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Financial Sense Newshour

The BIG Picture Transcription

September 27, 2008

Part 1

The Beginning of the End

JOHN: Hey, Jimmy P., it’s really good to see you. I haven’t seen you in a long time. Listen, I’ve got this little deal for ya. I’m from the government, and I got this little bailout that I want you to get involved in here.

JIM: Uh, no thanks. Not interested.

JOHN: Let me see if I can explain this to you a little better. You really do need this bailout.

I had to admit to myself that, if you remember, just 24 months ago when we started into this whole presidential cycle, remember when on both sides you had all these men and women standing up there in all of these debates, Ron Paul was considered a pariah. People would look at him – I remember Romney looking at Ron Paul like “where did you come from? What is it you’re talking about” blah blah blah. I remember that. All right. And yet everything Ron Paul was talking about as being essential –that we get back to sound money and get this nonsense under control – has now come home to roost. You don’t hear a lot of people on CNBC and elsewhere admitting that, but I think the man deserves his due on this.

JIM: And you know, I think you and I had the comment, John, I supported Ron Paul as a candidate to the presidency – I’m an independent – and you and I were talking about this: “I think he’s ahead of his time.” And of course, when the primaries – going back to the beginning of the year, we did have a little bit of a blowout in February and March and especially with the Bear Stearns crisis, but we recovered from that, the markets began to go up, we had the stimulus package come out, the Fed was still lowering interest rates and people were just saying, “Look, this stuff works, you’re a weirdo.” Remember in some of the debates he wasn’t even welcomed. In fact, he was excluded in a couple of them I thought because he was looked upon as this strange guy with strange ideas, and of course if you’ve ever watched the testimonies that take place twice a year in February and July when the Fed goes before the Senate Banking Committee and the House Finance Committee, he’s the only guy on the House that questions the Fed chairman that makes any sense. You notice lately, John, that in the last discussion they have bigger name tags now for Bernanke and Paulson.

CONGRESSPERSON: Seeing as how you were the former CEO of Goldman Sachs, what percentage level of investment were you not…

BERNANKE: You’re confusing me with the Treasury secretary.

CONGRESSPERSON: Is that the wrong firm? Paulson? Oh. Okay. Where were you, Sir?

BERNANKE: I was – I was the CEO of the Princeton Economics Department. [2:41]

These are the people that are now solving our crisis and they don’t even know who works at who, and that’s why they have to have big name cards. [2:48]

JOHN: Yeah, one of the Congressmen went up to Ron Paul a couple of weeks ago and said, “Well, I thought our monetary system was based on the gold standard.” It’s sort of like, okay, and you have been where?

I will say this much though: these congresspeople run from meetings to meetings and a lot of times they run into a hearing like that and they plop down and somebody has to shove a bunch of paper under their face and they’re supposed to act like they know everything about everything. And they don’t, let’s face it. They just don’t.

JIM: No, and it’s like you can see them when they walk in there: “What are we discussing here?” But it’s absolutely amazing to watch this thing unfold. You know, we call them weekend huddles, but with the case of Washington Mutual there was a run on the bank. We’ll get to that in just a minute – and they couldn’t even wait till the weekend, so here we are, another weekend as they go in with another bailout bill and who knows how long that’s going to last. You had Wachovia stock – they’re already supposedly in merger talks; they could be next. You have National Bank – they could be next.

Let me just bring up one of my screens here that takes a look at the amount of credit losses and write-downs. Oh my goodness, did we see a jump this week. Worldwide, we have now jumped to 557.3 billion in capital losses, and I started out this week or last week at 513; we’ve had 389.6 billion in capital raise – and you can see if you go down the list: Citigroup, 55 billion in losses; Merrill Lynch, they are now gone; Washington Mutual, 45.6 billion – they’re gone; Wachovia, 23 billion – they may be gone. It’s amazing to see. It’s going to be almost like ‘last man standing;’ we may have three or four large banks – or superbanks – it’s kind of like these collateralized debt obligations they used to put together; they called CDO-squared and cubed. You know, you put enough of these guys together and what they’re doing here. They’re resurrecting in many ways the old banking system before Glass-Steagall. [4:54]

JOHN: It’s interesting – we’re going right back to where we were prior to the crash in terms of what we are doing right now. But you know, one of the things if you’re watching this week, everybody is talking, “okay, we’re in the middle of a crisis, we’re going to do this bailout and this will fix the crisis. That’s it. Then it will be over with and we get back to business as normal.” That’s the way they’re talking. That’s not really what’s going to happen here; this is really the beginning of the end.

JIM: And that’s what we’re going to do and we’re going to sort of take you through this –how this all started – because it’s unfolded over the last century. And it’s amazing – almost 100 years ago in 1907 we had a banking crisis; that’s the famous story where JP Morgan locked up a bunch of bankers at his house in a room and wouldn't let them out until they all ponied up with some money to get us through the crisis. And as a result of the 1907 banking crisis, in 1913 they had the creation of the Federal Reserve; and if you take a look at the value of the dollar since the Fed’s creation – I forget what the latest figure is – we’ve lost, what, about 95% of the dollars purchasing value. And the Fed was created as a stopgap measure so that we would not have these boom and bust crises that we had seen before; and the only problem was the boom and bust crises we had had before did not last that long and they weren’t that severe. So the Fed was thrust upon the American banking system and financial system and governmental system as a means of preventing all of this, and as we have seen repeatedly – especially after the next significant point in this crisis, which was in August of 1971 when the US no longer honored its obligations of backing the dollar with gold. By severing gold from the dollar, from that point forward we have had perpetual deficit spending; we have had bailouts, we have had higher rates of inflation and it continues to worsen and worsen and worsen with the greater role of the government coming in to the political system and the economic system. So when you hear a lot about free markets, we really don’t have free markets. We have controlled markets, and a lot of the aspects of our free market today – whether it’s the setting of interest rates, whether what’s going on in the stock market, it’s what’s going on in the currency market, what is going on in the commodity market – you have constant, constant government intervention. The more they tinker, the worse it gets. [7:31]

JIM: What we need to do here is a bulleted item as we call it, item by item of how we really got where we are today. We started back with the creation of the Federal Reserve in 1913. That’s really where we ignored the Constitution – I think one of the guests on the metals roundtable said that - because the Constitution says that we’re supposed to have a monetary system based in gold and silver, and they did a little end run around it there. Then we went through the first crash, then they created the Glass-Steagall act.

Now, we’re going to have to jump forward here towards the Community Reinvestment Act of 1977, and that was during the Carter administration; and just so people know basically what the Community Reinvestment Act did – this required banks to make loans to minority groups in underprivileged areas. It was a social engineering project, which really had moved forward from the time of Lyndon Johnson and the Civil Rights movement, but as a result of this Community Reinvestment Act what it did was force banks to begin abandoning what to that point were very well accepted standards for making loans. That was the beginning of it, and then later on there would be changes to it which put it on steroids. [8:38]

JIM: That originally was in 1977, and of course they expanded that. But you know, another change also happened too that contributed to where we are today, and that was in the 1980s with Wall Street coming in and acting as almost as the beginning of the shadow banking committee – and that was securitization. So if you went back to the 70s, it was you sitting before your banker, you were submitting a loan application, you’d have to prove your income, supply several years worth of tax returns; the banker would assess your fiscal soundness and financial soundness. A loan was made and the banks would keep the loans on the books. [9:17]

JOHN: Basically what you’re saying here is that at this point the bank was at risk if you defaulted on the loan, so they had to be picky about this because it affected their balance sheet.

JIM: Absolutely. So – and that was also too, remember, you had to come up with 20 percent down – there was equity at stake here. You just couldn’t walk in like what we saw in this decade with no money down and no proof of income. But I think securitization came into play so banks could sit there and make a loan, turn around, take those loans to Wall Street; Wall Street would package them into some kind of mortgage-backed security and then investors would buy it. So maybe the banks would service – they would get a service fee – but since the loan wasn’t on the books, there was less of a risk for the banks and so they could offload those loans onto other entities. But securitization began with CDOs and mortgage-backed securities and in the 80s became a popular instrument – especially back then when you had 11 and 12 percent interest rates. I mean I can remember in the 80s doing a lot of business in Ginnie Maes. You could get 12, 13 percent monthly income from a Ginnie Mae and it was a very popular investment; it was backed by the government.

But I think the next significant change on the road paved to hell, so to speak, was in 1987 with the appointment of Alan Greenspan because remember, under Volcker, Volcker cut the supply of money, he raised interest rates, he put in a lot of safeguards in terms of what institutions could do and then all of a sudden, Alan Greenspan, appointed by Ronald Reagan in 1987, within a couple of months of being appointed we had the stock market crash of 1987, we had the beginnings of the president’s committee working on the markets (or the Plunge Protection Team). And then also in 1991 – here’s something very significant too because in 1987 to the S&L crisis in 1991, something that also became very popular which was broker CDs – in other words, you could be a small bank and all of a sudden brokers would raise large amounts of money for a lot of these S&Ls.

And by the way, that’s one measure to judge how serious of a financial strait your banking institution is in is the amount of broker deposits because when they’re not getting deposits, they need to get money in to keep their capital ratios. They need deposits. And a lot of times when that isn’t happening or they’re losing money, a lot of the banking institutions will turn to Wall Street and brokers and then all of a sudden, brokers start bringing money. So there’s another way to decide whether your banking institution is in serious trouble. [12:07]

JOHN: So when we started with Community Reinvestment Act –that was in 77 – and the securitization of the banks in the early 1980s, those were not directly connected were they – to start with. I mean these were two different events. Or was the securitization enacted to make this possible, even more so, or were they just simply saying separate things which ran parallel? [12:26]

JIM: Well, I mean Fannie and Freddie operated with securitization because that was their charter – they would sit there and raise money. But it became more popular as institutions looked for new ways, new products to sell; investors were looking for ways to maintain yields, and they became even more popular in the 90s and this decade as interest rates came down. Because remember, John, in the 80s under Volcker, you had real interest rates that were above the inflation rate – far above the inflation rate – and people were getting double-digit interest rates. They could get them in government bonds, Treasuries, T-bills, bank CDs, government backed bonds like Ginnie Maes that were paying 12, 13 percent. I can remember 13 and 14 percent Ginnie Maes from the beginning of the decade of the 80s.

Okay, when Greenspan came in, he was a serial money printer. Anytime there was a crisis – the stock market crash in 87, the S&L crisis and recession of 91, the Peso crisis of 94, Asia 97, Long Term Capital Management, Russia, Y2K, the recession of 2001, 9/11 – every single time that we were in a crisis he would lower interest rates. And if you were retired you were looking for double-digit yields, what happened is as he brought interest rates down, people extended their preference for risk and all of a sudden people were looking – “okay, where can I get a high rate of return?” Well, it was junk bonds – and that ended in a fiasco at the end of the 80s. Then it was mortgage-backed bonds and so on. So as interest rates came down – and today is a good example – as I call up my bond screen here for looking at bond interest rates around the globe, we’ve got rising inflation rates around the globe and we’ve got interest rates – there’s not a Treasury obligation today that compensates an investor for the effects of inflation. And that’s because the government is printing money, investors are scared, so money is going into the Treasury market, driving down yields, and it’s a situation today where people are grasping at straws. They are grasping at where can I get a rate of return that adequately compensates me for the not only business risk that I’m taking, but the inflation risk. It’s very hard to do. [14:51]

JOHN: So Greenspan came in 1987 and then almost immediately we went into a crisis. It’s like getting hit in the face right as you walk through the door. We inflated our way out of the Savings and Loan crisis of 1991, and then enter the Clinton administration and the Community Reinvestment Act of 1995. So what happened during that?

JIM: Well, what they did is they began to strong arm banks and they even created audit committees to make sure that banks were making enough of these loans to areas that were blighted, areas that had minorities, that began really the sub crisis in lending. I mean if you take a look at what they were doing, what we’re seeing today is all of those loans that have been made over decades are now causing these chickens to come home to roost. I mean a lot of this too gets backs to when the Fed inflates and they bring down interest rates they create the incentive for all these things to go wrong for banks that made all these loans. Now we want to whip them up.

Earlier this year, there was a lending institution that was held up as the model lender because of its involvement in making these large loans – we’re talking about Countrywide, which failed earlier in the year and was taken over, but Countrywide had made 600 billion dollars in low income or subprime loans as of 2003. And of course, essentially all those subprime loans bankrupt Countrywide and they are now merged with Bank of America. But it was held up by Washington as a prime example. They were also a major contributor.

Here’s the thing that you don’t see – Chris Dodd, head of the Banking Committee getting a sweetheart loan, well below market rates from Countrywide; Barney Frank – all of these guys were involved with Fannie and Freddie; and going back to 2001, to the president’s credit he tried to rein in Fannie and Freddie but there was just too much opposition in Congress. And now, of course, we’re seeing the after-effects of this.

But John, it gets down to once again, the Fed creates the boom; and then what happens when the bust comes around, they look for pointing fingers at somebody else. ‘It’s greedy lenders.” The government always points the finger away from itself. If you take a look at the 2001 recession – over the next couple of years, Greenspan would slash interest rates to one percent and he would keep them there; and when you bring interest rates down to one percent, you encourage borrowing, you encourage speculation. I mean we saw things in the banking industry – it encouraged Wall Street to securitize these loans because people were looking for high yields at a time that I can remember in 2003, the 10 year yields was down to 3.3 percent. People were saying, “I can’t live with 3.3 percent. I can’t live with one percent CDs.”

So what happened is people began to speculate and they began to go into investments that were unsound and Wall Street was there and as the old saying, when the ducks are quacking you feed them. And that’s what happened. People wanted and they were searching for high yields, and so there was a set up. And that’s what got us to the mess that we’re in right now. [18:08]

JOHN: Remember in 1999, everything really started to go flat then. If you’ve listened to CNBC they wouldn't admit that at that time, there was all the hype about – remember we went through the little upturns and the little downturns and “not to worry, it’s all back to normal.” But it really went flat, and then the real reason for this recession was offloaded onto 9/11 two years later. So we had Fannie doing something in 1999 as far as easing credit. And what did that involve?

JIM: They lowered their lending standards and this was urged on by the Clinton Administration and in fact, by Clinton appointee Franklin Raines became the head of Fannie, and this was one of the problems. At the time that we were going through at the beginning of this decade, the Enron, the WorldCom scandals – well, guess what? - Fannie and Freddie were cooking the books, and yet Franklin Raines who ran Fannie walked out of there with 90 million dollars in salary. Johnson walked out with multiples of tens of millions of dollars of salary and they were cooking the books, and that’s what happened when the government hired Morgan Stanley to look at Fannie’s books this summer: they were all cooked; the losses were much greater than what they reported. They hyped up their balance sheet and their income statement in order to get the big bonuses these guys were pulling out. And Fannie and Freddie were one of the biggest lobbyists on Capitol Hill contributing over 200 million dollars to Congressmens’ campaign coffers. [19:30]

JOHN: Which is why Congress was reluctant to do anything about it at that stage. So we went into this recession in 2001, Greenspan’s response to it was to do what?

JIM: Lower interest rates, slash interest rates very much in the same way Bernanke began last August cutting interest rates and I believe the Fed maybe getting ready to do that once again.

But you know, here’s something also that happened in the late 90s is not only were we offloading much of this mortgage debt into the securities market and we were creating these exotic instruments – whether it was collateralized debt obligations, or these SIVs, or CDO-squared and cubes – we created a lot of debt and a lot of times we were putting the debt off the balance sheet just as the government takes a lot of stuff off its balance sheet or off its budget. The thing is it still exists, but from an accounting point of view we don’t treat it like we normally do. We have our regular budget and then we have our off budget. And that’s what a lot of these entities have come back to haunt many of these financial institutions as they’re having to bring a lot of these SIVs back onto their balance sheet. And then on top of that, as homeownership was encouraged also by the way, in the Bush administration and because of securitization you had these no-documentation loans. Not only did we have no-money-down loans – and that’s what I think ticks people off is you have somebody who puts 10 percent down, 20 percent down on a house or even more – makes their payments, has a fixed rate mortgage, had been responsible – we’re bailing out people who put no money down, lied on their loan applications, people that did not tell the truth in terms of their income, who had no way of ever owning a home. They didn’t have the means for the downpayment, and they didn’t have the income to support the payments. And all of this is coming unwound right now and basically why I think people are so upset is because of these government programs – whether it was the Community Reinvestment Act or it was the securitization of loans, the loose lending practices that were used by many of these financial institutions –all of them that were making loans were using them – now it’s all come home to roost and we’re saying for those of you who have been responsible, you’re going to have to pay for all of this. [21:50]

JOHN: Ultimately we came to have to recognize that this thing really didn’t hold the value that everyone had on their books so we started to see a series of writedowns.

