Energy Trading: Why We Need Those Big Swinging Dicks

Our host asked me to pen this piece - and even came up with the title ... [BSD is © Nick Leeson - Ed.]

He'd seen reference to how Nicola Sturgeon was being disingenuous when she announced her new publicly-owned Scottish energy company saying it would have the advantage of not needing to pay "corporate bonuses":  but that her careful choice of words meant she knew full well there would need to be the customary big bonuses on offer to the energy traders involved.  How so? - couldn't energy trading be automated?  Might I be able to explain ..?

Well, many commodity markets are indeed already characterised by a lot of algorithmic trading.   But the gas and electricity markets are different (and also, for idiosyncratic reasons of market design, Brent crude oil at the 'spot' end of the market - though not in the longer dated, more liquid forwards).  It was once considered by some academics that gas, and still more electricity, was a paradigm case of a commodity that couldn't be traded (for "reasons" I won't bore you with, because they were fallacious). 

Turns out though, it's not impossible to trade them: this was proved triumphantly by *ahem* Enron, as a pure act of intellectual conviction and commercial will.  But it is more difficult - and in the case of electricity, much more difficult. The primary reason is that in most electricity markets there is virtually no inventory to act as a buffer in the market, so that relatively slight physical events (which happen all the time, with major events not uncommon) within and around the extensive infrastructure can have a rapid and profound impact on the supply / demand balance. In those few electricity markets where there is an effective buffer - which mostly means those such as Norway that are dominated by hydro-electricity, where the buffer is represented by water stored in dams and 'ponds' at the top of the mountain - trading is concomitantly easier.  Gas suffers from a similar, though less pronounced problem of limited inventory.

A secondary (and related) reason is the 'granularity'.   Copper, for example, trades in units of one month: gas is traded by the day; and electricity by the hour, or even the half-hour.  The gas grid needs to be balanced daily; and the power grid requires balancing in real time.  There are many, many other related contributory factors besides, making gas and electricity highly dependent on more than just the usual financial principles.  In consequence, gas and electricity prices (wholesale / traded markets) are hugely more volatile than has ever been encountered elsewhere - an order of magnitude more volatile in the case of gas, and often two orders more in electricity.  Phenomena like the growing amount of intermittent wind power in the 'fleet' only serve to make this more extreme.

Until, then, the advent of that Holy Grail - an effective and efficient form of electricity storage on a large scale(1)  - successful trading in these markets requires a unique blend of classical 'financial' trading skills, plus deep understanding of the very extensive physical / infrastructure aspects and their complex dynamics.   As a rule, financial traders hate getting their hands dirty with the physical stuff; and physical specialists don't understand the financial stuff (which can be deeply counter-intuitive to the novice, even the highly numerate novice, as most engineers are). 

So the winners - who really clean up - are those who can be arsed to acquire both sets of skills.   The amateurs get destroyed.  Some household-name big companies have really screwed this up over the years.  Many companies actually outsource their trading requirements to specialists - and pay a nice mark-up, but can then say "we don't need those nasty traders(2) & we don't pay those immoral bonuses".  But of course they do, really - like retaining an overseas 'agent' to do the dirty business with the backhanders. 

I wonder which route the pious Sturgeon is going down?   Sadiq Khan had promised to set up a municipal energy company for London, but seems to have thought better of it which, in my view, is wise.  Keep those big swinging dicks out of sight of the innocent Scottish politician ...

ND
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(1) Mr Musk has a very, very long way to go yet.  He's a great BS-merchant, though.

(2) The traders' culture is abhorrent to the engineering culture that quite naturally dominates the energy co.s.   There are many points of conflict.  When an energy co eventually realises it needs a trading floor (and be willing to pay serious bonuses), it can cause truly dreadful frictions.  Traders and the like have been heard to call the old-timers "Dougs" - dumb old utility guys ...  and since this is a family blog (is that right, Sackers?), I won't relate what the engineers call the traders.

Not enough O2 in the H2O?

Adam Nieman: "Global water and air volume" (Science Photo Library)

Professor Jason Box is continuing his research into the effect on Greenland snow melt of particulates from fossil fuel burning and forest fires, and this set me wondering about how much atmospheric oxygen is being locked up by the same processes.

O2 levels have varied radically during last 600 million years:

(from Wikipedia article "Atmosphere of Earth: Third Atmosphere")

- as corroborated by analysis of ancient gas bubbles trapped in amber.

Writing in the Guardian newspaper in 2008, Peter Tatchell said that research by Professor Robert Berner suggested "humans breathed a much more oxygen-rich air 10,000 years ago", though I can't track down the original statement and suspect Tatchell may have misunderstood. (A paper by Berner on oxygen in the Phanerozoic era can be read here.)

