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Friday, March 15, 2013

Perfect Storm: The Killer Equation: Decaying Growth Dynamics

The economy is a surplus energy equation, not a monetary one, and growth in output (and in the global population) since the Industrial Revolution has resulted from the harnessing of ever-greater quantities of energy. But the critical relationship between energy production and the energy cost of extraction is now deteriorating so rapidly that the economy as we have known it for more than two centuries is beginning to unravel.

If one asked a representative sample of the public what economics is all about, there is a very strong likelihood that the consensus answer would be “money”. The vast majority of economists do indeed frame the debate in monetary terms. The problem with this is that the economy is not, fundamentally, a monetary construct at all. Economics is really about the art of combining tangible components (such as labour and natural resources) to meet needs. Ultimately, money is a convenient way of tokenising this process. The process itself, on the other hand, is an energy equation.

The basic misunderstanding over this point – the treatment of money as the substantive challenge, rather than as the language in which that challenge is expressed – lies at the heart of the current economic malaise. In essence, an ever-widening wedge has been driven between the monetary and the ‘real’ economies. A central argument set out in this report is that economic problems will remain insoluble for so long as policymakers concentrate on monetary issues rather than on the ‘real’ economy. We go further than this, arguing that the physical economy is, in essence, an energy system or, to be somewhat more precise, a surplus energy equation.

the commonality of energy

If one is to understand the essentially energy-based nature of the economy, it needs to be appreciated from the outset that all forms of energy – including food and work as well as such ‘obvious’ types of energy as oil, natural gas, coal and renewable's – are dimensions of the same thing. We term this vital concept the commonality of energy.

The fundamental fact of energy commonality is often obscured by the use of different units to describe and measure different forms of energy. For instance, food is measured in nutritional calories; work can be measured as kilowatt-hours (kwh); and fossil fuels tend to be expressed as gallons (of gasoline or distillate fuel), barrels or tonnes (of oil), cubic feet or cubic meters (of natural gas) and tonnes (of coal). But these differing calibrations should not be allowed to disguise the fundamental commonality of all forms of energy.

As an illustration of the commonality of energy, imagine filling the tank of a car with one gallon of gasoline, driving it until the fuel runs out, and then paying someone to push it back to the start-point. The ability of this person to do this depends, of course, upon sufficiency of nutrition, itself an energy equation. Obviously enough, the energy contained in food is converted by the human being into a capability for work, is  exhausted, and requires continuous replacement. But this process is a circular one, in that the cultivation of food is a process which itself requires energy inputs, be they the labour of human beings (most simply in planting and harvesting), the labour of animals, the employment of machinery or the direct use of energy inputs such as fertilizers.

The exercise of putting one gallon of fuel into a car, driving it until the fuel runs out and paying someone to push it back to the start-point also illustrates the huge difference between the price of energy and its value in terms of work done. According to the US Energy Information Administration, one (US) gallon of gasoline equates to 124,238 BTU of energy, which in turn corresponds to 36.4 kwh. Since one hour of human physical labour corresponds to between 74 and 100 watts, the labour-equivalent of the gasoline is in the range 364 to 492 hours of work. Taking the average of these parameters (428 hours), and assuming that the individual is paid $15 per hour for this strenuous and tedious activity, it would cost $6,420 to get the car back to the start-point. On this rough approximation, then, a gallon of fuel costing $3.50 generates work equivalent to between $5,460 and $7,380 of human labour.

One could come to a similarly leveraged calculation of the energy cost-to-price mismatch by measuring the cost of employing workers pedaling dynamo-connected exercise bicycles to generate the energy used by electrical appliances in the typical Western home, and then comparing the result with the average electricity bill. 

the great breakthroughs – agriculture and the heat-engine 

The development of society and of the economy is, in reality, a story of how mankind overcame the limitations imposed by the energy equation. In the pre-agrarian, hunter-gatherer era (which lasted for at least 40,000 years), there was an approximate energy balance, in that the energy which each person derived from his food was roughly equivalent to the energy that he or she expended in finding or catching that food. Put simply, there was no energy surplus, and consequently no society. Each person had to be self-sufficient, or perish.

The first of the two great breakthroughs in human development was the discovery of agriculture. Farming seems to have begun in the “fertile crescent”, an area which stretched from the Upper Nile through modern-day Lebanon, Israel and Syria to the basins of the Tigris and the Euphrates in what is now Iraq, and to the upper coastal regions on both sides of the Persian Gulf. This region is also known as “the cradle of civilisation”. Evidence of cultivated grain suggests that the transition from a hunter-gatherer to an agrarian way of life may first have occurred in about 9,500BC, though millennia were to elapse before some of the staples of organised agriculture (such as crop rotation and the domestication of animals) were discovered.

From an economic standpoint, the significance of the development of agriculture lay in the liberation of surplus energy. If twenty individuals or family units could now be supported by the labour of nineteen, the twentieth was freed to undertake non-subsistant activities. He or she might be engaged in making agricultural implements, bridges to improve access to fields, or mills which could grind grain into flour. Investment, properly considered, began when the energy surplus created by agriculture was deployed into the creation of capital goods instead of products for immediate consumption.