JIM: Yeah, we started – we’re pretty much through the subprime mess, now we’re going through Alt-A liar loans, and then we saw with AIG what can happen with credit default swaps. And I’m very much concerned about between a 25 and 30 percent increase in corporate default rates next year as the economy weakens, we’re going to see a lot more of this come home to roost. I mean if credit default swaps can bring down a giant like AIG that had a trillion dollar balance sheet, you can look forward to more of this. And I think next year, the next crisis to really begin to unfold next year is credit default swaps and counterparty risk. I mean right now we’re just dealing with the bad mortgages and that’s why you’ve seen so many of these entities going on.

And then when you move forward into 2010 to 2012 you’re going to have to get into option ARMs which is amazing that JP Morgan is now owning Washington Mutual because Washington Mutual was a real big player in the option ARM market. In fact, they were the entity when I wrote my Day After Tomorrow series in 2005. I used an entity – I called them Citywide, it was really Countrywide; and most of the loans that they were making back then were option ARMs, and these were five year mortgages and what happens is you have the option of making a full amortized loan, making your principal and interest payments – you could do interest only, or you can make below interest and principal payments. In other words, let’s say your payment is 1500 dollars, you may have your payment set at 1200 each month, your mortgage gets bigger because you’re adding more interest and more debt onto the balance sheet.

Now, the problem is these loans or the payments only go up about 7 ½ percent a year during the first five years of the loan. At the end of five years, then they get adjusted to a full amortized loan at whatever the current interest rates are. So the loan’s generally going to be 25 percent bigger than they were originated and instead of below market interest rates you’re going to be making above market interest rates. So there is another crisis that’s going to hit us in 2010 and 12 between those two years. So credit default swaps, counterparty risk – that’s what’s coming up next; and then after that it’s going to be option ARMs between 2010 and 2012.

So folks, what you’re seeing Congress pass this weekend is just another installment payment of many, many more to follow. [24:36]

JOHN: Obviously, casualties have been falling like – what do we call it? – dominoes. It’s been astounding. Like you said last week, who would have imagined had we a year or so out from this whole thing that all of this would have been going on. If you had said that 24 months ago, people would have told you you were crazy. As a matter of fact, people were telling you that you were crazy!

JIM: They were. Here we’ve seen Bear Stearns gone, Lehman gone, Merrill gone, AIG gone, Wamu gone, Fannie, Freddie and probably Wachovia and next National Bank and a few others will be going next. And they let Lehman go and I think it was a major mistake. Lehman was a primary dealer and the next thing you know, you had massive runs on money market funds, so now the Treasury stands behind money market funds.

There are a number of things they need to do. First of all, they got rid of the uptick rule, they allowed naked short selling to take place. Then the other thing they did is they allowed mark-to-market accounting, and as you know, John, when you have fear in the market, you can have a dollar asset priced and fall to 20 cents even though its real value may be worth 60 cents. So they’re going to have to deal with mark-to-market accounting, or panic and fear is going to make this worse.

And the problem is this model that this economy operates on, it operates on a constant increase and flow of credit. If you look at the increase in Fannie loans, the increase of government loans, the increase of commercial loans, this is a system that runs on credit. What happens when this credit begins to dry up? Well, you know what, the government becomes the credit, and credit is what powers this economy and in a fractional reserve system, as you have today, in our banking system, it requires economic growth; and you know what, John, here’s another storm that we’re going to get into in our next topic, what happens when you can’t grow the economy, when you don’t have the energy to grow the economy – that’s going to be the killer storm – and it’s a topic we’re going to get into in just a moment. [26:42]

JOHN: The problem that you have when you deal with this – and we’re looking at the issue – remember, everyone’s been storming their congressmen and senators complaining about this bailout – as well they should. I’m just sorry they didn’t wake up to it, say, ten twenty years ago that this is where we were headed. But having said all of that, the moral argument for part of the bailout is either a) we’re going to keep the economy afloat – and there’s a lot of truth to that, let’s face that; b) but the second thing is you’re bailing out people who failed on their commitments. Now you can try to offload the blame for that to maybe bad lending practices or something like that – there’s always the old principle of caveat emptor – right? – that’s the buyer beware. But other people are just furious, saying, “Wait a minute, we struggled to keep good credit. We struggled to pay our loans – we succeed in doing that. Why should I be put on the line for this?” We’re transferring wealth again – almost conversely, transferring risk is what we’re doing.

JIM: I think it’s socialization of risk. And under a socialist system what you do is you take from those that produce and have the means and give to those that don’t. And that’s exactly what’s taking place here. The Community Reinvestment Act might have been a good, altruistic idea, but we’re seeing its chickens come home to roost here by keeping people who really can’t afford to buy a home, or make the payments. And when they can’t afford to make the payments, or can’t afford to come up with the downpayment, then what happens is the government has to subsidize that. Whenever they subsidize that, you’re talking about socialization. So you’re talking about taking money from people that work and produce and make their payments. [28:27]

JOHN: We’ve been getting some emails from listeners this week asking some really very important questions, like, “we hear about all this price tag for the bailout,” and they’re saying, how will this be paid? “Will I see a jump in my taxes; or how am I going to see this?” because they hear all this talk about taxpayer’s bailing out these bad loans. So why don’t you explain that because this is going to be a really big price tag.

JIM: It’s going to be a big price tag and it’s going to come with higher taxation; people that work and play by the rules are going to be asked to pay more of this, so taxes are going up. Don’t believe for one minute it’s just going to be rich people who are going to pay the tax, because rich people are already paying the majority of the taxes. Taxes are going to go up. And then you’re going to get hit with the invisible tax which is inflation. They can only raise taxes to a certain level then people begin to scream. So what is going to happen is you’re going to get hit with the invisible tax which is what you’re seeing right now. The cost of things that you need are going to go up, and inflation is going to go up because we have an 800 billion dollar trade deficit, the budget deficit numbers – who knows where they’re going to be because there is so much stuff that they have on budget and off budget. The Iraq war is off budget, the clean up of New Orleans is off budget; anytime you have hurricane damage and government assistance, that’s off budget. There are so many things taken off budget that we’re probably looking at in the next couple years where we’re going to be in true form – I mean last year the national debt went up by 900 billion dollars and yet we were running deficits in the 3 and 4 hundred billion dollars. So we’re looking at trillion dollar deficits, 800 billion on trade deficits – the government is going to have to finance 1 ½ trillion dollars. Where is that money going to come from? And that’s why this crisis – as I mentioned, what you’re seeing unfold this weekend in this bailout – don’t believe for a moment this is the last of it. You will see another bailout that will come into play with whoever becomes the next president of thee United States, they’re going to need another stimulus package – they’re already talking about that; and this 700 billion, believe me, folks, is not going to do it. It’s going to get worse next year, it’ll get worse after that. So like I said, eventually who’s going to bail the US government out, which is the current topic in one of the recent issues in Forbes – is the US going broke? An article by Laurence Kotlikoff.

Just in front of me, John, these are just some of the papers from last night’s reading. They were talking about FDIC. Kotlikoff talked about all these bailouts are going to mean that the coffers at FDIC, which were lowered during the good times, are not adequate enough to take care of what’s coming and FDIC is going to have to be recapitalized to the tune of almost 200 billion dollars. So there’s another bailout coming that the taxpayers are going to be on the hook for.

You know, a friend of mine expressed it rather aptly. He said you know, 20 years ago, the bank investigated you; 20 years later, you better investigate your bank. As many people woke up this morning when they logged on to their Washington Mutual account and it said “welcome to JP Morgan.” In fact, the Washington Mutual directors didn’t even know about this until after it happened. And this is just going to be an unfolding process, and all the 700 billion is going to just buy us a short period of time before we’re going to have come up with another bailout program. [31:53]

JOHN: What if I could get them to take my income tax off budget, what do you suppose? Or just take it off period, and we’ll call it good.

JIM: What you have to do is you have to take your income off budget, so that way when you file you have no income.

JOHN: I think that’s called fraud. Which is a good point. You see, if you or I were to do all this stuff, this would be illegal. Let’s face it, if you tried to do that, but there comes a point – think about this – we have this baby boom crisis heading toward us, nobody is talking about Social Security right now and the unfunded liabilities that are coming up on this side. We’re going to go roaring into this crisis virtually bankrupt. I don’t see how any way they can even make this one up now. They can’t even play with those numbers to make it happen.

JIM: No, it’s virtually impossible and that’s why Comptroller of the Currency as we mentioned last week, David Walker, said last year when he laid out two scenarios. Scenario 1) do it right now and take care of it, which would require raising tax rates 44 percent and lowering government spending 20 percent, extending the retirement age, placing limitations on who receives Social Security – that’s now. Wait until the next decade and it’s raising tax rates 88 percent and cutting government spending 44 percent. And as you and I have talked here, John, there is no way that you’re ever going to see a politician get up in front of a group of people and say, “if you elect me, I’m going to raise your taxes 88 percent and cut government spending 40 percent.” That’s just plain and simple – it will never happen. [33:26]

JOHN: So what happens when the day of reckoning gets here? What’s going to come out of this whole thing? I can see one thing and that is probably a big newly collateralized global type of currency because other currencies are going to be affected by this as well.

JIM: Oh sure, because I think next year you’re going to see – it’s going to be a year filled with currency crisis – not only with the dollar but you’re going to see a crisis in the euro and other currencies and those are some of the big themes that we’ll probably be talking about next year that I see unfolding is credit default swaps, counterparty risk and a currency crisis. So just a heads up. This is going to get more interesting as we move forward. [34:05]

JOHN: coming soon to a government near you. We might as well make a trailer for it, what do you think?

Anyway, all right, if you didn’t think that was bad enough, stay tuned, we’re going to do more. You’re listening to the Financial Sense Newshour at www.financialsense.com.

Next topic we’re going to talk about the killer storm. It sounds like a novel. I want to read this thing.

We’ll be back in a second.

FSN Follies: League of Ordinary Gentlemen

PRES. BUSH: Over the past few weeks many Americans have felt anxiety about their finances and their future. We’ve seen triple digit swings in the stock market. Major financial institutions have teetered on the edge of collapse and some have failed. There is a spirit of cooperation between Democrats and Republicans and between Congress and this administration. In that spirit, I have invited Senators McCain and Obama to join Congressional leaders of both parties at the White House tomorrow to help speed our discussions toward a bipartisan bill.

The League of Ordinary Gentleman. Their powers are ordinary. Their origins are Ivy League; their methods are extreme. But when our future’s at stake, they’ll be the nation’s last hope.

No one knows what to do. You could ask Bernanke, you could ask Paulson, they don’t know what to do.

LOG – League of Ordinary Gentlemen.

The Killer Storm

JOHN: Well, just when you thought things couldn’t get any worse, we are plowing right into the crisis window of 2009 to 2012. We might even scrunch that back to 2013 or 14, Jim, by the time that we’re done. But what is really clear – everyone is hyperfocused right now on this imminent crisis that we have right here – the fallout from Fannie and Freddie – what they don’t understand is that we’re coming into an energy crisis and the proposal that both candidates have proposed reflect a desperate ignorance of exactly what this crisis is going to look like. It is not an energy crisis, it is a liquid fuels crisis – in the real acute form. And furthermore, it’s a question not of total quantity out there, but rather the flow you can generate. I think that was the most important thing Matt Simmons said – was it Matt, or if it was Richard – but it’s flow that’s important, it’s not just exactly what you say is available on this oil field or that oil field. And these things are going to collide together and then we’re going to skid into the baby boom issue as we’re coming out of this. It’s going to be a disaster is what it’s going to be. I’m sorry but I don’t see how we can dodge this bullet right now. [37:11]

JIM: No, and the disaster – you know, when I went up to ASPO and I got a chance to listen to the talks there –as you’ll hear in the second half of the Big Picture as you listen to Robert Hirsch, Matt Simmons and Chris Skrebowski talk about what’s going on – the more and deeper you look into this the worse the picture looks and the more nightmarish the scenario is.

And one of the problems that relates to the credit crisis that we talked about in the last hour is our economy runs on credit; credit requires economic growth and increasing growth and to increase economy growth you need energy. And the problem that we have right now is 70 percent of the consumption of energy in this country goes towards transportation. It’s the cars that you drive, it’s the trucks that bring the goods to the store, it’s the trains that transport goods or materials such as coal to utilities; it is the jets and planes that people use to travel; it is the boats that cross oceans to bring us these products. They all run on liquid fuels, and we are doing nothing to increase the supply of liquid fuels and that’s why when you hear these nonsensical debates by the presidential candidates – “well, I’ve got a plan and a clean energy bill to create a gazillion jobs, and the US will be energy independent” – that is stupid. It is plain stupidity! You can’t put in a windmill on a boat. You can put a sail, but you can’t put a windmill on a boat. You can’t put solar panels on a 747. A crane that loads freight containers off a ship in Long Beach runs on diesel fuel. The car that you drive today runs on gasoline or diesel.

And when I see these people get up there and they give these soundbite clichés and everybody claps their hands, “oh, wow, he’s going to make us energy independent.” Neither candidate understands a damn thing about the energy issue, and it is remarkable – absolutely remarkable to me that they could be so energy illiterate. We did a roundtable back in February with Robert Hirsch, Jeff Rubin and Matt Simmons, and there were briefing papers that were prepared by Robert Hirsch to every one of the presidential candidates of both parties; there was only one candidate – and I won’t tell you which party that was interested – and he was obviously not one we would be voting for in November. There was only candidate out of both sides that really understood the critical importance and the issue that faces us in the next two years. And that’s something even the guys on Wall Street cannot see that this whole credit boondoggle that we’re dealing on right now is dependent on the creation of more forms of credit which require more economic growth which requires more energy. [40:37]

JOHN: You mentioned something there about trains. Trains could run if we converted out the infrastructure – they could run on electricity if we went to a European type system – you know, trains with pantographs that haul the electricity off. The could work. You could do that, but look at the amount of conversion time that’s available. But you’re right, you can’t do that with ships, you can’t do that with airplanes – it might be interesting, I could picture it; but I don’t think it’ll work. [40:59]

JIM: In anything we want to do, whether it’s converting to a train system like they have in Europe, if it’s building a nuclear power plant –if it’s building a refinery, goodness gracious, should we ever think of building a refinery outside of the hurricane belt; or you know, someplace where we don’t have earthquakes. Or something like that, if we’d ever think of something like that. If we’re going to get a lot of our heavy crude, which is what OPEC now produces the most of, or what we get from the tar sands or what we’re going to get from shale, that requires a different kind of refinery process than the light sweet crude stuff that we get from let’s say Nigeria or Norway, or even some of our own producers. But John, we’re not doing that. Any of the solutions that we’re talking about here have to be implemented immediately and we almost have to go to wartime footing to start putting these things in place: power plants, pipelines, alternative energy; all of that stuff takes time. Even if we were to enhance the railroad – and my goodness, it just absolutely blows me away.

And this is from Bloomberg, Friday, and it was interesting because I was having dinner – what was it? Monday night – in the hotel restaurant and there was a group of us at a table, and lo and behold, in walks the governor with his staff members and his security guard, and Arnold is going to hold a climate summit in Los Angeles. We were talking about global warming – and I hate to tell you, folks, but we’re going to global cooling. That’s what the climatologists and the scientists are telling us as we’re seeing unusually cold temperatures as we did in China, as we’re seeing in South Africa today, and even this summer which has been mild. But global warming, which may or may not happen 40 years from now versus peak oil which is right here on our doorstep, or certainly right around the corner – depending on how you define it, whether you’re looking at conventional fuels or non-conventional fuels. And Matt Simmons makes this comment – google global warming and find out how many hits you get, and then type in peak oil; and it just goes to show you the emphasis – we’re focusing our attention on the very wrong issues. You solve peak oil, you’ll solve global warming. [43:30]

JOHN: Well, the world consumes right now about 30 billion barrels per annum. Now, according to Matt Simmons, peak discoveries – we peaked out right at the end of the 1960s – that’s interesting in terms of finding new sources. In terms of conventional crude oil production we hit peak in May of 2005, and what we need based on the current demand versus supply issue, we need to find four million barrels more of oil per day, given the growth in demand; plus another million to allow for growth on top of that. Basically five a day just to keep par with where we are. That is not happening, and so, as you were saying before, everyone is fussed up about global warming – that may or may not come about and there is a shift in the scientific opinion on that but we won’t go into that – the point is this is crossing our doorstep right now, or at best, within this crisis window that we’re talking about.

JIM: And you hear demand destruction, demand destruction. I drove to Sacramento for ASPO because it was faster than taking connecting flights to get up there, which would have taken 8 or 9 hours. And it’s amazing because at the beginning of the 20th Century we consumed a little over a million barrels a day, by the 1950s it was 10 million barrels, by the 1980s we were up to close to 60 million barrels, by the 1990s, we were approaching close to 70 million barrels, by the beginning of this decade, it was close to 76 million barrels, and right now it is close 86 million barrels. So you can just see from this decade alone with the growth in China and India, and the fact that we’re not discovering, not replacing and I don’t know where these people are talking about demand destruction. They told us that oil consumption would have peaked in the 90s, and we found out that wasn’t the case. Even if you look at the numbers –and as you’ll hear with Matt and some of the others that follow in the next hour – we’re dealing with fuzzy data at best; but if you take the IEA’s latest mid term report which was issued in August, we’re talking about one-tenth of a percent demand destruction in OECD countries, and then we’re talking about almost 4 percent demand increase in countries like China, India and OPEC itself. The world makes 50 million cars annually, and over half of that growth is coming from China.

