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Forecast 2013: Contraction, Contagion, and Contradiction
By James Howard Kunstler
on December 31, 2012 8:25 AM

The people who like to think they are managing the world's affairs seem fiercely determined to ignore the world's true condition -- namely, the permanent contraction of industrial economies. They just can't grok it. Two hundred years of cheap fossil fuel programmed mankind to expect limitless goodies forever on an upward-swinging arc of techno miracles. Now that the cheap fossil fuels have plateaued, with decline clearly in view, the hope remains that all the rackets of modernity can keep going on techno miracles alone.

Meanwhile, things and events are in revolt, especially the human race's financial operating system, the world's weather, and the angry populations of floundering nations. The Grand Vizier of this blog, that is, Yours Truly, makes no great claims for his crystal ball gazing (Dow at 4,000 - ha!), but he subscribes to the dictums of two wise men from the realm of major league baseball: Satchel Paige, who famously stated, "Don't look back," and Yogi Berra, who remarked of a promising rookie, "His whole future's ahead of him!"

In that spirit, and as for looking back, suffice it to say that in 2012, the world's managers -- and by this I do not mean some occult cabal but the visible leaders in politics, banking, business, and news media -- pulled out all the stops to suppress the appearance of contraction, and in so doing only supplied more perversion and distortion to the train of events that leads implacably to an agonizing workout, or readjustment of reality's balance sheet. There's a fair chance that these restraints will unravel in 2013, exposing civilization to a harsh new leasing agreement with its landlord, the Planet Earth.

On a personal note, I published a book in 2012 titled Too Much Magic: Wishful Thinking, Technology, and the Fate of the Nation. By an interesting coincidence, folks in the USA were engaged that year in manifold strenuous exercises in wishful thinking, ranging from fantasies of "energy independence," to belief that central bank interventions could take the place of productive economic activity, to the idea that winks, suggestions, and guidelines were an adequate substitute for the rule of law, to the omnipresent mantra invoking "technology" as the sovereign remedy every problem of existence (including the problems caused by technology), to the dominions of utter stupidity where climate change deniers hold hands with the funders of "creation" museums. Since wishful thinkers, by definition, are allergic to arguments against wishfulness, my book failed to make an impression. Anyway, gales of propaganda were blowing across the land, especially from the oil and gas fraternity, with the added cognitive dissonance hoopla of a presidential election -- so the public was left wishfully bamboozled as it whirled around the drain of its hopes and dreams.

The Oil and Money Predicament

If you understand the basic formula that ever-increasing cheap energy resources were the fundamental condition for industrial growth for two centuries, then you must realize that they are also behind the modern operations of capital, especially the mechanism that allows massive volumes of interest on debt to be repaid -- hence behind all of contemporary banking. And if you get that, it is easy to see how the end of cheap energy has screwed the pooch for modern finance.

In fact, let's step back for a panoramic view of what happened with that relationship in recent times: In 1970 you get American peak oil production at just under 10 mmbd (million barrels a day). This chart tells the story:

US Oil production 1920 to 2012
US oil prod plain_edited-2.jpg

That event was little noted at the time, but by 1973, the rest of the world was paying attention, especially the OPEC countries led by the big exporters in the Middle East. All they had to do was look at the published production figures and by 1973 the trend was apparent. They apprehended that US production had entered decline -- predicted by American geologist M. King Hubbard -- and that they, OPEC, could now put the screws to the USA. Which they commenced to do during a decade of rather messy oil crises (messy because they were accompanied by geopolitical events such as the Yom Kippur War and the 1979 revolution in Iran). OPEC could put the screws to the USA because our still-growing industrial economy required a still-growing oil supply -- the growth of which now had to be furnished by imports from other nations. The catch was that those other nations raised the price substantially, virtually overnight, and since everything in the US economy used oil in one way or another, the entire cost structure of our manufacture, supply, distribution, and retail chains was thrown askew.

The net effect for the USA was that our economy went off the rails for a decade and lots of strange things started happening in the financial sector. They called it "stagflation" -- stagnant economic activity + rising prices. It was hardly a conundrum. The OPEC price-jackings of 1973 and 1979 made everything Americans had to buy more costly, in effect devaluing the dollar while throwing sand in the gears of industrial production. Meanwhile, dazed and confused American industry started losing out to Japan and Europe in things like electronics and cars. Price inflation was running over 13 percent in the late '70s. Interest rates skyrocketed. When Federal Reserve chair Paul Volker aggressively squashed inflation with a punitive prime rate of 20 percent in 1981, the economy promptly tanked.

