Our Investment Sinkhole Problem

We are used to expecting that more investment will yield more output, but in the real world, things don’t always work out that way.

Figure 1. Comparison of 2005 to 2011 percent change in real GDP vs percent change in oil consumption, both on a per capita basis. (GDP per capita on a PPP basis from World bank, oil consumption from BP's 2012 Statistical Review of World Energy.

Figure 1. Comparison of 2005 to 2011 percent change in real GDP vs percent change in oil consumption, both on a per capita basis. (GDP per capita on a PPP basis from World Bank, oil consumption from BP’s 2012 Statistical Review of World Energy.)

In Figure 1, we see that for several groupings, the increase (or decrease) in oil consumption tends to correlate with the increase (or decrease) in GDP. The usual pattern is that GDP growth is a little greater than oil consumption growth. This happens because of changes of various sorts: (a) Increasing substitution of other energy sources for oil, (b) Increased efficiency in using oil, and (c) A changing GDP mix away from producing goods, and toward producing services, leading to a proportionately lower need for oil and other energy products.

The situation is strikingly different for Saudi Arabia, however. A huge increase in oil consumption (Figure 1), and in fact in total energy consumption (Figure 2, below), does not seem to result in a corresponding rise in GDP.

Figure 2. Total primary energy consumed per capita, based on BP's 2012 Statistical Review of World Energy data and population data from EIA.

Figure 2. Total primary energy consumed per capita, based on BP’s 2012 Statistical Review of World Energy data and population data from EIA.

At least part of problem is that Saudi Arabia is reaching limits of various types. One of them is inadequate water for a rising population. Adding desalination plants adds huge costs and huge energy usage, but does not increase the standards of living of citizens. Instead, adding desalination plants simply allows the country to pump less water from its depleting aquifers.

To some extent, the same situation occurs in oil and gas fields. Expensive investment is required, but it is doubtful that there is an increase in capacity that is proportional to its cost. To a significant extent, new investment simply offsets a decline in production elsewhere, so maintains the status quo. It is expensive, but adds little to what gets measured as GDP.

The world outside of Saudi Arabia is now running into an investment sinkhole issue as well. This takes several forms: water limits that require deeper wells or desalination plants; oil and gas limits that require more expensive forms of extraction; and pollution limits requiring expensive adjustments to automobiles or to power plants.

These higher investment costs lead to higher end product costs of goods using these resources. These higher costs eventually transfer to other products that most of us consider essential: food because it uses much oil in growing and transport; electricity because it is associated with pollution controls; and metals for basic manufacturing, because they also use oil in extraction and transport.

Ultimately, these investment sinkholes seem likely to cause huge problems. In some sense, they mean the economy is becoming less efficient, rather than more efficient. From an investment point of view, they can expect to crowd out other types of investment. From a consumer’s point of view, they lead to a rising cost of essential products that can be expected to squeeze out other purchases.  

Why Investment Sinkholes Go Unrecognized

From the point of view of an individual investor, all that matters is whether he will get an adequate return on the investment he makes. If a city government decides to install a desalination plant, the investor’s primary concern is that someone (the government or those buying water) will pay enough money that he can make an adequate return on his investment over time. Citizens clearly need water. The only question is whether citizens can afford the desalinated water from their discretionary income. Obviously, if citizens spend more on desalinated water, the amount of discretionary income available for other goods will be reduced.

The same issue arises with pollution control equipment installed by a utility, or by an auto maker.  The need for pollution control equipment arises because of limits we are reaching–too many people in too small a space, and too many waste products for the environment to handle. The utility or auto makers adds what is mandated, since clearly, buyers of electricity or of an automobile will recognize the need for clean air, and will be willing to use some of their discretionary income for pollution control equipment. Mandated renewable energy requirements are another way that governments attempt to compensate for limits we are reaching. These, too, tend to impose higher costs, and indirectly reduce consumers’ discretionary income.

