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Nicole Foss joins Jim Puplava on Financial Sense Newshour in the first of a two-part interview to talk about peak oil, the next financial crash, and the challenges she sees coming our way.

Nicole is co-editor of The Automatic Earth, where she writes under the name Stoneleigh. She and her writing partner have been chronicling and interpreting the on-going credit crunch as the most pressing aspect of our current multi-faceted predicament. The site integrates finance, energy, environment, psychology, population and real politik in order to explain why we find ourselves in a state of crisis and what we can do about it. Prior to the establishment of TAE, she was previously editor of The Oil Drum Canada, where she wrote on peak oil and finance.

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Transcript

Jim Puplava:  Joining me on the program is Nicole Foss, and, Nicole, this interview is being done in person. You are actually in the office, and we are facing each other. It is a pleasure meeting you, but let us discuss why you are in my office. You are on a tour that will last about six weeks. You are going around the country. You have been in Northern California. You are in San Diego, and then you will be going up to LA. Tell us a little bit about the tour that you are taking and what are you telling your audiences?

Nicole Foss:    Well, basically, I am doing somewhere around 20 talks—not quite confirmed details for all of them, but about 20 talks around the country. I am doing one lap of the United States so started off in Ottawa and went out to Vancouver, and I am down in San Diego now. Then, I am going over to North Carolina and back up again, all in about six weeks. So I have got this whole series of talks, they very somewhat from place to place because there are different issues in different areas, but the basic gist of it is that I layout the basic case for peak oil and explain how financial bubbles work. Basically looking at what are the drivers at different times, and how energy is an enormous driver of expansion. When you have a windfall in term of energy, and in our case, fossil fuels, then you would have an enormous expansion and economic activity and socioeconomic complexity. But I point out that when you do this, if you have a large enough energy substance, the odds of producing a financial bubble are going to be significant. And I argue that that is exactly what we have done.

The most important point about that, though, is you do not have to run out of energy for a bubble to burst once you have blown one. They simply have their own internal dynamics. So when the bubble reaches it is maximum extent and bursts, then finance becomes the key driver to the downside. So when people think that you have to run out of energy to burst a bubble, I would say, well look at the 1930s when America was the global swing producer for oil. It had a virgin continent’s worth of resources, cheap labor. The only thing they did not have was money, because they had had a credit bubble that burst, and the depression really was the bursting of that bubble and the aftermath from that. So I am arguing that we have done the same thing again, only on a vastly larger scale this time. And so finance will be the key driver to the downside for the next several years, further down the line than that, I think we are going to be hitting some really hard resource limits.

So after I explain bubbles and their aftermath in my talks, I then come back to energy and explain how finance affects the energy sector. So that first, it actually buys you time because you have speculation go into reverse, and you have a sharp price fall from that. And I think we are building up to the peak of the bubble, the latest commodity bubble, which has been driving oil prices for the last while. I think we are going to see speculation go into reverse. Beyond that, I think we are going to start see demand fall as we move into really difficult financial circumstances. I think we are going to see demand fall a lot. And because production is geared for the previous level of demand, when demand starts to fall, price fall further, you undercut price support. So initially, financial crisis buys you time in energy terms, but at the price of making it worse later on. Because when you crash the price—and the price probably falls considerably faster than the cost of production—you actually make the whole business of exploration and drilling and productions an awful lot riskier, so private capital ends up getting out the game, potentially, under those circumstances.

And if you do not have the money for maintenance because you are moving into depression conditions as well and you may not have shipping because you disrupt the whole system of letters of credit, you have geopolitical upheaval as well. Down the line, you can end up with an enormous supply crunch a few years later, so I think the next few years will be well-remembered as a time of acute financial crisis. But beyond that, if the economy tries to recover, I think it is going to be hitting some very hard ceilings, hard limits in terms of resources, and absolutely energy will be one of them. In some places water will be another one that will put very significant absolute limits on what is possible. And, of course, a tight energy situation limits what you can do on all sorts of other fronts as well, including moving water around to deal with water limitations. So we are looking at a very challenging situation for a very long time, probably, at least a decade of depression, I would imagine.