Now look at this chart:

US Oil Consump.jpg
Notice that our oil consumption kept rising from the early 1980s until the middle of the early 2000s. Now look at the circle in the chart below. That rise of production from the late 1970s to about 1990 is mostly about production from the Prudhoe Bay oil fields in Alaska -- one of the last great discoveries of the oil age (along with the North Sea and the fields of Siberia). US production did not regain the 1970 peak level, but it put a smile on the so-called Reagan Revolution and on Margaret Thatcher's exertions to revive comatose Great Britain.

Post Peak Bump up from Alaskan Oil
US Oil Prod + Alaska_edited.jpg

Now look at the price of oil (chart below). You can see what a fiasco the period 1973 to 1981 was for US oil prices: huge rapid price rises in '73 and '79. But then the price started to fall steeply after 1981 and stayed around the same price levels as its pre-1973 lows.

1970s Oil Price Spike and Thereafter

Notice the price started to fall after 1981 and landed close to its pre-1973 levels by 1986 and hung out there (though more erratically) until the mid-2000s. Because of those aforementioned last great giant oil field discoveries, OPEC lost its price leverage over world oil markets. Through the 1980s and 90s the price of oil went down until it reached the modern low of about $11 a barrel. That was when The Economist magazine ran a cover story that declared the world was "drowning in oil." It was the age of "Don't worry, be happy."

The price behavior of the oil markets after 1981 had interesting reverberations in both the macro economy and the financial sector (which is supposed to be part of the macro economy, not a replacement for it). A consensus formed in business and politics that it was okay to yield manufacturing to other nations. It was dirty and nasty and caused pollution, so let other countries have it. We followed the siren call of clean and tidy forms of production: "knowledge work!" The computer revolution had begun in earnest. The financial sector began its metastasis from 5 percent of the economy to, eventually, 40 percent, and really cheap oil prompted the last great suburban sprawl-building pulsation into the Martha Stewart bedecked McMansion exurbs. In effect, financial shenanigans and sprawl-building became the basis for the vaunted "Next Economy." It lasted about 20 years.

That incarnation of the US economy failed spectacularly as soon as oil prices started to creep up in the early 2000s. And, of course, the final suburban sprawl boom went hand-in-hand with all the shenanigans in banking. So when it all blew up, beginning in 2007 with the collapse of Bear Stearns, the USA was left with a gutted economy, insolvent banks, and a living arrangement with no future.

The Current Situation

We're now entering the seventh year of a smoke-and-mirrors, extend-and-pretend, can-kicking phase of history in which everything possible is being done to conceal the true condition of the economy, with the vain hope of somehow holding things together until a miracle rescue remedy -- some new kind of cheap or even free energy -- comes on the scene to save all our complex arrangements from implosion. The chief device to delay the reckoning has been accounting fraud in banking and government, essentially misreporting everything on all balance sheets and in statistical reports to give the appearance of well-being where there is actually grave illness, like the cosmetics and prosthetics Michael Jackson used in his final years to pretend he still had a face on the front of his head.

The secondary tactic has been intervention in markets wherever possible and the intemperate manipulation of interest rates, all of which has the effect of defeating the principle purpose of markets: price discovery -- the process by which the true value of things is established based on what people will freely pay. For instance the price of money-on-loan. The functionally less-than-zero percent interest rates on money loaned between giant institutions like central banks and their client "primary dealers" (the Too Big To Fails) essentially pays these outfits for borrowing, which is obviously a distortion in the natural order of things (because it violates the second law of thermodynamics: entropy) as well as an arrant racket. The campaign of intervention and manipulation also deeply impairs the other purpose of markets, capital formation, by the resultant mismanagement and misallocation of whatever real surplus wealth remains in this society. What's more, it allows these TBTF banks to become ever-bigger monsters which hold everybody else hostage by threatening to crash the system if they are molested or interfered with.

Which brings us to the third tactic for pretending everything is all right: complete lack of enforcement and regulation by all the authorities charged with making sure that rules are followed in money matters. This includes the alphabet soup of agencies from the Securities and Exchange Commission to the Commodities Futures Trading Commission, to the Federal Housing Authority, and so on (the list of responsible parties is very long) not to mention the Big Kahunas: the US Department of Justice, and the federal and state courts. Aside from Bernie Madoff and a few Hedge Fund mavericks nipped for insider trading and arrant fraud, absolutely nobody in the TBTF banking community has been prosecuted or even charged for the monumental swindles of our time, while the regulators have behaved in ways that would be considered criminally negligent at best, and sheer racketeering at less-than-best, in any self-respecting polity. The crime runs so deep and thick through all the levels of money management and regulation that one can say the whole system has gone rogue, up to the President of the US himself, the chief enforcement officer of the land, who has not lifted a finger to discipline any of the parties involved. The fact that Jon Corzine, late of MF Global, is still at large says it all.