All types of mineral extraction, but particularly oil, eventually reach the situation where it takes an increasing amount of investment (money, energy products, and often water) to extract a given amount of resource. This situation arises because companies extract the cheapest to extract resources first, and move on to the more expensive to extract resources later. As consumers, we recognize the situation through rising commodity prices. There is generally a real issue behind the rising prices–not enough resource available in readily accessible locations, so we need to dig deeper, or apply more “high tech” solutions. These high tech solutions indirectly require more investment and more energy, as well.

While we don’t stop to think about what is happening, the reality is that increasingly less oil (or other product such as natural gas, coal, gold, or copper) is being produced, for the same investment dollar. As long as the price of the product keeps rising sufficiently to cover the higher cost of extraction, the investor is happy, even if the cost of the resource is becoming unbearably high for consumers.

The catch with energy products is that consumers really need the products extracted–the oil to grow the food they eat and for commuting, for example. We also know that in general, energy of some sort is required to manufacture every kind of product that is made, and is needed to enable nearly every kind of service. Oil is the most portable of the world’s energy sources, and because of this, is used in powering most types of vehicles and much portable equipment. It is also used as a raw material in many products. As a result, limits on oil supply are likely to have an adverse impact on the economy as a whole, and on economic growth.

The Oil and Gas Part of the Problem

A major issue today is that oil supply is already constrained–it is not rising very quickly on a world basis, no matter how much investment is made (Figure 3).

Figure 3. World oil supply with exponential trend lines fitted by author. Oil consumption data from BP 2012 Statistical Review of World Energy.

Figure 3. World oil supply with exponential trend lines fitted by author. Oil consumption data from BP 2012 Statistical Review of World Energy.

As noted above, the easy-to-extract oil and gas was extracted first. New development is increasingly occurring in expensive-to-extract locations, such as deep water, Canadian oil sands, arctic oil, and “tight oil” that requires fracking to extract. This oil requires more energy to produce, and more inputs of other sorts, such as water for fracking. Because of rising costs, the price of oil has tripled in the last 10 years.

Investment costs also continue to soar because of rising costs associated with exploration and production. Worldwide, oil and gas exploration and production spending increased by 19% in 2011 and 11% in 2012, according to Barclays Capital. Such spending produced only a modest increase in output–about 0.1% increase in crude oil production in 2011, and 2.2% increase in the first 10 months of 2012, based on EIA data. Natural gas production increased by 3.1% in 2011, according to BP. Estimates for 2012 are not yet available.

If we want to “grow” oil and gas production at all, businesses will need to keep investing increasing amounts of money (and energy) into oil and gas extraction. For this to happen, prices paid by consumers for oil and gas will need to continue to rise. In the US, there is a particular problem, because the selling price of natural gas is now far below what it costs shale gas producers to produce it–a price estimated to be $8 by Steve Kopits of Douglas Westwood. The Henry Hub spot natural gas price is now only $3.38.

The question now is whether oil and gas investment will keep rising fast enough to keep production rising. Barclays is forecasting only a 7% increase in worldwide oil and gas investment in 2013. According to the forecast, virtually none of the investment growth will come from North America, apparently because oil and gas prices are not currently high enough to justify the high-priced projects needed. The flat investment forecast by Barclays suggests a major disconnect between what the IEA is saying–that North America is on its way to becoming an energy exporter–and the actual actions of oil and gas companies based on current price levels. Of course, if oil and gas prices would go higher, more investment might be made–a point I made when writing about the IEA analysis.

What will the ultimate impact be on the economy?

I would argue that for most of the developed (OECD) countries, the ultimate impact will be  a long-term contraction of the economy, similar to that illustrated in Scenario 2 of Figure 4.

What happens if economy stops growing

Figure 4. Two views of future economic growth.

