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Posted Mar 5, 2014.
“For some years now,” Tim Morgan writes in Life After Growth, “global average EROEIs have been falling, as energy resources have become both smaller and more difficult (meaning energy-costly) to extract.”
You may have heard of this concept called energy return on energy invested (EROEI). It looks at how much energy we expend in relation to how much energy we extract. Some, like Morgan, think this is very important.
Consequently, falling EROEIs have become the basis of a variety of dire forecasts…
Be skeptical of anything that seeks to analyze our economy by taking money out.
In these scenarios, we spend more and more energy just getting energy, and we have less and less for other discretionary items. As Morgan writes, “If EROEI falls materially, our consumerist way of life is over.”
I’m writing to you today to slay this flawed EROEI concept.
I have to say I used to be taken in by this argument. I wrote an issue of my Capital & Crisis newsletter a couple of years back with the headline “Crack This Code: EROEI — Why It Matters Now and What to Do About It.” I included a list of approximate EROEI ratios for various energy sources:
- 1970s oil and gas discoveries: 30-to-1
- Current conventional oil and gas discoveries: 20-to-1
- Oil sands: 5-to-1
- Nuclear: 4-to-1
- Photovoltaic: 4-to-1
- Biofuel: 2-to-1
I noted that such ratios were falling and concluded that a lower mix of EROEI sources means higher prices for many commodities, because “it will take more energy to produce them.”
It means nothing of the kind.
I would like to right my old error and convince you why EROEI is fatally flawed, so you don’t fall for it. I’ll use Morgan as the foil, because he is an articulate and strong proponent of the idea in his new book.
Morgan’s crucial assumption appears on page 5: “The economy is not primarily a matter of money at all. Rather, our economic system is fundamentally a function of surplus energy.”
This is the key to the whole EROEI argument. Morgan repeats it often. And it is completely wrong.
You can’t take money out of the equation! Money is what it’s all about. It is the essence of the economic life. It’s at the center of decision making. As economist Hyman Minsky said, “Money isn’t everything. It is the only thing.”
Be skeptical of anything that seeks to analyze our economy by taking money out. Households and firms make decisions based on money. They certainly don’t use EROEI, nor should they.
When a firm decides to drill a well or not, it does so on the basis of estimated costs and profits. It makes a decision based on some expected return — as measured in money. They are not the same. High-EROEI projects can be losers. Low-EROEI projects can be winners — as measured in profits and return on investment in money terms.
According to Morgan’s logic, you wouldn’t bother generating electricity…
Here is Robin Mills, currently with Manaar Energy (and once a petroleum manager for the Emirates national oil company in Dubai):
“Generating electricity, usually at a thermal conversion efficiency of less than 50% plus transmission losses, has an EROEI of much less than 1, but is still rational and economic because electricity is such a useful form of energy.”
Put another way, the money costs of the inputs are less than the money prices of the outputs. It works because… it’s profitable! People value electricity more than they value the inputs. Looked at through an EROEI lens, though, it doesn’t make sense.
You can build any scary resource scenario you want if you exclude money prices. If, say, falling ore grades were predictive of prices, then we would see continually rising prices for copper and other resources. Clearly, this isn’t the case. But this does not prevent people (usually geologists) from taking these moneyless concepts to make economic forecasts of higher prices.
A general rule of thumb: If it doesn’t take into account money prices, then it isn’t about the real-world economy as it exists today.
That’s my biggest objection to EROEI. But I’m not making a comprehensive case against EROEI here. That would take too long. I won’t get into how EROEI is calculated: there is no agreement and when you think about it, maybe it’s impossible to know with any accuracy worth relying on.
In the end, I think Morgan doesn’t really get modern money. He repeats an old myth about its origins. He doesn’t seem to know why fiat currency has value. (He says money is a “claim on real goods and services,” which only begs the question: Why do people accept dollars in exchange for real goods?) He doesn’t seem to understand the primacy of making a monetary profit in a market economy.
Contrary to Morgan, you can’t take money out and hope to understand the modern economy. You have to study money. And in markets, you have to make a money surplus (a profit) — or you are out of the game before long. I can’t say the same is true for EROEI, which is perhaps the best I can say against it.
You can ignore EROEI, but you can’t ignore money.
