Hal O'Brien

Thought provoking piece from Reuters' John Kemp. He's taking dead-eye aim at gold bugs, peak oilers, and others convinced of doomsday scenarios.

A report to the trustees, staff and advisers of the California State Teachers Retirement System (CalSTRS) confirmed: “Investors should view commodity performance as analogous to insurance. Commodity investments may not always produce high returns and may impose some form of opportunity costs similar to an insurance premium. During unexpected investment-related events, such as high inflation, commodities are expected to outperform”.

A similar case is being made for why investors should include 100-year bonds, gold, commodity futures and a host of other insurance-like contracts in their portfolio to protect against a range of investment risks — from inflation and deflation to flash crashes, a global energy crisis or bad harvests.

OVER-PAYING FOR INSURANCE
The comparison with insurance should give investors pause. The only people who make money from insurance are generally the sellers. For buyers, they amount to a cost — and sometimes not very good value. Some companies such as BP and some other oil majors decide it is cheaper to self-insure against at least some risks.

Insurers make money because the amount collected in premiums and earned by reinvesting them exceeds the amount paid out in the event of insurable events. Providing insurance is profitable because (a) insurable events are not common; (b) insurers have reserves to absorb periodic large losses; and (c) insurers pool risks across uncorrelated markets.

The key is that buyers of insurance generally pay more up front in premiums (ex ante) than they ever claim in payouts (ex post). Precisely the same thing is happening in many of these newly popular markets for tail risks. Investors will pay far more for the exposure to tail risks than they will ever get back if and when those risks eventually occur.

Another aspect of the poor world-building in James Howard Kunstler's cautionary science fiction novel, World Made By Hand: Its all-or-nothing-at-all nature.

To remind: World is a novel set approx. 15 years from today, in a world where oil has virtually disappeared.

One of the things Kunstler posits is that a) the United States' government as we know it will mostly disappear, since it won't be able to exert power over distance, and b) nothing will take its place except in the extreme local sense -- local large landowners who will be proto-aristocrats with proto-serfs, local anarchy, etc.

This shows (as does his thoughts about tech that I've discussed earlier) a profound ignorance of history.

One of the things that governments do, in living memory no less, is ration things. Whether one is talking about the various rationing measures in the US during WWII, or "austerity Britain" after the war, or even as far back as Mesopotamian city-states -- governments ration scarce commodities, and keep the share needed to maintain power for themselves.

In this way, Walter Tevis' The Steps of the Sun is far more realistic than Kunstler. It too shows a world of dwindling resources, but it also shows a US government that manages to maintain supersonic fighters -- at the end of the barrel of a gun.

There's also just human nature at work. I've said before that Leopold Kohr's The Breakdown of Nations continues to be one of the most prophetic works of the 20th Century. Even if you grant Kunstler that the federal government would "wither away," to serve his polemic point, the likelihood is quite strong that the US would split up into a series of regional nations. (Which is what the states nominally are, but hey.) It's not as if US Grant and the Army of the Potomac will come along to force them back together. (Or, if they did, it would prove how wrong the idea of diminished Federal power is.)

But that splintering shows another problem -- Kunstler portrays a US which is uniformly on the skids, "powerless" in the literal black-out sense.

Given his background as an amateur urban critic, you'd think Kunstler had read Jane Jacobs. And, if so, you'd think he'd know about her idea that any given national economy is really the sum of individual urban economies (see her The Economy of Cities)

Assuming that the larger regional cities would become primate capital cities of new splinter nations, I suggest that they would have a wide variety of outcomes. Seattle, where I live, gets 90% of its electricity from hydro, and another 8% from other non-fossil sources. In our region, I imagine Vancouver and Portland have similar non-petroleum sourcing.

I don't know the strengths and weaknesses of other cities. But this region's cities in particular are fairly well off compared to others if it comes to the great darkness Kunstler foresees.

And that's the problem. In the same way JMS used to make fun of some science fiction series for portraying the species of any given planet as being uniform, without ethnic, sectarian, or other divisions, Kunstler's attempts to make the entire world one vast homogeneous passive pity party are absolutely laughable. Even in the nightmare scenario he gives to himself, there will be winners, losers, and imbalances of outcome.

Paul Krugman had a column the other day at the New York Times. It's about the fragile nature of world trade, and how nationalism and protectionism could cause it to unravel more easily than one might think.

The eye-opener, though, is how he uses the pre-WWI economy as an example of a global one not unlike our own:

"Writing in 1919, the great British economist John Maynard Keynes described the world economy as it was on the eve of World War I. “The inhabitant of London could order by telephone, sipping his morning tea in bed, the various products of the whole earth ... he could at the same moment and by the same means adventure his wealth in the natural resources and new enterprises of any quarter of the world.”