What I do when I have finished explaining energy, finance, and the confluence between the two, I look at what sort of things people can do. So I have been looking at building bottom up scale structures in order to take over some of the functions of things that probably will not work so well when they are starved of tax revenues under depression conditions and all the things people can do at an individual level and at a community level in order to get themselves through, what I would argue for the next few years, will be a period of economic seizure. And economic seizure really results from when credit collapses so that you crash the money supply and you compound that with an enormous fall in the velocity of money because people do not know where they are pay check is coming from, so they do not spend. And so you get this period where you have almost no money in circulation, and I would call that an economic seizure. So I am trying to explain to people how to navigate that sort of period of time by holding liquidity and perhaps holding supplies of certain things they might not be able to get later on.

Jim Puplava:     During this period of seizure and also given the limitation of resources that we are facing going forward, it seems to me, Nicole, that things are going to become more local in terms of a corporation that designs things in San Jose, like Apple buys raw materials from Brazil, ships them to Singapore and China, then back to the United States, puts them on a train, sends them across the country to New York. I do not think that is going to work in the future, so it seems like what you are going to have to do for either industry or even food supply—I mean, here in California you can go to the supermarket and you get berries, fruits, and vegetables that are flowing in by plane all year around. That is not going to operate in this kind of environment that you are talking about, is it?

Nicole Foss:    No, not at all. And in fact, if you look what happened during the depression of the 1930s, trade fell by some 66 percent in two years because you had trade wars. You just had conditions that were not conducive to maintaining trade as they had known it previously. And we are drastically more dependent on trade now then we were then. I think we are going to see the same kind of dynamics set up again. Trade is also dependent…shipping is dependent on letter of credit. Letters of credit depend on functioning credit markets. If you do not have that, much, much less moves. So yes, absolutely we are going to have to do things much more locally. So that is one of the things, absolutely, that I talk about that we need to rebuild our capacity to provide for some of the essentials of our own existence. We have offshored too many things. We have created very long and vulnerable supply chains for very important things that we depend on. And we are going to have to go back to figuring out how to do some of these things for ourselves.

I would also argue that the scale that things work effectively at is going to contract with the economy because in times when economic contractions occur, you also get—apart from trade—you also get trust contacts. And when trust is contracting, there is less tendency to work with people at great distances. And you also end up with higher-level institutions finding that they become stranded assets from a trust perspective. So institutions, international institutions perhaps even national ones, in some occurrences, end up not having the general trust of the public anymore. So you do not have an internalization of rules that people feel that they must follow because it is in everyone’s interest. If they no longer feel that these institutions are operating in their own interests, they no longer institutionalize or internalize these rules, so then you end up losing political legitimacy for institutions at that level, that it becomes stranded assets. And then when you lose legitimacy, you end up with those institutions which would very much like to continue to exist, substituting surveillance and coercion for the lack of internalization of those rules on behalf of the public. So then you end up in a much less pleasant situation politically, and I would argue that these localization efforts that I am trying to encourage—one of the reasons that they work is because they work within where the trust horizon still lies. So they work within where trust still exists. And trust makes everything function so much more effectively. In some areas they won’t have to stay local. I think they have to start from the bottom up. They do not necessarily have to stay at, a very, very small scale though. They can build up from the bottom to whatever level the trust will support, which could be county, it could be state, it is hard to tell. It may vary enormously from place to place.

Jim Puplava:    You know, it strikes me also, too, that when you look at the situation that we have seen in the last couple years, we saw the bailout of the bankers, the Goldman guys got paid 100 percent on their credit default swaps. We had the TARP, TALF, and all these various devices that government used to sort of restabilize the market, but if I look at, Nicole, a graph from the OCC on the derivative market, we have more derivatives in this country today than we did three years ago. If you look at the global derivatives market, we have a larger amount of derivatives structure—I forget the figures—over 600 trillion. It is hard for me to imagine even that amount. Let us move on to the financial system right now, because I have got a computer monitor with a video with the Greek riots on the day you and I are speaking. This enormous amount of debt that we have seen accumulated in the system, whether it is person debt, whether it is corporate debt, and now we are seeing sovereign debt. Do we get to the point where like Iceland, which is trying to come to grips with its problems, they, in order to…or insert their sovereignty, have basically said to their creditors, we are only going to pay you so much, what our economy allows us to do based on GDP. Take it or leave it or take us to court, but we are not going to be strapped. We are not going to see our economy collapse just to pay the bankers, so I wonder if we might spend some time talking about that.

