APRIL 2014

The Devil’s Excrement

Buying cheap energy has been essential to maintaining the Western world’s standard of living. Since the US dollar left the gold standard Central Banks have been able to contain energy prices with the growth of credit, however, the ‘Central Bank of Energy’ ultimately holds the trump card.

Hyman G. Rickover, the four Star American Admiral and ‘father of the nuclear naval fleet’ gave a speech nearly fifty years ago (1957) titled ‘Energy Resources and Our Future’ in which he stated: “We live in what historians may some day call the Fossil Fuel Age…fossil fuels, being coal, oil, and natural gas, resemble capital in the bank. A prudent and responsible parent will use his capital sparingly, a selfish and irresponsible parent will squander it in riotous living.”

For the last two centuries we have blithely utilized inexpensive high quality fossil fuels to increase our standard of living and produced, as bluntly put by Matthew Boulton, the man on our £50 note, “a commodity which is the desire of kings - power.” Two great military and economic empires have harnessed this power, the British Empire with coal priced in Sterling, and the American Empire with oil priced in Dollars. Energy coupled with currency equals power.

Energy Pricing
Until 40 years ago energy was priced in a currency which was fixed to gold. This stable relationship between numerator (energy) and denominator (gold) allowed for the successful extraction of high calorific fuels, providing the economy with the critical energy leverage for growth. However, as the calorific quality of the fuels dropped and costs of extraction increased, the energy equation de-levered, economies slowed and the standard of living came under pressure. The inelastic price denominator of gold led to the inability to offset the energy deleverage. Something had to be done to maintain growth.

New Rules - just in time
In 1968 President Johnson eliminated the need for the Fed to hold gold to back the US$; this break was sealed in 1971 when President Nixon took the US$ off the gold standard. The denominator in the energy equation became the US$ backed by credit rather than by gold. The first test of the new credit denominator arrived in 1973 with the oil crisis, which was a direct reaction to the prior years’ US$ devaluation, even though under the guise of a political event (the Yom Kippur war); energy prices spiked three-fold.

The second test arrived with the 1979 Iranian revolution which came at the end of another two-year US$ devaluation; energy prices subsequently rose four fold. The third test occurred in 2008 with rocketing energy prices that followed another period of currency devaluation.

Put simply, credit leverage has increasingly replaced energy leverage. Central banks have sanctioned and encouraged the use of credit to offset the de-leveraging effects of energy. This can be clearly seen in a rather easy way. Energy prices have risen 30-fold since the early 70’s. As the US$ is now simply credit, we can apply the Total Credit Market Debt (TCMD) numbers from the Fed’s flow of funds report as a proxy for the denominator; this has also grown 30-fold in the same time period, from approximately $2 trillion to $60 trillion. The purchasing of cheap energy is intractably linked to the Western world’s standard of living. Therefore the Central Banks have continually endorsed an increase in credit in order to maintain the status quo relative to energy. This outlook has a ‘spillover effect’ on asset prices that are being buoyed by credit.

Schoolyard bully
There are effectively two central banks at odds with each other - the central bank of credit and the central bank of energy; each with its own leverage mechanism; these are infinite for credit, and finite for energy. Central banks have used credit to manage energy, but on three occasions their shortcomings have been displayed, and energy has broken the bank. 

Juan Perez Alphonso, co-founder of OPEC understood and feared the central bank of energy, famously uttering that energy “is the devil’s excrement.” Central bankers should heed these words.

Let the games begin...


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