Of course, the energy surplus created by agriculture was extremely modest by later standards. It was sufficient to create a very limited range of specialist trades (such as smiths, millers and cobblers) and to provide rudimentary structures of government and law. The most complex organisations of the pre-industrial age – religious establishments, and the shipping and trading industries – were extremely simple by later standards, though trading companies did begin to point the way towards later corporate enterprises (in England, the East India Company and the Hudson’s Bay Company received their Royal Charters in 1600 and 1670, respectively, whilst the Dutch East Indies Company was established in 1602).

The importance of the discovery of agriculture lay in the creation of the first energy surplus, because it would be this surplus that would make possible the vastly greater advances of the second breakthrough. As Daniel Webster put it, “When tillage begins, other arts follow. The farmers, therefore, are the founders of human civilization.” 

Following the discovery of agriculture, the second (and vastly greater) breakthrough in the development of society and the economy was the invention of the heat engine, which enabled mankind to access the vast energy resources contained in coal, oil, natural gas and other exogenous (non-human) sources.

Although, in antiquity, Archytas of Tarentum and Hero of Alexandria seem to have played around with jets of steam – and gunpowder was discovered in China almost a thousand years ago – it is generally accepted that the invention of the true heat engine occurred in 1769, when Scottish engineer James Watt (1736-1819) patented his steam engine. Although it is arguable that the truly efficient heat engine did not arrive until 1799 – when English inventor Richard Trevithick (1771-1833) built a high-pressure steam engine, and applied it to drive the first locomotive – the industrial revolution was well under way by the end of the eighteenth century

The real importance of the industrial revolution lay in harnessing exogenous energy resources to apply vast leverage to the economy. Fig. 5.1 shows the truly enormous increase in the consumption of fossil fuels since the onset of the industrial revolution. Fig. 5.2 shows how, as typified by the United States, this expansion has been reflected in an equally-dramatic increase in economic output measured as real GDP.

 As well as contributing to a massive quantitative increase in the economy, the energy dynamic has resulted in the extraordinary social and economic complexity and specialisation that are an accepted part of the modern economy. In the agrarian era, the overwhelming majority of people laboured on the land, and nonagricultural trades were not only few in number but, for the most part, were closely associated with farming. In today’s developed economies, agricultural labour occupies only a very small minority of the workforce, with the majority engaged in an almost bewildering array of specialised occupations, trades and professions, the vast majority of which have no relationship whatsoever to agriculture.

exponential population, exponential energy

A glance at figs. 5.1 and 5.2 reveals a distinctive common feature, which is that the trajectories both of energy consumption and real economic output display clear exponential characteristics, something which is equally apparent in fig. 5.3, which charts global population numbers since 2000BC.

Historians estimate that the population of the world totalled about 27 million in 2000BC, and grew only very gradually thereafter, rising to 170 million two millennia later. As recently (historically speaking) as 1400, the population of the world still totalled only 350 million, and did not reach the first billion until 1840, by which time the Industrial Revolution was well under way. 

Thereafter, however, population growth accelerated very rapidly, reaching 2 billion by 1930, 3 billion by 1960, and 6 billion by 2000. The total recently passed 7 billion, should reach 8 billion well before 2030, and could be 9.3 billion (or more) by 2050.

If resources were infinite, this progression would be of little or no significance other than to sufferers from agoraphobia. Since resources are not infinite, however, some experts postulate a maximum global carrying capacity somewhere within the 8.5 and 11 billion range shown on the chart (though others believe that, under certain conditions, even the lower end of this range may become wildly over-optimistic).

The striking feature of the exponential growth in the global population over the past two-and-a-half centuries is the way in which it parallels similarly exponential growth in the consumption of energy (fig. 5.4). Before about 1750, the consumption of energy was almost entirely untraded, and therefore impossible to measure, but it was also too small to show up. In 1750, annual consumption of fossil-based energy (consisting at that time entirely of solid fuels) was about 3 million tonnes of oil-equivalent. (mmtoe), rising, pretty dramatically, to about 52 mmtoe by 1850.

Oil did not become a measurably significant component of the energy total until 1870, by which time fossil fuel consumption had reached an estimated 142 mmtoe. Thereafter, this total escalated, to 200 mmtoe by 1880 and 400 mmtoe by 1895. The total exceeded 1,000 mmtoe in the late 1920s, reaching 2,000 mmtoe by the mid-1950s and almost 4,500 mmtoe by 1970. By the end of the 1980s – and despite intervening energy price shocks – consumption exceeded 7,000 mmtoe. Energy consumption broke through the 8,000 mmtoe barrier in 2000, and exceeded 9,000 mmtoe just four years after that. In 2010, and despite the onset of the economic slump in 2008, total fossil fuel consumption exceeded 10,000 mmtoe.

the subservient role of money

Though economists, policymakers, investors and the general public customarily think in terms of money, this conventional thinking is profoundly mistaken because, ultimately, the economy is a physical rather than a financial construct. Rather than being in any sense fundamental, money serves to tokenise output into a convenient form. After all, the world economy has survived the demise of an estimated 3,800 different paper currencies. 

