Sunday, December 16, 2012

Scope of analysis


Awareness of boundary issues and scope of analysis is essential in critical thinking.

Let’s take a look at energy. We tend to bucket energy sources in buckets like renewable, fossil fuels and nuclear, but what does that really mean?

On the face of it fossil fuels and energy sources like solar, wind and hydro have nothing in common and are seem contradictory.  Solar energy obviously is energy captured from the sun and as wind is also a phenomena caused by solar heat it too is a solar derivative.  With respect to hydro, the sun heats water which, with the help of wind evaporates, forms clouds and then rains down in mountains where we can use the water to run turbines and capture kinetic energy. Therefore hydro is also a solar derivative.

Fossil fuels are the product of organic remnants of primarily plants which lived a long time ago, died and were transformed under heat and pressure into various forms of fuels like coal, oil and natural gas. Those source plants however were powered by the sun, so as we zoom out fossil fuels too are a form of solar energy.

That leaves us with nuclear as a true separate and distinct energy source. Or is it?

The sun is a ball of gas which is so large that the particles on the inside are squeezed together to the point where they fuse. In other words, a nuclear (fusion) reaction. The sun then is a form of nuclear energy.

That leaves us to the inevitable conclusion that at the macro-most level all energy sources that we have access to and are aware of are nuclear at their core. So when we talk about renewables, fossil fuels etcetera keep in mind that these are distinctions which exist only because of a choice in the scope of analysis.

Saturday, August 25, 2012

Fed Musings


I’m going to post a short series on The Federal Reserve, its mandates and some of the consequences.

The stated mandates of the Federal Reserve, an institution which is neither federal nor has reserves, are laid out in section 2A of the Federal Reserve Act (as amended) the triple (not dual as so often is stated) goals are : "to promote effectively the goals of maximum employment, stable prices and moderate long-term interest rates”.

With regard to stable prices note that on February 25th, 2012 Dr. Bernanke announced that the Fed’s inflation target was 2% because it was best aligned with the mandated goals of full employment and price stability.

The first observation is that Dr. Bernanke appears to be doing congress’s job by changing the mandate of stable prices without any apparent instruction to do so from congress.

 An inflation target other than zero by definition means that prices are not stable. If balance in your Certificate of Deposit went down by 2% per year you would not call the balance of your CD “stable”, yet that is exactly what Dr. Bernanke’s announced goal is.

Inflation has not been zero for a long time so one way to interpret Bernanke’s inflation target as acknowledging that the “stable” part of the mandate is not reality. However, as the only time in recent history the US has had negative inflation was in the 1920s and 1930’s and, depending on the horizon of analysis long term inflation seems to have settled out around 3 percent even the non-congressionally mandated target of 2% is problematic and a systemic bias which has socially disturbing consequences.  An inflation rate different from zero causes winners and losers by means other than the actor’s actions, and to the extent the Fed has an effect on inflation the Fed is in the judge’s seat against the specific direction (“Stable prices”) of congress.

Let’s take a look at inflation.

Inflation causes a transfer of wealth from those who save currency to those who borrow currency. Inflation is also a wealth tax on the currency part and the non-currency part of one’s wealth which depreciates and which requires currency to be maintained. An inflation rate other than zero therefore introduces an asymmetry in the financial system at large and in the allocation function between savers and investors/borrowers specifically.

Please note that the US government, with whom the Federal Reserve is closely aligned is a significant borrower in the financial markets. 

Inflation, and perhaps even more importantly, the variability of inflation and inflation expectations over time and the variability in extend to which specific baskets of goods and services are subjected to inflation therefore introduces a temporal bias in the term structure of inflation expectations and biases other than the fundamental value (whatever that is (a topic for another post perhaps)) of specific asset classes and economic sectors.