Nicole Foss:    Yes, I think Iceland has done exactly what it needed to do. Mind you, it is easier to do that if you are a small island in the middle of the Atlantic with only 300 thousand people. I think everyone realizes that there are simply limits to what could ever be extracted from that situation, so they are in a better position to walk away. The European peripheral countries are much more tied into the system, and I think they are going to find it much more difficult to walk away. But I think they will eventually do so and probably in the not too distant future. I think Greece could easily be first, but if Greece does that, then there will be a domino effect because so many countries in the periphery are in a state of unpayable debt that default is inevitable, and I think it is only a matter of time. So they are being force to take these bailouts or having their arms twisted to take these bailouts in order that their tax payers can bailout bankers in the European center. But the people are waking up to the fact that that is what’s happening in these countries, and at some point they are going to say, no more.

So what you have in Europe in the Eurozone—because it is a single currency, you cannot adjust exchange rates to deal with disparities, you cannot restructure the debt without crashing the banking system, you do not want countries to default because then this will trigger CDS payouts. There is so much counter party risk in the CDS market that you could then crash that market if the payouts are triggered and cannot be delivered, and then that creates a wider panic than merely sovereign debt default risks. So what is happening at the moment is a sort of desperate attempt to prevent all that from happening, that giant kind of unwind, so they are trying to force countries to take these bailouts. When you cannot change…alter the exchange rate and you cannot restructure the debt, then you end up trying to force austerity measures into the periphery and that is exactly what we are seeing. So those peripheral countries are being told that you must cut services, raise taxes, selloff assets, and essentially what that does is it is going to force economic contraction, but when the rate of growth is drastically less than the interest on the debt, then you are in an exploding debt scenario anyway. So it is not that this is actually helping, it is digging a deeper hole.

But trying to kick the can down the road a little ways and that is all these measure are trying to do, not just in Europe, but almost everything governments have done has been to just kick the can down the road to try and avoid the comeuppance, the wall that we are racing towards at 100 miles an hour. And I think we are going to see that the consequences of that in the European periphery before almost anywhere else, at some point these austerity measures become political suicide for domestic politicians to implement, so Argentina went through, I believe, five presidents in two months when they had their financial crisis. I think you are simply going to find domestic politicians cannot implement the austerity measures that are being insisted upon and so governments will fall. Eventually, someone will end up in a position of power who will then default, and then you will get a domino effect in the whole European periphery. It is not just Portugal and Spain and Ireland and Greece, but it is Italy, it is Eastern Europe. Belgium is getting close to having problems with its dept. There are going to be an enormous number of problems, and I think that unpayable debt is going to destroy the Euro as a single currency.

And I would actually argue that the Euro is really not a single currency anyway. It is a glorified currency peg, because the level of primary loyalty is not the level that issues the currency, and you just have too many disparities between different areas. I do not think this is going to stand. I think it is going to come apart at the seams, and probably in the not too distant future. The Eurozone may survive in a much smaller form, but it is entirely possible that the Euro might not survive at all. I certainly think at the very least it is going to be a lot smaller and probably by the end of this year.

