TAGS: Peak Oil Conservation Shale gas Incentives Energy policy

Since the beginning of the Industrial Revolution, driving down input costs for processes has been a strategy to increase profits or margin, as the price of a good sold must include the costs of production, without recovering these plus a return, there ultimately is no industry at all.

In the beginning the input costs – that is, the envelope of total input costs altogether – were unknown. There was insufficient history of industry to gain experience with all costs besides labor and rent. Labor costs could be (mis)managed by creating – or taking advantage of – arbitrage opportunities that existed as a consequence of over- population, the ethnic competition between and within populations; of war and disease or by conquest/slavery. A systematic ‘economic’ approach was tentative, rents and outright labor costs became the relative standards for other inputs. Abstracts as depletion of resources, air and water pollution, increased capital flows, urbanization, mechanization of war, were hard to place within the labor/rent context of ‘natural prices’. The ‘philosophy’ of production orbited for a long time around the arithmetic rationale of human labor plus money capital, plus property costs subtracted from the cost of the good sold.

Everything else, that could not actively claim a price was ignored.

Ultimately, this goods- cost threshhold became a straitjacket. The labor regime has not changed – see the flight of US union manufacturing jobs to China and India – while costs outside of money capital, management expenses, marketing, transportation and ‘tail costs’ (taxes and fees) are pushed out of the regime.

Many economists such as Herman Daly and Robert Costanza have decried this short- sightedness. The consequence of ‘externalities on the rampage’ has been both exponential liability growth in the money economy and massive deleterious consequences to the environment that we all must live in. Mispricing of basic capital inputs has also led to a competitive and highly organized sack of vital resources without heed to the obvious outcome of such a perversely organized process.

Currently, the trend of oil depletion over the next five years will see a parallel deflation alongside the rate of that depletion; perhaps as little as 2% for awhile but accelerating without pause! Oil depletion is given as an ‘investment opportunity cost’ that has subsidy value that can be transferred. It is hard to see anything more self- destructive than for a nation – operating through its proxy government – paying companies to exploit resources ever faster.

How to address this and allow consumption to become a purchaseable asset in and of itself seems to be a small economic puzzle, one that can be solved by a non- economist like myself.

At issue is the development of large reserves of newly available ‘tight gas’ or ‘shale gas’ deposits. These are found in the southern and eastern parts of the US. The ability to release the gas in these formations is the result in a process where gas drillers pump water and other fluids into gas wells at high pressure. The resulting fracturing of the sub- surface rocks releases large amounts of gas unrecoverable by ordinary drilling.

Both the technical media and the mainstream news organizations claim large new deposits that can be exploited in this manner, allowing ample supplies for current users into the far future as well as diverting excess to power automobiles.

As it stands, this gas will be produced, large quantities will flood the market to depress the price. The large quantities will seek new users as the excess has little per- unit value. Producers will press increases in consumption as the returns necessary to finance more production can only come from increased sales. The sales per- unit times the amount sold must be large enough in total to provide sufficient capital for new leases, wages, new equipment and support infrastructure. Here, the production regime is at war with itself; the low, per- unit price cannot support increased production by itself, accelerated production is required. This level of production rapidly exhausts all reserves. This is the ‘depletion trap’. In order to produce profitably, total cash flow must be sufficient to support production, this means a greater and greater rate of depletion. At the same time, the availability of reserves relative to demand lowers their value. As relative prices decline, accelerating production is necessary to maintain the level of cash flow required … to maintain production. It’s a vicious cycle ending in rapid and ultimately total collapse of the resource base.

This cycle operates regardless of whether fuels are inexpensive to recover or otherwise: easily accessible or otherwise. For example, current oil prices are too low to finance current production levels for any extended period. Increases in price ‘destroy’ demand, which brings prices down to the too- low to finance production level again.

This has happened repeatedly in the oil and gas producing areas; oil and gas have value for the work that can be done with them, that does not show up in the price paid. These differences in value are arbitraged for the benefit of industrial – or in this case commercial – proprietors who use the input with little heed to consequences elsewhere.