The roles of money can be defined as a medium of exchange, a unit of account and a store of value. The development of money paralleled the emergence of agriculture, the role of money being to tokenise the output of the economy into a convenient form. Obviously, the creation of money was a secondary stage in the economic process, as there was no point in having money unless there were things that could be purchased with it, and the physical economy formalised by money was, as we have seen, an energy dynamic of inputs and outputs.

It is important to note that, in the agrarian age, anything that could be purchased with money was the product of human (or animal) labour, be that labour past, present or future. Purchasing, say, a plough amounted to paying for a product of past labour. Employing someone to plant a field involved payment for current labour. Commissioning someone to build an item of furniture meant paying for future labour. 

As we have seen, however, the terms ‘labour’ and ‘energy’ are coterminous through the commonality of energy, so anything which could be purchased with money was the product of energy, past, present or future.

With the broader term ‘energy’ replacing ‘labour’, exactly the same relationship prevails in the industrial societies of today, except that exogenous energy inputs (overwhelmingly dominated by fossil fuels) now provide the vast majority of the energy used in the economy. So overwhelming is this preponderance that, in Britain today, human labour probably accounts for less than 0.5% of the aggregate human-plus-inputs energy used in the economy. In other words, all goods and services on which money can be spent are the products of energy inputs either past, present or future.

The appreciation of the true nature of money as a tokenisation of energy also enables us to put debt into its proper context. Fundamentally, debt can be defined as ‘a claim on future money’. However, since we have seen that money is a tokenisation of energy, it becomes apparent that debt really amounts to ‘a claim on future energy’. Our ability, or otherwise, to meet existing debt commitments depends upon whether the real (energy) economy of the future will be big enough to make this possible. 

Therefore, the viability (or otherwise) of today’s massively-indebted economies depends upon the outlook for energy supply. If one chooses to believe that the exponential expansion in energy use that has powered the growth of the economy (and the global population) since the dawn of the industrial age can continue into the future, debts may be serviceable and repayable out of the economic (for which read ‘energy’) enlargement of the future. If such enlargement cannot be relied upon, however, then the debt burden can only be regarded as unsustainable.

Where debt is concerned, individuals and businesses have only two possible courses of action – they can repay their debts, or they can default. Governments, however, have a third option, which is to repay debts using money newly created for the purpose. Instead of the ‘hard’ default of reneging on debt obligations, government can opt for the ‘soft’ default of ‘repaying’ their debts in a currency which has been devalued by inflation. 

In any case, the real value of money is subject to a constant process of destruction as its value is eroded by inflation. According to official figures, even the US dollar – one of the most resilient currencies that the world has ever known – lost 87% of its purchasing power between 1961 and 2011. To regard money as the building-block of the economy is profoundly mistaken.

at Hubbert’s Peak?

As we have seen, then, the economy is, in reality, an energy dynamic onto which has been grafted not just a system of monetary tokenisation but, much more seriously, a system of anticipatory finance which is viable if (but only if) it can be assumed that there will be no significant check to the process of exponential economic growth. Of course, the most obvious threat to this anticipatory economic system would arise if the availability of energy were to diminish (or even simply cease to increase in the way that anticipatory finance necessarily assumes). Since the 1950s, this threat has acquired a name – “peak oil”. 

This peak oil concept – pioneered by M. King Hubbert and accordingly known as ‘Hubbert’s Peak’ - contends that, at some time in the relatively near future, we will have consumed half of all originally-available reserves of oil. This concept is illustrated in fig. 5.5, which combines past consumption data with a representative subsequent downwards curve.

At that point, Hubbertians argue, the supply of oil will decline, in pretty much a mirror-image of the increase in consumption which has taken place since the 1850s. Much the same, they argue, will eventually happen to supplies of natural gas and of coal, with depletion of these sources accelerating as a result of substitution from oil.

The peak oil process can already be discerned in the context of individual provinces such as the UK North Sea, or of multi-province plays such as the Lower Forty-Eight (L48) States of the US. Annual rates of petroleum discovery in America peaked in 1930, and peak production occurred forty years later, in 1970, since when output has declined relentlessly. Since the global peak discovery rate occurred in the mid-1960s, it has been argued, a similar time-lag implies that global peak oil is now imminent.

Advocates of the peak oil interpretation argue that, seen on a timescale of social evolution, the era of the petroleum-based society is not so much a manageable trend (fig.5.6) as a one-off event (fig.5.7, which depicts exactly the same data as 5.6, but extends the time-scale from two hundred to four thousand years). Again, it has been argued that this same interpretation applies to other fossil fuels such as coal and natural gas, and that the current chapter in economic history amounts to nothing more than a one-off event in which mankind has squandered a multimillion-year energy inheritance in an evolutionarily-brief moment of history.

As we have seen, a distinct exponential pattern links global population, energy consumption and, it should be added, a host of other linked parameters including economic output and food supply. If the availability of energy is the critical exponential driver in this agglomeration, might a reversal in the energy exponential bring all of the others crashing down?