So if you take a look at this great demand growth that’s coming from the transportation sector, which goes back to a point made at the beginning: This is a liquid fuels problem. And as you’re going to hear in the next hour with Matt – even in the IEA’s most recent report – and I imagine that’s going to be revised because they’re issuing a report that’s going to come out in the middle of November that talks about where they’re studying the 250 largest oil fields in the world, most of them are now into decline. But the IEA increased its depletion rate from 4 percent to 5 percent and as Matt has talked about, if you talk to people in the industry like the executives at Schlumberger or Baker-Hughes that actually work on these rigs and decline rates in fields, they’re saying that the depletion rate is probably closer to 8 percent. And so Cantarell for example the second largest oil field in the last 12 months, its depletion rate is 32 percent. And John, we’ve seen it so many times from 2001 when you and I started doing this program together – every time we have a run up in oil to a new level and then it pulls back and people breathe a sigh of relief, and they go, Phew, we’re getting back to normal again. And we saw a run up into July where there was oil prices up at 140 and then it pulls back, and whenever it goes up to a new, higher level they gotta find a new scapegoat rather than deal with the problem. This last one, it was the speculators. Well, the government Interagency Task Force said, no, it wasn’t the speculators. And where is the talk about the speculators now that the price is at 106 dollars a barrel. You don’t hear anything coming from these guys. And every time it goes up – last time it was the speculators, before that it was the oil companies, before that it was the dollar, before that it was the weather, before that it was terrorism, before that it was because of the war – all the way up, from 20 dollars a barrel they’re looking for somebody to blame. And if there is one thing that is they're running out of scapegoats. Who’s going to be next? Maybe it’ll be OPEC they’ll talk about. But they’ve not done a damn thing about this, and this is going to be the biggest crisis we’re heading into, and you can forget about the Fed printing money, creating money – it’s not going to create barrels of oil. And this crisis we’re facing, you’ve got Schwarzenegger talking about a global climate crisis. There’s one thing I got driving up to Sacramento is how dependent the state of California – the seventh largest economy in the world – is on the automobile. After 20 years of economic growth and 2 million new people in San Diego, we’re adding two lanes to the freeway. This is how stupid all of this is. [49:01]

JOHN: It has become really obvious to me of late in watching what everyone’s been saying – the pundits – when you realize they haven’t gotten it right at all, when we’ve been making these ups and downs in oil prices – as a matter of fact, they were always casting blame in one direction or other: it was the speculators, et cetera – and then we had the unseasonably warm weather for a while there and everyone starts yelling global warming, and that ran for awhile, but it’s not tracking in those directions. And when I watched last week I thought to myself, you know, for the last 8 years these guys haven’t gotten hardly anything right. Why are people still listening to them? So that’s the puzzle mark on there. Maybe it’s important to understand that because as we go forward, we don’t want to be listening to those who don’t get it right.

JIM: And you know, there are a lot of people saying the bubble is over, and if you take a look at the price of oil it begins a run, and then in the final stages of that run before it corrects, it’s almost like a parabolic rise. We saw that leading up to 2005, we saw it again in 2007, we saw it again this year – and that’s the way it runs. It runs right up, then it comes back and if you look at it on a chart, you’ve got higher lows and higher highs and anybody who knows anything about reading a chart, that tells you we’re in a bull market. I get so angry when I see them – and John, you can see this – “have we hit bottom in the financials yet; have we hit bottom in the financials yet? Are the homeowners bottoming? Is the commodity bubble over?” I hate to tell you folks, we’re going to 200 dollars oil and after 200 dollar oil, we’re going to 300 dollar oil. And at some point, we’re going to go to 4 and 5 hundred dollar oil, and at some point the price of oil is going to get so high it won’t matter what the price is – you will not be able to get it. And speaking of don’t get it, you’ve got 535 people in Washington that still don’t get it.

Right now, they’re looking at this bailout in credit and our society has moved from a manufacturing society to a service society to a financial economy society that is dependent on the government creating a constant flow of debt – borrowed money, more fiat currency that depends on economic growth and economic growth is made possible only from energy; without energy you don’t get economic growth. And the point is this whole economic model is coming to an end. That’s what we’re going to see in this crisis window, and the biggest storm that is ahead of us is not this credit crisis – this is a sideshow. The real crisis is going to come when you won’t have the electricity to flip on a switch, or you won’t have the gasoline to put in your tank or the diesel fuel to fill the truck. And as Matt Simmons said this week if you watched the Hunting for Black Gold – it’s a CNBC special – and by the way, you might want to check your program listings, they’re going to reshow that, I believe it’s on Sunday – he goes, When the trucks don’t get diesel, the goods – the food on the shelf – disappears in five days. [52:25]

JOHN: Plus he said people tend to – and he said you can take this one to the bank, but as people perceive a shortage – especially in fuel – they go and top off. It’s the same thing as a run on the bank, this is a run on the gas station. That alone, he said, if Americans just start doing that, that will drain the system in a very short amount of time. He said getting the system back up and running from a drain off would be a challenging, daunting task.

JIM: It would not only be a daunting task, I mean anyone who’s ever been in an area that’s been affected by some accident of nature or weather – whether it’s a hurricane, a tornado, or it’s an earthquake – knows what’ll happen. Everybody wants flashlights, batteries, try going to a Home Depot after something like that happens. We had an E. Coli breakout a couple of years ago, and you went into the grocery store and there was no bottled water; it was gone. And that’s what’s going to happen. One of the speakers talked about I forget which city or state the main colonial pipeline that comes in from the Gulf that was damaged with these last two hurricanes, the newspeople – typical what they are – came on and said, “we’ve only got two days left of fuel in the city.” What do you think happened, John, within less than 24 hours? [53:36]

JOHN: Run on the stations; right?

JIM: Yeah, a run on the stations. And that’s what’s going to happen here, and the fact that we’re not addressing these issues – this storm will be bigger. Like I said, this is going to be the killer storm. It will be the storm that really deals the death blow to the credit system that we’ve built our entire economy on – the fractional reserve system, the ability to create money out of thin air, the ability to expand credit, securitize credit – all of this is going to come to an end, and if you own good energy stocks, if you own energy service stocks, don’t panic, don’t fear, don’t let your broker talk you out of it. We’re going to have to rebuild this energy system that we have that is corroded, it is built on steel, steel rusts. You’ve got prices right now, they’re messing around in the futures market – not only do we have shut in capacity in the Gulf of Mexico, you’ve got natural gas producers that are shutting down their rigs right now because they can’t produce at the prices where they are. So they’ve messed up the futures market, so badly with intervention here, that you now have energy companies that are shutting down. They’re saying, “we’re not going to drill at this level. I’m not going to take precious resources out of the ground and sell them at a loss.” That’s what we’re seeing. That’s how distorted this is. [54:59]

JOHN: So we’re doing the opposite here of what we need to do. In other words, at a time when we need to be exploring and drilling, we’re not doing it, we’re shutting down.

JIM: And what was it, the Pelosi No Drill bill, which would have virtually shut down the building of clean-coal, it would have shut down nuclear plants and it would have shut down drilling. It’s like that college exam, the answer’s not a, b, c, or d; it’s e, all of the above. And we need to be doing all of that. so what is going to be forced upon us will be conservation because that has the most immediate impact. You just simply are going to have limited access to travel when this crisis hits. I always love when they demonize the big oil companies – and that’s a misnomer – they’re no longer big. In fact, we call them ‘Baby Oil’ because the Exxons, the Chevrons, the Texacos have access to only six percent of the world’s reserves. The other 94 percent is owned by either OPEC, the former Soviet Union and various other countries and we’re sitting there trying to demonize these people. You just look at this debate and all of this stuff – this nonsense that is going on in Washington, it is so corrupt. It really reminds me out of reading chapters out of Edward Gibbon’s The Decline and Fall of the Roman Empire of the corruption. I mean you’ve got guys leading this charge that were taking campaign contributions from Fannie and Freddie; they were getting sweetheart loans from Countrywide and they’re out sitting there pontificating about their concerns when they are as corrupt as can be. It’s no wonder the American people are angry. [56:40]

JOHN: Let us do some recapping here. Let’s recap what we’re talking about because this is important: 1) We’re not doing what we need to do right now to deal with this situation; 2) remember that the situation is a flow problem – it’s an availability of how much you can make flow at any one time; 3) and especially it’s a liquids fuel problem (that really gets lost, you’re right about that, Jim, in the public debate; they keep confusing wind and solar with what is required to keep the world’s transportation system going – this is a liquid fuels issue); 4) the alternatives –of which I’m very much in favor – will not be ready to go for another five, 10, 15 years before you can change out the infrastructure and the fleet. So that means that we are coming into what I call a bottleneck period. This is an unavoidable period. The clock is ticking and we’re not doing anything. So conservation will work. However, people need to begin thinking in those terms as far as their own personal activities as far as, what, Jim, commuting? As far as what kind of cars they drive, how they work, where they do their work, and even where they live at this stage of the game. [58:02]

JIM: And they’re also going to have to think in terms of how they invest in the future; what’s going to be impacted when you have limited access to energy. I mean there is the whole consumer-based society, and that’s one of the topics that I gave at ASPO – the death of the consumption society. It’s not going to work when you have limited access to fuel, or when oil is at 200 or 300 dollars a barrel.

The economist, Jeff Rubin, from CIBC has talked about the wage differential between the United States right now and China, it is actually cheaper to produce steel here because even though the wage rates may be cheaper in China, by the time you add transportation costs, which act as a tariff on fuel, it is actually more expensive by the time you put it on a ship and ship it over here. And this is something that you’re going to have to think going forward in terms of the type of investments because the economic paradigm, the economic model that we have built on the constant expansion of debt and credit in a society is going to come to an end here in the next two to three years during this crisis window. And we’re going to go back to a much simpler society, or as Charlie Maxwell said in his Barron’s interview recently, “you will live closer to your friends, your vacation’s are going to be local.” Well, you’ve got to expand that to think of how you’re going to live, what kind of investments are going to make sense in this kind of energy constrained world because, folks, do not be fooled by what the price is. Just as, you know, you might have thought I was crazy in January when I said it was going to be 125 dollar oil, and then 145 dollar oil, we’re going to be right back up to those kind of prices by the time we get to winter and it could even be worse if we start having geopolitical factors start to kick in. As you’ll hear in the next hour with Chris Skrebowski, when he talks about the project delays that we have in many of these large oil projects – I shouldn’t say large because by comparison to what we were doing 20 and 30 years ago, they’re small by comparison – but these projects have been delayed, they’ve been extended due to weather related items, cost items, personnel problems; and these delays are becoming more frequent.

You’re also seeing the big giant oil fields in decline, and you know, I have never seen a society and especially what is most important here for the United States, we’ve got about 4 or 5 percent of the world’s population and we’re consuming 25 percent of the world’s energy. I can tell you, that mix is going to change in the next decade, and especially when people are unwilling to take dollars. In other words, we are going to have to start producing goods and trade by producing goods to get the other things that we need because just printing dollars and money out of thin air, that model is not going to work in the next couple of years. [1:00:57]

JOHN: I think we need to tie this back to the crisis window as we talked about it because we’re in this issue right now, or in this storm. Politicians are trying to tell us it’s a storm if we just do the right things, ie a bailout, that everything will stabilize; that we need to do this for the economy. And the implication is that everything is going to go back to business as usual. That’s not going to happen; we’re going to have a continuous series of storms, just on the financial side of the issue alone. But what happens when these hurricanes collide with the whole energy issue and it’s all going to be in the same window. I think at that point, as you say, Jim, when there’s no more expanding credit and expanding economy, that’s going to sink it right there and that will take it under.

JIM: And you know, when it all emerges, it’s going to be a different society. It may look very much like the kind of society that we had at the beginning of the 20th Century. You won’t have the kind of social transfer programs that we have today, like Medicare and Social Security because the system we simply won’t be able to afford it as Laurence Kotlikoff has so eloquently expressed in his book, The Coming Generational Storm, and more recently in his article in Forbes. We simply will not be able to afford 4 trillion dollars a year. It’s going to be a simpler society. It’s going to be a society where you don’t go out and hey, I want something, and I go out and borrow it, put it on the charge card or take out a home equity loan. It’ll be like our grandparents were; you will work, you will save, you will not spend like you do today and if you do want to buy something, you’re going to pay for it with cash. It won’t be: run it up on the credit cards and when my credit cards get run up, I’ll just take out a home equity loan and pay that down. That is not going to work. And so, like I say, the economic landscape, the market landscape and the governmental landscape and lifestyle landscape is going to change dramatically. And I just don’t think people have any idea of what’s coming. I mean you’re getting a glimpse of it, and what you’ve seen in the last four weeks – but folks, this is just the warm up; this is, like I said, a warm up and a prelude of things to come. [1:03:14]

JOHN: The sociological implications here, as I see it, are very important because you have a whole flock of baby boomers here and in Europe and in Japan that are moving into retirement age, right as this storm is hitting. They are expecting a certain amount of Social Security to be there; they’ve been assured Social Security is going to be solvent up through 2040 or something like that. That’s horse hooey. It is not going to be there, period. And that will have tremendous sociological, medical and other implications that I don’t think anybody is thinking about right now.

JIM: No, they’re not even thinking, they’re just assuming. And that’s where I think energy is going to play a very important role because all of these debt-based, socialized economies are based on this constant economic growth where the social system can tap into it to pay for all these things. It’s not going to work. It’s not going to work; you will not have the wherewithal to pay for this. And simply printing money when this – all of this debt is inflated away is definitely not going to be working, and you’re seeing part of that right now. The chickens are coming home to roost. The Community Reinvestment Act that told banks that you have to go into these blighted areas and minorities and people that didn’t have the means, start making loans and a certain percentage of your loans had to be proven that they were being made to these kind of constituencies – that is coming home to roost. All of the money printing, the lowering artificially of interest rates, the artificial booms that were created in technology in the 90s and real estate and mortgages in this decade – those chickens are coming home to roost. And I think what people are really getting a glimpse of and why they’re so angry is they know this was artificially created and they’re being asked to pay for it all. And that’s what I think angers most people. [1:05:17]

JOHN: All right, Jim, we’ve talked pretty rough today on the program in terms of where things are going because I know you’re really passionate about this at this level because you care. I think that the caring comes through. But now for the people who are listening, what are they going to do? You know, because we’re going to get that from emails, we’re going to hear about it. People want to know: What do I do? That’s always the question.

JIM: We’ve had pretty much a consistent message here over the last six, seven years. One, don’t take on debt that you can’t afford. Yes, we’re probably headed for a hyperinflation – a lot of people think, well, my debt will be inflated away. But how do you know that you’re going to have a job, or the wherewithal to maintain your debt. So don’t take on debt that you can’t afford. And a message that we’ve been talking here over the last 7 years about we’re getting down to the basic things of life: energy – and that’s going to become more important going into the future; precious metals - because it is the only money out there and store of value that is worth anything when you live in a fiat currency based world where paper can evaporate or the value of a company can evaporate overnight; so we talked about precious metals and we talked about even in this pull-back that you take precautions – if you don’t have enough money to buy gold, well, you know what, you can buy silver. We talked about the importance of food. Our warehouses are at the lowest level that we have seen in half a century for our grain supplies and the amount of week’s worth of food that we now have. Water – where you have half the world that does not have access to potable water. Because that’s the kind of society we’re going to be in. And if you live in a house that’s leveraged and if you can’t afford to make the payments, then maybe your best case right now with the bailouts is to walk away from it and try to rebuild. If you work or live in a place where you have to commute long, long distances, you need to rethink that because it’s not going to work because when oil is at 200, and 300 you’re not going to be able to fill your tank because the access to gasoline may not be there. It may be rationed, it may be controlled. And think about yourself. And all I can say is do not look to Washington to help you out of this. Start thinking about yourself, your own community, your own family because when it boils down to everything – family, that’s what you need to take care of, and you need to do it yourself because one promise after another is going to be broken by government. And if you’re basing your future on government being able to bail yourself out, help you out, provide for your future you’re going to be sadly disappointed. [1:08:20]

JOHN: And when you’re done thinking about yourself and your family, remember your tax deductible contributions to the Save the Loefflers foundation because we could sure use it.

Anyway, coming up next we’ll be listening to some of the talks and addresses which were given at the ASPO conference in Sacramento, California last week, featuring among others, Robert Hirsch, Matt Simmons and Chris Skrebowski. And later on we’ll take your calls on the Q-Line. You’re listening to the Financial Sense Newshour at www.financialsense.com.