One outcome, obviously, is Peak Oil, where the amount of production at any cost becomes insufficient to satisfy demand. Here, the increases in production inputs do not gain sufficient return, the difference between the two states is reflected in a steady increase in price – a scarcity premium. Now that the physical peak in oil production has been reached, the scarcity premium will become the dominant (deflating) force in the economy that surrounds it. Oil will be hard to find, the cost of producing it out of cash flow will be very high.

Ultimately, it will be too high to allow production out of cash flow at all. This is the heart of the ‘EROEI argument’, where the energy required to produce an energy source is greater than the energy that can be recovered from that source.

Maybe its the desperation, but the usual (or is it unusual) caution gets tossed to the wind when descriptions of newly discovered energy sources such as the new gas fields include ‘inexhaustible’ and ‘massive’. This leads to the inevitable, “Maybe we can run our cars off of this …”

Absent any policy or an industry governor the downstream infrastructure is likely to see the ‘massive’ and ‘inexhaustible’ investment while an accurate assessment of real reserves remains elusive. Gail Tverberg remarks:

Once companies have gone down the wrong road in making estimates, it is my experience that it is awfully hard to turn around. The financial implications get to be huge. It is hard for an auditing firm (or firm selling ongoing consulting services) to do more than nudge the estimated decline rates a bit in the right direction, and hope that things will get better over time.

Next, the ‘sunk capital’ arguments emerge. This is the way things are done all around the US’s and world’s economies. Shoot first, ask questions later. We have enormous infrastructures that make continuing claims against all resources and these claims are … non- negotiable.

Not only is an assessment feedback cycle needed but one that starts looking at user priorities. This needs to be done now, when the issue is uncertain and setting priorities can be relatively straightforward. Allottments are commonplace with water rights, the same can be done with gas reserves; even if the amount of reserves turns out to be less, the proportion of gas supply to each user category can be determined ahead of time.

Priorities being building space heating/cooking, fertilizer (nitrate) production, industrial process (plastics, chemical, dyes, process heating), general electricity production (load balancing, base load particularly away from coal), and LNG export. Note that aside from export, all priorities here have fixed plant/bases of consumption. This should be the only qualification gateway allowing the use of gas.

Using gas for private autos would be – and should be – expressly prohibited. Only commercial transport and mass transit fueled from fixed bases would be permitted, gas used only as a transition fuel to overhead electric from fixed sources.

There would be no – as in zero – permitted auto use, excess would be exported under a rationing regime as LNG to Europe or Japan for hard currency (gold and silver, Phosphate as well as Uranium/Thorium trade). Some sort of economic transition is needed so that when the gas runs out there will be replacement processes. Hard currency will be needed for the post- debt collapse recovery phase.

This is opposite to the ‘Picken’s Plan’ which substitutes wind for gas electricity generation and gas for ICE car use. Picken’s idea is good for him but a disaster for any possibility of longer term transition use, fortunately this plan is falling by the wayside on account of Picken’s money- market difficulties. Nevertheless, the plan illustrates the infrastructure ‘bias’ that emerges almost instantly to support auto energy consumption. This bias emerges from powerful social (read oligarch) forces that see the profit opportunities that exist within the personal auto ambit.

The gas business is in a difficult situation of having to ration demand particularly when it comes from what could be its best short- term customer, but the longer term requires just this. Until there is a way to manage the gas use along with its production, it may as well not exist. Unless the gas is used properly, environmental issues that are now lodged behind credit and peak oil concerns will elbow the way to the forefront, systematically removing our ability to transition from fossil fuels. Gas reserves will be gobbled by recreational auto use and consumption would then revert to (depleted) oil/coal sources that the gas would otherwise replace.