Nate is a well-known authority on global resource depletion. Until recently he was lead editor of The Oil Drum, one of the most popular and highly-respected websites for analysis and discussion of global energy …
Something has bothered me of late: why is the price of crude oil still elevated? Other commodities have taken a battering since 2011. Gold, copper and iron ore – all are way down off their peaks. But oil has seemingly defied gravity. And that’s despite increased supply from shale oil in the U.S., still soft demand particularly in the developed world and declining rates of inflation growth across the globe.
What gives? Well, shale oil proponents will say falling oil prices are just a matter of time. And that the boom in shale oil will reduce U.S. reliance on foreign oil, leading to cheaper local oil, which will free up household budgets and spur consumption as well as the broader economy. Perhaps … though I’d have thought all of that would be already reflected in prices.
On the other side, you have “peak oil” supporters who suggest high oil prices are perfectly natural when oil production has peaked, or at least the good stuff has disappeared. Yet the boom in U.S. shale oil appears to put at least a partial dent in this thesis.
There may be a better explanation, however. It comes from UK sell-side analyst, Tim Morgan, in an important new book called Life After Growth. In it, he suggests that the era of cheap energy is over. That the new unconventional forms of oil are far less efficient than old ones, meaning they require significant amounts of energy to produce. In effect, the energy production versus energy cost of extraction equation is rapidly deteriorating.
Morgan goes a step further though. He says cheap energy has been central to the extraordinary economic growth generated since the Industrial Revolution. And without that cheap energy, future growth will be permanently impaired.
It’s a bold view that’s solidified my own thinking that higher energy prices are here to stay. And the link between cheap energy and economic growth is fascinating and worth exploring further today. Particularly given the implications for the world’s fastest-growing and most energy-intensive region, Asia.
Real vs money economy
First off, a thank you to Bob Moriarty of 321gold for tipping me off to Morgan’s work in this well-written article. Morgan’s book is worth getting but if you want the skinny version, you can find it here.
Morgan begins his book outlining four key challenges facing economies today:
- The biggest debt bubble in history
- A disastrous experiment with globalisation
- The massaging of data to the point where economic trends are obscured
- The approach of an energy-returns cliff edge
The first three points aren’t telling us much new so we’re going to focus on the final one.
Here, Morgan makes a key distinction between what he terms the money economy and the real economy. He suggests economists around the world have got it all wrong by focusing on money as the key driver of economies.
Instead, money is the language rather than the substance of the real economy. The real economy is a surplus energy equation, not a monetary one, and economic growth as well as the increase in population since 1750 has resulted from the harnessing of ever-greater quantities of energy.
In fact, society and economies began when agriculture created surplus energy. Before agriculture, in the hunter-gatherer era, there was an energy balance where the energy which people derived from food was largely equivalent to the energy that they expended in finding the food.
Agriculture changed that equation. It allowed for the creation of surplus energy. In essence, three people could be supported by the labor of two people, allowing one person to engage in non-subsistence activities. This person could make better agricultural tools, build bridges for better infrastructure and so on. In economic parlance, this person didn’t have to concentrate on products for immediate consumption but rather the creation of capital goods. The surplus energy equation allowed for that.
The second key development was the invention of the heat engine by Scottish engineer James Watts in 1769, although a more efficient version was produced later in 1799. This invention allowed society to access vast energy resources contained in oil, natural gas, coal and so forth. In other words, the industrial revolution allowed the harnessing of more energy to apply vast leverage to the economy.
In sum, the modern economy is the story of how society overcame the limitations of the energy equation. Or as Morgan puts it: “…all goods and services on which money can be spent are the products of energy inputs, either past, present or future.”
The creation of surplus energy during the Industrial Revolution and subsequent explosion in economic and population growth isn’t an accident. They’re tied at the hip.
Understanding the distinction between the money economy and the real economy can also help us better understand debt. Debt is a claim on future energy. The ability of indebted governments to meet their debt commitments will partially depend on whether the real (energy) economy is large enough to make this possible.
Era of cheap energy is over
Morgan goes on to say that the era of surplus energy, which has driven economic growth since 1750, is over. The key isn’t to be found in the theories of “peak oil” proponents and the potential for absolute declines in oil reserves. Instead, it’s to be found in the relationship between the energy extracted versus the energy consumed in the extraction process, also known as the Energy Return on Energy Invested (EROEI) equation.
The equation maths aren’t difficult to understand. If the EROEI is 10:1, it means that 10 units are extracted for every 1 unit invested in the extraction process.
