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Ending a Century of Oil Addiction

This is a syndicated repost published with the permission of Global Edge Investors. To view original, click here. Opinions herein are not those of the Wall Street Examiner or Lee Adler. Reposting does not imply endorsement. The information presented is for educational or entertainment purposes and is not individual investment advice.

Ending a Century of Oil Addiction
The Challenge of an Outmoded Transport and Living Infrastructure
by Michael Hampton
August 14, 2007

Innovation is has brought huge changes to our industrial landscape, and our global economy. It has created, and decimated industries, encouraged new energy sources, and discouraged old ones. To see the background, it is useful to step back and look at the big picture. At a distance, it is easier to connect the dots, and put them in the context of long term cycles. What is very clear is that America and other post-industrial countries are today facing a huge new challenge. The age of oil and the automobile is ending. Companies and countries which led in the 20th century are not likely to maintain their leadership in our current century. Past successes have bred complacency, and a resistance to change. 

   

Of course, there were challenges in the transition from the 19th to the 20th century. But we are seeing even bigger challenges in the early years of the 21st. Like then, the new global leaders of this century will be those that embrace innovations, and move to accept change, rather than staying mired in their existing ways, simply because they worked in the past. The US has been slow to face the facts- it needs to change its outmoded transportation and living infrastructure. What we are seeing instead is that a transition from old to new is being delayed by America, as it struggles to hold onto its comfortable old way of life. That has resulted in large and growing financial imbalances, and expensive military adventures. But current trends cannot persist indefinitely. At some stage, a tipping point will be reached, and a serious crisis will unfold. Then, the pain from the imbalances may trigger a new awareness and a transition towards new sources of energy, new forms of transport, and major changes in the ways people live and work. However, by then, leadership may have slipped away to emerging countries.. 

A Great Energy Source for Each Century

At the risk of over-simplifying complex historical processes, I want to suggest that the 200 or so years since the start of the Industrial Revolution can be divided into three major phases. The first two lasted approximately one century, and the third is just beginning. Each phase had important new innovations, a major source of energy, and new transportation methods which utilized that source of energy. And each century had a different global leader, which in the first two centuries was the country that invented much of the new technology, developed its transport system around that technology, and built industries to exploit the changes. I summaries the three centuries as follows: 

CENTURY ENERGY FORM TRANSPORT MODE LEADER
1800s Coal Locomotives, Steamships Britain
1900s Oil Cars, Aircraft U.S.A.
Millennium Low Emission “Sustainable Transport”? BRIC Countries?

The changes in global leadership did not happen by accident. There would not have been a British Empire in the nineteenth century without the invention of the steam power and the UK’s huge reserves of coal. In the last century, American power grew with the rise of the Automobile. Big reserves provided an early lead by the US in oil production, and led to the eventual pre-eminence of American companies in developing global oil resources. These two countries were the home of the principle inventions, triggering the new age. They were blessed with huge reserves of the dominant energy, and were quick to exploit them, feeding capital into the companies which became the fast-growing industry leaders. However, leadership in one century did not persist long into the next. By the end of their centuries, both countries were left with a legacy of ill-investment in outmoded technologies and infrastructure. Mired in the past, they found it difficult to move forward, as new energy sources and infrastructure emerged.

The British Century and King Coal

James Watt was a Scottish-born inventor and engineer who worked in England. In the later decades of the eighteenth century he produced a series of key enhancements to the steam engine. He developed an engine which had two chambers, including a main one that pressurized the steam to enhance its motive power. The second chamber captured the used steam, permitting it to condense back into water, and freed the main chamber to act as a pure power device. This addition improved the efficiency, the reliability, and the motive power. Within a few decades, the steam engine had been adopted and used to power locomotives, and ships. Britain, with its huge coal reserves, soon built the world’s strongest industrial economy around these innovations. Railways connected all the major cities, and Britain was able to export machines and its manufactures around the world. Steam engines and coal powered its textile industries, and the ships which moved its goods to its far-flung colonies.

Today, we speak of peak oil. By the early years of the 20th century, it was beginning to be obvious that Britain’s high grade, and easily exploitable coal reserves were not going to last forever. Output per coal worker peaked in the 1880’s and began a long slow decline, from a peak of 310 tons in the early part of that decade, to 247 tons in the four years before the Great War, to only to just 199 tons in 1920–4. (*1 ). 