To be sure, reversing any of the critical exponential progressions (be it energy availability, economic growth or population expansion) will be painful Indeed, society has absolutely no prior guide to how to manage successive (and perhaps rapid) decreases in population and in economic output.A mass collapse of exponential's could be catastrophic.

The classic Hubbertian argument is that oil production must soon enter an inexorable decline, because half of the world’s originally-recoverable petroleum has already been extracted. The first flaw in this argument is that it is simply not true. The application of the Hubbert thesis at this point implies that reserves were of the order of 2,200 bn bbls (billion barrels). Ample evidence exists to suggest that the originally recoverable reserves base was at least 3,000 to 3,500 bn bbls, and very possibly much larger. The Hubbertian case has considerable merit if it is applied to conventional oil, by which is meant light, sweet crudes which can be extracted relatively easily. But there is seemingly incontrovertible evidence that huge quantities of unconventional oils remain to be extracted. 

In North America, tar sands reserves in Canada are estimated at no less than 170 bn bbls (billion barrels), whilst shales in the US alone may hold as much as 1,400 bn bbls of oil, though the extraction of much of that oil may be, to put it mildly, problematical. In South America, reserves of very heavy crudes in Venezuela are thought to be well in excess of 350 bn bbls. To be sure, there seem to be many cases of overstatement where conventional reserves are concerned, most notably in OPEC countries, where, for many years, the quota allocation process incentivised the over-statement of reserves. But the overall picture is one of relative abundance of reserves of oil of all types.

The second error within the Hubbert’s Peak theory is that it tends to ignore economics. A scarcity of oil would cause prices to rise massively. As we have seen, a US gallon of gasoline costs about $3.50 but, in energy terms, displaces human labour worth perhaps $6,400. Scarcity-induced price escalation could be expected to change this equation in at least two material respects. 

First, a dramatic escalation in prices would reduce demand by causing greater frugality in the use of oil. As world-leading energy expert Robert Hirsch argued (in a thesis that essentially leant towards the concept of an oil production peak), there is a great deal that can be done to mitigate the economic impact of oil shortages, always presupposing that action is taken at least ten years ahead of the event.

A society threatened by oil scarcity would be required to change fundamentally. Suburbs – the quintessential characteristic of a car-based society – would be replaced by denser forms of habitation in a move that might yet be rendered necessary anyway by environmental considerations. The thirstiest vehicles (such as SUVs22) would be consigned rapidly to the scrap-heap, and private car ownership would be displaced by public transport. The second effect of very high oil prices would be to incentivise exploration for, and development of, resources currently rendered uneconomic by their geological nature or their inaccessible location. 

These arguments – and the apparent scale of remaining recoverable reserves – have generally enabled peak oil sceptics (sometimes known as ‘cornucopians’) to counter the Hubbertians and thereby, in general, to win the public debate.

In so doing, they are providing the right answers to the wrong question. The critical issue with peak oil does not hinge around remaining reserves. Rather, the critical issues are energy returns on energy invested (EROEI) and deliverability. 

The best way to illustrate the deliverability issue is to compare oil sands reserves in Canada (about 170 bn bbls) with conventional reserves in Saudi Arabia (about 270 bn bbls). Given that Saudi production capacity is about  12 mmb/d (million barrels per day), one might, on a simple pro-rata basis, expect Canadian oil sands output to reach perhaps 7 mmb/d. But the reality is that output is most unlikely to reach even 3.5 mmb/d. Deliverability from the Canadian resource, will, then, be less than half of that attained from conventional reserves in Saudi Arabia.

Not surprisingly, and for perfectly logical economic reasons, oil reserves have been ‘cherry-picked’, meaning that the cheapest, highest-quality and most accessible reserves have been exploited first. What this in turn means is that, even if reserves remain substantial, production levels might hit a ceiling in the relatively near future. It also needs to be remembered that net changes in output represent a two-piece equation -substantial new sources are needed each year simply to replace natural declines from already producing fields. As the industry moves from higher- to lower-deliverability fields, maintenance of existing production levels, let alone growth, becomes ever more difficult.

In the 2007 issue of the World Oil Outlook, OPEC predicted that global consumption of oil would rise to 114 mmb/d by 2030, amounting to a 31% increase over expected 2010 demand of 87.5 mmb/d. Five years on, the demand projection for 2030 had been reduced from 114 mmb/d to 101 mmb/d, whilst consumption in 2010 turned out to be a lot lower (84.9 mmb/d) than OPEC had expected in 2007 (87.5 mmb/d)23 (fig. 5.8). The significance of these figures is that the downgrading of OPEC’s future demand forecasts resulted from the sharp lowering in economic growth expectations that occurred between 2007 and 2012. 

Though appreciably lower than the cartel’s estimate five years ago (114 mmb/d), the current projection for oil demand in 2030 nevertheless represents a big (19%) increase from the out-turn in 2010 (84.9 mmb/d). Is this achievable? We doubt it, not least because supply from existing sources of oil is declining by about 6.7% annually. On this basis, an overall supply increase of 14.4 mmb/d between 2012 and 2030 would require the development of new sources delivering 76.4 mmb/d (more three quarters of all output) by the latter date (fig. 5.9). This seems extremely improbable, not least because of the deliverability issue described earlier.