What happens is that as we increasingly reach limits, more and more investment capital (and physical use of oil) is allocated toward the investment sinkholes. This has a double  effect:

(1) The prices paid for resources that are subject in investment sinkholes need to continue to rise, in order to continue to attract enough investment capital. This is true both for goods that directly come from investment sinkholes (oil, gas and water) and from products that have a less direct connection, but depend on rising-cost inputs (such as food and electricity).

(2) Products outside of essential goods and services will increasingly be starved of investment capital and physical resources. This happens partly because of the greater investment needs in the sinkhole areas. Also, as consumers pay increasing amounts for essential goods and service because of (1), they cut back on the purchase of discretionary items, reducing demand for non-essentials.

In some real sense, because of the sinkhole investment phenomenon, we are getting less and less back for every dollar invested (and every barrel of oil invested). This phenomenon as applied to energy resources is sometimes referred to as declining Energy Return on Energy Invested.

As discussed above, world oil supply in recent years is quite close to flat (Figure 3). The flat supply of oil is further reduced by the additional oil investment required by sinkhole projects, such as the ones Saudi Arabia is undertaking. Also, there is a tendency for the developing world to attract a disproportionate share of the oil supply that is available, because they can leverage its use to a greater extent. Both of these phenomena lead to a shrinking oil supply for OECD countries.

The combination of shrinking OECD oil supply, together with the need for oil for many functions necessary for economic growth, leads to a tendency for the economies of OECD nations to shrink.  It is hard to see an end to this shrinkage, because there really is no end to the limits we are reaching. No one has invented a substitute for water, or for unpolluted air.  People talk about inventing a substitute for oil, but biofuels and intermittent electricity are very poor substitutes. Often substitutes have even higher costs, adding to the investment sinkhole problem, rather than solving it.

Where we are now

When resource prices rise, the impact is felt almost immediately. Salaries don’t rise at the same time oil prices rise, so consumers have to cut back on some purchases of discretionary goods and services. The initial impact is layoffs in discretionary sectors of the economy. Within a few years, however, the layoff problems are transformed into central government debt problems. This happens because governments need to pay benefits to laid-off workers at the same time they are collecting less in taxes.

The most recent time we experienced the full impact of rising commodity prices was in 2008-2009, but we are not yet over these problems. The US government now has a severe debt problem. As the government attempts to extricate itself from the high level of debt it has gotten itself into, citizens are again likely to see their budgets squeezed because of  higher taxes, lay-offs of government workers, and reduced government benefits. As a result, consumers will have less to spend on discretionary goods and service. Layoffs will occur in discretionary sectors of the economy, eventually leading to more recession.

Over time, we can expect the investment sinkhole problem to get worse. In time, the impact is likely to look like long-term contraction, as illustrated in Scenario 2 of Figure 4.

Is there an End to the Contraction?

It is hard to see a favorable outcome to the continued contraction. Our current financial system depends on long-term growth. The impact on it is likely to be huge stress on the financial system and a large number of debt defaults. It is even possible we will see a collapse of the financial system, or of some governments.

In a way, what we are talking about is the Limits to Growth problem modeled in the 1972 book by that name. It is the fact that we are reaching limits in many ways simultaneously that is causing our problem. There are theoretical ways around individual limits, but putting them together makes the cost impossibly high for the consumer, and places huge financial stress on governments.

67 thoughts on “Our Investment Sinkhole Problem

  1. A comment in a previous article is very pertinent: that the cost of effecting infrastructure repairs today is rising, and is in excess or considerably in excess of the original construction cost due to rising oil and other commodity prices.
    One tends to look upon crumbling roads and the like and wonder why the civic authority seemingly cannot get its act together and keep its estate in good repair. Just standing still is becoming a demanding sinkhole.

    • I agree. Exactly. We can’t afford to maintain the roads, waterways, water and sewer systems, and electricity transmission lines we have built. Building electric cars doesn’t fix the problem, especially if they are even higher-cost than other cars.