Despite those nagging concerns about coal, at the end of the 19th century Britain was massively powerful. The saying was, “the sun never sets on the British Empire.” And so it was, with a series of colonies around the world. The empire was supported and help together by a huge shipping fleet of military and merchant vessels. At the turn of the 20th century, about 50% of the gross tonnage of ships afloat was under the British flag. And the mighty British Pound was the reserve currency for the world.

Unfortunately, Britain was slow to give up its reliance on coal and switch oil for transport, and electricity and gas in home heating. By the time of the General Strike of 1926, it still had 1.2 million workers employed in coal mining. In 1973-74, just a few years before North Sea oil started flowing, there was a series of Miner’s strikes, by Arthur Scargill’s NUM, which put Britain into blackouts. There are many more examples of how old coal-based technologies lingered. Some may be unaware that London’s famous “pea soup” smog, which lasted up until the late 1950’s, was due to Britain’s continuing burning of coal to heat residential homes. This practice only ended in London, with the Clean Air Act of 1956. It then took some years for the smog to fully dissipate.

The American Age of Oil in the 20th Century

Henry Ford was born on a farm near Detroit. To escape a dreary life on the farm, he went to work in the city. He took various jobs, including one where he maintained steam engines, before settling into a position as an engineer with the Edison Illuminating Company. While in this position, he began to tinker with gasoline engines, and used them to power small vehicles. In 1896, he launched his Quadricycle, a four-wheeler powered by a gasoline engine. This success helped catch the attention of potential investors, and in 1903, he founded the Ford Motor company with 11 outside investors. He continued to innovate across his business with such breakthroughs as a land speed record, mass production in manufacturing, and an astonishing $5 a day wage rate, so even his own workers could afford the car they produced. Ford’s breakout product was the introduction of the Model T automobile in 1908. It was not only simple to drive, it was easy and cheap to repair. It’s original cost was $825, and it fell every year after that, hitting $360 by 1916. Demand rocketed. Sales passed 250,000 in 1914, and by 1918 half of all cars in America were model T’s.

America’s love affair with the automobile, also brought an addiction to oil, and committed the country to building (with help from federal subsidies) a huge highway system to accommodate private cars. America now has about 250 million automobiles, and by far the world’s largest network of national highways, with 6.43 million km. This network is present in every state and connects every major city, and has made possible “the American way of life” with its trademark suburban areas, with one or more cars in every driveway. Let’s look at how this compares with the world’s second largest highway system. China has 4.3 times as many people, a similar land area (3.7 million sq. km), and only 1.55 million km of highways. That’s only 24 percent as much highway. America has 18 times as much highway per capita, and uses 14 times more oil per capita, when compared with the Chinese.

Meantime, America does not lead in everything related to transport. It has a much smaller mass transit system, and far fewer passenger railways than most other developed countries. (Perhaps this is one reason why Warren Buffett has begun to invest in US railways.) The Japanese are the world champions in travel by rail, with a per capita average of 1,900 km (*2). At 1,730 km, the Swiss are not far behind, and further back you will find France (1,060 km), Germany (890 km), and the United Kingdom (490 km). Three BRIC nations use a decent amount of rail, considering their less mature stage of economic development, with Russia tops (at 990 km), followed by China (504 km), and India (370 km). No data was available for Brazil, which has a much less mobile population than the other three. Where does the US fit in? Way behind all of those that I have listed, at only 140 kilometers annually per capita, sandwiched between Thailand and Pakistan. The average American has only 7% of the rail travel of Japanese passengers. These skewed statistics demonstrate a basic fact, the American transport infrastructure was built primarily in the 20th century, around the automobile, and has left America with a huge reliance on cheap oil, virtually the oil fuel used in America for cars. (Note: Ethanol is rising as a fuel source, but is less efficient, uses plenty of oil in its production, and so far is heavily reliant on tax subsidies- so it does not look like the long term answer.) This oil reliance is a critical vulnerability, which is known by all American politicians and military strategists. Unfortunately the problem of US oil import dependency is rarely addressed as a glaring inadequacy in the American transport system.

In understanding America’s recent actions, and its future economic imperatives is useful to compare the increasingly outmoded US transportation system with the burden that Britain had in shaking off its coal dependency. I think of the American transportation infrastructure as a once-friendly beast of burden, which proved useful in building the economy in the 20th century. But now in the 21st, that beast is obsolete and has grown to become a voracious monster, crying out to be fed, and pushing America to act as a global bully to get what US consumers need. Unfortunately, it is not easy to get rid of such a beast. Huge capital expenditures have been made to build and sustain the system the way it is now. For example, the past 5-10 years have brought a huge increase in property prices, with new condos and suburban homes springing up across the country, all supported by a big jump in US mortgage debt. This has left America with two related and dangerous addictions: to cheap oil, and to cheap dollar debt. They are unlikely to stay cheap. America is uniquely and hugely vulnerable to a rise in oil prices and/or to rising interest rates.