Moreover, future supply projections assume that a large proportion of all future net gains in production will have to come from OPEC countries. This might be difficult to achieve, particularly given that Saudi Aramco admits that it is injecting 13 mmb/d of treated seawater, most of it to sustain production at its giant (but ageing)Al Ghawar field, historically the source of about half of the kingdom’s production. 

Another way to look at the deliverability issue is that reserves need to be quality-weighted. We may have used up much less than half of the world’s originally-recoverable reserves of oil, but we have, necessarily, resorted first to those reserves which are most readily and cheaply recovered. The reserves that remain are certain to be more difficult and costlier to extract. 

Production may not ‘peak’ just yet, but a new concept (which we term ‘resource constraint’) may soon kick in, implying that an economic model based on abundant and ever-increasing hydrocarbon inputs might be running out of road. 

Neither should policymakers be fooled by the cornucopians’ argument that technology will necessarily ride to the rescue. As remarked earlier, this argument is essentially equivalent to the statement that, if one locked some boffins up in a bank vault with enough cash and a powerful enough computer, they would eventually materialise a ham sandwich. Technology is not the Seventh Cavalry, poised to ride to the rescue.

energy returns – the killer equation

An absolute decline in available energy volumes, serious though that would be, is not the immediate concern. The truly critical issue is the relationship between energy extracted and the amount of energy consumed in the extraction process. Known as the Energy Return on Energy Invested (EROEI), this is the ‘killer equation’ where the viability of the economy is concerned. Put very simply, there is no point whatsoever in producing 100 barrels of oil (or its equivalent in other forms of energy) if 100 barrels (or more) are consumed in the extraction process. 

Though described earlier as an energy equation, a more precise definition of the economy is that it is a surplus energy dynamic, driven by the difference between energy extracted and energy consumed in the extraction process. As we have seen, society and the economy began when agriculture liberated the first energy surplus. Subsequent economic history has been a process of increasing that surplus by harnessing ever-larger quantities of surplus energy.

The mathematics of EROEI are pretty straightforward. If the EROEI is 50:1, this means that 50 units are extracted for each unit invested in the extraction process. The division here is 50:1 between ‘profit’ and ‘cost’ energy, meaning that the net ‘cost’ of energy is 1.96% (1 divided by 51). Similarly, the ‘energy cost of energy’ is 0.99% (1/101) at an EROEI of 100:1, 3.8% (1/26) at 25:1 and 9.1% (1/11) at 10:1.

The best form of graphical presentation of EROEI is the “cliff chart” (fig. 5.10). The horizontal axis shows EROEI as a multiple, running in this instance from 100:1 to zero. The vertical axis divides gross energy produced into “profit” (the dark, lower area on the chart) and “cost” energy (the light area). At an EROEI of 100:1, the picture is overwhelmingly one of “profit”, in a profit-to-cost percentage ratio of 99:1. The percentage ratio remains very strong (98:2) at 50:1,and is still robust (96:4) at 25:1.

Below an EROEI of about 15:1, however, the “profit” element falls off a cliff, because there is an exponential increase in the “cost” component, which rises from 4.8% at an EROEI of 20:1 to 6.3% at 15:1, 9.1% at 10:1 and 16.7% at 5:1. This process of “cost” escalation is illustrated in fig. 5.11, which shows that energy cost is yet another addition to the collection of exponential progressions (including population, energy consumption and economic output) which dominate the world as we know it. This time, however, the exponential progression is a negative one. 

It is important to emphasise that the cliff chart depicted in fig. 5.10 is not time-linear. Even so, and as fig. 5.12 makes clear, the progression in energy sourcing is moving unmistakably and inexorably towards ever lower EROEIs. 

Oil discoveries in the 1930s offered EROEIs well in excess of 100:1, whereas this ratio had declined to about 30:1 by the 1970s, and few discoveries today offer an EROEI of much better than 10:1. In the heroic pre-War days of the oil industry, the ratio was high, because a small energy investment (often consisting of little more than rudimentary onshore drilling and wellhead equipment) could access extremely large oil fields. By the 1970s, these ‘easy’ (low-cost) sources were well on the way to being exhausted, and the industry was developing fields which were both smaller and costlier, an increasing proportion being offshore. 

The petroleum industry has shown enormous resourcefulness in developing techniques such as water- and gas-injection, horizontal drilling, remote production and various forms of advanced oil recovery (AOR) as discoveries have become ever more technically and geographically challenging, but the underlying trend has been a relentless deterioration in EROEIs as costs have risen and average field sizes have declined. 

Believers in peak oil have seen this progression as an indication of evergrowing reserves stress, which indeed it is. But the real economic significance of this progression lies in a rapid deterioration in EROEIs rather than in an exhaustion of absolute reserves. The overall EROEI of the North Sea today may be no higher than about 5:1, a far cry from ratios in excess of 100:1 yielded by the pioneering discoveries  in the sands of Arabia. 