One way the industry can regain control of its own ‘resource capital’ is to contract for long terms with utilities and industrial users which have fixed facilities, this would include prohibitively large royalties back to producers to penalize 3d party sales or resales. The idea is to auction access to fuel and reserve use to those who can provide a real return on that use. High dollar amounts and long time durations written into these contracts would ‘lock out’ users with non- fixed consumption assets. Per- unit prices would manage demand, the meter price of gas rising and falling to insure that demand does not outrun available supply. The contracts would also provide an investment base for gas producers support ongoing production directly. The same would also provide a royalty structure for (currently bankrupt) states. The opportunity exists for system- wide renegotiation/reform of pricing structures that can be knitted into these contracts.

This includes labor contracts and service environments; the outcome being to solidify a ‘gas dollar’ relationship that would enhance currency stability, particularly at a regional level. Exports would also do the same on a national level. Exports would also serve to reform our energy relationship with both Mexico and Canada; both would enhance currency (and social) stability in both these countries. How valuable is our gas? A way to find out is to cut it off and see!

What value is our (potential) conservation? A way to find out is also to stop using and see! Without getting into current supply- demand imbalances, the current high (and increasing) availability of gas energy compared to oil energy is a benefit that needs be extended as long as possible. This can only be accomplished through restraint and proper management of both production and consumption and avoidance of the usual ‘boom and bust’ cycles. This could be an argument for a management conservatorship with both environmental and production responibilities.

A similar system is in place in Costa Rica where Energy production and the Environment are under one ministry.

There will be no change in the energy picture, no solution to the ‘crisis’ until the public gets serious about eliminating personal automobiles. If there is no change from the auto- centric status quo energy starvation will be amplified until all consequencial fuel sources are exhausted.

It won’t matter how much gas we have now.

In addition to ministry priorities there would be economic incentives to produce and use responsibly. To buy gas (or oil) one would have to invest in long- term gas contracts denominated in $1 million- to- $100 million increments, only these ‘investment licenses’ would allow the license holders to purchase gas. Obviously, this would favor utilities and large fixed industrial users. The duration of these contracts would be 50 or 100 years, the producers guaranteeing production for those intervals and returning an inflation- adjusted principal at the end of the contract period. No gas (or oil) left, no return, obviously … so the producer has the incentive to both produce product but not too much or too fast.

Long term contracts would be in the producers’ interests first and foremost. Government could be on the outside except to provide a legal/transparency framework with the ministry acting as a referee to settle disputes. There would be no subsidies. The process of long contracts would be self- reinforcing. Companies that committed resources for long time periods would have gas to sell long after other producers have depleted themselves out of business. The contracts, or ‘Consumption Licenses’ would be investments, having cash value like Taxi Medallions have in New York City.

These contracts would have two features:

– Per- unit prices will be set by producers to control consumption.

– Raising investment capital would be independent of unit sales regardless of per- unit price.

Since the investment aspect of the contracts require it, prices would be set to conserve the gas (or oil), not to encourage consumption of it. However, since gas (or oil) is actually worthless in the ground, gas (or oil) will be produced to service operating costs of the producer and allow dividends, pay salaries, production expenses, etc. Demand itself would set by auction a high per unit price, higher than the cash flow model which assigns greater values to flow rates rather than to value of work product of the gas (or oil).

Since capital requirements are met elsewhere, the price per- unit would more accurately reflect the work value of the gas. The fuel would be utilized at its ‘highest and best use’ and priced accordingly.

The capital requirements would be met by investors directly rather than by the diversion of unit cash flows back into production (in an auto- destructive feedback cycle). Investment funding would be separated from cash flow

Needless to say, only contracted investors could purchase or use the gas (or oil) at the meter (or at the pump). Third party sales would have to return a large royalty payment back to the original producer, which would make such sales unprofitable.

Separating investment from per unit cost would do two things; allow for more (replacement production) since the contracts would give companies more investment capital than production derived from cash sales might allow at any given time: (see Chesapeake Energy’s cash squeeze last summer). Producers would thereby free investment from cash flow constraints.