If one’s net worth is greater than zero cash is not the place to hold your net worth when inflation is greater than zero. Inflation drives wealth out of cash and into non-cash / real assets because generally non-cash assets will keep pace with inflation. One of the consequences of this is that it reduces liquidity because the holder of the asset faces a hurdle in switching asset classes – transaction costs and lack of pricing transparency. Furthermore, viewed purely from a “store of value” perspective, not a business venture approach, the non-income producing real assets most investors have access to have are negative carry assets. The negative carry on a home owner occupied house with zero financing is somewhere around 2% - the same as Bernanke’s inflation goal.  As a private individual even if you own non-income producing assets such as a forest or oil fields you will have negative carry because of property taxes, ongoing expenses and amortized transaction costs. The only holders of real assets who have significantly less negative carry, and perhaps even have positive carry are entities which receive taxes, not pay them – entities with the power to tax. Precious metals come with storage costs, whether implicit such is when one buys an ETF or explicit when one rents storage space.  

As an aside, don’t confuse commodity futures with real assets – for every long position there is a short position and the net of both is always zero.  Even if one were to buy a physical commodity and put it in storage, because of the negative carry nature of storage at some point the commodity will be sold back into the market so the net effect on quantity supplied is zero. However, it is possible that speculation increases the volatility of the commodity price and that very well may have knock-on effects on longer term supply and demand decisions.

Inflation then drives holders of cash to relative illiquidity with the attendant lack of price discovery and thereby interferes with capital formation because it hinders capital movement.

Note that this is in direct conflict with what the Fed and other central banks have been doing in recent times by attempting to “create liquidity” in a greater than zero inflation environment.

The medicine then is partially responsible for the disease.
 
To be continued.
 

Friday, July 6, 2012

On EROEI


Energy Return On Energy Invested and its variations is a metric frequently used to look at our efficiency in harvesting energy with respect to the energy input.

As an aside, regarding fossil fuels in day to day use we talk about energy production when strictly speaking we don’t produce coal/oil/gas but extract it and sometimes convert it.  Strictly technically speaking fossil fuels as well as renewables are solar energy; one is previously accumulated stock and the other is flow. Think balance sheet versus income statement.

EROEI is an attractive concept but has a number of issues which can reduce its utility significantly.  The main issue with EROEI is that it suffers from boundary issues along a number of vectors.

1.       The first boundary issue is that although it is relatively easy to measure the energy produced it is significantly more difficult to determine the energy consumed in producing the energy. Should only direct energy inputs be counted (for example the energy to turn the drill on an oil rig), or should second order inputs (the energy the workers on the rig used going to work) or even third order inputs (the energy used to make the car which the worker uses to go to the rig) count?

2.       Another boundary issue is that of the input fuel source. If the Input energy is fossil fuel based the EROEI analysis will tell you how efficient the energy extraction process is with respect to energy use, and therefore how much energy ultimately can be extracted. If, however, the input energy is renewable even if the energy conversion process is seemingly inefficient in at the end of the process one has in total more energy than one started, which is quite the opposite from when the input was fossil fuel based.

3.       Another consideration is that of the energy density of the fuel produced/ extracted. Generally the higher the energy density of a fuel the higher its utility is. Methanol and gasoline are both liquid fuels but one has a higher utility because of its higher energy density. Specifically, in mobile applications the energy density of the fuel you carry has a very direct impact on the end user utility.

Aside from boundary issues EROEI does not take into account the different utility associated with different energy carriers. Instead there is an implicit assumption that all BTUs are created equal. In real life though some BTUs are more equal than others.

Once you move from an entropic system (where energy flows from a highly concentrated state to a less concentrated state) to a negative entropy system (where you capture some form of diffuse solar energy and concentrate it) everything changes. Instead of running down finite energy sources you are now adding to the quantity of energy available. There will be other limits, but not energy per se. In a system relying on non-renewable energy, no matter what your EROEI is eventually you'll run out of fuel. In an open system therefore EROEI is interesting as a conversion efficiency measure, but irrelevant with respect to sustainability of the energy input of energy production.


If humanity wants to continue to exist in a form recognizable to us making the switch from an entropic energy supply to a negative entropy energy supply is unavoidable. Without making that switch the game will be over at some point.  We are starting to feel the first hints of limits to growth along a number of vectors, both on the input side as well as the output side of economic activity. Specifically, what you're seeing now is that there is a tension between a financial system which requires growth to exist and a natural system (resources) which naturally deplete and which have an extraction rate which at some point can no longer be increased. Switching to a negative entropy energy system would be an important step towards dealing with this problem.