Much the same applies to other fossil fuels such as coal and natural gas. Where coal is concerned, fuel quality has deteriorated just as costs have risen. Almost all of the world’s original reserves of anthracite (the best coal in terms of energy content per tonne) have already been exhausted, pushing miners into ever greater reliance on bituminous and even sub-bituminous coals, the latter offering barely half the energy content per tonne of bituminous coal.

Newer energy sources display a similarly disturbing trend. At first glance, the claimed EROEIs for onshore wind power look pretty reasonable at perhaps 17:1. However, the returns claimed for wind seem to make some pretty heroic assumptions about the longevity of generating plant and, in any case, wind turbines produce electricity, not the highly-concentrated transport fuels upon which the economy depends. 

Other energy sources look even worse in EROEI terms. Biofuel EROEIs seldom exceed 3:1, and some are negative. The much-vaunted “hydrogen economy” is a myth, because hydrogen acts as a store (not a source) of energy, and is very inefficient in the way in which it converts energy obtained from conventional sources. About 40% of the initial energy is lost in conversion, perhaps another 15% is lost in the collection process and, if the hydrogen energy is reconverted into electricity, the process losses mean that one finishes with barely 15% of the energy put into the process in the first place. 

Policymakers who pin their hopes on unconventional hydrocarbon sources are guilty of a quite extraordinary degree of self-delusion. The EROEI of surface-mined tar sands is probably little better than 3:1 (if that), and those sands (accounting for about four-fifths of the total) which cannot be surface-mined can only be extracted using massively energy-intensive techniques such as SAGD (steamassisted gravity drive), such that EROEIs are minimal, or even negative. 

The latest fashion in collective delusion concerns shale gas and oil. These may indeed exist in vast quantities, but EROEIs of barely 5:1 should make it abundantly clear that shales most emphatically are not the quick-fix that many governments (and their electorates) might like to suppose.

where are we now?

As we have seen, then, there is an unmistakable trend towards lower energy returns on energy invested, with EROEIs falling within the fossil fuels slate just as society is turning both to renewables (such as wind power and biofuels) and to unconventional sources of hydrocarbon energy (including tar sands and shale gas). The critical question (though it is one to which scandalously little official attention has been devoted) has to be that of where the world is in terms of the overall EROEI, and where this critical equation may be heading. 

In an excellent discussion published in 2010, analyst Andrew Lees suggests that the overall EROEI, having declined from 40:1 in 1990 to 20:1 in 2010, might fall to as little as 5:1 by 2020. Though Mr Lees does not cite sources for these numbers, his figures for 1990 and 2010 accord pretty closely with our own estimates. 

Policymakers must hope that he is very wrong indeed, however, about the global average EROEI in 2020 because, if this ratio does indeed decline to just 5:1 over the coming seven years, the economy as we know it is finished. It is as simple as that. 

The cost point here is critical. At the 40:1 ratio cited by Andrew Lees for 1990, the theoretical cost of energy would have been 2.43% (1/41) of GDP. If the correct figure for 2010 was indeed 20:1, then the ratio in that year would have been 4.76% (1/21), a painful increase since 1990 but, nevertheless, a ratio at which the surplus energy economy can still function. 

At a ratio of 5:1, however, energy would absorb 16.67% (1/6) of GDP, meaning that energy costs would have increased by 250% (16.67 compared with 4.76) over just ten years. Put very simply, and ignoring (for now) intervening inflation, this would be equivalent to the annual average reference price of Brent crude oil having soared from $79.50/bbl to almost $280/bbl.

Our own analysis begins with an estimate of the overall cost of energy as a percentage of global GDP, which is plotted for the period since 1965 in fig. 5.13. Energy costs, historically very low before 1973, were driven to extremely high levels by the oil crises of the 1970s before falling back markedly in response both to demand destruction and to the incentivisation of previously non-commercial sources of supply. 

As a result, energy was remarkably cheap during the 1980s and 1990s, averaging perhaps 3.1% of GDP between 1986 and 1999, compared with an estimated peak of almost 15% in 1979. 

Of course, and as we have seen, the value and the cost of energy are very different concepts, and short- and medium-term cost oscillation can be created by political and economic events largely unrelated to underlying fundamentals. Even so, we believe that there is sufficient alignment over the longer term in the relationship between EROEI and cost for us to plot an estimated EROEI trend (in its costequivalent form) on a ‘best-fit’ basis. 

Remember that what is being measured here is not the value of energy, but its cost as a proportion of the value that we derive from it. Cost and value could only be the same if no surplus existed, which would also mean that the economy could not exist either. 

Our assessment of the trend in EROEIs is shown as the red line in fig. 5.13. On this basis, our calculated EROEIs both for 1990 (40:1) and 2010 (17:1) are reasonably close to the numbers cited for those years by Andrew Lees. For 2020, our projected EROEI (of 11.5:1) is not as catastrophic as 5:1, but would nevertheless mean that the share of GDP absorbed by energy costs would have escalated to about 9.6% from around 6.7% today. Our projections further suggest that energy costs could absorb almost 15% of GDP (at an EROEI of 7.7:1) by 2030.

Though our forecasts and those of Mr Lees may differ in detail, the essential conclusion is the same. It is
that the economy, as we have known it for more than two centuries, will cease to be viable at some point within the next ten or so years unless, of course, some way is found to reverse the trend. 