For instance, if there is a ‘flood of gas’ from cash- flow dependent producers, contract producers could hold their gas off the market because their contracts provide a funds reserve. Contract producers would avoid the price wars while allowing at the same time cash- flow producers to bankrupt each other or deplete each other out of business.

This is somewhat parallel to KSA bankrupting the British and Norwegian North Sea producers in the 1990’s by means of an oil price war. The Saudi’s ‘contract’ was their enormous reserves, here the reserve would be investment capital. Here, the capital would be a proxy for the reserve that gains value as the competition depletes itself. Both the natural reserves and the funds that stand for them gain value.

In fact, the tie between money funds and a physical resource would be self- reinforcing, funds would flow to the physical resource rather than the ‘abstract’ financial resources such as a CDO. The increase in funds relative to the resource – the dollar competition for it – would revalue the resource upward as this should be. The combination of the funds plus the resource that is the basis for the funds would be greater that the resource itself. This would be as if Saudi Arabia’s contract was not only their reserves but the funds available to produce and manage those reserves. The natural increase in funds and the intent to use them to husband the reserves would amplify a positive feedback cycle. This is in contrast to the current perverse incentive to use funds to deplete reserves and use even more funds to deplete them even faster.

As cash flow producers observe their depletion relative to the others, they would enter into longer termed production contracts themselves simply to survive. It would become the only sure means of acquiring capital as the competition would be between those who capitalize raw overconsumption for short- term gain against those who capitalize longer- term gain and consequent resource appreciation. In a depletion environment, the longer term capitalists will always outlast their competition. Eventually, all production would be committed to contract purchasers; it would allow producers to escape the ‘depletion trap’ or the punitive feedback cycle of capital chasing diminishing cash flow returns.

The producer gains the incentive to manage his energy capital, either by using the investment funds wisely to expand recoverable resources, or to purchase other reserves (taking them out of the per- unit pricing regime) to manage/constrain demand and to not damage his fields. A hundred years is a long time to produce an amount of fossil fuel, but if the incentive is there, a producer will do just that!

Shares would be sold in contracts, as with Berkshire- Hathaway stock.

Selling gas (or oil) for auto use would void the contract with producers having their capital redacted without recourse. Such a covenant would not be necessary as contract participants would see – and gas would be priced – to insure the supply lasts as long as the term of the contract. This by itself would eliminate auto use of the product, which is stupendously and tragically wasteful.

Applied the crude oil, the same results would occur. Cash- flow operators would deplete themseelves out of business while producers selling into long term purchasing licenses – with unit prices set to conserve product for the length of the contracts – would have oil to sell for the duration of the contracts long after the cash flow producers are ruined.

One producer using these contracts would set the stage for the concept to go ‘viral’; depletion is the incentive. Depletion – like rust – never sleeps and producers can easily see the advantage of not self- depleting to chase a market that has proven itself to be witlessly self- destructive.

One way to look at this is that the purchase license would flatten the depletion leg of the Hubbert curve from the dispersal model to a flat, horizontal line, albeit at a far lower production/consumption level.

Another way to look at this is to consider what a customer here is buying: a guarantee of fuel for his and his childrens’ lifetimes. Not much at any given time, perhaps, but fuel will be there. This is in contrast to the ‘buy it and use it up now’ alternative. Here, consumption itself is turned into a product that can be bought and sold, with its value increasing proportionate to the overall rate of depletion of whatever the item is that is being consumed.

Ultimately there would be consolidation to a small number of producers with monopoly control over energy sources, but managing/controling monopolies is much easier that having to gin up energy out of nothing!

Or living in a cave as a hunter/gatherer.

This is not a new idea, New York City taxicab medallions have been used since the 1930’s. Many NFL teams require a season- ticket buyer to purchase a ‘seat license’ prior to buying the season ticket itself. One or the other is transferable, making the ticket or the license an investment rather than a consumption item.

Why the ‘high- falutin’ economists haven’t thought of this beats the livid sh&&t out of me. I guess it’s all the cocaine …