America’s Gas-guzzling Economy, Implications

Let’s take a look at America’s energy usage, and see how it compares with the World, and some other major countries. Keep in mind that the transport sector is about one-quarter of America’s total energy usage. And residential use of all forms of energy is another one quarter of total US enegy consumption:

Energy Efficiency per capita

COUNTRY OIL DAILY ELECTRIC PER ANNUM
 United States  68.81 bbls  12,187 kWh/year (2006)
 Japan  42.01 bbls  7,424 kWh (2006)
 France  32.43 bbls  7,142 kWh (2003)
 United Kingdom  30.18 bbls  5,784 kWh (2003)
 Russia  17.66 bbls  5,674 kWh (2004)
 World  12.55 bbls  2,215 kWh (2003 est.)
 Brazil  11.67 bbls  1,975 kWh (2003)
 China  4.97 bbls  2,140 kWh (2006)
 India  2.18 bbls  481 kWh (2003)

Source: Wikipedia: Petroleum#…consuming_countries, List_of_countries_by_electricity_consumption

For those who don’t like dry statistics, here are some examples of how the US wastes oil, as reported recently in Hong Kong’s South China Morning Post:

  • 250 Million cars, and eight parking spots for every car in America
  • Only 1% of American 4-wheel drive vehicles ever go off-road,
  • Only 15% of the energy in a gallon reaches the wheels of an American car
  • Americans use 14 times as much oil per capita as the Chinese
  • If the US managed the same energy efficiency as Europe, it would not need oil from the Middle East

Suburban homes also waste plenty of energy, as individual dwellings are much less efficient to heat and light, as compared with apartment blocks in a city.

Despite all this waste and inefficiency, America often tries to dictate energy policies for the world. And this is happening at a time when the US has become the world’s biggest debtor nation, and it relies “upon the kindness of strangers” in China and Japan to get the capital it needs to keep its gas-guzzling-economy growing.

Connecting the Dots: 

The British Empire, with its steam engines and coal had a century of dominance. In the same way, and after a similar time period, the age of autos and oil is reaching its own built-in limits. Tight supply (Peak Oil), and rising demand from fast growing countries like China and India, appear to have pushed oil prices into a long term upwards trend. More people have begun to talk about a coming shock (and a possible “end to Suburbia”) as the American economy is forced to cope with the inevitable clash between its oil-dependent economy, and sharply rising oil prices. In the past few years, various short term factors, like rising house prices have provided a temporary fix, as many American merely refinanced their mortgages to cover higher energy costs. But now that the housing downturn has arrived, this solution doesn’t work anymore. As Jim Puplava has pointed out on recent FS broadcasts, instead of tapping their equity, stretched American consumers are turning to expensive credit card debt. This looks like a dangerous last resort. Can a debt crisis be far away?

To understand how future events may play out, it is useful to consider three big trends and think about how they are inter-connected:

  • The weak US dollar

  • Rising Oil Prices

  • The increasing vulnerability of America’s housing and transport infrastructure
    It is easy to imagine how the future could play out…

  • Eventually, China, Japan, and the Middle East oil nations will reach a point where they are no longer willing to go on building their reserves of Dollars. They stop buying, or slow their purchases of dollars. For a dollar crisis, it is not necessary for them to sell dollars, they must simply stop adding to their reserves at the historic fast rate.

  • The Dollar will begin an irreversible decline, breaking the major support near DX-80, on its way to a fall of 10%, 20%, 30%, or more. In the 1970’s and 80’s, many countries reduced their holdings of Pounds, as it became a less popular reserve currency. But that did not happen without some extreme volatility. There was a particularly dramatic period of just over four years when oil slid off its peak, and Sterling’s popularity as a possible petrocurrency waned.

