Note that this section of the website is not particularly active; I hope to publish about one personal finance article per month.

Wednesday, September 3, 2014

Peak Oil And Personal Finance

Resource limits hang over the long-term outlook for societies - often summarised as "Peak Oil" or "Peak Food". In order to make a personal finance plan, it is a factor that ought to be taken into account. Unlike other macroeconomic trends, how you structure your portfolio probably matters less than how you structure your spending. This article provide a high level summary of my views on this topic, which will filled out in later posts. Correspondingly, I will give the justification for these arguments in later article.

What Is Peak Oil?

As a quick summary, Peak Oil is a heavily studied and argued over topic. The worry is not that we will not run out of oil, rather that the rate of oil extraction will slow, after growing for decades. As we go the other side of the peak, there will be less energy to fuel our economies, which are highly dependent upon fossil fuels.

Additionally, there is the related problem of "Peak Food": our ability to provide food for a still-growing global population is under increasing strain. Part of the problem is the heavy dependence upon fossil fuels in modern industrial farming - which is the only way achieve the high yields needed. But many countries are also hitting limits on their fresh water supplies.

A Peak Oil Scenario

If we are looking at long horizon, it appears that we are facing two regimes for the economies of the developed world under a Peak Oil scenario. At first, we will be muddling through, and the-growth period sets in.

Muddling Through Developed economies will continue to grow, even though the amount of energy consumed will probably shrink. There is considerable controversy over the forecast for energy production (most Peak Oil theorists are unsurprisingly pessimistic about growth). But using mainstream forecasts, global energy production will continue to grow until 2030. However, the amount of energy available to the developed economies will probably drop, as the emerging markets will bid away more and more of the production.

Some Peak Oil theorists have been too pessimistic about this period, to the point of arguing that economic growth is impossible in an environment of shrinking energy supplies. I discussed in a somewhat technical article why this is not the case; very simply, Gross Domestic Product is not a measure of well being, and so it can continue to grow even standards of living are falling. Although I do not dispute the broad "Peak Oil story" (although there are fairly dubious arguments on the fringes), I appear more optimistic about the prospects for economic growth than many Peak Oil theorists.

Note that although I expect growth to continue, we will of course continue to have recessions. As energy supplies get tighter, there is a greater risk of disruptive oil spikes which will cause recessions. But it should be noted that frequent recessions were a feature of other periods, even in the 1950s which featured strong average growth and cheap oil.

De-Growth The "de-growth" phase is more worrisome. The reason why the economy can continue to grow during the "muddling through" phase is that it will be possible to substitute away from energy-intensive activities. They will get too expensive, and so people will do something else. However, this can only go so far. There are no substitutes for some activities, such as growing food. If energy availability fell far enough, there would need to be a reversal of urbanisation, as muscle power would be needed to grow crops instead of fossil fuels. This would represent a collapse in productivity, and force fairly radical changes upon society.

I would not hazard a guess to the timing of such a shift. My view is that there is a lot of excesses that can be worked out of existing energy use, that allows such an event to be pushed far outside my usual forecast horizon (1-3 years). If I am in an optimistic mood, I would guess it could be more than 50 years in the future. As a result, I would mainly focus on the "muddling through" phase, but the possibility of the transition to de-growth cannot be ignored.

Oil Prices And Inflation

There is no reason to expect oil prices to rise in a persistent, steady fashion. Instead, it will probably follow its previous post-1970s trajectory of spiking upwards quickly, then retracing until the next spike. This is the most pernicious path, as the spikes cause a disruption in activity, but then the falling prices later disrupt conservation efforts. Car sizes in the United States fell after the 1970s oil shock, but crept right back up in later decades.

But it probably seems safe to expect that the trend in oil prices will be rising faster than the broad inflation rate.

In terms of the overall CPI inflation rate, it will be entirely possible that it will remain around the 2% average that has been the target for central banks. If energy and food prices rise more than 2% per year, the other components can get squeezed and they end up with lower inflation rates. (Note: in the short term, an oil price spike will cause overall CPI to rise by more than 2%, but this tends to get retraced as the economy contracts in response to the energy spike. What I am referring to here is a multi-year average rate.)

One thing to keep in mind - the CPI is not a "cost of living index". Over time, the consumption basket for consumers will change, and declining energy supplies mean that by definition the volume of energy consumption will fall. In other words, your "cost of living" will rise faster than the CPI index if you have a higher weight of energy consumption in your personal spending than that used to calculate the index. In particular, if you intend to keep an energy-intensive lifestyle in a Peak Oil world, your personal cost of living will be rising much faster than CPI inflation.

Can This Scenario Be Avoided?

The Peak Oil community disparages the easily observed tendency for people to wish that energy supplies will rise forever. There have been a large number of schemes that have been proposed to provide future energy needs, and they have all essentially failed. Renewable energy sources - such as solar, wind, hydro - will become increasingly important, but it appears that they can only provide a fraction of current energy consumption.

I cannot rule out a fix that makes these concerns go away, but it is a bad idea to assume that things will happen just because it is convenient.

Positioning Your Portfolio

The gradual nature of the changes in the economy make it hard to position for this scenario. Doing things like buying oil companies is not an obvious win - the whole point is that it will be harder and more expensive for them to produce oil, and so they may not benefit from higher prices. (Companies with large easily-extracted reserves will benefit, but that may already be in the price.)

I worked as a macro interest rates analyst, so picking companies is not in my skill set. But I am somewhat skeptical about the bias of equity analysts - they tend to want to "pick winners". In this case, that may be dangerous; the correct course of action is "avoid losers". Since there is a well-documented tendency for people to want to believe in quick fixes to avoid thinking about resource limits, they may be easy targets for dubious get-rich-quick energy schemes.

And if the inflation rate is stable around 2%, there is no reason to believe that bond yields will explode higher based on the analogy of what happened in the 1970s.

Positioning Your Spending

Although it is unclear that portfolios need to be changed in response to this scenario, thinking how you spend your money is a much more important topic. Moreover, the changes you make are probably sensible even if a new source of energy miraculously appears.

Energy costs are embedded in most consumer goods. Being careful how you structure your spending habits will make you less exposed to a rise in energy or food prices. And at the same time, it would help you hit retirement savings targets. Since consumption habits are followed for a long time, it makes sense to avoid creating self-defeating habits, even if the shocks associated with Peak Oil hit after a long delay. Some simple examples:

  • In hot or cold climates, a large house will generally have a much higher energy footprint than a small house. Think carefully about long-term trends in utility costs before buying a McMansion.
  • Cars are a major energy sink, and are damaging for personal finances. In addition to the energy used when filling up the tank, there is a massive amount of energy embedded in their manufacture. The full costs of a lengthy commute are impressive once you add in the depreciation of the automobile. 
  • A useful hobby like having a home garden will use less energy - and provides what may be an increasingly important skill - than something like driving to a golf course and spending the morning tormenting some innocent golf ball.

As I noted above, this article is just a sketch of my thoughts, and I expect to cover these topics in further detail as time passes.

(c) Brian Romanchuk 2014

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