Tatchell appears to be on firmer ground voicing concerns about air quality in cities, though what's in the air is more worrying than what's absent, as this article from last month's Mail Online India edition says. That said, cities that are prone to temperature inversion layers (e.g. Los Angeles, Beijing) may find that not only is smog locked in, but oxygen not replenished from the surrounding area as fast as it is being consumed.

Globally, there seems to have been a very small decline in atmospheric oxygen since 1990, according to an 18-year longitudinal study by Dr Ralph Keeling. According to a post on the Climate Emergency Institute website, the decline is even less than Keeling had expected, and it's possible that increased CO2 is stimulating the growth of vegetation.

Certainly the self-styled "Rational Optimist" Matt Ridley claims greenery is increasing, but I am inclined to take his professional bullishness with a pinch of salt. Surface spread as seen by satellite misses the third dimension: the UN FAO estimates (2012 forest report) that forest cover has dropped by around a third in the last 10,000 years, and the loss has accelerated from an average of 360,000 hectares per year since civilization began, to 5.2 million annually over the last decade.

Which brings us back to the carbon dioxide-global warming debate. CO2 is a "greenhouse gas" but there are so many other factors affecting the Earth's surface temperature that I don't think anyone can say which way the thermometer is going to move. However, if the sea continues to warm up there is a danger that the level of dissolved oxygen in the oceans will be reduced. A study reported last year in Science Daily says that 15% of the seas are "dead zones" and suggests that an increase of a couple of degrees - as has happened since the end of the last Ice Age - can have significant effects. Again, industrial pollution and waste dumping exacerbate the damage.

http://peswiki.com/index.php/Directory:Oxygen_Depletion


The Tatchell article also refers to a claimed 30% drop in oceanic oxygen-producing phytoplankton in the thirty years since 1980, though this is disputed. Even if true, our gas tank will keep us going for the foreseeable future: the Earth's atmosphere has a total mass of some 5 quadrillion (10¹⁵) tonnes, a fifth of which is oxygen. There's so much that the CEI article concludes "even when fossil fuel reserves (mostly coal) are exhausted, the maximum potential loss in oxygen is only small (Broecker, 1970)."

Further, as this 1994 paper by Duursma and Boisson says:

"Oxygen concentrations are ... the consequence of larger terrestrial and aquatic loops in which factors of temperature, light, nutrients and co2 play a role; for longer periods, elements such as sulphur and iron are involved. Hence the present level of 20.946 vol. % of atmospheric oxygen is merely temporary, and will change in the course of millions of years. The question of an optimum concentration for sustaining life on earth is equally time-dependent; but bearing in mind that these changes occur over periods of the order of millions of years, evolutionary processes are likely to keep pace with oxygen changes."

Those evolutionary processes may or may not have a place for humanity in the long run, but we have plenty more pressing threats to worry about. One of which is that the health and productivity (for us) of the seas may be compromised if warming continues and subsurface oxygen is depleted.

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The sun also rises

Jesse:

... the governance of Britain which as we have said is semi-feudal, ruled by a few corporations and the wealthy elite in partnership with essentially a one party government.This will go a long way in helping to understand the "British disease" of economic stagnation. You start by crippling the middle class through debt indebtedness to a corporate elite.

So sorry, an error in transcription: for Britain and British, I should have written Japan and Japanese. Gomen nasai. But an understandable mistake, you may think. How much difference will a regime change in the UK make? The inclusion of Ken "fags and Bilberberg" Clarke on the Opposition team seems a deadly marker to me.

Returning to our muttons... Jesse has been focusing on the Land of the Rising Sun recently. He's pointed out that an ageing demographic structure is a major brake on the economy, especially with tight controls on immigration (though we in the UK may have have drawn the wrong conclusion from this); and today he looks at how the Japanese have organised themselves to reduce energy costs and oil dependency.

Especially the car: "I have long thought of cars as vampires sucking the economic life out of every household in the US. And the risk of death and serious injury from car accidents is about half what it is in the US (although the statistics may not be directly comparable)." And considered from a coldly economic point of view, think of the enormous overall costs of those deaths; and the possibly far greater costs of medical care and other support for the vast and growing army of injured and permanently disabled.

It's well worth reading the whole letter from Jesse's friend in Japan - not just about energy, but preventive healthcare etc. They walk to McDonald's - not waddle. They're organising themselves; so can we.

Janszen says next bubble will be in energy

A "bubble cycle" instead of a business cycle... house prices to revert to trend and fall 38% from peak... a $12 trillion gap to plug with fresh securities in a different sector as the current bubble collapses... government legislation to clear the way for the speculative rush... $12 tn + an extra $8 tn = $20 tn... it's going to be... ALTERNATIVE ENERGY.

Read iTulip founder Eric Janszen's Harpers article.

"Caloriefornia or bust!" Any views from energy investment specialists (e.g. Nick Drew)?

The answer to Olduvai?

I am most grateful for a comment by "APL" on the heroic "Burning Our Money" blog, which directs us to an article on the potential of radiation-free fusion energy.

There is an international project (ITER) in the south of France to develop this, and if it works...

UPDATE

Thanks to GMG for a link to this discussion of fusion power, which tends to the conclusion that a successful and economically viable fusion system is a very long way off, if feasible at all, and we'd do better to concentrate on fission, i.e. the present type of nuclear power station.

Money vs The People

(Picture source)

Money can improve happiness, below a certain income level; but above that point, the relationship is not so clear. And maybe there are distinctions between money, investments and wealth...

In Financial Sense yesterday, Robert McHugh comments:

When the Master Planners devalued the dollar over the past five years, they raised the cost of living for everyone. The Middle Class is getting annihilated from this silent event. Incomes are not keeping up. This was done because this administration “equates stock market success with economic success and has directed their efforts to drive up equities at literally any cost,” to quote one of our subscribers.

...but Tony Allison looks forward to a more energy-efficient future:

Change is seldom welcomed by most humans, but it can often bring about positive results. It is impossible to know what year the effects of peak oil production will barge into our living rooms, but change is on the way. The adjustment period to a permanent supply crunch will likely be very difficult, but some effects may be beneficial. For example, we could see a re-birth in local farming and manufacturing, as food and industrial products become exceedingly expensive to transport. We would see more public transit, more freight train transportation, more bicycles, more energy efficiencies of all kinds working their way into society.

Puplava: this isn't the big one

I'm a bit behind on my listening to Financial Sense Newshour, but as ever, the issues we're talking about aren't momentary. Jim Puplava's view (8 September) is that this crisis isn't the big one: the US will reflate its way out. It can't do that on its own without sacrificing the dollar, so (as has been happening for a long time) there will be cooperation with other nations' central banks. In effect, we are in an international currency inflation cartel, since no trading nation wants a hard currency that leaves its industries high and dry.

But, says Jim, the next recovery will be shorter, and the next fall back much worse. He sees this as happening around 2009/2010, which coincides with the time of Peak Oil, in which he is a big believer. That's when he feels the energy and credit crunches may come together. He sees gold and silver soaring to levels that currently seem fantastic.

For us ordinary people, that may be less interesting than the effects of energy shortage on our daily transportation and domestic heating.

The outlook from Financial Sense

Some voices and topics from Financial Sense, 25 August:

inflation, deflation, gold, cash...

Jim Puplava: ...I've had Bob Prechter on this program and Bob is a deflationist and Bob believes that we get deflation first and then hyperinflation where I guess my views are we get hyperinflation and then what follows will be deflation. And that's the way it has unfolded with great debtor nations. And I think history will repeat itself here with the US. There is too much debt here and it has to be inflated away...

...I really believe that the full force of these storms aren't going to hit until somewhere between 2009 and 2010 when this really comes home to roost. And all of these debt problems, the problems that we have with energy today, availability, peak oil, the geopolitical problems in the Middle East – I do not expect the next decade to be a pleasant one, John. I wish I could say otherwise because as a father with three children, one to get married shortly and looking forward to grandchildren, you know, this is something that you don't like to think about...

credit bubble, credit crunch, commodities, East delinking from West...

Doug Noland: ...the economy is much more vulnerable than many believe because of the credit that was going to the upper end; and I think the upper end mortgage area is where we had the greatest excesses.

So I think when all is said and done, subprime losses are going to be small compared to the losses we see in jumbo and Alt-A, and especially, unfortunately out in California...

...there’s desperation out there to find buyers for mortgages... Washington generally doesn’t understand the risk of Fannie and Freddie [US government-sponsored entities - "GSEs" - that offer mortgages], so of course they would think it’s their role to step in and provide the liquidity.

But... their total exposure is over 4 trillion dollars now. And this is a huge problem, and I fully expect down the road these institutions to be nationalized. And I think the US taxpayer is going to pay a huge bill for this... To be honest, I don’t mind the GSEs if they want to play a role in affordable housing; if they wanted to try to rectify some of the problems at the lower end because of the lack of the availability of credit in subprime. But to think that the GSEs should start doing jumbo mortgages, to try to be the buyer of last resort for California mortgages, my God, it’s hard to believe that makes sense to anyone because that’s just a potential disaster. It’s also reminiscent of the S&L – the Savings and Loan problem that, you know, was a several billion dollar problem during the 80s that they allowed to grow to several hundred billion by the early 90s. And definitely, the tab of the GSEs is growing rapidly right now...

...even if the central banks add a trillion dollars of liquidity to help out this deleveraging we still have this issue of how are we going to generate the trillions of additional credit going forward to keep incomes levitated, to keep corporation earnings levitated, to keep asset prices levitated, to keep the global economy chugging along...

...The global economy may be something of a different story because we have credit bubbles all over the world. Like the Chinese bubble right now is pretty much oblivious to what’s going on in the US and in Europe. You can see a scenario where, you know, you have serious credit breakdown but let’s say Chinese demand keeps energy and resource prices higher than one would expect. So I’m going to be watching this very carefully because we’re going to see some very unusual dynamics as far as liquidity and inflation effects between different asset classes and different types of price levels throughout the economy.

Puplava on the coming oil crisis

Jim Puplava's Financial Sense, 14 July (3rd hour transcript): this leads with the coming energy crisis, especially in oil. Puplava's programme features an interview with Basil Gelpke, who has made a documentary on oil called "A Crude Awakening".

Demand is rising, and will continue to do so even if there is a world economic slowdown, because the developing world aspires to Western standards of living; supply is not keeping pace, as exploration and extraction become more difficult and expensive. R&D in alternatives has been inadequate. The crunch could start as early as 2009.

Jim draws two broad conclusions:

1. Prepare to live in a world where energy is much more expensive. There are obvious implications for your transportation and housing.
2. Invest in energy stocks.

Puplava on the commodities bull market

Jim Puplava's Financial Sense Newshour, July 7: having discussed what he sees as a long bull market in energy, Puplava turns to other commodities such as gold and silver: "the best protection in inflation has always been gold and silver, which represents real money". He sees a new "leg up" in the market within 3 to 6 months, because of the continuing inflationary expansion of money and credit. Another factor will be A&M - "junior producers" being acquired or merged to achieve economies of scale.

So as a hedge against inflation for the small investor, he recommends regular savings into a mutual fund in energy and precious metals, or even commodity ETFs (exchange traded funds) in energy and food.

Puplava on the energy market

Financial Sense Newshour, July 7: Jim Puplava sees a long bull market in energy.

This is because there is a long-term upward trend in demand. In the West, we use more devices in the home - and in the US, new homes are actually getting bigger, requiring more energy for space heating; and in the developing world, people are keen to join the consumer lifestyle - "Next year, emerging market energy demand will surpass industrialized countries' energy demand for the first time in history". Meanwhile, extraction costs are rising.

Puplava sees 3 themes in relation to the energy market:

• efficiency
• new types of transportation (e.g. hybrids), or more use of old types (e.g. railways, barges)
• substitute fuels (e.g. ethanol) / alternative energy resources (especially nuclear, solar and wind)

Peak oil, commodity prices, globalisation, back to the land

An interesting article from Tom Stevenson in Britain's Daily Telegraph, on oil. He reaches two conclusions:

1. it's good news for the commodity investor
2. when supply hits its limit, demand will have to change, and so will our lives

The second is far more interesting. I think we will eventually start listening to the dreamers who are even now formulating new currency systems for localised commerce. And we'll need to unwind our dependence on the car. Think of the implications.

Energy crunch = higher food costs

Continuing the theme of energy demands, the Contrarian Investors' Journal comments that the search for alternatives to oil is causing inflation in food prices.

Energy crunch?

Frederick Sheehan's article Reaping the Whirlwind, originally posted in Whiskey & Gunpowder, is reproduced today in Prudent Bear. The prose is rather poetic, but the issue is how an overheated world economy is straining the world's capacity to grow energy supplies to cope. Worse still, new housing designs in the US and upgraded housing in the developing world, are building-in permanent excessive energy demand.

What a bear!

I am reading Richard Duncan's book "The Dollar Crisis" and plan to review it in detail here soon.
Meanwhile, searching for information on him, I stumbled across a different, but similarly-named author, Richard C. Duncan, who propounds what he calls "Olduvai Theory". This is a real spine-tingler. It looks at the history of world energy consumption per capita and concludes that we passed the peak a generation ago. He says industrial society is a unique and unrepeatable period, has a life-span of some 100 years, and will decline fast, starting in 2008. I hope he's wrong, but it gives us a terrific motive to look after the world much more carefully.

But instead of concentrating on the fear, which is how journalists sell their papers, let's look at the themes this throws up: increasing world population and everyone's aspiration for a higher standard of living. So there are very powerful driving forces pushing up the demand for food, water, land, metals, and energy sources. This is why the Daily Reckoning says commodities are an asset class that will dominate investment for the next 15 years.