Sterling, Since 1976

From late 1980 to early 1985, Sterling fell by an eye-popping 67% from $2.45 to $1.05. A fall of a similar magnitude in the dollar is possible, and also in only a few short years. Afterall, the dollar is now much more widely held as a reserve currency than Sterling was when it plummetted. And if big dollar holders (like China and Japan) panic and sell, there will be few to stand in their way. Of course, a sharp drop need not start from current level. North Sea oil discoveries, and an oil price surge helped Sterling to rally by over 50% in the 4 years before its big drop. But poor fundamentals of people exiting Sterling as a reserve currency won out in the end, and buyers deserted Sterling. Sterling did later recover when the North Sea oil and Thatcher’s revolution helped to restore its economy. By comparison, it is hard to imagine what macro factors could boost the dollar dramatically before its fundamental oversupply drives it lower.

  • Inflation will rise in the US because imports will become more expensive in terms of dollars. Oil will be the critical commodity to watch. For the US, there will be a vicious cycle, of a falling dollar, leading to rising oil prices and higher inflation. If rates are unchanged as inflation rises, then they will be evn more pressure on the dollar.

  • Oil is the largest US import, and there is increasingly fierce competition between the US and other rising energy consumers like China and India. Demand in the US may fall as dollar oil prices rise. But that may not be sufficient to drag global oil prices down, at least not in dollar terms. It is possible that the oil price may remain stable when calculated in renminbi or rupees. Within the oil market, rising demand from China and India may balance falls in the US. So do not expect dollar oil prices to fall much, even if the US heads into a severe recession.

  • Some think that as long as oil is priced in dollars, the currency will remain strong. That is only true if those who sell oil retain an important part of their reserves in dollars. If instead they unload the dollars, as soon as they receive them, the currency will not be stable. Once a falling trend in the dollar is widely perceived, those who buy oil in dollars can will tend to wait until the last moment to acquire the dollars needed for oil transactions. If the dollar falls faster than the dollar oil price rises, then waiting until the currency is actually needed will be a smart move. The weak American currency, will mean that countries holding strong currencies will have an easier time buying oil, even as the dollar price of oil rises,

  • Eventually, the oil price will reach a point ($100, $150, $200, or higher?) where the economic slowdown becomes a full-blown recession within the US. According to broadcasts on FS, Americans are already foregoing purchases of other goods, such as imported consumer items, to feed their gas tanks. At some stage, when oil prices are high enough, people will realize that they need to make permanent reductions in their oil consumption. They will think hard about how they use their cars, and where they live in relation to work. Politicians will start talking about the Federal subsidies (gasoline taxes, etc.) which helped pay for the building of highways, and how they can be diverted to paying for the construction of new mass transit systems. Expect some big adjustments in real estate prices, with suburban properties far away from public transport likely to lose value in relation to those that have mass transit connections. There will be more “urban” shopping malls, where shoppers visit by foot, train, or bus, rather than the suburban malls surrounded by parking lots.

  • The US will be between a rock and a hard place, where the inflationary pressures and the weak dollar may require a rise in interest rates, even though the economic pressure would have normally lead to rate cuts. If the Fed ignores the falling dollar and cuts rates, then inflation will just get worse, and hyperinflation will become a real possibility. And that would be followed by a worse economic disaster.

  • America’s trading partners already see that the US is over-geared, and will be unable to continue its consuming binge, spending the world’s savings. These countries have benefited from that over-consumption by building their manufacturing capacity by selling to customers in the US. But that over consumption has left them with a problem too- a heavy concentration of their FX reserves in dollars. To keep their factories humming, they kept their exchange rates competitive by recycling dollars into dollar securities. There’s something like $2 Trillion of reserves held by Japan and the BRIC countries, and perhaps 60-65% of that is held in dollars. Now if the dollar falls, those reserves will lose purchasing power. So countries like China have recently begun to reinvest those dollars in assets like commodities, hedge funds, and private equity that they expect will hold value even if the US dollar falls. China has also been restructuring its own banks through tens of billions of dollars worth of equity issues done in the Hong Kong market. Chinese banks are preparing to channel more credit to their domestic consumers. And they will be joined by dozens of foreign banks, currently obtaining Chinese licenses and planning to build branches all over China. The middle classes of the BRIC countries are mostly under-levered, and their homes have appreciated in value too. So if the credit can be efficiently provided, to consumers better educated in how to use it, much of the business lost in America can be reallocated to consumers in their domestic economies, and to countries that have a smaller challenges built into their infrastructures.*

  • China and India have so far shown some willingness to follow the US model in building an oil-and-auto transport sector, but it is not too late for them to seek alternatives. Where the streets of Chinese cities like Shanghai and Beijing were once filled by bicycles, they are now choked with private cars, and the air is polluted with excess emissions. This has now become a hot topic of political debate in China, and a real sense of urgency is developing. Shanghai has built one of the world’s first Maglev trains to carry passengers from its airport to the city center without crowding its highways. The world’s largest eco-city is being designed by UK architects to be built at Dongtan, an island near Shanghai. Inner Mongolia is building some of the world’s largest wind farms. And China has 40 nuclear power stations approved or under-construction, as does India. Meanwhile, the US continues to debate the merits of nuclear power. In short, the BRIC countries seem to be the ones to look to for leadership on low emissions energy, and new forms of transport for the 21st century.