Part 2

JOHN: Well, how was the ASPO conference last weekend. You were up there, and what happened?

JIM: It was amazing, and you heard this from a lot of speakers – you had geologists up there, you had scientists up there, you had professors up there, people from government – and the amazing about all of it is the closer and the more information you find about this, there really isn’t a happy ending to this. I mean it wasn’t one of humor and we thought it was bad but it’s getting better. No. The more you dive into this, the more details you look into this, the more frightening it becomes because unlike the credit crisis that we’re going through now almost on a weekly basis in fact with the takeover of Washington Mutual – there was a run on the bank and they couldn’t even wait for the weekend. And of course, this weekend, what do we have? We have Congress debating on a bailout bill, and this will be the first of many to come. But you know, the thing with a credit crisis, the Fed can print money out of thin air. When you hit an energy crisis, it exacerbates the credit crisis because the credit crisis is based on all these economic growth models. Well, how are you going to get economic growth when you don’t have energy? And that is what is facing us in the next decade where we could be looking at rationing, we could be looking at price controls. And if you think things are bad now, then unlike the credit crisis, the Federal Reserve and the Treasury can’t flip a switch and create barrels of oil, power plants or refineries out of thin air. A lot of that stuff takes time.

What we’re going to do is we’re going to listen to three speakers from the ASPO conference. The first one will be Robert Hirsch, who was part of our energy roundtable from earlier in the year; he will be our first speaker. That will be followed by Matt Simmons and then a gentleman by the name of Chris Skrebowski, who writes for Petroleum Review. And Chris is rather interesting as he takes a look at a lot of these mega projects – many of them are being delayed three years, five years, some as much as 10 years. And when you look at the energy supply side – let’s forget the demand side because demand is still growing – it’s growing at around one percent a year which means we’re needing to find roughly about a million barrels a day of new oil just to meet existing demand, but everybody talks about these projects, but a lot of these projects keep getting delayed from lack of personnel, lack of materials, cost structures going up.

And John, as I said, the more you look into this crisis, the worse it gets. So we’re going to hear from three speakers here. We’re going to begin with Robert Hirsch, then we’ll move on to Matt Simmons and we’ll end with Chris Skrebowski. And that’s coming up right now. [2:53]

Robert L. Hirsch, Senior Energy Advisor, MISI

What I’d like to do in the few minutes I have this morning is to talk to you about what we’re going to do about peak oil. We will mitigate. We don’t exactly know what will mitigate. We probably won’t know until the time actually comes. So what I’ve tried to do is to lay out some scenarios as to how this might develop. Let’s see.

Okay.

When peak oil comes, we’re going to begin to run into oil shortages. Oil shortages mean escalating prices, and shortages are going to mean economic downturn – very, very significant problem ahead. We’re going to mitigate. The question is how much and how fast. And that’s what the analysis is that I’m going to talk about today. I like to show simple pictures. This one shows oil production and demand increasing linearly over time. It shows that there is spare capacity – has been in the past – we’re now getting down to the point of having less and less spare capacity and as indicated last night, it may even have run out. At some point then, there will be a turndown in world oil production. There will be shortages develop and those we will have to mitigate in various ways. The question is: how big is that particular wedge we are talking about there? I note on here the very important recent announcement by the IEA that they expect – they didn’t say peak – they expect spare capacity to run out around 2012.

Okay. A lot of background material. Here are two points I think are of particular note. One is from the Oil Shockwave experiment in 2005, and basically they make the point only a small shortage can lead to significant economic and security problems for the country. The spokesman for that, as I think you know, was Robert Gates and he is now the secretary of defense, and by golly, we’re seeing some interesting things out of the Department of Defense related to peak oil. The GAO study – and we’ll hear from Mark Gaffigan this evening – he was a lead in that study. They indicate the rate of decline after peak is an important consideration because if it’s a significant decline rate we have significant troubles.

From our study in 2005, a number of you will recall, we developed crash program mitigation, and our interest was in defining the best that we thought the world could do, not just the United States because this is world problem and we looked at technologies that were ready for implementation at that point. Implementation to work the liquid fuels problem – very important and sometimes people get confused this is an energy problem. It is an energy problem broadly in the century time scale, but in the very near future it is a liquid fuels problem. We looked at what was available and we showed that there would be a delay and then there would be a growth over time of both conservation and substitute liquid fuels. We had to plug that into a model for the world, and the model we assumed at that time was the pattern that occurred in the United States lower 48 states – which was well past its peak, which as you know occurred in 1970. That model, if you put some straight lines through, the usual wiggles one sees in the data, one can see a two percent increase up until 1970 and then a two percent decrease after that, and that showed then this wedge that had to be filled.

In that analysis we assumed that we didn’t know the date of peaking. So as this graph shows we assume that date to be zero. Okay. So the question then is we show this two percent growth and two percent decline and we went further in the analysis I’m about to describe to ask is indeed that the likely pattern, and what are the likely decline rates. [7:28]

Something that’s very important in all of this business and it’s the thing that a lot of people who think we can fix things quick really don’t realize and that is that small is huge in this business. First of all, US GDP world GDP - the world GDP dropped something like three percent due to the 1973 embargo and that put the world into recession. Also, one percent of today’s consumption is over 800,000 barrels a day. To save that amount of liquid fuels with a crash program in vehicle fuel efficiency - because we can do better with light-duty vehicles – would require much more than a decade under the best of conditions. To produce 800,000 barrels of let’s say coal-to-liquids in a crash program situation would cost well over 100 billion dollars and that number is probably low in light of what’s happened recently in terms of cost and it would take more than a decade. So small is huge.

What I’m going to talk about today is the relationship between oil shortages and world GDP. We’ve got an analysis model, we’ll talk about. We’ll take a quick look at giant oil fields and how they behave. The experience in North America and Europe I think is very worthwhile noting. Look at a number of future forecasts; see what they have to tell us. Talk about resource nationalism which is the wild card in this whole business and then come up with some scenarios.

Okay. First, world oil supply, world GDP. We need a number to be able to correlate what is likely to happen to world GDP as world oil shortages develop. We have data from 1973 to 1979, but the world had changed considerably since then, and indeed, there are many uncertainties and complications and unknowns, so precision in this endeavor is impossible. There’s no question about it. I will show you how we came to a conclusion that the percent change in GDP divided by the percent change in world oil supply is about unity. What that is is that is an order of magnitude number; that’s not an exact number. It is not 10; that would be too large. And it not .1; that would be too small. So something, a half to two – in that range – is probably likely.

This picture shows world GDP from 1986 to 2005, and world oil production and you see that the two tracked very well. Deutsche Bank calculated this ratio that we’re looking for for that period of time when there were no shortages. This is on the plus side of the ledger and that indicated a ratio of about 2.5; others use 2.0 and so forth. The point is it’s of order unity.

Okay. If you look at 73 and 79 where we had inflation, higher unemployment –growing unemployment – recession and high interest rates, the US GDP – this is US now – dropped by 3 percent in both cases. Oil supply was off by 4 percent and 5 percent in the two cases. You have to be very careful because of periods of times and lags and so forth; again, this is an approximation. So the ratios there were 0.7 and 0.8, which ends up being of the order of unity. If you look at what Oil Shockwave came up with in the analysis that they did where they were concerned – not about peaking but severe problems associated with terrorism – they saw a 4 percent global shortfall leading to oil prices of the order of 160 dollars a barrel and the US going into recession and millions of jobs being lost. Again, if you look carefully there, the ratio is about unity. Again, Robert Gates involved there along with a number of very other distinguished people.

Okay. So let’s develop a model. A number of things are kicked around in this business which I think all of you understand. One is the sharp peak which looks like what I showed you earlier, namely an increase to a sharp break and then a decline. In a number of forecasts you see a rollover and a roll down, and in other cases you have people talking about and showing plateaus. So those are the patterns that we’re going to deal with. A model that fits in that particular case is show here. You’re looking at oil production on the vertical axis as a function of time; oil production increasing until there is a trend break and then you go into a period of plateau, after which you go into a period of decline. The width of that plateau is very important because it certainly will not be without fluctuation – so that’s an important parameter in the problem we’re going to deal with. If you collapse the plateau and have a rollover and roll-down and you pick a number for what we’ll call a pseudo plateau, you have a plateau-like period where things are changing more slowly than they were on the upside and the downside and so that represents a special case of the model.

Let’s look at giant oil fields and what happened. This of course is Prudhoe Bay and many of you are familiar with what happened there; oil – by the way, interesting story, Harold Jamison was the geologist and he was the senior person at ARCO and they were ready to fold up and leave and Harry said, “let me drill one more well.” And they did – Harry did good after then. What happened is oil production increased; reached a maximum determined by the capacity of the pipeline and then went into decline and then it’s been in steady decline ever since. If you look at the reasonably well-managed giant oil fields in the world, ones that were not in places that had political revolution or managerially screwed up badly, if you look at a number of those you see the kind of decline rates that are shown here, which range from 8 to 16 percent. That’s a limiting case. I don’t expect – and I think very few people who would expect decline rates to be that large, but is kind of a marker as to what could happen.

Let’s look at North America and Europe. First of all, there’s North America and in particular the lower 48 states. I showed you the pattern earlier of 2 percent increase until 1970 when we peaked and then a relatively sharp peak and we went into decline at about a 2 percent a year decline rate. So there’s one of our patterns.

If you look at what happened in Europe. Europe, like all of North America was reasonably well managed according to free market principles without major interruptions or distortions due to politics. If you look at Europe in particular you see that they went along and their oil production increased to about 1996, and then they had a period of plateau which was about a 3 percent variation. Now, think back to what I said before – a 3 percent variation, 3 percent shortage, 3 percent problem in world GDP. At the end of that period they went into a 5 percent decline and that’s what they’ve been doing since. That’s a plateau example.

Another peak and plateau example is what happened in North American liquid fuels production. There was a rise to what is considered – ought to be considered a very sharp peak. There was then a decline rate of the order of 3 percent per year for a total of 15 percent decline before North America went into a plateau period and in this case it was a 4 percent variation over a significant period of time.

Now, one can dig into both cases and understand exactly what happened and one can then correlate that to what might happen in the world. We haven’t done that; that’s to be done by somebody in this audience I hope.

Okay. Summarizing then the patterns of what we saw there, the sharp break and 5 year decline. Sharp break in North America – 15 percent decline. If we were talking about a 15 percent decline in world GDP we would be talking about very, very serious trouble. The plateau case we had 6 years and 16 years of plateau and that was at 3 to 4 percent width, and then the decline phase in these cases was 3 to 5 percent. Keep that in mind and think back to what impact that might have on world GDP. [17:08]

Okay. A number of folks have made forecasts – and I’ll show just some of those that are representative. Colin Campbell in the graph on the left hand side shows a break occurring after a relatively steady increase to 2009; a peak to 2010 to 2011; and then 2 percent decline rate after the rollover occurs. There’s approximately a 4 year pseudo-plateau in that period with a 4 percent – for a 4 percent bandwidth decline. If you look at what Jean Laherrere shows. He shows a break in 2010, and much more gentle rollover of the order of 8 years going into then a 2 percent decline. [18:05]

So we’ve taken the 4 percent rollover decline as a pseudo quasi pseudo plateau, and that would of course lead to a significant but relatively moderate recession. So that’s how we’re looking at these

slow rollover forecasts. Chris Skrebowski who’s going to talk to you very shortly shows this. A maximum around 2010, 2011; a break in 2009; three years to a 4 percent decline in the rollover and roll-down that could be pulled out of his data. Friedrich Robles [phon.] at University of Uppsala did a number of different cases looking primarily at giant oil fields and came up with decline rates – plateau in one case, sharper and sharper rollovers in each case, and decline rates there ranging from 2 to 4 ½ percent. And I’m sorry – the slide slipped a little. And CERA indicates a growing production to a plateau in 2030. I communicated Peter Jackson on this. He says their data is good up until 2030. They think a plateau will occur after that and so they kind of draw it in. So that shows you their view of the world. [19:28]

Okay. If you take these pseudo-plateaus and the decline rates as indicated by these forecasts, you see what’s shown here. You can scan through that very quickly. Six years, 15 years, 5 years and varied period of plateau or effective pseudo-plateau for Friedrich, and decline rates of 2, up to 5 percent. And CERA, as Peter said, did not go into detail about the plateau, they just expect that will occur and they didn’t forecast a decline rate. [20:11]

Okay. A summary then of what comes out of looking at these forecasts as it is indicated here. These pseudo-plateaus as indicated by that little box with the rollover rolldown – a width that we assumed of the order 4 percent, which seemed reasonable based on what we had seen earlier for what actually happened in Europe and the United States; and that can last anywhere from 2 to 15 years; decline rates of 2 to 5 percent a year after that.

Okay. Now the wild card – Resource nationalism. We’re all well aware of the fact that things have been changing dramatically over recent decades. If you go back to 1950 or shortly thereafter the second world war, the national companies were relatively modest in terms of control of world oil, and the international oil companies – the Exxons, Chevrons, Texacos and so forth – basically were the big kids on the block. Over time, and this is strictly notional – it’s not an exact graph – we get to the situation that exists today, and that is the national oil companies have taken over and control the majority – the vast majority of the oil in the world. Those folks have different agendas than the international oil companies. And I’ll talk about that in just a minute. [21:29]

So the major players now are Saudi Aramco, the National Iranian Oil Company, PEMEX, Petrobras, Lukoil – so forth, and you can develop a long list. The diminished players – and the term ‘baby oil’ came from Red Cavaney, who is the president of the American Petroleum Institute. The Exxon that we love to hate every time there was a problem in fact is a very small player in the world now, as is Chevron, BP and so forth. Still very significant companies, with very significant cash flows and money and they will play significant roles in the future, but they are now small. The American public is going to have a fit when they can’t blame Exxon. [22:16]

Okay. The international oil companies were profit oriented; for their stakeholders they were well managed generally. They were technologically strong, they were efficient, they were transparent. They had long time horizons and they were good solid corporations. They screwed up along the way like any of us do of course, but they were by golly very sound operations.

The national oil companies on the other hand owe their allegiance to their capital and to their president or whoever their emir or whoever it may be. Bringing cash out of the business is important in many cases. Some have very poor management, low reinvestment – which is something the IEA is worried about – very short time horizons and in fact some are financially very weak. [23:05]

Okay. The reality is that there are more people at ASPO-USA conferences as Steve indicated and there are more people paying attention to peak oil, but peak oil has not yet passed into a major factor in public and governmental thinking in most places in the world. It hasn’t crossed that threshold yet. My feeling is that the situation will be that there will be a panic when people begin to realize that this is a terrible, terrible terrible problem. That’s basically what happened in 1973 and 79. The announcement came – there was still plenty of oil, but many people – all of us maybe – many of us – went out to fill up our tanks and put some gasoline or other fuel in shortage, and by god we sucked the system dry and shortages appeared right away because of panic. [24:08]

For oil exporters, when people begin to realize that this is a problem, I believe that oil prices will increase dramatically from where they are now. The good old days will be 90 dollar oil, and these oil exporters will have another major windfall. Some of them are likely to reduce their exports. Why shouldn’t they? If you were Mr. Putin, who’s already written a doctoral thesis on this very subject; if you were an emir in the Middle East, you’ve got a lot of money coming in, you don’t really know what to do with all that money, you’ve got a resource which is being depleted. A number of those folks are very likely to cut back on their exports and I call that ‘oil exporting withholding.’ If you were involved – if it was your responsibility and your country and you were reasonably concerned about the well-being of your people, then I suspect most of you would hold back in a situation like that. But for the rest of us who are importers, we’ve got problems. [25:16]

So the notional picture – and I like to put up these notional pictures – looks like this. World oil production if it was a geological limit might look something like the rollover that the forecasters talk about, but this oil exporting withholding scenario – OEWS – would indicate that the exporters will withhold oil from the market and peaking would occur at an earlier date. IEA, of course, has – as was indicated last night – begun to talk about these problems. They said that the increase of the surge in funds that have gone into oil and gas investments are illusory because the cost of everything has skyrocketed, and they say real investment in 2005 was barely higher than the year 2000. That’s not a good sign. The future is unsustainable – remarkable to come out of a political body like the IEA and we are doomed to failure. We’re on a course for an energy system that will evolve from crisis to crisis. I don’t understand how this didn’t make the front page all over the world. Anyway, excess capacity and demand are converging, and peaking (which is effectively what they’re saying) will be 2012 and the reason for this is the national oil companies and their behaviors. [26:42]

Okay. So let’s then come up with our scenarios. The original pattern shown on the left hand side – sharp peak, a rollover and a plateau – out of that and from this analysis we come up with three planning scenarios: the very best one, the first one, is a plateau case; the second one is a middling case – I call it a ‘middling’ case – it is a sharp break like occurred in North America; and the worst case is we’re headed towards a sharp break and oil exporters begin to hold back. That’s shown here – plateau might be 2 to 15 years, decline rate of 2 to 5 percent (that’s the range that we saw); middling case sharp break, 2 to 5 percent again; worst case – a decline rate faster than 2 to 5 percent. And as you think about that in world GDP, it’s not a very pretty picture. [27:41]

So let’s go back and take a look at what we did before. A number of you remember this picture – what could be done on a crash program basis; the most optimistic that we could conceive that could happen in the world – that kind of a pattern. A delay, then rapid growth. The question we raised then was can mitigation overtake oil decline. All right. Let’s put that together into two different pictures. In this particular case we’re looking at crash program mitigation – let’s assume (because we’re doing an approximation) that we get to 100 million barrels a day and have a 2 percent decline rate (it’s shown in the heavy blue line there) and in comes our crash program mitigation which is started at the date – at the date of the decline. It shows what the shortages would be, and with our correlation, world GDP might look like that. If we have a 5 percent decline rate, we’re talking about a very rapid drop and again going back to our correlation we’re talking about an extraordinarily serious world GDP problem. [28:58]

In summary, to remind you – I think you all know this – that small percentages represent huge impacts in this whole business. I’d remind again because of some things that were said yesterday – this is a liquid fuels problem, it is not an energy problem. Windmills are not going to run the cars that we have now and the machinery that’s out there that represents 50 to 100 trillion dollars worth of investment. That isn’t going to change quickly and electric power isn’t all of a sudden going to run our vehicles and our trucks and airplanes and so forth. A percent reduction in world oil supply about equal to a percent reduction in world GDP – there will be maximums that can occur either sharply, but in all cases they’ll be followed by decline. Resource nationalism is the wild card in this business and it is essentially, I believe, unpredictable. We came up with three cases: A best, a middling and a worst. Plateau if we’re lucky – if we’re really lucky. That would be good. As people begin to plan on what they do with their personal lives and hopefully what government begins to do in planning on what happens after peak oil, you have to choose how you’d behave in each of these three cases.

And then the last slide – the more you think about it, the uglier this business gets. [30:24]

Thank you very much.

JOHN: That was Robert Hirsch speaking at the ASPO conference this weekend where you also spoke, Jim.

And by the way, their website is www.aspo-usa.com.

Coming up next we have Matt Simmons. I listened to his talk – and I think the most salient thing he said and mid to normal that he presents is the fact that so much of the data that we’re dealing with here as far as who has what in the way of oil and what will be available are very fuzzy numbers. We don’t really have hardcore numbers when we’re trying to figure all of this out.

JIM: No, because if you take a look at OPEC data which is supplied, the numbers from OPEC are numbers they give us; there is no auditors, there is no accounting firm that goes in and says, “well, okay, you produced this,” or, “is this the number you have produced?” We have no idea, all we can do is guess at it. The same thing when it comes to their reserves. You notice when you read the BP Statistical Review, the more that they produce each year and every year, their reserves virtually stay unchanged. And so a good portion of our energy complex, John, is never audited. They’re just best guess numbers. It’s kind of like the inventory reports that come out every week, and as we have said so often on this program there is nobody out there with a dipstick that is monitoring everything to report on it. So, absolutely amazing.

Let’s listen to Matt Simmons. [32:00]

Matthew R. Simmons, Chairman, Simmons & Company International

And I’d like just say that as someone who attends probably more energy conferences than almost any of you here, I thought the quality of the speakers yesterday afternoon and evening and all throughout this morning was really as high a quality as any conference I’ve ever attended. Now, I think the clarity of the information – this is a very complicated area because we have such unbelievably fuzzy data. It would be fabulous if we could end up finally some day having data reform, so that we wouldn't have to keep groping with connecting so many different dots. But I was also struck by Bob Hirsch’s last slide that the more you dig into this, the uglier it gets; and the more dots I dig into, I feel that – ever find something that makes me feel better. I think the problem is getting worse. So let me basically see if I can quickly walk you through where I see the issue of peak oil today and how to gauge the risk. [33:00]

The debate between and the optimists and the pessimists persists. It’s getting actually louder. The growth though in the people interested in the issue can be measured just by the simple statistics of the growth of membership of the various ASPO chapters around the world. I earlier this week went to Google and hit peak oil and I got 303.1 million hits; then I went to global warming just to see how that compared and there were 80.5 million hits. So that gives you some idea that we’re getting some awareness and traction, but we are infinitely behind an issue that most people think is more important; and it’s an issue that won’t impact us for years – global warming – and peak oil could literally change our lives over the course of the next few years. [33:44]

There’s a spate of new peak oil studies, the GIO report that came out in the spring, the NPC report on Facing Hard Truths that I’ll mention in a minute. Then you have the other side of the issue – a report that basically CERA has rebuttled on finding critical numbers –what are the real decline rates, et cetera – so the argument is going on. [34:08]

On October 5th, 2005, right after Katrina and Rita, Secretary Sam Bodman sent a letter to the National Petroleum Council and asked if they would undertake the most serious study the NPC has ever tackled on assessment of peak oil. What it ended up being a group of over 1500 people, created a 256 page report, the website has apparently 7 or 8 hundred additional pages; and what I found quite disappointing and registered my disappointment loudly with the senior people within the NPC is that the peak oil discussion in the executive summary, which ran about 25 pages, was this two paragraph table you see here.

And what the table basically says is that here are the arguments that the pessimists use, and here are the arguments that the optimists use and who knows what the answer is. And then they refer you to the further discussion in the supply chapter, and there are 19 paragraphs in page 127 to 130 that say the same thing. So they dealt a lot of the hard challenges the industry has to face and they totally copped out on addressing anything meaningful about peak oil. I think to spend a year and a half, to get so many people involved was really a disappointment. [35:22]

In the meantime, there are a continuation of supply data points that I look at that point to many danger signals. I’ve been following this page that you see here – this is “11.1 b” out of the monthly energy report of the DOE, it comes out once a month, and it’s basically world crude production. And what I’ve circled there is May 2005 when as far as we know – if these numbers are accurate and they might not be, but they’re the best we have in the world – that’s when we set an all-time crude oil record of all time. And it’s been dwindling since, which I’ll show you in a few minutes. [36:00]

We’ve all spoken this morning about dwindling new oil discoveries, the accelerating decline rates and the rising output of heavy sour oils and the shrinking output of light sweet crude. And all of that would basically be interesting and maybe imply higher prices if demand doesn’t grow. However, oil demand still seems to be insatiable. This phenomenal growth that we’ve had despite soaring oil prices has been really astonishing to me; and the big risk we now face is that demand will soon outpace supply if growth continues, unless we have some amazing turnaround in supply.

The optimists still loudly scoff at the peak oil risk. I’m sure you’ve all heard their views: It’s ample resource endowment of 9 to 100 years of current use; proven reserves can grow through reserve appreciation and yet to be discovered new oil. And yet as Richard Nehring pointed out today, even if they do, his numbers in the low case had a peak – if I did my math wrong – 93 million barrels a day; we’re going to be 88 next year. Advancing technology will recover more oil in place and technologies will unlock vast unconventional oil sources. [37:06]

The optimists’ caveat is actually spelled out – this is where the NPC’s Facing Hard Truths did a good job of saying they are all above ground risks, we don’t have any below ground risks. And will enough capital at least be in when it should, will access be available when it should, will R&D advances continue as they should, and will skilled people make the right decisions.

And then what I worry most about is that there is a chance – and a growing chance – that peak oil could actually now be past tense. I refer to this page, Table 11.1b, you can go back now over 78 months of data on global crude production from the beginning of 97 through June 2007, and then in that long period of time we’ve only had four months as far as we know, that crude oil only exceeded 74 million barrels a day: April 2005, May when it set the record, December when it basically bounced back – that should be a ‘2’ by the way, as opposed to a ‘7’ – and July of 2006 when it just barely crossed 74; and as of June 2007, the number was 73.8, so we’re 1.5 million barrels off the old all-time peak. [38:26]

Decline rates are a steep treadmill. The scarcity of solid data on decline rate has created sort of a fog of war. Some authorities still argue that decline rates are low and manageable. CERA’s report this summer really pooh-poohed any danger of rising decline rates, and said through their incredible database, the average of the world is only 4.5 percent per annum. Other authorities estimate 8 percent per annum. I was surprised at an energy conference our firm gave in Scotland, we had Andrew Gould of Schlumberger as keynote speaker, and several times in the last three years, Andrew has used the number of “we think the average rate is 8 percent.” He was asked about that afterwards, and he said, “Well, I don’t want to go there. I got the 8 percent per annum from Harry Longwill at Exxon. He’s retired now, so I don’t know what it is.” I addressed a group of the top 150 people at Baker Hughes a year ago from all around the world, and I talked a lot about the mystery of the decline rates and these various averages, and I said, “Okay, of all you 150 people here, I’d be interested in a show of hands, how many of you think the average decline rate of all the projects you’re working on is only 5 percent or less?” And not a single hand went up. “How about around 8 percent?” And about half the room raised their hands. And I said, “How about over 10?” And about half the room raised their hands. [39:41]

And maybe they’re just working on a really complicated projects or maybe they know more than we think, but then I come back to a question: How easy would it be for the world to cope with an even 4 ½ percent decline? Figure 1 you see here is coming out of the CERA report this summer, and what they basically show is if the decline rate is only 5 percent and demand growth is a little bit less than most people forecast, then we only have to add 60 million barrels a day in the next 10 years. Is there anyone here that thinks that we could add 60 million barrels a day in the next 10 years? And then in the National Petroleum Council report, this was the table that basically hit the cutting floor as they were putting the final thing together until several of us really protested loudly and said if you’ve got all these other tables, get that one back in because it’s the bottom line scary thing. This existing capacity declines at a rate of about 7 percent per annum – the reason they decided to leave it out, they weren’t comfortable that was hard data. But if you then do the delta of what we’d have to do to get back on the top of demand, it’s adding over 100 million barrels a day in 23 years. And I don’t care whether it’s 60 million in 10 or 100 million in 23 years, the likelihood of that happening is extremely low. [40:57]

And then I also step back and look at this phenomena of we seem to basically to be sort of maxing out now of crude oil supply at some place between 73 and 74 million barrels a day, how are we able to use 85 and growing. Well, it’s this funny gap that we have created, between crude oil and how we top off the supply, of primarily natural gas liquids and a little bit of refining processing and then finally a tiny sliver of biofuels. It’s just been interesting to see that gap grow from 7.7 million barrels a day in 1995 to 8.2 in 2000, to 12.3 in the first six months of 2007. Natural gas liquids have had a steady and mysterious sort of growth, but I think it’s very important to remember that as mature oil fields decline they cough up their gas cap. That wet gas becomes natural gas liquids, so these are not long term sustainable sources of steady growth. The LNG projects, when they come on, also create as a byproduct some liquids; but it’s hard to grow LNG projects, they’re slowing down now. So the stealth growth in the NGLs has masked declines in crude oil. [42:12]

So, is oil demand actually our biggest single above ground risk? And I would argue that all these other demand risks above ground risks are real. They’re important. But the risk number one, two, three, four, five, seven, eight, nine, ten is called oil demand. Conventional wisdom has consistently sustained oil demand growth. Many oil observers were certain that global demand for oil had peaked between 1990 and 1994 when we had about a five year period of time of being stuck between 66 and 67 million barrels a day. That was the illusion of the collapse of the former Soviet Union and eastern Europe’s oil demand – actually perfectly offsetting the steady growth everywhere else in the world. And then finally that came to a halt, and in 1995 the world crossed 70 million barrels a day for the first time in global history and basically once you broke through that ceiling we just kept going. The Asian flu stopped the train, 9/11 had only a de minimis impact, several warm winters simply slowed down fast-paced growth. Was it China that everybody missed, or can oil demand growth ever stop? [43:23]

So let’s spend just a few minutes questioning is growth in oil demand sustainable, and then turn the question around: How would you actually start putting the brakes on it if, in fact, supply can’t keep pace? Most economists fret about continuation of growth and they also presume supplies about to surge; many have been convinced for decades that high prices would kill further growth, but they believed that at 30 dollars, they believed it at 40 dollars, they believed it at 50 dollars. There has been no sign that high prices have had any impact yet on demand. Many question the sustainability of China’s growth. Back in the summer of 2004, ‘china is about to have a hard landing’ became current sort of energy wisdom to convince you, ‘don’t trust China.’ Others point to the stagnant or falling demand in Germany and Japan to say that’s going to spread around the world, but so far it hasn’t. [44:11]

And I look back on oil demand and say one of the remarkable things in my opinion is it was the 20th Century’s most enduring event. In 1900 we don’t have any good numbers for how much oil we were using, but it might well be a number of around 100,000 barrels a day, and it was primarily used for lighting and Vaseline. By 1920 we’d just finished the war, oil demand had grown to an astonishing 1.5 million barrels a day; by 1950 it was 10.4; by 1980, it was 59.3; by 2000, we had already grown between 95 and 2000, from 70 to 76; and by 2006 we were at 84. So between 1920 and 2006 we had an average annual compound growth of 4.8 percent per year and we had something like about nine years out of that long series when oil demand didn’t grow. The recent rise in oil demand is not just China, it’s actually every place. Here are the numbers between 92 and 2006, when we added 16.9 million barrels a day more oil use, and that was actually held back by the collapse of the former Soviet Union. Had the former Soviet Union stayed flat, that number would have been over 20. And then we have 2005 through estimated 2008, whom we basically add another 4.5 million barrels a day. And if you look at the increases there, they’re coming right across the board from every part of the world. [45:42]

Oil demand outside the OECD is growing fast. Here are all the key numbers coming out of the IEA’s database between 2001 and 2006. And when you get consistent in a five year period of time – double-digit growth, these are really astounding. That basically turns to average 3.1 percent per annum. The OECD demand has been a mixed bag with many moving parts, but look at the United States of America, with basically a five percent change – but basically it’s over one million barrels a day in five years. That’s really a lot of oil to tax our system.

Where does the recent projected growth come from? I’m just going to show you the numbers of the fourth quarter of 2006 versus the fourth quarter estimate next year of 2008 when the IEA has us nudging almost to 90 million barrels a day; and the growth is basically coming from all around the world. What’s interesting is that cumulative increase – if it turns out to occur – in a two year period of time, is equal to 90 percent of the total amount of the oil that the United States of America now produces. So these are powerful numbers. And all serious demand forecasts assume continued growth. The IEA, the EIA, the World Bank, the United Nations – they’ve all basically taken a very serious crack at what will oil demand need to be, and they basically look at population and interestingly enough they assume across the board that population growth will be slower in the next 20 years than it was the last 20. They look at vehicle registration et cetera, et cetera and they come up with this astonishing increase in total energy and increase of about 50 percent in oil. And essentially 50 percent of the total growth in energy demand is coming from their assumption of growth in transportation fuels and basically that’s all oil. And so the question this raises is: Can that really happen and does it need to happen? And underlying that is a basic question of: Are 6.4 or 6.5 billion people too many, and 894 million vehicles enough? [47:54]

Why transportation energy is so difficult to stop is that the world is now producing 50 million vehicles per year and that global vehicle registration is now almost 900 million, and the global population is 6 ½ billion. But look at the disparity. If you take North America and you look at the per capita vehicle ownership, for every thousand people we have an average of 641 cars, and that’s held down enormously by Mexico’s numbers. If you take a look at the total OECD, it’s 534 cars per thousand people. If you drop down to the former Soviet Union and eastern Europe, it’s 182 but that’s going to change very rapidly. If you look at China it’s an astonishing 18 per thousand people. 18 per thousand people compared to our average in the United States of about 800 cars per thousand. And then the interesting rest of the world, this funny 3.6 billion people who on average have 51 cars per one thousand people. So this is what makes the long term demand forecast for continued oil growth so daunting and so hard to see how we’re going to bring that to a stop. [49:02]

Creating mobility just frankly uses more oil. These are just some interesting what-if numbers: if the former Soviet Union and eastern Europe’s vehicle use rises to western Europe, how much oil do we add? 11 million barrels a day. If China’s vehicle use rises to the levels today of the FSU and eastern Europe – 26 million barrels a day. If the rest of the world’s vehicle use rises to FSU levels today – another 24 million barrels a day. So the impact of these relative modest assumptions would basically require 61 million barrels a day of additional oil. Could any one of these changes be supplied? I would say, realistically, I don’t think so. [49:41]

So oil demand is not likely to slow down or decline. It turns out that oil demand on a short term basis is unbelievably fickle. It can slow temporarily year over year or quarter over quarter. It has a little bit of seasonality, it always has. It can slow in certain parts of the world. When we had the Asian flu that did knock about 8 countries into negative demand for about 18 months. Weather can dampen demand growth, but the fundamental growth engine appears to me to be literally unstoppable on the blueprint that we’ve created for the world.

The big question is can supply keep pace? It turns out supply and demand for oil has no relationship to one another. The right hand literally doesn’t know the left hand. Growing supply is not fickle. It takes a relentless effort. Chris this morning commented about the 6.5 years on average it takes a project to get developed. Look at the projects today that are basically now announcing a three-year delay, a five-year delay, a ten-year delay. We’ve run out of everything, and so that’s going to get harder and harder to bring on supply. And then so quickly after the new projects come on, the declines start and then we’re back to the treadmill.

If demand growth could be supplied. Let’s assume that basically we have ample resources and we make them all available, it will require vast amounts of increased spending to translate some of the vast amounts of physical activity – drilling activity would need to soar, and since we’re using every high quality rig in the world today, that would require a massive amount of new rigs being built. Then energy infrastructure needs a rapid expansion, but at the same time, the energy infrastructure is so rusty we have to rebuild our current system at the same time. Our people scarcity, which is a genuine crisis today needs a very fast resolution, and I’m not sure how that works. And massive spending needs to happen ASAP. And I look at that list and I say, I don’t think any one of those are particularly likely events to happen. [51:39]

Meanwhile, how secure is our current supply? To really honestly answer that, you’d have to answer the following questions: how fast are most producing fields currently declining; are these decline rates stable or are they accelerating; how robust is our deepwater play, which has certainly been the last great horizon; are any new frontiers to be found, and if so, when; will the trend of dwindling size of new fields continue, or will we reverse that; and are most mature supergiant fields –where we have an utter lack of any accurate field-by-field production data – now actually in decline? [52:18]

Here’s a profile of about 18 North Sea fields that were taken about three years ago out of Saga Petroleum’s report. These are all fields they had ownership in. And I was just struck by the similarity in the decline profile of everyone of these fields. This is why basically the North Sea peaked in 1999, and is off by close to 50 percent in the next seven years.

This graph though was a real surprise to me when I finally gathered the data together. These are basically 10 key deepwater fields that came on in the sort of last seven years. You’ve got Ram Powell, Pompano, Hoover, Genesis, Europa, Brutus, Boombang, Ursa, Mars and Auger. Ursa and Mars collectively –as referred to this morning – is the largest producing oil field in the Gulf of Mexico, but it’s also interesting to see that these two fields collectively produce 362,000 barrels a day in 2001, and by 2007, they’re down to 132,000. The other eight fields peaked in various years but at the peak they produced almost 400,000 barrels a day – 397,000 – and as of the first half of 2007, they’re down to 110. And when you divide the 110 into the eight fields, the average production is 13,000 barrels a field. To see a field like Auger – I remember when that came on and it seemed so monstrous – or Ram Powell, basically now be down – Auger is now to 14,000 barrels a day, Ram Powell is down to 12,000 barrels a day. It took five years for these fields to go from peak to basically 20 percent of what they peaked. And this same production profile I’m told with some bit of authority will be exactly what we experience in the deep-water in west Africa, in Angola and Nigeria. We’re basically doing just-in-time production to make the IRs work on deepwater production. [54:14]

Then look at sort of just some interesting macro-statistics. These all come out of the Oil & Gas Journal’s worldwide production report that they publish about the end of each year. These are the December 18th 2006. If you just take their country by country numbers and look at what they have as production in 2006 versus 2005, they’re reporting on 78 countries that produce all of the world’s crude oil and basically 43 of those countries – this is not volume weighted, this is just statistical – actually declined between those two years; and the average decline rate was 6.7 percent; and 35 grew, and the average growth was 6.8 percent. I’d feel a lot better if it were 43 growing and 35 declining. Once you start getting behind the S curve, it’s just the law of numbers.

Then I went back to the 44 pages in this same report out of curiosity. I was actually at a board meeting and sort of bored so I had on my lap and doing all this, and I said, it’s interesting in their database they basically accumulate all the US figures by state by state because we have basically 37 – 36,000 oil fields in the United States. In Russia they only report their production by company as opposed to field. In every other country they have field-by-field of all the fields in production. It’s a database of about 44,000 fields. And I went through because after each field name, they had discovery data. And I underlined all of the fields that had been discovered since 200, and to my astonishment when I added them up, there were only 42. None are large fields. Quite a few don’t have production reports, but basically about 25 of the 42 do, and the cumulative production of those fields in 2006 was an astonishing 27,000 barrels a day. There were discoveries in Norway, Angola had one, Brazil had one, UK had six tiny fields that averaged in 2006 about 2.2 thousand barrels a day, Nigeria had three, Colombia had two. So I took all of these key countries and said, let’s just go back and see how many fields are in the database that were discovered between 1990 and 94; that turned out to be 143. And I said how about between 95 and 99 and it was 102; and then 25 in 2000 and 2005. Now, there’s a likelihood the Oil & Gas Journal could have missed a few, but missed many big fields? I don’t think so. I’ve found that absolutely astonishing. [56:48]

Then basically there’s a snapshot of key oil producers’ shrinking discoveries.

Then the question is does the world really have a safe supply cushion assumes global spare capacity today is somewhere between 2 and 4 million barrels a day, and there are some that basically toss numbers out of 6 and 7 million barrels a day. What’s missing in these lists – any list of individual fields that people assume that capacity is coming from – most of this of the 2 to 4 million barrels a day is presumed to be Saudi Arabia’s 11.3 million barrels a day capacity. That’s the number that they continue to publish. The IEA uses that. Current Saudi Arabia production is assumed to be 8.6 million barrels a day, so implied within that is that they could basically quite easily go back to 11.3 if the world really needed more oil. Saudi Arabia is in the middle of a massive – the biggest amount of money they have ever spent. The numbers range – the official numbers with Saudi Aramco are 54 billion dollars on these fields they are rehabilitating. But what they’re basically saying is by the end of 2009, all but one will be done and they will have increased their productive capacity to 12.5 million barrels a day. And they also acknowledge that some of that is to replace declines taking place in their immature fields. Well, if you do the math, and they have 11.3 today and they’re adding 4, they’re basically acknowledging that their decline rates today are maybe 1.8 million barrels a day; or maybe they’re just being confusing. So, how fast are the mature fields now declining? [58:26]

And then you come into a very important question – how are the Saudi Aramco new projects that were done between 2004 and 2006 actually performing? They’ve been so silent on that that I frankly am a little bit dubious that they’ve hit their targets. I think if they had hit their targets they’d be a lot more forthcoming. And then as Chris raised this morning, an enormous amount of the projects he has in his database that matter are these giant fields that are being rehabilitated where they basically think they’ll get another 4 million barrels a day, and the question becomes: How likely is that? How likely is it going to happen on time? Everyone of those projects are tough complicated projects. There’s a great article in the Atlantic Monthly this month called Ghawar Running Dry, and they use established data that Stuart Staniford’s report has done that many of you saw yesterday. Just this simple picture of Ghawar and what it used to look like when north Ghawar was heavily saturated with oil, compared to the pockets of oil left behind – a picture’s worth a thousand words. [59:21]

Saudi Arabia’s candor also suggests that not all is well within the kingdom. I thought it was amazing – several month’s ago oil prices had reached 75 dollars a barrel, Ali Naimi was quoted in the Oil Daily as saying “nobody seems to want our oil.” And then I also think it is interesting to see the consistency with which senior spokesman within Saudi Aramco are basically saying some of the increased output from the 7 billion dollars spent is to replace declines from our mature fields. And then I listened to other senior Saudi Aramco officials that quietly say, it would be folly to plan on producing more than 12 million barrels a day. And then I see here even others –seniors –say I think we can hit maybe 10 ½, but only for a matter of months and then we’ll be in decline. So to meet all of these long term projected demands that we looked at Saudi’s output has to grow, or some other source has to come out of thin air to replace. [1:00:23]

There’s also some troubling evidence that I look at every month that happens to be Table 6 of the oil monthly report of the International Energy Agency and of all the numbers in the International Energy Agency’s report, these are the only real hard data. It’s exports to the IEA member countries because it’s an important reporting requirement of being a member of the IEA to actually report your imported oil by country of origin. And they report every month Saudi light, Saudi medium and Saudi heavy as it comes into the member countries of the IEA, which is about 85 percent of Saudi’s exported oil. It’s just interesting to see the steady of staying around 4 to 4 ½ million barrels a day, and then finally in 2003 they peak at 4.65 million barrels a day and in the first six months of 2007 they’re down to 3.92 million barrels a day. The question is: are they shutting in supply? But were they shutting it in in 2004, 2005, 2006, or is that actually the arrival of the evidence that the mature fields are down into steady decline. [1:01:28]

And then I step back and I say – as I dug through all of this new data this fall – I said, why didn’t I find any good news because I actually look for it. Well, perhaps the good news is hiding, or perhaps it’s still on its way. Perhaps big discoveries, you know, that were real just can’t find rigs. I was addressing a very impressive of the sort of leading, next-generation people at Chevron who were all mentored by the Chevron fellows at a program on Tuesday afternoon. I basically went through this entire presentation as a dry run. And one of the comments I got afterwards is we have some fabulous discoveries in the lower tertiary and starting with the Jack, but we cannot find a drilling rig. It might be three years before we can actually do the second test well on Jack. Where are the rigs? Well, the rigs aren’t going to be here for a long period of time. Perhaps we had an unusually bad last few years. When I thought about the 42 skimpy new discoveries, I said, well, if it takes 6 ½ years, we did have that awful period in 98 and 99 when people just froze. But on the other hand, we had the rig count up to basically a hundred percent in 95, 96 and 97. It certainly wasn’t due to lack of spending or low prices, the E&P spending has soared in recent years; the major oil companies are now spending almost three times what they were four years ago. It wasn’t through lack of drilling because every high quality rig in the world is now in use. And so unless some good news comes soon, I think we’ve basically – frankly – ran out the clock. But coming soon, just around the corner is the real risk: A clash between rising demand and shrinking supply because unless demand growth slows, or begins to decline, or unless crude oil slippage starts to soar then, my friends, demand will outpace supply. [1:03:20]

So we then have to come back to the whole card and say how ample are our winter inventories and how fast can stocks drop before we breach minimum operating levels. And this is the single biggest risk in my opinion of the 21st Century. And so while the newspapers have been loaded the last few months with the subprime loan debacle and global warming, these are basically ones and twos on a scale of 10 affecting our lives over the next two or three years than getting through the winter of 2007 and 2008. Can winter demand be met? Well, the IEA projects the fourth quarter to have demand at 87.8 million barrels a day, and the first quarter at 88.2, and so basically if you round that off at 88 and you say: Can crude production that’s been stalled and slightly declining at 74 down to 73 suddenly rise by 2 ½ to 4 million barrels a day? Can these other fuels – natural gas liquids rise by that same amount? Or, can our global system tolerate 180 days of a 2 ½ million barrels a day or greater stock draw which is basically 450 million barrels, which will be the largest stock draw we’ve ever experienced during the winter? [1:04:28]

Let me just show the stress in meeting 88 million barrels a day. The simple math is cause, in my opinion, for alarm. If crude oil is at 73, if NGL is at 12, then we basically have total supply of 85 and the 88 requires a 3 million barrels a day stock draw – I gave you the numbers of 2 ½, what if demand is higher? What if crude supplies continue to drop? How tight can elastic be pulled before it snaps is the question we need to be addressing today.

Then we have another insidious above ground risk. Our system is frankly too old. Our oil and gas infrastructure is rusting and too old. The oil service and drilling rigs are too old. Our refineries, tank farms and pipelines are too old, and our industries workforce is rapidly graying – with no relief in sight on any of those issues. Where will added refinery throughput come from? If you take the world crude oil nameplate capacity in 2007, versus the world’s petroleum use, we now have a cushion of 1.7 million barrels a day refinery capacity. Port Arthur’s Motiva refinery is scheduled to double its output over the next five to seven years to increase by 300,000 barrels a day at a cost of 7 billion dollars. But I’d also point out that the core refineries in Port Arthur were built to support Spindletop; they are 105 years old.

Kuwait’s proposed refinery is now estimated to add – that’s a brand new refinery, grassroots – 615,000 barrels a day at a cost of a staggering 14 to 16 billion dollars and probably close to a decade to build. [1:06:09]

Our oil and gas infrastructure has to be rebuilt ASAP. Even if well head output can grow, soon the infrastructure will start to shrink if we don’t rebuild our systems, so we need now refineries, pipelines, drilling rigs and tank farms; and some are needed to support the potential growth just in case it can be supplied, but the balance – maybe 99 percent – has to be done to ensure that our current flows continue. What would really be an inconvenient truth would be to end up five years from now with crude oil supply at say 68, 69 million barrels a day – which might be really good news – but find that we have an infrastructure that’s collapsed and we can only get 40 million barrels a day through our pipes. And we have our rigs which are basically two or three offshore rigs toppled because they’re too old and then we basically shut down about half the fleet while we rebuild. So this is going to be a big, big issue. [1:07:00]

And then I had the slide in already and then I heard the numbers before lunch of this unbelievable soaring of all these raw material costs and these scarce resources. I think we realistically have to address the fact that if we tried to rebuild the system, do we have any concept of how many raw materials, raw resources that would take? Iron ore prices have doubled, copper prices have soared, the backlogs to get projects done gets longer and longer each month, the lack of engineers is getting scary, the project costs are doubling or tripling. So if we tried to do that it would basically tax the workforce of the world, probably as great as any project we’ve ever done.

So, finally, what happens when demand outpaces supply. Well, energy demand is fickle. It doesn’t have any link to available supply. When demand is higher than supply, then inventories decline. But the problem is today’s inventories are extremely low as far as we know on day’s usage, and we still have no inventory stock data period outside the OECD other than Singapore. Once minimum operating levels are breached somebody runs short. That’s the bottom line. When oil peaks, demand is unlikely to slow down and peak then quickly turns into a Pearl Harbor event. And the likelihood of this occurrence arises with every passing month because once shortages begin, consumer – human behavior is like clockwork – you can make book on it – the users top up their tanks and this leads to a classic run on the bank. And since the world has no accurate fuel gauge – predicting this event is impossible – literally if we started our topping up the tanks – and I’m not talking just about automobiles, I’m talking about the rackers, the service stations, the ship channel – we could probably drain our system in five or six days. And once we’ve drained it do the math: until we shut down everyone using anything we’d never get them rebuilt. So this is the danger that we’re now headed into. [1:09:03]

You come back to the issue of above ground risk and below ground risk and frankly I don’t think it matters which one is the worst. Why does it matter why Chicago burned down? Fire literally destroyed Chicago in 1871. The rumor was the fire was caused by Catherine O’Leary’s cow kicking over the lantern in the barn. After the fact, did it matter? If we run out of usable petroleum, will it matter if it was caused by above or below ground risk materializing or a combination of both. Is it too late to create an early warning radar system? Had we had radar in Hawaii, we could have easily seen the Japanese air fleet and the US Navy fleet could have been saved. But we didn’t. We, the world, can suddenly rise up if we want to and absolutely demand energy data reform. Field-by-field production reports for the last 60 quarters on all key fields would actually resolve this problem and create a radar system. And let me tell you how we basically enact that: the OECD says anyone who wants to import oil into the OECD that doesn’t cough up the mandated field-by-field reports gets slapped with a 20 per barrel transportation fine. And I will guarantee you within about three months you would get the data. This data I think within about a week of analysis would end the peak oil debate full stop; we’d see the planes on the horizon. [1:10:24]

Is there any downside to data reform. World oil leaders have amazingly shown zero interest in field-by-field data reports, and the reasons they use: it’s our confidential data, we might suffer competitive disadvantage, we’re as transparent as everyone else. Well, let me tell you, there’s been field-by-field production report in the North Sea for 30 years and I’ve never heard an operator say, I was hurt by that report. In fact, I’ve been surprised by how little they looked at it, otherwise they would have seen the North Sea was peaking. Flying blind has extreme dangers. Once we crash we will bitterly resent the lack of data reform. We all win if reform’s enacted and everyone loses if there is no reform. So if there is any one thing all of you could do when you leave here is call your Congressmen and say, We want data reform. [1:11:08]

Will peak oil surpass global warming as the 21st Century’s greatest challenge? If peak oil is imminent, it will be a crisis in 2008 to 2012. Global warming, if it’s real, will not be a crisis for another 30 years at the outset. Most of the experts’ stuff I read say 50 to 100 years. If mitigating global warming risk has become the highest priority in the world, why are so few people worried about peak oil. Peak oil could actually solve global warming by creating a resource war that ends the 21st Century.

So, in my opinion, and I hope I’m not being an alarmist, but I’m alarmed. The peak oil risk is genuine. There is a chance that oil will not peak soon, but it’s a small chance. It might stay at an undulating plateaus for decades but there’s no evidence of that. But if all the public data that I keep going through argues that demand growth will not be met, the higher demand grows the steeper oil will then decline. Gauging the risk of peak oil being imminent is far higher than our homes burning down, and far bigger immediate impact to us than global warming. The risk might be 50 percent. It might be 75 to 90 percent, so it’s time to take the peak oil risk seriously. Thank you. [1:12:30]

JOHN: Voice of Matt Simmons speaking to the ASPO conference last weekend in Sacramento, California. And Jim, we’re down to our final speaker here. Our listeners may not be as familiar with Chris Skrebowski as they were with Robert Hirsch and Matt Simmons.

JIM: Chris edits the Petroleum Review out of London. What makes Chris rather interesting when it comes to peak oil is Chris started out as a skeptic when peak oil began to surface at the beginning of this decade, and what he did is start looking into all the world’s oil fields and taking a look at their decline rates, and as he did what Matt Simmons did, he came to his own conclusion through his own fundamental analysis, studying the detail that oh my goodness, this peak oil thing is real, and now he’s become a convert over to the peak oil argument and that’s what makes his analysis rather interesting.

What you’re going to hear from Chris now is just all of the delays and the things that the energy industry faces. We not only have to go to more dangerous and more places that are harder to find oil – it’s the easy oil that has been found. I mean where are we getting it? We’re getting it deep in the ocean, we’re getting it in areas of the world where there’s political risk, we’re going into areas like the Arctic and at a time when the energy industry needs not only personnel but materials; and plus we have weather changes. I mean just look at these two hurricanes. We still have shut in capacity in the Gulf. It’s just absolutely amazing. So I think this idea you hear on the political campaign stump that, hey, we’re going to be energy independent in 10 years, it’s nothing more than a pipe dream. So let’s listen to Chris Skrebowski next. [1:14:21]

Chris Skrebowski, Editor, UK Petroleum Review

This is all fairly obvious. The only thing I really want to stress is the idea that it is very important in all analysis to take yourself out of the analysis. You have hopes and dreams, fears et cetera, it doesn’t help there are all sorts of subconscious biases that come in. What we’ve got to try really hard to do is find the best data and see what the data tells us in an unblinking sort of way. And hopefully that’s what we’ll try and do. Unfortunately, the trouble with peak oil is, as Bob was hinting, there’s not a lot of humor in it and it’s getting all a bit stressful.

So let’s just remind ourselves what peak oil is. At peak oil we haven’t run out of oil, we haven’t even run out of discovery or development – all those things will be going on. It’s just that the amount of oil coming onto the market will be more than offset by the loss to depletion. So what you’re running out of is incremental flows, and when you do that, oil of course cannot pick up the marginal energy demand any longer. [1:15:41]

This I’m told in one of those ‘divided by a common language’ is called a teeter-totter in this country, and we call it a seesaw at home. But basically this is the idea that you get to this peak oil point where the two sides if you like are just balanced. A whole lot of production is going down, a whole lot of production is going up – but you get to the point where like a scales, it just starts to tip. And you can see this quite clearly from some IEA numbers here. Now, at the moment as you can see reasonably clearly – the stuff on the expanding side is still winning. It’s still winning quite handsomely, and the stuff that’s declining has if you like a lesser weight. But over time, some of those countries in the middle are going to move into rather more rapid decline, some of those ones on the left are going to be expanding rather less, and then like the teeter-totter or the seesaw, the thing will simply start to tip. [1:16:48]

This is the IEA – as ever being very optimistic about future production coming out of the OPEC countries. In fact, if you look at the dark blue which is what’s meant to have happened this year where Angola has probably made it, Saudi Arabia hasn’t, Nigeria has done slightly better than that. Kuwait’s done worse, Qatar has done worse, UAE has done worse, Libya has done worse – so it’s not great forecasting. And this is only a few months ago. So when they promise us rather a lot of jam tomorrow in the form of the mauve 2008 stuff, I think we’re entitled to be reasonably skeptical.

So what I’m going to show you is that we really are very close. The key thing as was mentioned earlier by Steve is it’s all about flows, this is what really matters. If the flow isn’t there, the system doesn’t work. If the system doesn’t work, then our economies start going ragged and all sorts of unpleasant things start to happen. My analysis is basically not what will happen, but what could happen if everyone does what they say they’re going to do. So we’re defining the outer bit of the envelope. So rather startlingly, what we’re saying is we can’t get further than about 2011; and 2011 is just 1200 days away. [1:18:18]

Now this rather strange thing was an attempt to show you why I think you can do analysis like the Megaprojects. The oil industry is in fact quite slow moving. The average time between when a large discovery is made and the first oil flows is currently 6.5 years. If you think of those lines as either supply or demand, without – sorry, I’m not explaining this terribly well – what this does is it shows there is a fairly narrow range you can have for both your supply and demand trends for quite an extended period; beyond that, they can diverge almost anywhere you like. If you go back 20 or 30 years, we used to talk about indicative planning and we used to talk about scenario planning. Well, on the left hand side where they’re all tightly bound, you can still do indicative planning; on the right side, where there are many outcomes, you can only do scenario planning.

Now, it’s worth reminding ourselves just how oil dependent our economies are. We might have created them in other ways, but this is the reality of the moment, that literally our entire society is predicated on oil: the plentiful supply of, the reasonable price of. It’s very difficult to envisage a contemporary society in which oil supply is severely constrained or even very high priced. [1:19:56]

Now, some of these have been covered by Bob perfectly well, but I think these are the key things that tell us we’re in trouble. The discovery rate is falling; whichever series you care to favor. There are relatively few large discoveries – in fact, very few large discoveries. There are more countries which are moving into sustained depletion. The companies are palpably struggling to hold production. There’s a series of non-geologic threats – this is the resource nationalism business, loosely defined. There is a clear lack of incremental flows. They seem to be sort of stuck, they’re not coming through in the way you might have hoped. There is now relatively few countries around the world that have real growth potential; and what that means of course is you have a great transfer of power, and people who find themselves in a powerful position don’t always act in your interest. And already we have sustained high oil prices which once again have been moving north. [1:20:58]

Just a quick glimpse to try and get things into proportion, we hear an also lot about biofuels – those are the IEA’s projections for the three years. You see that really the impact is quite limited, which is the equivalent of a couple of smallish oil fields. The tar sands – another great hope that is going to solve many problems – again, it’s a couple of reasonable oil fields a year as the rate is growing; and the Venezuelan heavy oil – well, we’re not even using the capacity we’ve got because Mr. Chavez political aspirations and the fight with the companies means that in fact we’re not utilizing the capacity that’s in there, and even if Mr. Chavez was to sanction new projects in the morning, it would be at least six years before you could see an increment in that.

I’ve been fighting very hard with Mr. Gates’ Vista which is why this graph is out of date and only goes up to January – but what I’m – this is simply the latest IEA data, I’m sure you’ve all seen it before. The really disappointing things if you like is if we look at the crude and lease condensate which is the green line, since January it has in fact drifted off, but it’s been on a plateau more or less since about February 05. We look at the natural gas plant liquids – there has been quite considerable expansion in the Middle East with contraction in North America, so it too has been operating within a very narrow limits. And the great white hope which is the biofuels and the tar sands and the other fuel which also has barely increased over the period. So as of now, it really does look as though CERA’s bumpy plateau has arrived 25 years earlier. [1:22:59]

Now, I’m actually not that gloomy and I’ll show you why. That’s simply the OPEC 11. The OPEC 11 drifts off further – again, this wasn’t up to date because I really can’t get to grips with this Vista business. The oil companies as we’ve noted are struggling hard – I’ve had a privileged look at this report that is coming out next Monday in Europe, there’s a rather neat diagram there where they carefully aggregated the companies and the mergers and they demonstrate that the companies production has in fact flatlined for a very considerable number of years in fact – a frightening number of years. The really rather unfortunate piece here as we see that where the companies don’t have some new capacity going on, we’re actually seeing decline rates of 5 percent and we’ve even seen one of up to 8 percent. Now, this in fact means that the companies are experiencing faster decline rates than the global average. Now, that’s a rather sobering thought from a group of people who claim to be the smartest investors in this business. [1:24:17]

Bob talked a little about these non-geologic threats. I just wish to itemize them a little more. We have straight resource nationalism which we’ve seen in Russia, Venezuela, Bolivia, Ecuador and undoubtedly other countries will follow. This manifests itself as quasi-nationalizations and much tighter terms and conditions. Now, the tighter terms and conditions literally affects everyone; we’ve even seen places you wouldn't expect it from like Nova Scotia suddenly deciding that they need a slice of the action. Now, this is totally and radically altering the sort of financial landscape – very much to the detriment of the traditional international oil companies [IOCs]. And only was it yesterday or the day before, I was listening to BP’s new chairman explaining slightly pitifully over an Energy Institute lunch that the IOCs had a lot of good things going for them, and really they did have a future. The fact that he had to reassure his audience that the IOC’s had a future I think says it all. [1:25:30]

Cost inflation is almost out of hand in the oil fields. We’ve seen earlier that, you know, even the large increases in the notional investment are not translating to real increases in expenditure. We’ve had a terrible lack of skilled people, which is arguably the most intractable one. You can only give someone 15 years experience in 15 years. And what we’re seeing on big projects is if you have a number of key people and project A is going late, project A has to have the best people on it, but that means that project B is going later still. And by the time they get onto it, it’s well late and project C is drifting. So we’re getting these escalating delays and these escalating costs, and it’s very hard to see how this is going to improve. [1:26:23]

Now, having said that we don’t see much improvement in all these threats to supply, the next one is the one that Bob raised, is the idea that at some point certain countries in the world are going to actually cap off their production, or they’re going to ration it out in some form. The Russians have been flying the kite of capping it off at around 10 million barrels a day for some time now, and it seems ever more likely they will in fact do this. Again, just as resource nationalism has spread slightly like a virus around the world, I think once one or two countries actually start doing the ‘we’re going to save this for our own future generations’ we will see that go round the world quite rapidly.

Lots of people still have enormous faith in economics. Many years ago I studied economics, and economics certainly in this industry isn’t working very well. We have distortions more or less every place you look. We have the large scale subsidization of fuels in Asia and the Middle East. This produces very rapid growth rates. These are very often not particularly democratic governments and cheap fuel is seen as a reward to their populations. You can go round the planet and you can pay anywhere from 20 cents a gallon to 9 dollars a gallon, so that’s a hardly a coherent economic message. So I think all the price signals are pretty scrambled. All the producing governments are wanting more tax, and the idea that there is some coherent economic signal that’ll lead to a desirable result is only just this side of fantasy. [1:28:16]

Depletion. Well, the great thing that’s happened this last few months is we’ve now got a pretty sensible handle on what the depletion rates are. Now we know for individual fields it can range all the way up to these 16 percents and more that Bob talked about earlier, but the global net depletion rate we’re now fairly sure is about 4 percent a year. We know this because as I mentioned last night, the IEA’s medium term report gave 3.2 percent for the OPEC areas and 4.6 percent for the non-OPEC areas, which when you weight it gives you 4 percent. 4 percent has been used by a very senior oil man in a closed conference I was informed. CERA is using 4.5 percent but on the smaller oil production number; 4.5 of 73 also comes to about 3.3 million barrels a day per year.

Now let’s think about this for a moment. First thing – is this rate accelerating? Well, I think it probably is accelerating but very slowly. That’s to say if you go back to the 80s and you ask people what the depletion rate is, they’d probably say something like 2 percent. In 1999, Dick Cheney very clearly said it was 3 percent at an Institute of Petroleum lunch in London; we’re now hearing it’s around 4 percent. That gives you about a 0.1 percent a year increase, which probably would be a reasonable way to think of it. However, 3.3 million barrels a day is twice the demand – twice the demand growth. We have analysts all over the place fretting as to whether US demand is slowing as a result of the subprime crisis, fretting as to whether Chinese demand is going to remain robust, and fiddling about with plus a hundred thousand barrels and minus a hundred thousand barrels. This is to completely ignore the elephant in the corner of the room. That’s that 3.3 million barrels a day of new capacity you need every year just to stand still. And if we’ve got that, you know, half a percent wrong – it’s not inconceivable it could be half a percent wrong – half a percent of that is 800,000 barrels a day – sorry, 400,000 barrels a day. So that’ll drown out all of this fiddling about as to whether US demand is up a tick or down a tick, and Chinese demand is up a tick or down a tick. [1:31:04]

This just summarizes from my Megaprojects database what has happened. As you see, the OPEC countries were arguably slower to respond to the price signal of the big upturn in 2003 – 2002, 2003, 2004 – and then of course it took a considerable time to get all this stuff going. And this is what they say they’re going to do if you like – we’re going to make some adjustments for delays but we may still be too enthusiastic on that score.

So, what are the new supply sources that we have. Well, we have supply from what I call the ‘mega projects.’ As I’ve taken it down it down to 40,000 barrels a day plateau production, they aren’t really very mega anymore. But if you take true mega projects, it’s a very short list. We then have the really difficult one to establish which is the incremental supply problem, or the little projects which aren’t fully documented and all the in-fill work. There is no data on that, so we have to work that by inference. We now have good data on the loss of supply to depletion. So the only other source of supply that we have is OPEC spare capacity. Now, we really don’t know how much there is, and we really don’t know under what circumstances they’re prepared to use it. So we have to leave that almost as a pending item to one side. There have been limited additions from discovery and these in effect are included in this second point. So we can calculate out to – by looking at the last couple of years for which I’ve got reasonable data, and we find that this second category this previously ill-defined category was in 2005 it was about 2.1 million barrels a day, in 2006 it fell to 1.7. Now, you can’t really draw any satisfactory lines from two data points, and I think that the fall off is too rapid and the other one – so I flatten that out. I start at about 2 million barrels a day and decrement it at about 100,000 barrels a day on the grounds that we’ve taken all these hits, the companies have gone out and started to pull in all the most advantageous ones, so in the ensuing years there will be slightly less coming from that source. [1:33:47]

Now what’s the status of the database at the moment. There are 175 projects in which there is reasonable deep dates and details. Now, 144 of those again will be onstream by 2010, or at least on the current plans; and 170 –or nearly all of them – by 2012. However, we’re now up against this fact that this business is pretty slow moving. So if it’s averaging 6 ½ years, then we should know about an awful lot more projects in 2013, which is only five years away; and probably in 2014. As I can only find four projects, that’s a really rather frightening thought. Now, I have a further 47 large discoveries in the database, but there is very little chance of those coming onstream before 2014; at this point they’re ill-defined and probably not in a position to go ahead very rapidly. That’s where – 12 in the FSU, 7 in Canada, 6 in Iraq, and 4 in Iran. So those may or may not go ahead at any speed. The FSU is circumscribed by a possible capping off of production; the Canadian ones, well, once they get their inflation and tripping over each other sorted out those will go ahead. Iraq is Iraq and Iran is Iran. [1:35:23]

Now, this is what I would regard as my best estimate. Now, as you see, what I do is I do the totals in the blue. I then attempt to put in an allowance for delays which is this pinky mauvy line. What I’ve put in is a three-month delay, which sounds dramatic but it isn’t really.

Now, delays – you know, we’re seeing delays of several years but obviously not in all projects. So that could be too small. The impact of that is to in effect smear things forward, so the height is lower and it moves that way if you like. Then finally, because I’m using publicly available data, they always quote a peak flow which is too high, so a sustained plateau is probably 90% of that, which is the yellow which just takes that down; and the remainder – it’s relatively easy certainly in the spreadsheets to move the assumptions around and see what happens, but even visually you can see this has to move quite a way up or quite a way down to make any real impact in terms of timing. The shape of the graph is in fact pretty clear. You’re going to have to move things quite a lot to really get much date movement. [1:36:54]

So what I’m now going to show you is a rough sensitivity analysis if you like. So my best estimate is we’re looking at about 93 million barrels a day in 2011, 2012. If I – instead of reducing that infill number by 100,000 barrels a day, I simply keep it flat then you jack up the peak a bit, you delay it maybe six months; if I say I’ve got all my numbers really screwed up and that 2008, 2009 should be five percent higher –2010 to 2011 ten percent higher, et cetera – then in fact we can push the outer bit of the envelope out to 2012 and we can get the peak up to 96.8. It’s interesting that as you change the assumptions it’s the height of the flow rather than the date that changes. If we make the little projects decline rather more rapidly, then it comes back to 2011; it comes back to the 93, which is the best estimate. That’s if you like putting 0.3 and 0.4 together.

And finally if I make depletion worse, on the best estimate I get it back to 2011 but at a slightly lower level. So what we can see is that changing the assumptions tends to move the peak volume up and down. It doesn’t alter the date of peak as such very much. We’re talking about plus or minus a year. Now, obviously if we had – if by some strange chance this amount of supply proved too great for the market in those years – and those are the good years, 2008 and 2009 – then what would happen? What would happen was OPEC with great relief would turn down the valve a bit, the available amount would decrease and you would in effect save that slightly for a later year. So you would in effect give yourself a bit less here and a bit more there. But again, it doesn’t really alter the true cross over point, and it’s worth pointing out that the 2009 being a good year is totally predicated on the Saudi Khurais field coming in in the way that they hope at the flows they hope – both of which seem to be quite large assumptions. [1:39:36]

Now, I need to speed up a bit. So that’s putting the things – the worse case if you like or the best case, however you like to put it – we can get it back to the middle of 2011. If we push all the numbers the other way, we can push it almost into 2013 but still our overwhelming problem is the absence of any significant number of projects in the 2012 to 2013 time frame; which if they’re to happen, we need to know about now. And we don’t.