This point requires further explanation.

EROEI decline – the road from wealth to poverty

When looking at how a sharp decline in EROEI affects the economy, we need to take note of two key points. The first of these is that the slump in energy returns means that an ever-higher share of total output will be absorbed by the cost of energy, meaning that less value remains for all other purposes. The second is that energy is central to the entire economy, and that its effects go far beyond the obvious ‘costs’ of energy-related activities such as transport and the generation of power. 

Let’s start with the straightforward EROEI equation by comparing a high- and a low-EROEI economy, represented here by figs. 5.14 and 5.15. Each chart subdivides the totality of produced energy into three streams. The red component is the proportion of the extracted energy which has to be reinvested into the extraction process, whether as infrastructure (capital) or in extraction (operating) expense. 

In a high-EROEI economy (fig. 5.14), the reinvestment requirement is small, leaving most of the produced energy to be used to power the economy. Of this, some – shown in light blue – is used for essential purposes, such as food production and the provision of healthcare, law and government. The remainder, shown in dark blue and substantial in the high-EROEI economy, powers all discretionary activities, including all other forms of consumption and investment.

If EROEI falls sharply, as in fig. 5.15, much more of the gross energy is consumed in the extraction process,
resulting in a corresponding squeeze on the energy available to the economy. The essentials may still be affordable, but the leverage in the equation is such that energy available for discretionary uses diminishes
very rapidly indeed. There, through the EROEI squeeze, goes the car, the holiday, the bigger home, the MP3, the meal out, toys for the children, the afternoon at the golf club or the soccer match. If EROEI falls materially, our consumerist way of life is over.

There are two really nasty stings in the tail of a declining EROEI. First, net energy availability may fall below the amount required for essential purposes including healthcare, government and law. It is hardly too much to say that a declining EROEI could bomb societies back into the pre-industrial age. 

Indeed, a decrease in net energy below subsistence levels is an implicit consequence of EROEI decline beyond a certain point – one which is difficult to estimate, but is likely to occur within the next decade – which means that this is when the nastiest results of all start happening. 

Second, of course, a decline in net energy availability could (indeed, almost certainly will) result in conflict driven by competition for access to diminishing surplus energy resources

an unfolding collapse? 

As we have seen, energy is completely central to all forms of activity, so the threat posed by a sharp decline in net energy availability extends into every aspect of the economy, and will affect supplies of food and water, access to other resources, and structures of government and law.

The story of modern agriculture is one of feeding an ever-growing global population from an essentially finite resource base. At the time of population theorist Thomas Malthus (1766-1834), it would have seemed inconceivable that the world population could increase from 870 million in 1810 to 6,900 million in 2010. That this has been achieved has been solely due to the application of exogenous energy to agriculture, a process which has created an expansion in food production which has exceeded the 7.9x increase in human numbers over the same period.

Essentially, there are two ways in which agricultural output can be increased. The first is to bring more
land into production, which has indeed happened, but virtually all viable farmland was under cultivation
by 1960.

The second is to increase output per hectare, which is what the “green revolution” has achieved – between
1950 and 1984, for example, global grain production increased by about 250%. 

The snag with this, of course, is that the green revolution has, overwhelmingly, been the product of energy inputs. Most obviously, planting, harvesting, processing and distribution have been made possible by fossil fuels, principally oil. Fertilizers have been sourced from natural gas, whilst most pesticides are made from petroleum. The impact of energy inputs on agricultural productivity cannot be calculated exactly, but some estimates suggest that these inputs have increased output per hectare by at least 85%. The apparent implication – which is that food production might decline by almost half if these inputs became unavailable – is almost certainly a severe understatement, because it ignores both the leeching of naturally-occurring nutrients and the conditioning of the land to input intensive monoculture.

It seems highly probable that recent food crises are directly linked to rising energy costs, and that escalating food prices owe at least as much to energy constraint as to continuing increases in the global population. Of course, the cultivation of crops for fuels worsens the squeeze on food availability and, as we have seen, offers such low EROEIs that it is a wholly futile response to the squeeze on energy supplies. 

The knock-on effects of energy constraint go far beyond food issues, serious though these are. The production of most minerals would be uneconomic without access to relatively inexpensive energy. The giant Bingham Canyon mine in Utah, for example, produces copper at concentrations of about 0.25%, which means that some 400 tonnes of rock must be shifted for each tonne of copper produced, a process that is hugely energy-intensive. Most plastics are derived from either oil or natural gas. Desalination is extremely energy intensive, which means that any sharp escalation in energy costs will undercut an increasingly important source of fresh water. Current plans call for the quantities of water produced by desalination to increase from 68 mmc (million cubic metres) in 2010 to 120 mmc3 in 2020, a plan which looks wildly unrealistic if the availability of net energy is declining at anything like the rate that our analysis of trends in EROEI suggests

The logic of a deteriorating EROEI suggests that investment in energy infrastructure will grow much more rapidly than the economy as a whole in a process that has been called ‘energy sprawl’. In essence, declining productivity means that the energy infrastructure must increase more rapidly than the volume of produced energy, and this process is clearly under way, though principally in the emerging economies (where energy demand continues to increase) rather than in the developed world. This is most evident in the massive investment that is being poured into all aspects of the energy chain in China. 