From 1750-1950, the EROEI of oil discoveries was very high. For instance, discoveries in the 1930s had 100:1 EROEIs. That ratio declined to 30:1 by the 1970s. Today, that ratio is at about 17:1 with few recent discoveries above 10:1.
Morgan’s research suggests that going from EROEIs of 80:1 to 20:1 isn’t disruptive. But once the ratio gets below 15:1, energy becomes a lot more expensive. He suggests the ratio will decline to 11:1 by 2020 and the cost of energy will increase by 50% as a consequence.
Non-conventional sources of oil will provide little respite. Shale oil and gas have EROEIs of 5:1 while tar sands and biofuels are even lower at 3:1. In other words, policymakers who pin their hopes on shale oil reducing energy prices are seriously deluded.
And further technological breakthroughs to better locate and extract oil are unlikely to help either. That’s because technology uses energy rather than creates it. It won’t change the energy equation.
While some unconventional sources offer hope, such as concentrated solar power, they won’t be enough to offset surplus energy turning to a more balanced equation.
Oeuvre to growth tool
If the real economy is energy and the days of surplus energy are coming to an end, then so too is economic growth, according to Morgan. In his own words:
“…the economy, as we have known it for more than two centuries, will cease to be viable at some point within the next ten or so years unless, of course, some way is found to reverse the trend.”
This terribly pessimistic conclusion requires some further explanation. Morgan explains the link between energy and the economy thus. If your EROEI sharply declines, it means more energy is needed for extraction purposes and less energy is available to the economy. Ultimately, this results in the cost of energy rising as a proportion of GDP, leaving less value for other things. Put another way, with the leverage from surplus energy diminished, there’s less energy available for discretionary uses.
Now I don’t have total buy-in to Morgan’s thesis. It certainly solidifies my thinking that the era of cheap energy is indeed over. It provides a unique and compelling way to think about this. And the proof is seemingly all around us. It explains the high oil prices and the surge in agriculture prices (agriculture relies on energy inputs).
You can’t help but being more bullish on energy and agriculture plays in the long-term. Oil drillers for one as they’re more reliant on increased work than the price of oil. Also, the likes of fertiliser companies given agriculture land is tapped out, making an increase in output essential and thereby requiring greater quantities of fertiliser.
Morgan thinks inflation is on the way given a squeezed energy base with still escalating monetary bases. Regular readers will know that I am a deflationist over the next few years. But nothing is certain in this world and Morgan’s arguments on this front have some credibility.
As for whether this spells the end of a glorious 250 year period of economic growth, well, I’m not so sure. The link between energy and economies is compelling. But whether we’re at a tipping point where surplus energy disappears is a guess. I’m convinced that we’re coming up against resource constraints that will inhibit economic growth. To say that we’re imminently coming to the end of economic growth requires further evidence, in humble opinion.
Impact on Asia
Asia has been the largest demand driver for energy over the past decade. The region’s net oil imports total 17 million barrels of oil a day. China is now the largest net oil importer, having recently overtaken the U.S.. Other large net oil importers in Asia include India and Indonesia. Obviously, higher oil prices would be detrimental to these net importing countries.
It may be somewhat offset by agricultural prices staying higher for longer. China and India are agricultural powerhouses. And the impact of agriculture on their economies is still profound (agriculture accounts for 14% of Indian GDP and 10% of China).
On the other hand, higher agricultural prices mean higher food prices. And given lower incomes in Asia, the proportion of household budgets dedicated to purchasing food is much higher than the developed world. Therefore higher food prices has a larger impact on many Asian countries. Witness periodic recent protests on this issue in Indonesia, Thailand and India. So net-net, higher energy prices would still be a large negative for Asia.
Turning to resource constraints potentially inhibiting future economic growth: given Asia has the world’s strongest GDP growth, it would be disproportionately hit if this scenario is right. The past decade may represent a peak in the region’s economic output. Whether there’s sharp drop or gradual fade is impossible to forecast.
These are but a few of the potential implications for Asia.
AC Speed Read
– The real economy is a surplus energy equation, or the harnessing of ever-greater quantities of energy.
– That equation has deteriorated to such an extent that one can now declare the era of cheap energy over.
– If the economy is energy and cheap energy is gone, future economic growth will be inhibited.
– Consequently, higher energy and agricultural prices can be expected in the long-term.
– The impact on Asian growth may be disproportionately large.
This post was originally published at Asia Confidential: