Posted by nate hagens on March 9, 2011 - 11:37am Topic: Economics/Finance Tags: gold production, harold hotelling, oil production, resource extraction [list all tags]
The following is a guest post from Gregor Macdonald, adapted from his website Gregor.us.
One of the reasons that gold retains its competitiveness as a capital-storage unit is the rather slow and plodding rate at which supply is brought to market. Since 1900, compound annual growth of world gold production comes in at 1.163%. That particular rate is below the growth rate for a number of other natural resources. But in particular: it’s well below the rate of credit production–the “resource” which now plagues the developed world. Indeed, the over-production of credit the past twenty-five years has once again driven capital back into hard assets such as gold. This brings up an intriguing subject: the conversion of resources into financial capital, and the conversion of financial capital back into resources. First, let’s take a look at a century of gold production. | see: World Gold Production in Metric Tons 1900 – 2009.
From 1980 -2000 global gold production grew at a strong, compound annual growth rate (CAGR) of 3.836%. But that was after a very slow production rate for forty years, between 1940 and 1980. In the past decade global production of gold has not only slowed again but fallen steadily, with a notable uptick in 2009 as the decline temporarily reversed. Indeed, since the new millennium, the story of gold will be familiar to those who have watched oil: as prices steadily rose, supply growth fell.
The migration of capital, between the world of natural resources and the world of finance, has been addressed by any number of thinkers, one of the more compelling being Harold Hotelling. Writing in the Journal of Political Economy in 1931, Hotelling proposed that a rational producer of resources would only be inclined to extract and sell that resource if the investment opportunities available with the capital proceeds were greater than simply leaving that resource to appreciate in the ground. So, given Hotelling’s theory of resource extraction, what has happened to gold production since the year 2000? Does the chart reflect geological and cost limits to increasing gold production, even as the price rose from $250.00 to $1000.00 per ounce? Or, has there been some moderate yet gathering decision on the part of global gold producers to extract gold more slowly? After all, why extract gold to merely convert gold into paper currency, beyond the need to pay for the cost of production and provide, say, a dividend to shareholders? In other words, at the rate at which the price has been rising, why hurry to extract the gold?
These same questions have long been asked in the world of energy extraction as well. Why did global oil production advance so quickly into late 2003 as the oil price was rising towards the high 30′s, only to peak out for the past six years as price skyrocketed? We must assume that oil producers in the West, governed mostly by for-profit enterprises, were doing everything possible to lift production. The conclusion is rather easy: they couldn’t lift production, even with a doubling of price. But in contrast to BP, Shell, Exxon, Total, Chevron, and Conoco, what about the NOCs–the National Oil Companies? Is it possible they were inclined to apply some form of scarcity rent, holding back production slightly? Echoing statements made at least twice last decade, King Abdullah of Saudi Arabia repeated himself last Summer when he remarked about future Saudi oil production: “I told them that I have ordered a halt to all oil explorations so part of this wealth is left for our sons and successors God willing.” | see: Global Crude Oil Supply 2002 – 2010 in mbpd (updated through November 2010)
As lovely and reasonable a view offered by Hotelling in his The Economics of Exhaustible Resources, there is little evidence that oil producers are any more rational than individuals. The history of global oil production would appear to be governed more by geology, than any future projections of how to best invest oil revenues. North Sea oil was largely extracted in the cheap oil era, and peaked as oil prices began to take off earlier last decade. This was also true for Indonesia, and of course several decades before with the United States. Indeed, the bulk of world oil production was sold too cheaply. I discussed this phenomenon in my 2009 piece, The Fate of An Oil Exporter. By contrast, one of the few modern states that has spoken openly about husbanding scarce energy resources is Brazil. President Lula declared in 2009, as Brazil changed its resources policy that year, that the country’s new offshore discoveries were a “passport to the future.” Misunderstood by right-leaning commentary at the time as a form of resource-nationalism, Lula’s remarks were instead very much in the Hotelling vein. "We don't have the right to take the money we're going to get with this oil and waste it,” Lula remarked. But Brazil has been an exception.
Given that both gold and oil production are now either flat or falling, what should a producer of these two commodities do with the proceeds of their sales? Let’s again consider the insurmountable problem at hand. Western economies and especially the United States have been on a credit binge for decades. When that bubble burst in 2008, punctured in large part by rising energy prices, the response from OECD governments was to create more credit. In Eric Zencey’s terrific New York Time’s essay on Frederick Soddy, which captured the views of the 1921 Nobel Laureate, the connection between debt limits and energy supply was made plain for a general readership:
Problems arise when wealth and debt are not kept in proper relation. The amount of wealth that an economy can create is limited by the amount of low-entropy energy that it can sustainably suck from its environment "” and by the amount of high-entropy effluent from an economy that the environment can sustainably absorb. Debt, being imaginary, has no such natural limit. It can grow infinitely, compounding at any rate we decide.
Whenever an economy allows debt to grow faster than wealth can be created, that economy has a need for debt repudiation. Inflation can do the job, decreasing debt gradually by eroding the purchasing power, the claim on future wealth, that each of your saved dollars represents. But when there is no inflation, an economy with overgrown claims on future wealth will experience regular crises of debt repudiation "” stock market crashes, bankruptcies and foreclosures, defaults on bonds or loans or pension promises, the disappearance of paper assets.
To Soddy’s point on the problem of infinitely created debt, let’s take a look at 60 years of debt growth in the United States. | see: Total Credit Market Debt Owed 1940 – 2010 (updated through December 2010).
As the United States has now (long) embarked on a massive dollar devaluation program, in part to bust the CNY-USD peg, but mostly to mitigate the next leg down in real-estate and debt deflation, we should consider how resource extractors might behave in such an environment. Two obvious possibilities are as follows. First, oil producers rather than chasing higher prices in dollar-terms might start to demand full or partial payment in gold. Meanwhile, gold producers might consider banking some of their capital not in cash, but also in gold. And yes, both oil and gold producers could simply leave more of the stuff in the ground. What may become more clear is that, beyond the need for operational cash, turning excess production of resources into paper currency will increasingly become, per Hotelling, a losing proposition.
Data Sources:
USGS Historical Statistics for Mineral and Material Commodities in the United States (includes global data).
Economic Research: Federal Reserve Bank of St Louis.
What an odd view of the world. Although you mentioned that oil production doesn't follow "Hotelling" at all, you didn't mention why. I would suggest that it's simply that Hotell wuz rong. The reason that oil folks produce oil through good times and bad is the same reason that folks who make giant anchor chain keep making anchor chain and Port-a-Potty makers continue to make Port-a-pottys is because it's what they do--it's what they know. Sure, in modern times some mega corp. will put their money into commodities or ETFs or DOT-COMs or whatever, but most businesses stick with what they know. It is thru that the NOCs only have to operate as a quasi-business, so ROI, dividends, cash flow, EBITA and so on, while not irrelevant, do not need to be driven by the same metrics as IOCs. So yes, it's true that Saudi has made several important discoveries if scattered press reports, the grapevine and Yamani and Abdullah statements to that effect are true. Beyond that, the only "redirection of capital," even by the NOCs, seems to be foot-dragging on drilling/investment as a way of OPEC quota compliance, especially by Venezuela. Mostly, there simply isn't any evidence of any economic theory actually working in the last 30 years. When Reagan nearly tripled the federal deficit and more than tripled the annual debt, I thought for certain that inflation would raise its ugly head. But Volker was successful in breaking inflation via massive unemployment (first started under Carter), and even when government spending and size grew under Reagan, inflation remained low. But surely inflation had to come back under H.W. Bush, who again doubled both the annual deficit and the national debt. Again, no significant inflation. But surly when G.W. Bush turned a $4 trillion surplus into an $8 trillion debt, with massive government growth in spending and size, inflation must come roaring back, right? Rong! Now under Obama, again, massive growth in spending and deficits MUST result in rampant inflation, right? The truth seems to be that nobody knows. But since 1932, when the U.S. went off the gold standard, it's been a pure faith proposition. And that's what Bernake is counting on: pure faith, confidence. And he might just get it. The right paradigm in MHO lies more in Black Swans shaking (or bolstering) confidence in unexpected, dramatic ways. The asset bubbles that form and bust--from DOT-bombs to Mortgage Backed Securities (and CDOs) to Whatever Bubble Comes Next--I doubt that it'll be in keeping with economic theory from the 1930s. Interesting article, Perryeh
Perryeh,
I agree with your idea about prevention of inflation somewhat. Indeed more and more "debt" was made to cover the lack of growth in production. But these debts cannot stack eachother indefinetely. I am quite certain that one day there will be no more "belief in the relief efforts", and creating more debt and with that more promises will simply not work. You say that there have been many of these schemes made to prevent inflation from rising. But what prevents this one moment from being the last scheme?
And going on in that line of thinking, why would this moment not be the one moment for the hotelling theory to work? Possibly, and probably, not "cashing in" on resources because of the major bust coming up seems like a reasonable bet.
Perryeh has it pegged correctly.
Hotelling suggested a very naive theory. The idea of discounting is most often applied when studying how drug addicts will reason about getting their next fix. That is the problem with potential riches: what idiot is going to let some resource lay fallow in the ground when the possibility of immense riches awaits them? It's the same theory as a drug fix.
Hotelling's result shows that in an efficient exploitation of a non-renewable and non-augmentable resource, the percentage change in net-price per unit of time should equal the discount rate in order to maximise the present value of the resource capital over the extraction period.
So does that rule really tell us much, or is this another indication that economics is not about studying scarcity but about studying the exploitation of resources to maximize profit?
WHT, call me dumb, but I don't understand what you mean.
I have a bit more elaboration elsewhere in this thread. I don't know what you mean when you say I don't know what you mean. Or else read the link.
There is a key ambiguity in the idea of owning "a finite resource". It can, in theory, mean two things. Either you own a finite amount of some infinite resource, or you own a finite share of a finite resource.
In practice, the world has acted as if mine-owners own a finite share of an infinite resource. When in that situation, you say to yourself, "I've got my capital tied up here, so I want the best return I can get on it as quickly as I can, so I'll mine it at the fastest rate my capital equipment will allow". When the you realise that the resource itself is finite (and won't be replaced by something better & cheaper before it runs out), your thinking changes. You say, "Why should I sell cheap today when I can sell dear tomorrow? And if somebody undercuts me and steals my market, the more fool them, since tomorrow they'll have less themselves and I'll be able to sell even dearer".
Certainly, people will admit in abstract that certain resources are finite, but the ubiquity of technological progress has encouraged people to assume that "Well, X may eventually run out in theory, but we'll find something even better than X before we get near that point". With oil, this is demonstrably not the case, so some actors in the market are starting to think in terms of the coming scarcity. Some, but not yet all. And, of course, rational players in the market who have twigged to Peak Oil (and gone long on reserves) don't want everyone else to do so, since the more oil is consumed today, the more expensive it will be in the years to come.
Adam Smith had a wonderful fable about the "hidden hand" of the market ensuring that people's greed ensured that they'd do the right thing by others. The fable had certain assumptions. One of them, the relevant one in this context, is the assumption that everyone had all the relevant information. When that assumption doesn't hold, however, the "hidden hand" rewards people who do things that are very wrong indeed. Or, in the famously (but doubtfully) reputed words of P.T. Barnum, "There's a sucker born every minute". So a "rational" Peak Oil investor wouldn't discourage cornucopian illusions.
"Well, X may eventually run out in theory, but we'll find something even better than X before we get near that point". With oil, this is demonstrably not the case, so some actors in the market are starting to think in terms of the coming scarcity. Some, but not yet all.
So Hotelling had his theory back in 1931, and it has taken 80 years for a degree of discounting rationale to come true for oil?
So Hotelling had his theory back in 1931, and it has taken 80 years for a degree of discounting rationale to come true for oil?
Yes, that's true. And there's another factor at work, too. Keeping your resource back from the market in the hope of higher prices tomorrow only makes sense if the resource will still be yours tomorrow. In Australia & most other industrialised countries of which I am aware, mining & drilling licences are issued on a "use it or lose it" basis. Governments have disapproved of hoarding reserves and wanted them brought to market ASAP. Companies that just sit on reserves, therefore, are in danger of having their permits revoked and re-issued to a competitor. This happened in Australia a few years ago with a large bauxite deposit.
The assumption behind th "use it or lose it" policy is cornucopian & may take some time to be rooted out by reality. The National Oil Companies in the Third World are better able to follow Hotelling's logic.
So what's happening to the inflation that QE ought to be causing?
It's being exported.
A new twist on neo-colonialism! Instead of stealing your natural resources, we'll send you our financial toxic waste.
The conflict in North Africa was a predictable outcome of the US Monetary Policy of Quantitative Easing. It is not plausible that the US Federal Reserve, as the manager of the world's Reserve Currency, did not fully recognize the global ramifications of such monetary inflation actions well in advance. Quantitative Easing like the Intercontinental Ballistic Missiles (ICBM) of the cold war era has had the same devastating pre-emptive impact on Libya.
There can also be little doubt that the bi-monthly meetings of the Bank of International Settlements (BIS) board of directors, which specifically meet to discuss coordinated monetary policy outcomes, did not consider this eventuality. The board of directors of this global power center includes all G7 Central Banks chiefs, with the conspicuous absence of a single member of the Arab League not receiving US military financial aid.
Our Process of Abstraction research methodology (shown below) has been signaling looming political conflict and social tensions for eighteen months. Our Tipping Points have proven once again to be surprisingly accurate predictors. Though Tunisia as an initial flash point was somewhat of a surprise, we knew it was going to soon emerge somewhere due to serious inflationary pressures injected into the global macro. As we will discuss, it is a direct result of the US policy of Quantitative Easing (QE) igniting global inflation in food and basic resources of survival. The social unrest this triggers is still in the early stages of what we call the "Age of Rage".
I am no economist.
As far as I can see, this concept of Hotelling is very rational in a relatively stable economic system. Unfortunately we are no longer in a remotely stable system. We have the OECD deep in debt and being squeezed on oil supply, with in the short to medium term is the lifeblood of economic activity. Less oil means economic contraction. That makes debt unpayable.
We are facing default or hyperinflation. Each member of the OECD will hit the crisis point at a different time, unless we hit a MENA style domino effect. Presented with this inevitability the clever money will get out of fiat currency and into non-perishable commodities or long term fixed assets. However, the controllers of most of the fiat money appear to be anything but rational. Fear and greed rule the roost. A few OPEC countries may be rich and stable enough to implement Hotelling. However, most are economic and social basket cases with rampant corruption, massive overpopulation and on the brink of anarchy.
Libya has just tipped over the edge.
It is too late to think about concepts like Hotelling on a national or international scale. It is time to act as rational individual and make personal preparations.
Yesterday I bought a more fuel efficient car. (literally less than half the fuel consumption). In a BAU world it will pay for itself in 4-6 years. In the future I expect it will make the difference between driving and walking far sooner than that.
When Reagan nearly tripled the federal deficit and more than tripled the annual debt, I thought for certain that inflation would raise its ugly head. But Volker was successful in breaking inflation via massive unemployment (first started under Carter), and even when government spending and size grew under Reagan, inflation remained low. But surely inflation had to come back under H.W. Bush, who again doubled both the annual deficit and the national debt. Again, no significant inflation. But surly when G.W. Bush turned a $4 trillion surplus into an $8 trillion debt, with massive government growth in spending and size, inflation must come roaring back, right? Rong! Now under Obama, again, massive growth in spending and deficits MUST result in rampant inflation, right?
My hunch on this effect was that the increase in global trade with the US having the benefit of being the reserve currency for the world was the cause for inflation not returning for Reagan and Bush. Think through this logically... A larger world economy requires more cash to operate. All things being equal, a 2% larger global economy will require at minimum a 2% increase in world money supply...anything less is deflationary. So the US in its role as world financial leader can take advantage of this to continue to deficit spend.
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