And Keynes’s Londoner “regarded this state of affairs as normal, certain, and permanent, except in the direction of further improvement ... The projects and politics of militarism and imperialism, of racial and cultural rivalries, of monopolies, restrictions, and exclusion ... appeared to exercise almost no influence at all on the ordinary course of social and economic life, the internationalization of which was nearly complete in practice.”

But then came three decades of war, revolution, political instability, depression and more war. By the end of World War II, the world was fragmented economically as well as politically. And it took a couple of generations to put it back together."

Why was this particularly striking to me?

Well, there's a sub-set of those who believe in peak oil who also clearly think that industrial society cannot exist without oil. One loud exponent of this view is Jim Kunstler, of whom I've written before, and he's expressed it in his nominally non-fiction book The Long Emergency and his novel World Made By Hand. He says at the web site for the novel that one of his main goals was to provide a "credible" scenario for our future. So he shows us a world about 15 years from now (or as far into the future as we are from 1993) -- that has been ravaged by disease, has had a complete economic and political breakdown, has no real communication other than by foot or horse, etc., etc. In other words, he posits a world at about 1830's levels of tech in about 15 years.

And he calls this "credible."

So, what about the Keynes quotes up there from Krugman? Well, the Age of Oil really began with the gusher that was found at Spindletop, Texas, in 1901. But it took a long time for oil to percolate through society. The world Keynes is describing is one without oil.

But, notably, it's one with industry.

And that's the largest problem I have with the with the most pessimistic among the peak oil crowd. I'm willing to give them their premises regarding oil production itself. Although, if Hubbert, Deffeyes, Campbell, and others are to be believed, that means a symmetrical curve. Just as I remember Keynes' London, I also recall the US of the 1950's, which was when the interstates and the suburbs were first being built -- and that was with global oil production of roughly what one would expect in the 2060's if we're at peak now.

What this goes to is what Patrick Nielsen Hayden once described as the real surprise of the Boomers -- they never expected to live this long. That wasn't just because of shooting their collective wad so young. It's because they were told, incessantly, throughout their youth that either they'd go up in nuclear smoke, or a population crisis, or an environmental one. And now they're in their 60s, and they're not dead yet. Hell, they're more prosperous than they ever thought possible.

Kunstler gets to sounding like that a lot. Just like there are some fans who (mostly jokingly) complain about not having their jet packs, Kunstler comes across as complaining as not having his apocalypse yet.

I'm willing to give him peak oil. But that means a rollback to 1910 or so, at worst.

But he's a moralist at heart. Which means his beef isn't really with petroleum, or even the car suburb he so soundly excoriates, it's with industrial society as a whole. So he overreaches, and becomes, well...

Not credible.

It doesn't get to the really useful stuff until late in the article, but this piece in the New York Times has some interesting insights about commodity markets -- both food and oil:

"“Concern about manipulation is not misplaced,” said Patrick Westhoff, an economist at the University of Missouri’s Food and Agricultural Policy Research Institute. “But speculation doesn’t equal manipulation, and I am concerned that there’s been a confusion between the two concepts.”"

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"The stage of the speculation that is alarming Washington is the commodity futures market, which trades a financial derivative called a futures contract, an agreement for the future delivery of a fixed amount of a commodity at a certain price. The prices at which these futures contracts change hands are the benchmark for pricing commodities around the world.

In essence, speculators are the only voluntary players in the commodity futures markets. They could use their billions to dabble in currency markets or buy distressed real estate or pile up Treasury bonds.

But farmers, miners, oil producers and all the other players engaged in commodity production and consumption — the so-called commercial players — pretty much have to be there. There just are not many other places they can hedge the price risks that arise in their commodity-based businesses.

So speculators become the ballast in the market, making the contrary trades, taking on the risks the hedgers want to shed, reacting quickly when news jolts the markets and, most important, creating liquidity by pouring in enough money to allow everyone to make very large trades quickly without causing wild price swings.

Liquidity is, in effect, the hostess gift that speculators bring to every market party, and without the capital poured into energy markets by institutional investors, prices may well be far higher and more volatile than they are, said Philip K. Verleger Jr., an economist and energy policy consultant who testifies frequently before Congress on energy issues."

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So, that's the real question -- Are these markets being manipulated toward a price that has nothing to do with supply and demand? Or are they reflecting a real tightening of supply even as demand grows? (Bonus question on the oil side: Where are the new discoveries? Note this page, which uses work by Colin J. Campbell, the geologist who founded the Association for the Study of Peak Oil and Gas (ASPO). It appears discoveries peaked in the mid 1960s, and have been in a declining trend ever since, even as demand rises.)