  • With growing domestic demand in China and India, there will be less need to recycle dollars back to tapped-out consumers in the US. The US could slide into a vicious cycle of falling exchange rates and rising inflation, while the BRIC countries would see the virtue of their stronger currencies delivering stable or even cheaper oil. The US may then slide into a serious recession, or while much of the rest of the world enjoys a more stable economy. The US would go on paying for the inefficiencies of its oil infrastructure through years of impaired growth, or even a depression.

…At some point, a more positive scenario may appear:

  • I certainly hope that the US gets truly serious about its dilemma, and hit upon its new and healthier mission: to become the global leader in finding energy alternatives, and in rebuilding its economy so that it effectively conserves energy, using it more efficiently. Such a dawning would be a great relief to many other countries, who have tired of seeing the US as a global policemen, and a country which uses bully-boy tactics to protect its so-called “strategic interests”, projecting its military power to give it preferred access to world’s oil and energy assets. 

  • Despite my hopes for this conclusion, there is a long way to go. We are just over 500 days away from the next Presidential election, and the politicians are continuing to speak to voters showing their usual favoritism to suburban interests, rather than identifying the suburbs and the current transport infrastructure as part of the problem. Perhaps a more enlightened politics can only dawn after a severe crisis, and when a new leader is in place in Washington.

Conclusion:

The US has created a 20th century living standard, the suburban lifestyle, which consumes oil with a voracious appetite. The US must put itself on a diet, and perform radical surgery on its energy consumption, its housing arrangements, and its transport infrastructure. If it fails to do so, the the rest of the world will force a diet upon it. For some years a crisis has been delayed, as the exporting nations bought dollars to keep their currencies weak, and to buy time to make changes of their own. But the US is approaching the end of its consumption orgy. House price appreciation has reversed, and will no longer readily accommodate refinancing, and foreign exporters are nearly ready to stimulate consumption by their own growing middle classes.

As the dollar recycling slows, the dollar will fall. And this will have mixed effects outside the US. The exporting countries will lose an important percentage of their main customer market. The global economy may slow down for a few years. However, if other countries boost consumption in their domestic markets, they will find they have more control of their customers, and experience less overt political pressure from the US. Another important benefit is that they will gain a competitive edge over the US in their future oil buying. As the dollar falls, the dollar price of oil will rise, and perhaps very dramatically. Countries with stronger currencies will find that oil priced in their own currencies does not rise so quickly, and it may even get cheaper. Oil exporters will be less willing to take dollars, and may insist on denominating oil sales in alternative currencies, or even gold equivalents.

The winners in this brave new world, will be the countries that embrace the change, innovate their sources of energy, and reconfigure their transport infrastructure away from oil, the automobile, and a suburban way of living. Meantime, countries that behave like the US and maintain an oil and auto infrastructure will find that more and more of their wealth is burnt up by this outmoded and expensive way of living. And the apparent free-lunch of over-consumption, will not be free much longer. Instead of being innovators, they may find themselves left trailing behind, reacting in a world where the important changes are wrought by others.


© 2007
Michael Hampton
Editorial Archive

Notes:
*US consumer spending is almost 30% of global GNP. Chinese consumers cannot pick up the burden on their own. At least not for many years to come. The annual spend of urban Chinese consumers in 2005 was estimated to be only $200 billion- that’s only 1/43th of US household spending of $8.7 trillion in 2005. Japan and the Eurozone together were a similar amount to the US. So there will be an inevitable loss in sale for Chinese factories and Indian software companies, until a new mix of customers can be found, and the domestic consumers in those companies will only be a part of the solution. The ability of the Chinese, the Russians, and other to draw on their massive reserves, means that a solution is eventually likely, even if they must operate on a vendor-finance basis, lending money to those who buy – just as they did with America.

Resources

1. http://en.wikipedia.org/wiki/UK_General_Strike_of_1926
2. http://en.wikipedia.org/wiki/Rail_usage_st…tics_by_country

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