  2. Dear Gail
    Very good post.

    As an example of something that might become (or maybe already is) a sinkhole, consider Agriculture. The USDA has just issued a very detailed report on climate change and agriculture. There are several lead authors and over 150 contributing scientists.

    Click to access CC%20and%20Agriculture%20Report%20(02-04-2013)b.pdf

    Let me note that plants flourished during the age of dinosaurs, when CO2 levels were higher than they are now and when our fossil fuels were mostly laid down. Plants live on CO2. Nevertheless, there are challenges and the report tries to enumerate them.

    I was in a meeting with one of the lead authors on Friday, Laura Lengnick. She said that, in her opinion, what we really need is ‘to design a self-organizing ecosystem capable of sustained food and fiber production using renewable resources in a variable climate’. I can’t argue with that…it sounds like Permaculture or Food Forests or similar endeavors. But if you look into the details of what is published, you will find many, many studies which change one variable only, while assuming essentially unlimited availability of other variables. For example, a study may quantify the amount of the increase in a particular crop’s yield with an increase in CO2, while assuming that the availability of oil, phosphate rock fertilizers, and irrigation water are unlimited. But suppose we are faced with the situation where CO2 increases and all those other factors are quite limited.

    I understand why scientific studies tend to control everything except one variable. But the net result, I think, is that we really have little idea what will happen to yields under the most likely scenario.

    Toward the end of the report, the authors lament that humans, including farmers, don’t make entirely rational decisions and thus the actions which they believe must be taken to mitigate climate change impacts on agriculture may not, in fact, be executed.

    Here is where I see the potential for an Investment Sinkhole. Large investments which assume that ‘everything else will be equal’ are likely to be a waste of money. I think that investments in very robust things like forming the earth to slow down and hold water are likely to pay off–while building more big dams to store water probably won’t. Investments in retaining nutrients such as phosphates are likely to pay off, while investments made assuming that the supply of phosphate rock is unlimited probably won’t.

    I am sympathetic to the authors in terms of the problems such an analysis would have raised, but I think that Laura Lengnick’s one sentence description of what we need to do is on the money.

    I think that there are probably similar potential sinkholes everywhere in our economy. Thus, the current Keynesian thinking of just spending money to try to get everything started again is desperately wrong.

    Don Stewart

    • You raise very good points.

      I think nature has provided a perfect adaptation for changing climate. Every plant gives off seeds that differ a bit from the parent. The seeds that are best adapted to the changing climate survive. Also, seeds blow in from neighboring areas. If they are better adapted, they survive.

      Of course, we have very fixed ideas about what needs to grow where. Certain areas have land that is better adapted for farming. We would like those areas to produce the crops we are accustomed to, in part because they have very high yields per acre, when adequate fertilizer and water are used, and when steps are taken to prevent “weeds” and crop loss to pests, both large (deer, squirrels) and tiny. For most of humans history, we were hunter-gathers and we could easily adapt to changing climate.

      Any change from our current agricultural system has big costs involved, I expect, so is in a way, an “investment sinkhole”. Even over the long run, we may not be able to grow as much per acre, and harvesting will likely require a good deal more hand labor.

      • Gail
        Since you are a skilled actuary….which is the best choice for the American citizen
        1. Have a Congress which denies climate change and cope as best you can
        or
        2. Have a Congress which concludes that climate change is real and that they have a duty (opportunity?) to do something about mitigating the harm?

        I sort of lean toward coping. I figure the second alternative is just a wonderful opportunity for them to give trillions to those who funded them.

        Don Stewart

        • I am afraid I am not at all convinced that there really is a good way of mitigating climate change, other than reducing population significantly. Carey King reminded me recently of a quote from Joe Tainter and Tad Patzek’s book. “Drilling Down: The Gulf Oil Debacle and Our Energy Dilemma.” The quote is, “… contrary to what is often suggested in debates about energy, climate, and our future, it is usually not possible for a society to reduce its consumption of resources voluntarily over the long term.”