Fourth-and-finally, the news media in league with the public relations industry have undertaken a campaign of happy talk to persuade the public that everything is okay and all the machinations cited above are kosher so that there is absolutely no political agitation over these crimes against their own interest, which is to say, the public interest. The PR/media happy talk racket is also aimed at maintaining various subsidiary fictions about the economy, such as the fibs that the housing market is bouncing back, that "recovery" is ongoing, and that the channel-stuffing monkeyshines of the car industry amount to booming sales of new vehicles. Perhaps the most pernicious big lie is the bundle of fairy tales surrounding shale oil and shale gas, including the idea that America will shortly become "energy independent" or that we have "a hundred years of shale gas" as President Obama was mis-advised to tell the nation. It is pernicious because it gives us collectively an excuse to do nothing about changing our behavior or preparing for the new arrangements in daily life that the future will require of us.

The Shale Ponzi

Well, because that's what it is: a Ponzi scheme, aimed at gathering in sucker-investors to boost share prices of oil and gas companies, with the hope that some miracle will occur to make financially broke societies capable of paying three or four times the price for oil and gas than their infrastructure for daily life was set up to run on, back when it seemed to be running okay. This is just not going to happen.

Let's start with shale gas. The gas is there in the "tight" rock strata, all right, but it is difficult and expensive to get out. The process is nothing like the old conventional process of sticking a pipe in the ground and getting "flow." It's not necessary to go into the techno-details (you can read about that elsewhere) but to give you a rough idea, it takes four times as much steel pipe to get shale gas out of the ground. I have previously touched on the impairment of capital formation due to machinations in banking - themselves a perverse response to the loss of capacity to pay back interest at all levels of the money system, which was caused by the world's running out of cheap oil and gas. (Note emphasis on cheap.) The net effect of all that turns out to be scarcity in another resource: capital, i.e. money, rather specifically money for investment in things like shale oil and gas.

Ironically, plenty of money was available around 2004-5 when the campaign to go after shale oil and gas got ramped up over premonitions of global peak oil. How come there was money then and not now? Because we were at peak cheap oil and hence peak credit back then, which is to say peak available real capital. So, the oil and gas companies were able then to attract lots of investment money to set out on this campaign. They brought as many drilling rigs as they could into the shale oil and gas play regions and they drilled the shit out of them. Natural gas was selling for over $13 a unit (thousand cubic feet) around 2005, and it was that high precisely because conventional cheap nat gas production was in substantial decline.

That was then, this is now. As a result of drilling the shit out of the gas plays, the producers created a huge glut for a brief time. They queered their own market long enough to wreck their business model. Unlike oil, nat gas is much more difficult to export -- it requires expensive tankers, compression and refrigeration of the gas to a liquid, seaboard terminals to accomplish all that (which we don't have), so there was no way to fob off the surplus gas on other nations. The domestic market was overwhelmed and there was no more room to store the stuff. So, for a few years the price sank and sank until it was under $2 a unit by 2011. Since shale gas production is just flat-out uneconomical at that price, the companies engaged in it began to suffer hugely.

In the process of all this a pattern emerged showing that shale gas wells typically went into depletion very quickly after year one. So all of the activity from 2004 to 2011 was a production bubble, aimed at proving what a bonanza shale gas was to stimulate more investment. It required a massive rate of continuous drilling and re-drilling just to keep the production rate level -- to maintain the illusion of a 100-year bonanza -- and that required enormous quantities of capital. So the shale gas play began to look like a hamster wheel of futility. After 2011 the rig count began to drop and of course production leveled off and the price began to go up again. As I write the price is $3.31 a unit, which is still way below the level where natural gas is profitable for companies to produce --say, above $8. The trouble is, once the price rises into that range it becomes too expensive for many of its customers, especially in a contracting economy with a shrinking middle class, falling incomes, and failing businesses. So what makes it economical for the producers (high price) will make it unaffordable for the customers (no money). Because of the complex nature of these operations, with all the infrastructure required, and all the money needed to provide it, the shale gas industry will not be able to go through more than a couple of boom / bust cycles before it begins to look like a fool's game and the big companies throw in the towel. The catch is: there are no small companies that can carry on operations as complex and expensive as shale requires. Only big companies can make shale gas happen. So a lot of gas will remain trapped in the "tight" rock very far into the future.

Obviously I haven't even mentioned the "fracking" process, which is hugely controversial in regard to groundwater pollution, and a subject which I will not elaborate on here, except to say that there's a lot to be concerned about. However, I believe that the shale gas campaign will prove to be a big disappointment to its promoters and will founder on its own defective economics rather than on the protests of environmentalists.