"The rise and fall of oil production is asymmetrical."

Ah. Revealed at last, why Kunstler thinks a novel is "credible" when it shows people living at 1830's levels in about fifteen years from now.

As may be... Colin Campbell, the founder of the Association for the Study of Peak Oil & Gas disagrees with him. Kenneth Deffeyes, geologist at Princeton and author of "Hubbert's Peak," disagrees with him. Hubbert himself, the original exponent of the peak oil theory, disagrees with him.

Peak plus 15 years should see global production at Peak minus 15 years' levels. Remember the great oil shortages of 1992, and the famine and death of industrialism that followed? No?

Me neither.

And that's before we get into, if we're "sleepwalking into the future," then OPEC is sleepwalking right along with us, given that they've become increasingly insistent in asking for guarantees of demand, and no replay of the glut of the 1980's caused by conservation.

UPDATE: Note this fairly detailed discussion at The Oil Drum (a site recommended by Kunstler in the past), titled, "Hubbert Theory says Peak is Slow Squeeze."

The following are some posts I've been making to MetaFilter. Blocks of italics indicate quotes from other posts.

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"Sprawling, isolated" subdivisions continue to exist, and new subdivisions are opening regularly because that's how American suburbanites want to live.

Oh, if only it were so.

See, the thing about a free market -- or even a market subsidized by great big whomping tax write-off, like the mortgage interest deduction -- is that price indicates demand.

So, what't the most expensive housing? Apartments in dense, multi-purpose downtowns.

What's the least expensive? Cookie-cutter, SimCity Classic, monoculture Burbland.

That's because discounting those "houses" is the only way to get people to buy them.

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"Low blow, by the way, putting scare-quotes around "house," as if a house in the suburbs isn't just as much a house as one in the city... most of my interaction with my home occurs on its inside.

I would certainly hope so. Here's why:

I put the quotes around "house" both to protest current poor building practices, and the abuse of the words "house" and "home". A house is a physical structure. A home is an abstract institution. There's a reason why people who disregard marital obligations are called "homewreckers", not "housewreckers". :)

But to turn back to your demand vs supply observation -- demand determines supply. Or at least, the perception of scarcity. If I personally drip some paint onto a canvas, it's worthless, even if it's unique. If I can find one that's known to have been dripped by Jackson Pollock, it's ain't worthless anymore. :)

The same applies to real estate. A 100-unit building at First and Pine will command a higher price per unit than a 100-unit building in Bellevue. The most expensive house in London, I'm fairly sure, is on the south bank of the Thames, just west of the Globe Theatre, because it's about the only single house on that side of the Thames. (It overlooks St. Paul's on the other side of the river, and is in fact where Christopher Wren lived while St. Paul's was under construction.) Put that same house in Croydon, and it ain't worth as much.

I live in Orange County, Calif., and I think it's no accident that almost all the big development companies here are privately held. If they were public, they could be sued massively for lack of return, because of the cheapo kind of suburban construction they specialize in.

The thing about Burbland is that a), it's familiar -- not just to the customer but to the construction guys; b) it's quick to build; c) it's cheap to build. It really is the physical equivalent of fast food.

But a residence with texture, with feeling, with depth behind it -- the structural equivalent of haute cuisine -- is still pretty much only possible in places like London, or Paris, or the Upper West Side, or Queen Anne/Capitol Hill, or Vancouver, or the Strand in Stockholm, or San Francisco, or Sydney, or... Well, you get the idea.

My personal ideal would be a Greene & Greene bungalow in either downtown Seattle, Vancouver, or Stockholm -- but hey, that's just me (and shows my affinity for water).

But what I really object to is the idea that people are getting what they want. I think people are both smarter and more sensitive than that. They know they want something better, but are willing to muddle through with the limited palette of choices presented to them.

And (he said, coming full circle), I think Burbland's low, LOW prices reflect that muddling through.

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aaron:Yes, and the main reason for its cost is lack of supply.

Perhaps you were typing at the same time I was, but to repeat: Supply is defined by demand.

If I have 30 million houses, but 40 million people want them, they're going to be expensive. If I have one house and nobody wants it, it's going to be cheap.

It follows from what you say that even with prices artificially jacked up, demand for urban downtown housing is so high that people are still willing to pay those prices. And what I'm saying is that, even with suburban housing being deeply discounted, subsidized, and in abundant supply -- that such high urban demand and pricing still exists.

This, to me, is a clear indication of what the overall market wants.