Jim Puplava:    It is amazing because Barron’s had a front cover story in their late May issue, “How to Fix Greece” and they basically said we are giving them money and we are just delaying the day of reckoning. They simply cannot pay the debt that they have now, does it really make any sense to give them even more debt that they cannot pay. So they were suggesting, which is I am sure some of the bankers do not like, is get 50 cents on the dollar now and restructure or kick the can down the road and you are lucky if you are going to get 20 cents. And I cannot help but believe, judging by the news today, that politicians are going to do what they always do, which is kick the can down the road and hopefully, they will be out of office getting a pension and somebody else’s problem…well, they will have to deal with it, but that is what they are doing. And you mentioned something that I think, and I agree with you 100 percent, if you look at the Euro even as an entity, when you do not have the taxing authority or various monetary or fiscal measures to run a country—like, for example, in our country. You get a state like Mississippi or somebody has problems with either a hurricane, a tornado, or a flood, the federal government can come in and help that particular state out of its issues. It does not work that way in Europe. You cannot say the Greeks are having a problem, well we will just give them more money, but how does all that work politically. It does not seem like they have the institutions to hold this thing together.

Nicole Foss:    They really do not. And what is happening is already a buildup of recrimination in Europe. So for instance, Germany is saying to the European periphery, you were greedy, this is all your fault, you spent money that you could not afford to pay. And the periphery is looking at the center, Germany in particular, and saying you were predatory lenders just like the subprime lenders in America that gave Wal-Mart greeters 500 thousand dollar mortgages because they got a fee and they did not care about the risks. So basically, you have got both sides blaming the other. And in fact, both those arguments are true. If you did not have the combination of predatory lending and willing victims, you would not end up in this situation. It is gone as far as it has, precisely because everybody benefited in the short-term, and everyone was prepared to just let the long-term look after itself, which it is going to in it is own peculiar way, but not in a way that is going to appeal to anybody on either side of that fence.

I think it is going to just generate even more recriminations going forward because so many assets are going to be sold off, people like the Irish and the Greeks could find that they are essentially slaves in their own country. They do not own anything anymore. Their sovereignty is completely gone. Everything’s been sold out from underneath them. It was too easy to get into debt, unfortunately. The Euro brought the interest rates down in some of these countries so far that basically it was just an enormous trap and people walked, people and companies and countries, walked right into the this trap. Periods of very low interest rates encourage people to take on debt—not just people, but all levels—to take on debt, and then they are acutely vulnerable to rises in interest rates, even small rises in interest rates. And because interest rates are a risk premium and what we are walking into is a hugely risky situation, I think we are going to see interest rates go up enormously. We are already seen bond rates spike in places like Greece and CDS spreads spike as well, and I think we are just going to find that this enormous edifice of debt, this pyramid of human promises is simply going to pancake.

Jim Puplava:    I want to come back to the oil markets for a minute because this is, in essence, the center of your tour that you’re giving right now. When take a look at oil prices…I mean, if we take a look at from about 2006 to 2008 we saw oil prices almost triple, going from 50 to almost 150. And then within the brief short time, almost four or five months, we saw it go from a 150 down to like 30. What was interesting to me, Nicole, in 2008, nobody paid much attention to it, but the IEA did a major study that they released in November, and unfortunately, it was released at the wrong time because everybody was worried if the credit markets would function. But they had studied the 800 largest oil fields and they said, my goodness, the depletion rate is much higher than we thought, we need to invest 350 to 400 billion dollars a year just to try to stay even. Unfortunately, the price dropped to 30, the credit crisis made it very difficult for some of the people in the oil industry to get financing, number one. And number two, when you go from 150 to 30, how do you plan a long-term project? How do you finance cash flows and heavy expenditure when you just saw a major drop?

Let us talk about that because I recently interviewed an oil trader, Dan Dicker, who talked about he believes in peak oil like you and I do, but he said sometimes now that we have these commodity ETFs, we have got hedge funds coming into the market, you have a, what I call, a momentum element that now exists in the energy market that has nothing to do with the production coming out of the Gulf of Mexio, what oil companies are doing, what is peak oil. How do you operation in that kind of market? I mean, if I am an oil company, or if you are Exxon Mobile, I guess you are okay. But if I am an midsize or a small size oil company, how do I go to a bank if we get another one of these periods where if you say if we get a financial contraction this time, the momentum crowd goes out, you get through leveraging, we could be looking at lower oil prices again, and what does that do? That delays all the needed investments we need to make.

