On Monday, I published a post entitled “Dangerous Exponentials”, which summarised recent research by Dr Tim Morgan, Global Head of Research for Tullett Prebon. In this research, Dr Morgan presents a series of “dangerous financial and non-financial exponentials” that are not sustainable and ultimately risk destroying the economy, environment, and overall living standards.
Chief amongst these “dangerous exponentials” are: (1) the world’s population, which has grown exponentially to the point that human’s demand for resources is pushing against capacity constraints:
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And (2) the world’s consumption of hydrocarbon energy, which has displayed a similar degree of exponential growth:
In a follow up Strategy Insight entitled End Game – The Denouement of Exponentials (provided below), Dr Morgan delves further into what he calls “exponential economics”, which is a method of interpretation that uses long-run analysis to identify the key drivers of society and the economy. Chief amongst these drivers are abundant and cheap hydrocarbon energy:
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…the economy is an energy equation. Society as we know it today is a product of the use of extraneous energy to leverage the limited capabilities of human labour. The leveraging effect of abundant extraneous energy alone permits the earth to support a population of almost seven billion people.
To be clear, Dr Morgan does not believe in the Peak Oil ‘doom thesis’. Rather, he argues that the world is approaching a kind of peak cheap oil, whereby the costs of extracting energy ratchet-up significantly. And this increase in the cost of energy is on a collision course with higher debt loads, which have also grown exponentially:
Whilst we do not believe in a ‘Peak Oil’ doom thesis, we do believe that the critical equation, which is the relationship between energy extracted and energy consumed in the extraction process, is deteriorating markedly.
If a deterioration in the energy returns equation is clearly one of the two great threats facing the economy going forward, the other is the intrinsic contradiction implicit in exponentially-growing financial aggregates which, logically, cannot go on growing indefinitely. An economic system which, by its nature, must grow, seems to be approaching a collision, not just with simple mathematics, but also with a finite resource set which can not grow.
This, we must emphasise, does not make us in any sense Malthusians. Far from believing that solutions cannot be found, we are confident that they can be. But what we do contend is that we are entering a period of unprecedented change, in which all prior assumptions, all structures and all political and social relationships will need to be reconfigured, rethought and, in many cases, completely replaced.
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Dr Morgan also argues that the exponential growth in population has only been possible via exponential energy use, which is itself unsustainable:
There are two wholly valid explanations – a simple one, and a more fundamental version – which explain the relationship between population numbers and the consumption of fossil fuels. The simple explanation is that the ‘green revolution’ – the dramatic expansion in food production over the last two centuries – has been almost wholly energy-driven. Across the gamut of its activities, modern agriculture is massively (and increasingly) energy-intensive, relying hugely on mechanised planting, cultivation, processing and distribution, and on extraneous inputs such as fertilisers and pesticides. All of these inputs are energy-dependent (through extraction and delivery) even when they are not sourced directly from hydrocarbons.
The ability of the earth to feed 6,900 million people, where two hundred years ago it fed less than 900 million, is a direct function of the availability of energy-derived inputs. But the energy-population nexus goes much deeper than the simple energy dependency of modern agriculture. Essentially, the entire economy is an energy equation...
Agriculture itself was made vastly more efficient, initially through the use of motive power and latterly through the introduction of hydrocarbon-based fertilisers and pesticides. Within a hundred years of the first commercial use of steam-power, the proportion of the populations of most developed countries engaged in farming had fallen to less than ten percent. Specialisation had arrived, courtesy of the harnessing of the energy contained in fossil fuels.
Dr Morgan then questions what would happen if energy consumption were no longer able to grow or become far more expensive to extract:
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What would happen, then, if the exponential progression of energy consumption ceased to function? Might specialisation and social complexity – and therefore the economy as a whole – unravel and start going backwards if the exponential energy equation were to go into reverse?
Some analysts believe that this unravelling is exactly what is in store for the economy if – or rather, in their analysis, when – we hit ‘Peak Oil’… Whether or not one agrees with the Hubbertian [peak oil] thesis, we are in no doubt that the future outlook for fossil fuel availability is critical, because the economy is, ultimately, an energy driven construct…
Peak Oil is not, we believe, a near- or medium-term threat, but no-one should be lulled into complacency by seemingly-abundant oil reserves. Rather, the issue is one of resource constraint, which is likely to be reflected in deliverability and cost rather than in the absolute availability of producible reserves…
Essentially, oil reserves have been cherry-picked, with the cheapest, highest-quality and most accessible resources exploited first. This means that production levels might hit a ceiling in the relatively near future even if reserves remain substantial. It also needs to be remembered that net changes in output represent a two-piece equation – substantial new sources are needed each year simply to replace natural declines from already-producing fields. As the industry moves from higher- to lower deliverability fields, maintenance of existing production levels, let alone growth, becomes ever more difficult. Further implications naturally include higher costs and greater risks, as the exploration and development focus swings towards reserves in ever more technically-challenging locations…
Another way to look at the deliverability issue is that reserves need to be quality-weighted. We may have used up much less than half of the world’s originally-recoverable reserves of oil, but we have, necessarily, resorted first to those reserves which are most readily and cheaply recovered. The reserves that remain are certain to be more difficult and costlier to extract…
It is evident that we need a new paradigm if we are to interpret energy constraint in an economy of exponentials. The appropriate energy-based equation already exists, and is known as EROEI (energy return on energy invested). The theory of EROEI is extremely simple, but its application is complicated. The basic requirement is that the amount of energy extracted should be divided by the amount of energy involved in extracting it. The problem here is how far the calculation should be carried back up the supply chain.
Our belief is that the lack of a consistent basis of EROEI calculation is a huge flaw in our understanding of economics. Indeed, we think that the lack of a definitive and standardised EROEI methodology is the greatest single shortcoming in the way in which economic trends are interpreted.
Notwithstanding the lack of accurate calibration, we can develop an approximation of the EROEI landscape, and this can best be depicted in the form of a ‘cliff chart’ (fig. 11). The horizontal and vertical axes are linked – the horizontal axis is calibrated to EROEI as a multiple, whilst the vertical axis expresses the same calculation by dividing energy output into percentages of ‘cost’ (energy in) and ‘profit’ (the surplus of energy out minus energy in).
The general pattern which emerges from this approach is highly instructive. Within the oil industry itself, EROEIs are deteriorating as easy-access sources deplete and are replaced by ever more challenging alternatives. Although the cliff chart is not time-linear, the broader energy picture shows steady movement from left to right along the EROEI curve, with newer sources of energy delivering ever lower returns. At EROEIs of less than about 15, the energy returns equation drops off a cliff, and the overall average is clearly worsening as traditional high-returns sources are displaced by resources which offer successively lower EROEIs…
Slippage along the EROEI curve – and not the simple issue of ‘running out of oil’, as some fear – is the clear and present threat to an economy based on dangerously energy-dependent exponentials…
Dr Morgan also discusses in detail the exponential growth of the money supply and debt, which are equally unsustainable. However, those issues are secondary (in my opinion) to the predicament of exponential population growth and resource use in a finite world.
Readers seeking a better understanding of the folly of exponential growth are encouraged to watch the following YouTube video from legendary Professor Albert Bartlett, who coined the famous phrase: “The greatest shortcoming of the human race is our in ability to understand the exponential function”.
Leith van Onselen is Chief Economist at the MB Fund and MB Super. He is also a co-founder of MacroBusiness.
Leith has previously worked at the Australian Treasury, Victorian Treasury and Goldman Sachs.
