of The Financial Commons, Pascal’s Wager – For Richer, For Poorer

Copper at Morewellham Quay

Victorian Copper

As you gaze around the tiny Devon hamlet of Morwellham Quay, fifteen miles up the River Tamar, deep in an area of outstanding natural beauty, it’s hard to imagine you’re standing at the gateway to the biggest copper mine in Queen Victoria's far flung empire. By 1850 Morwellham Quay was a more important port than Liverpool yet within a few decades the port was subsiding into ruin, from which it’s only now re-emerging as an industrial archaeology site and post-industrial tourist attraction.

Once this leafy backwater was a blasted and desolate wilderness – the pollution generated by the multiple mines along the Tamar turning what is now a green, leafy beauty spot into a Hell on Earth. All because of the most precious base metal of them all, copper.

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Gold!

Inflation, Insurance and Warren Buffett's Dad

From King Midas to Gordon Brown gold has always attracted legendary behaviour – although the latter’s sale of the UK’s gold reserves at a cyclically low price looks with hindsight to have been, well, less than optimal. All right, it was completely rubbish. Still, the nature of the stuff fascinates people. It’s bright and shiny, heavy and it doesn’t tarnish. And people are willing to pay good money for it. What’s not to like?

However, gold really isn’t the stuff of basic investment. It has no intrinsic value, creates no cashflows and pays no dividends. It can go radically out of fashion, sometime for decades and it doesn’t have much commercial use beyond adorning rap artistes and gilding lilies.

As an asset class it’s a very odd thing to invest in.

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