The calculations here are daunting. If we assume (for the sake of simplicity) that real GDP remains constant over a ten-year period in which the overall EROEI declines from 20:1 to 10:1, energy costs must rise at a compound annual rate of 7.4% whilst the rest of the economy shrinks by 0.5% per year.

knowing the score

Where the surplus energy equation is concerned, one question remains – how will we know when the decline sets in? The following are amongst the most obvious decline-markers:

- Energy price escalation. 

The inflation-adjusted market prices of energy (and, most importantly, of oil) move up sharply, albeit in a zig-zag fashion as price escalation chokes off economic growth and imposes short-term reverses in demand.

- Agricultural stress. 

This will be most obvious in more frequent spikes in food prices, combined with food
shortfalls in the poorest countries.

- Energy sprawl. 

Investment in the energy infrastructure will absorb a steadily-rising proportion of global capital investment.

- Economic stagnation.

 As the decline in EROEIs accelerates, the world economy can be expected to become increasingly sluggish, and to fail to recover from setbacks as robustly as it has in the past.

- Inflation.

 A squeezed energy surplus can be expected to combine with an over-extended monetary economy to create escalating inflation.With the exception (thus far) of inflation, each of these features has become firmly established in recent years, which suggests that the energy surplus economy has already reached its tipping-point

PN: this in an extract from Financial Times document.

The original document first covers other reasons for the Zero Growth future.. and tackles energy issue at the end. Though the most important issue is the energy issue. The take away is to understand what we can do to reduce the consumption/waste of energy that happens all around. 

A more important step would be to make lifestyle changes, public transport, railways instead of air travel. I see a future of joint family system. Future ready jobs is also a must and assets that will hold value in the future.. 


Anonymous said...

WhatsUP Ji,

Thanks for sharing. I'll read the entire piece this weekend and feedback.

What'sUp Prahalad said...

Anonymous ji:

yes looking forward to it..

I hope you have also downloaded the completed document "Financial Times document."

=happy investing

Anonymous said...

WhatsUP Ji,

Did go thru the entire 84 page document. The energy cliff graph is very pertinent. Fig 5.12 on page 75 of 84 clearly shows the sources and EROEI. As per it, Hydro Electricity has the high EROEI (100:1) or better.

I'm bit bearish on NHPC as it has a whopping 1260 crores share capital. That's too many shares for meaningful return for retail investors like us unless we invest 10 lac shares or more.

JAOL in larger scheme of things is a blip on radar. It's impact on energy crises and peak oil is too niche and too small. But a worthwhile investment nonetheless.

GAEL addresses the food part. They are more financially sane organization. I hope they don't resort to producing energy from corn (read ethanol).

Tata Communications do act like a "toll bridge" in peak oil economy where transport becomes expensive. But we have Marissa Mayers (of yahoo) who is now reversing tele-commuting work culture.

In a nutshell, I seem to have a rather bleak view of things around and try to focus on 3 things:

1) Emotional, physical & financial health.

2) Hope friends, relatives and community at large, are safe financially. (else they create problems for us).

3) Things in life are not linear but a series of crests and troughs (a.k.a bubbles or cycles). Ride the wave.

What'sUp Prahalad said...

Anonymous ji:

Hydro EROI is 100:1
tar sands shale gas and low quality crude oil have all got lower EROI ..

but electricity is sold at the same rate.. so hydro electric power profits are going to be much higher..

large equity is due to the fantastic amount of reserves NHPC had accumulated.. to make the price of IPO "affordable" govt did give bonuses to itself..

So just watch as reserves of NHPC pile on even as it increases Dividends regularly.. being the largest player (and govt owned) it will also get access to complex projects which will be lucrative in the long run..
with regards Jayant.. I think it is the real multibagger (of the 4 best buys..) Chemicals are everywhere.. and castor is a multifaceted source of different chemicals..

bed - polish,varnish - castor
bed sheet- colours, pillow-foam,
tooth paste,soap, lipstick, perfume,shoes leather treatment, food-organic fert, house paint, electrical wires-plastic, water-proofing chemical.. the list is long ...too long actually..
Marissa Mayers .. ban on telecommute... actually shows how fast the culture is spreading..
- Whatever the reason for the ban.. it will increase telecommute..

Just like after the internet dot com bust.. the next gen internet companies (survivors) are really breaking the old industries.. so the bust was good for removing ..excessive froth and improving the quality of the end product..

GAEL as you pointed out ..is fundamentally the best.. it already produces ethanol (in pvt company owned by the same management..in Maharashtra I think..) my real worry for GAEL is that corn starch(high fructose corn syrup) is a leading cause of obesity related diseases..

but all said and done GAEL management has really kept its energy cost under control with captive co-generation plants.. and strong balance sheet.. In case of survival of the fittest its right on top..
"Ride the Wave" I have'nt caught up on that yet.. still on the learning curve..

=happy investing