Nicole Foss:    That exactly true, and that is what I have been addressing in my talk, where we go from here. And people who work in peak oil often seem to think that when supply and demand get tight, what you get is a one-way moon shot in terms of prices, but it really is not. What you get is an exaggerated boom and bust dynamic. So you get these enormous swings in one direction and then the other, and we have been seeing that since 2006. So as you say, we have this enormous spike, and if you look at the crude prices, it is a classic speculative bubble. It is a parabolic rise and a very sharp crash. That is exactly what bubbles always look like. So what you got when supply and demand are tight, there is this perception that supply is going to be scarce and prices are going to be high, so you start to build momentum. And momentum becomes a self-fulfilling prophecy. Bubbles are Ponzi schemes so they are self-fulfilling prophecies, there are swings of positive feedback if you like. So what happened is people started chasing that momentum, and an enormous amount of money flooded into the sector between 2006 and 2008. So you had prices pushed up enormously in excess of where the fundamentals would have justified them being at the time, and then they crashed.

So what happens when a bubble reaches its maximum extent is the speculators will get out the sector, they take their profits, they dump the sector, they short it quite often, and then the price absolutely crashes. And then you are down to a bottom again and you start…we have started to rebuild the whole thing. So we are going to, I think, see more of these huge swings. It is momentum chasing in both directions. So traders will make money whichever way the market is going. They really like volatility. They feed of it. And I think we are going to see an enormous amount more of that going forward. So I do think prices are going to come down. I think we are building up that same momentum chasing movement again. This why I argue that finance becomes the key driver in the short-term because these enormous flows of money in and out of sectors actually overwhelm the real economy, that part of the real economy, and the finance flowing out of that sector can just crash things in the real world. So I think we are going to see prices of oil come down as speculators abandon the sector, and then we are going to start seeing prices fall from demand falling as we move into hard times economically. And that, as you said, is going to make it desperately difficult for people to plan. The cost of production probably does not fall particularly sharply, so when the cost of your product declines, the cost of production does not. You could actually drive oil prices down to the cost of the lowest price producer for a period of time, so we could see them come down further than they did last time.

However, I would point out that if oil were to hit, say, 20 dollars a barrel, that would not necessarily mean that oil was cheap because in a deflationary or deleveraging environment, basically you crash the money supply through the elimination of credit to such a great extent that purchasing power falls faster than price. So even as prices fall, affordability gets worse. So even if end up with what would appear, from today’s vantage point, to be cheap oil, from the vantage point of that particular time when we hit that price level, it would not necessarily be cheap at all. And I think it is going to mean that we get a lot less investment in the sector if prices come down, but as you said, time horizons for these projects are long, if you cannot plan because prices are so volatile, then I think private capital is going to want to get out of that particular game, and then you set up a supply collapse. So initially, financial crisis buys you time because you simply…if your economy is contracting, you do not burn through anything like the same amount of energy that you were before. And if people do not have the same purchasing power they had before, they are not going out and purchasing as much energy as they did before.

You get this period where prices fall, there is no price support, economic contraction takes route. So it buys you time initially when you move into financial crisis, but at the expense of making the whole thing worse later when you end up with this situation where nobody’s being involved in the business because they couldn’t make any money at it and you do not maintain the infrastructure. As you said as well, you would have to put an enormous amount of investment into the system just to keep it where it is now. Where’s that money going to come from in a period of acute credit crunch? So I think we are looking a real problem, and we are going to be setting up a supply collapse in a few years’ time. And then we are going to find that there is our hard ceiling. So the economy when it ties to recover, it is going to be struggling against some very significant headwinds.

Jim Puplava:    Well, we have been speaking with Nicole Foss and, Nicole, give out your Web site one more time as we close.

Nicole Foss:    It is called The Automatic Earth, and the address is theautomaticearth.blogspot.com.

Jim Puplava:    All right, well thank you so much for joining us on the program and what a pleasure to meet you in person.

Nicole Foss:    Thank you, very nice to meet you, too.

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