Much of what I wrote about shale gas is true for shale oil with some departures. One is that the price of oil did not go down when US shale oil production rose. That's because the amount of shale oil produced -- now about 900,000 barrels a day -- is working against the headwinds of domestic depletion in regular oil + world consumption shifting to China and the rest of Asia + the declining ability of the world's exporters to keep up their levels of export oil available to the importers (us). We still import 42 percent of the oil we use every day.

The fundamental set up of life in the USA -- suburban sprawl with mandatory driving for everything -- hasn't changed during the peak cheap oil transition and represents too much "previous investment" for the public to walk away from. So we're stuck with it until it manifestly fails. (Life is tragic and history doesn't excuse our poor choices.) The price of oil has stayed around the $90 a barrel range much of 2012. Oil companies can make a profit in shale oil at that price. However, that's the price at which the US economy wobbles and tanks, which is exactly what is happening. The US cannot run economically on $90 oil. If the price were to go down to a level the economy might be able to handle, say $40 a barrel, the producers of shale oil would go broke getting it out of the ground. This brings us back to the fact that the issue is cheap oil, not just available oil. As the US economy stumbles, and the banking system implodes on the incapacity of debt repayment, there will be less and less capital available for investment in shale oil. As with shale gas, the shale oil wells deplete very rapidly, too, and production requires constant re-drilling, meaning more rigs, more employees, more trucks hauling fracking fluid, and more capital investment. This is referred to as "the Red Queen syndrome," from Lewis Carrol's Through the Looking Glass tale in which the Red Queen tells Alice that she has to run as fast as she can to stay where she is.

The bottom line for shale oil is that we're likely to see production fall in the years directly ahead, to the shock and dismay of the 'energy independence' for lunch bunch. 2012 may have been peak shale oil. If the price of oil does go down to a level that seems affordable, it will be because the US economy has been crushed and America is mired in a depression at least as bad as the 1930s, in which case a lot of people will be too broke to even pay for cheaper oil. Hence, the only possibility that America will become energy independent would be a total collapse of the modern technological-industrial economy. The shale oil and gas campaign therefore must be regarded as a desperate gambit by a society in deep trouble engaging in wishing and fantasy to preserve a set of behaviors that can no longer be justified by the circumstances reality presents.

Macro-economic Issues

Major fissures began to show in the Ponzified global financial system in 2012 and it is hard to imagine them not yawning open dangerously in 2013. All the Eurozone countries are in trouble. Its collective economy has been tanking faster than the US economy because the member nations can't print their own money and it is harder to conceal the financial tensions between debt accumulation and government expenditures. These tensions end up expressed as "austerity" -- meaning fewer and fewer people get paid, which makes people angry and makes governments unstable. Bailout procedures are transparently laughable under the European Central Bank and the other bank-like "facilities," giving money to governments so that they can give it to insolvent banks, so the banks can buy government bonds, which only stuff the banks with more bad paper, and take the national debts higher. Several Euro member countries are contenders for default this coming year: Greece, Spain, possibly Italy, and perhaps even France, which is now a basket-case dressed in Hollandaise sauce.

A perfect storm in the global bond market has formed with Europe crippled, Canada and Australia entering their own (long-delayed and spectacular) housing bubble busts, the USA sharply losing credibility as it fails to politically address its balance sheet problems -- or even continue to pretend that it might -- and Japan utterly floundering under a new lack of commitment to nuclear power, the need to import virtually all the fossil fuels it needs for its industrial economy, a consequent negative balance of trade (for the first time in decades), and a deadly debt-to-GDP ratio around 240 percent. Many observers see the new Japanese government under Shinzo Abe as determined to inflate his own currency away to nothing in an effort to unload exports and erase debt, and nobody understands how that strategy turns out well. My own view, expressed here before, is that Japan is on a fast track to become the first advanced nation to opt out of industrialism and go medieval. It might sound like a joke, but its not. And it would be consistent with Japan's historic cultural personality of making stark choices, even if it was not clearly articulated in the political theater. The journey to that destination could include a war with China, which also would be consistent with Japan's suicidal inclinations, so clearly displayed in its last major war with the US.

The global bond market is held together with baling wire and hose clamps. Since money is loaned into existence (in the words of Chris Martenson) the global financial system is underwritten by its bonds, and the bonds are underwritten only by the faith that issuers can pay the interest due to bondholders. Risk rises in an exact ratio as that faith wanes. And interest rates must rise hand-in-hand with that rising risk -- unless the ruling authorities (central banks and governments) conspire to repress them. These "unnatural" interventions will only cause the trouble to be expressed elsewhere in collapsing currencies and economies. It is already happening under the various ZIRP regimes, setting up a feedback loop in which it becomes even less likely that bond-holders will be paid and more faith erodes until nobody wants any bonds and the market for them seizes up and all that paper becomes worthless.

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