          I personally think that the money spent on carbon capture and storage research so far is just plain silly. The scheme has little chance of working, and burns up our coal supply more quickly. I think I agree with you–the government would simply spend more money on CC&S and other equally ridiculous schemes.

  3. Your readers might want to visit the Zero Hedge website and search for Kyle Bass. If you type his name into the Zero Hedge search box, a bunch of his CNBC TV interview videos will come up in articles on Zero Hedge. He made a huge fortune betting against the subprime debt, as shown in the ‘CNBC Originals’ documentary, ‘House of Cards’ available on hulu. Anyway, he is now predicting the collapse of the Japanese debt bubble within the next couple of years. With a 240% debt to GNP ratio, and rapid additional debt creation being planned, they soon won’t be able to pay the interest on their debt without creating more and more money. That will raise interest rates even more, creating a vicious circle. Japan will be unable to pay its’ debt with paper money with real value. That will happen in the world’s third largest economy. I don’t think it will happen in the next couple of years, but it will happen, especially since the Japanese are shutting down their nuclear power plants forcing them to import expensive natural gas. Gas isn’t cheap over there in Asia, like it is here.
    So Japan may be the first developed country to undergo the collapse you have predicted. And if billionaire Kyle Bass is correct, it won’t be gradual, like in your Figure 4. The question is, since we can’t stop it, how do we make money on it? Any ideas, Gail?

    • Other investment experts assume that Japan will be forced to go back to nuclear, in fact that we will be seeing a global renaissance of nuclear. Uranium is rather cheap right now, because Germany and Japan said they will stop using it. But Russian export of cheap demilitarized uranium is declining. It might be possible to make money buying uranium assets now.

    • I am not good on the “making money” angle. Shortly after the Fukushima Earthquake, I heard a talk by James Howard Kunstler in which he predicted that Japan would be the first first-world country to collapse. I may be making more out of it than I should be–when I talked to him later, it seems like he had toned down his forecast.

      I think we have a contest among a number of countries on timing–Japan (for all of its debt); the Eurozone falling apart, taking many countries down at the same time; the United States and its funding problems; and Britain with its big financial industry, which could implode pretty easily.

      • Thanks for your reply. I wasn’t really making the point specifically for the money angle, but rather to continue on the previous comment. Also, following the money can often give many good indications – not so much about the fundamentals, but about near term developments and decisions by the powerful.
        Europe “falling apart” is a very U.S. centric perspective, it won’t happen soon. Even if Greek, Portugal and Spain leave the currency, that would make the Euro stronger, and not damage the world economy much. France and Italy will stay in for many years. After the German elections this fall, Germany will slowly step away from it’s hawkish position, especially if the left wins. The Euro has never been weak for money printing like the Dollar or Yen, but for (so far irrational) fear of disruption. The ECB hasn’t even started to print big time, they have lots of room for that. And they get all the swaps from the Fed they ask for. It’s all about bailing out insolvent European banks. In the few cases that came up, they immediately stepped in, and will continue to do so.

        • We seem to have different views of the European situation. For example, I think that Germany would be in very bad shape without Greek, Portugal, and Spain, because the Euro would float higher. Its a co-dependency problem.

          • German exports are at record highs, but at the same time they are just slightly higher than German imports! (I don’t have the exact numbers ready)
            Wouldn’t you agree that a strong currency is positive to buy energy and resources for a resource-poor country?

            Germany has been export champion already in the good old times of the (very strong) D-Mark. Germans workers could afford cheap holiday destinations – like Spain and Italy! That was European harmony by accepting the natural differences, now we have crisis by denying them.

            The Suiss central bank just went into the same thinking model – cheapen your currency to help export companies. But the Suiss people liked very much the purchasing power their strong Frank enjoyed in Italy or France.

            As Jim Rickards said it so well – nobody can win in a currency war.

            • I will have to admit Germany has always been hard working and resourceful. A strong currency would help keep import cost down. Maybe they can succeed in a competitive world market place.

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