So production will follow a pattern rather like that. Another way of putting it is that. We know that the economists insist that supply and demand must almost meet, which they must, so how do we square the circle. Again, I’m aware that this is slightly repeating what Bob said –we can do this the hard way, or we can do it a slightly easier way if we can expand supply in some shape or form or really impact in terms of efficiency and use, and utilizing substitutes. [1:40:54]

Prices – that it looked as though in 2006 that the prices had turned into a channel with Middle East uncertainty giving you the high end of the range and the marginal cost of Canadian tar sands giving you the low end of the range. It now looks as though we’re about to break out going north, and simply reestablish a line parallel to the earlier one having got a slight dog leg in the middle.

A quick look at the barrel. I’m sure you’ve all seen this, but if we instead of worrying about what the individual products are, we turn it into what we’re doing with it, we find that overwhelmingly on the right hand side we’ve got transport that’s somewhere north of 70 percent and maybe as much as 80 percent of a barrel. So if we’re to avoid economic disaster coming, what we’ve got to do is shed a lot of oil demand and shed a lot of oil demand rapidly. Now obviously there is conventional substitution which has been going on since the 70s – if you like, the substitution of fuel oil and substitution of heating oil and the efficiency in use – but there isn’t enough left to really make an impact. So you can either think of the thing as a liquid fuels crisis in the sense of needing more liquid fuels, or you can think of it as a crisis of how can we stop using so much liquid fuels for transport. [1:42:28]

Now, as we know, it’s very difficult to substitute jet fuel. We can extend it and we can make it from coal. Ship’s bunkers are even worse. No one is going to have nuclear ships all around the world, so we’re more or less going to have to power ships the way we do now. But that still leaves 50 percent of the barrel going to surface transport. Now, the big ‘get out of jail’ card here is undoubtedly going electric. If we’re to shed lots of demand quickly, we’ve got to have technologies we can take off the shelf. It’s no good waiting for all the clever technologies that might or might not come through: we know all about electric propulsion; we can make electric trains, we can make electric buses, we can make electric trams, we can make electric cars. There are little bits that aren’t fully sorted and compatible but it is a soluble problem. So this is the one area we could really break out with is a determined move in this area. And we’re seeing very considerable progress starting with the rechargeable hybrids –

[beeping]

Right, I think I may have to more or less finish there. So actually I was only one slide off. So those are my conclusions, ladies and gentlemen. [1:43:59]

JOHN: And that concludes this part of the Big Picture here, listening to three different addresses to the ASPO conference in Sacramento last weekend. Robert Hirsch, Matt Simmons and Chris Skrebowski all looking at the issue of peak oil.

Coming up next, we’ll be taking your calls on the Q-Lines, as the Financial Sense Newshour at www.financialsense.com continues.

Part 3

Q-Calls

JOHN: Well, time to turn to the Q-Lines, meaning the question lines, which is really just one line, but it's open 24 hours a day to record your calls, questions and comments to the program. Toll free in the US and Canada 800-794-6480. Curious to what all you people have been thinking about this week given everything that's going on. As we answer your questions here on the Q-Line, please remember the radio show content on the Financial Sense Newshour is for informational and educational purposes only, and you should not consider it as a solicitation or offer to sell or purchase securities.

And our responses to your inquiries are based upon the personal opinions of Jim Puplava and because we don't know a lot about you or have a lot of information about you, we can't take into account your suitability, your objectives, your risk tolerance. As such the answers are generic and Financial Sense Newshour is not liable to anyone from financial losses that result from investing in company's profiled or recommendations made here on the program. Again, the phone number is 800-794-6480. When you call in, please give us your first name is fine and where you're calling from. We'd like to know that. And please remember to keep everything down to a minute. The first call is from Brian in Tennessee.

Hey, Jim and John. Brian from Castle City, Tennessee. With all of the financial turmoil that's going on, I'll give you a couple of light questions. First of all, I want to say, John, is that your voice on the intro for the McAlvany news hour or weekly commentary, and if so, how did you get hooked up with them. They seem like a good group of folks. And also wondering how the two of you hooked up. I find it a little by the unusual that you do a weekly broadcast and yet you're states apart. But just always kind of wondered that.

JOHN: Witchcraft, my mother would say, but yes, that is my voice on the opening of the McAlvany weekly commentary, and Don McAlvany and I have known each other since 1983 when I began doing some work for him in Denver. And Jim and I got hooked up through Don McCalvaney.

JIM: Was that in the fall of 2001 I was interviewed?

JOHN: 2001. Right.

JIM: And you were engineering Don's program. Yeah. That's how we got hooked up, and it's amazing with technology because John, you're in Coeur D’Alene outside and I'm in, we call it paradise down here in San Diego as long as you don’t drive on the freeways. [2:29]

JOHN: Lodo objected to that by the way. She thinks this is paradise.

JIM: Oh. Okay.

JOHN: It's only your interpretation of paradise. You have earthquakes, we have volcanoes that dump on us from time to time. But that's how we did it, so in answer to your question, Brian, that's it. So let's go to the next question here. [2:42]

This is David calling from Chicago. It's just after the close of the markets today on Thursday the 18th, and Frank Barbera did a nice job of predicting this shotgun V-bounce in gold and silver. Up until about an hour before the close today when everything turned and got slammed the other way. Curious if you have any explanation for what happened there?

JIM: It could have been an oversold condition that reached extreme levels. Remember we were down at, what was it, 747 dollar close on September 10th, and we went from 747 all of the way up to 900, which is 150 dollar gain per ounce, so any time you have a sharp V spike like that, you do have some pull backs, and I think that's what you're seeing here. [3:34]

JOHN: You know, we should also give credit to a lot of other people, Jim. I just thought of it, that work on the program that work behind the scenes and I know Mary has done a tremendous amount, your wife, on the website. Carol and I have been doing radio and have together for 30 years now. We met working for a major network and Carol produces a lot of the ends, the outses, the bumpers, the opening montage and does a lot of research for the program; and we have editors like Glen Meyer, Jack Beuchelman [phon.] and others, so every once in a while I think we should give them credit here on the program as well.

JIM: Yeah. A good idea. A lot of people don't realize, what is there, about eight of us involved in producing this? [4:09]

JOHN: Right. And it's still a pretty daunting task. We have to slam this together on – it's about a 12 hour day for us, 12 or 13 hour day every Friday to make this happen. In addition to all of the pre-interviews and canning that's going on in the week and screening and conferences that we have, but we enjoy doing it. It's sort of a labor of love here. Next question comes from Hong Kong.

Jim and John, it's Charlie from Hong Kong. It's Friday morning here in Hong Kong. I've just woken up to the news that the Fed, the Treasury and government are in talks and planning to provide a half a trillion dollar bailout of the financial institutions over there. It appears to me these people in the Fed and government are trying to treat a symptom rather than provide a meaningful cure for the cause of this program. I think instead of providing a bailout of these financial institutions, they should be bailing them up and charging them – and throwing them into jail for gross incompetence and negligence. They have been totally irresponsible and dishonest with the American people, and I think Americans overall should be totally outraged to what is going on and how they are being treated not only by these financial institutions but by the American government. I had a feeling that the storm clouds are just building up on the horizon and worse is still to come.

JIM: Charlie, you expressed a lot of feelings that many have here. We're outraged by what we see and the incompetence of our elected officials and I agree with you this is just the beginning. People think that this 700 billion dollar bailout is going to solve it. You're dead on –there are more storms that are going to be even bigger than this coming in the future. [5:51]

Hi Jim, this is Mark from Edmonton, Canada. Now, I'm calling more with a comment rather than a question. I've been listening to your program for quiet a few years. You folks down there in the States are going to be having an election soon. So are we in Canada. Now, our man up here named Harper seems to be a shoe in for being the next prime minister. The only thing that isn't a shoe in is whether he's going to get a majority or not, but we could potentially throw us Canadians a huge grenade in his lap by throwing at him out of the blue this whole issue of naked shorting of Canadian securities, which many of us – especially in the middle classes – have had our portfolios smashed to pieces with. Jobs have left the country, the junior mining sector is now left begging for capital where it's probably one of the most vibrant mining sectors in the world. So I just want to encourage the Canadians that listen to this program to call up your MLAs and let them know how offended you are by this issue, and the government refuses to do anything about it, and that our Securities Exchange Commission is among the most inept in the world and doesn't see this problem as being a problem at all. Thanks very much, Jim, for giving me a chance.

JIM: Mark, very well stated. It was amazing when the SEC suspended naked short selling here, you could see the coverage in the juniors and those juniors listed in the AMEX rose, some of them even doubled. That's how big the naked short position is where those that were not listed and still in Canada did not go up as much because what they were doing, I think, was covering over here and yet shorting over in your neck of the woods where it's still allowed. And it absolutely amazes me, but there are going to be some class action lawsuits and there are going to be some big lawsuits coming in. I had several discussions with a couple of mining companies and a big law firm this week, and I can just tell you bankers beware because trouble is coming for those involved in this illegal activity. [8:07]

Hi Jim and John, this is John from Utah. I'm out for my early power walk. It's early Friday morning. The markets were up over 400 yesterday and they are up 250 in the overnight session. What the Fed did yesterday, they put the final nail in the coffin of the inflation versus deflation argument. The Fed apparently, is going to buy everything. I have been a doubter on your hyperinflation theory for many, many months, but now I am convinced. I will sell all of my gold and silver when Nancy Pelosi comes up and says “even if we have to cut social programs, we have got to balance the budget;” and when Ben Bernanke says “we can't cut interest rates that would be inflationary.” Until then it's hyperinflation.

JIM: John, you hit the nail on the head. It's something we saw four years ago as I took a look and read the Fed papers of 1999 and 2000 because a lot of what you see unfold today with what the Fed is doing was outlined in those papers going back 8 years ago. [9:17]

My name is Susan and I have been a trader for about 27 years. And I just had to mention something about your show last week. I listen to you religiously because in the old adage of keep your friends close and your enemies closer, I never really believed in gold or the border guard story etc. But this week, actually last week after I listened to your show, I heard even the most diehard gold bugs of all time gave up on everything: the physical, the mining stocks the metals, the whole thing. And I thought to myself this is really probably the buying opportunity of a life time. So anyway. Congratulations, you guys called it beautifully and with all the laws that were broken by the United States Fed and about half of Congress last week, I think gold might be in favor for a while. Congratulations again, and I'll be listening this week.

JIM: Thank you Susan for the kind comments and I do agree with you. I think this is the buying opportunity. Not only just in the gold sector but even in the energy sector. They are just trashing them. They are throwing them out and you're absolutely right. Most of the gold bugs that I know are predicting lower prices. This is it for the mining sector, the bull market is over and whenever the people that are in the industry believe it the least, you know you've hit a bottom. [10:42]

Hello, Jim, great Joe, my name is Stan. I'm from London, Ontario. I'd just like to say I'm noticing that we're getting strange rules regarding shorting. I was wondering if you or someone else might organize a petition so that us small shareholders can maybe sign on to both North American markets, meaning the US and Canada because I'm getting shocked by these strange rules to protect the financials. And yet the gold sector is being allowed to be raped continuously.

JIM: You know, Stan, listen to Mark, an earlier caller on the Q-Line because you need to let your MLPs know about this because the regulators are doing absolutely nothing. [11:27]

Hi Jim and John, Rod from Costa Mesa, California. I'm watching the markets very closely of course on this eventful week. One big question has popped up. I think we just had a late-in-the-day slaughter of Northgate Minerals, NXG on the Amex, it was doing really well for the week and all of a sudden it's just dropped like a rock in the last minute. Down 27% today. So wondered if you could maybe figure out what's going on with this one. It seems like an anomaly. Everything else in my portfolio is doing very well this week.

JIM: You know, Rod, there was an unusual block trade; a very, very large volume of trading that day and of course it got down to a dollar and spiked right back up. In fact, the company itself noted that a large volume in the company shares were traded on that day were at a price of 1.01. This share price was considerably outside the interday trading range and inconsistent with the price in Canada at a buck 57 closing price on the Toronto exchange. So somebody was trying to do something here at the end of the day. A drop down or something. But there was some hanky panky going on in the market. [12:42]

Hey Jim and John, this is Rocco from New Jersey. It's Saturday morning after the crazy week on Wall Street. With all of the liquidity being pumped into the system now –it looks like several trillion to deal with the banking crisis – when do you all anticipate that to start to really spread into the inflationary scenario which appears to be imminent at this point, just a matter of time. I know we're seeing it, obviously, you know, over the last year, but it looks now like this thing is going to get out of control at some point. And when do you feel it's really going to hit the markets where between the cost of things really start to rise and people are just going to be dumbfounded when it happens because with these trillion dollar bailouts, we know it's on the way? But could you articulate and explain what you feel the next steps to this actually unfolding with all of this money being created.

JIM: You know, Rocco, what you have right now is money and credit that are being created to absorb the collapse of credit, so that's where a lot of this money is going. And remember the side pockets or depositories of inflation, which is money wealth, debt markets or even in the stock markets, so right now, a lot of this inflationary impact is being absorbed in the market to keep the market afloat, to keep the financial institutions afloat. But I think you're going to see a disinflationary trend as a result of declining prices for manufactured goods of things that you don't need; or in certain asset markets like real estate, I don't think we’ve bottomed in real estate yet, but you will start seeing the rise in prices of things that you do need whether it's food, whether it's energy, the cost of services, those things are going to go up. It's going to be gradual and it's probably, you know, it's going to be a 12 to 18 month period and it's when the public finally wakes up to, “oh my god, there is real inflation out there.” And when people start saying I'm ditching my paper money because 1) the interest rates paid at the bank or in treasuries are virtually worthless in terms of what the real inflation rate is; 2) and people start getting out of their dollars and spending it, that's when money velocity increases and that's when you see the increase in inflation. [14:58]

Hi guys. This is Ed calling from Toronto. I have a very simple question. Let's say I bought a long futures contract on the COMEX and took delivery of one contract which is 5000 ounces of silver. I think what happens is I get like a silver certificate for the silver stored in a vault somewhere in New York City. If I wanted to take physical delivery in Toronto, how do I do that? Do you have to incur a lot of expensive transportation in security and border crossing charges or is there some way I can transfer it from one bank to another and pick it up in Toronto. Please let me know.

JIM: You know, Ed, I have not done that, so you're going to have to arrange for transportation to pick it up. I'm not sure on the transfers, how that's going to be done. You're going to have to find a bank, and if you're going to take it from the COMEX or storage in New York and transfer it to some bank in Toronto, there is going to be some type of transportation charge. Right now I wish there was a detailed answer. I've never done that before, so I'm going to pass that on: If there is somebody listening to this program and you have done that, if you would please email or give us a call and tell us how that is done if you've done it, then I'll be glad to read that on the air. [16:15]

Hi Jim and John. It's Andrew from Colorado. My question this week is can you talk a little bit about in terms of inflation versus deflation. In Japan, when their real estate bubble crashed, the government did exactly the same as what the Fed is doing now. They flooded the market with a lot of money, but the banks hoarded it and as a result, they just had massive deflation, and lots of recessions. Why is what the Fed is doing now going to produce inflation rather than the deflation that we saw in Japan?

JIM: You know, Andrew, you said a couple of things. What happened in Japan it was not only as the money was created, not only did the Japanese banks hoard it, not make loans because they had built up quite a bit of manufacturing capacity and there was surplus real estate, there was surplus manufacturing capacity, so there wasn't the impetus to lend, but also the people themselves did not spend the money into the economy because as they saw the value of their stock market investments drop, the value of their real estate drop, they began to hoard money, so what happened is money supply was increasing, money velocity was decreasing. And then another factor is a lot of the money that was created was exported. That's where you got the carry trade, so the money didn't stay in the Japanese economy. It went into other economies around the globe, into the US and other areas seeking a higher rate of return. That is not what is happening here. [17:45]

Hi Jim and John. This is Richard calling from San Francisco north bay. I suppose I'm struggling like everybody else trying to figure out what really is going on in this credit crunch and there is one small piece that perhaps you can explain and that is why commercial interest rates have not gone up sharply like to, say, 10 or 15%. The destruction of the capital has greatly reduced the amount of money that is available for lending and yet according to government statistics, business is carrying on as usual; and if that's true, that should mean that business use of debt is unabated and given these two opposites, wouldn't that mean that loans in the face of a constricting supply of money available should have the interest rates forced up? You mention Wamu being 30% for six months paper, but that was because Wamu was a credit risk. But why has the supply and demand not driven up interest rates for credit worthy business? Can you explain what's going on.

JIM: You know, Richard, there are a number of factors. Number one, commercial always lags what's going on in residential, so that's part of it. Secondly, a lot of the projects that have been going on for borrowing like you look at the skyline in San Diego, you've got four high rise condominium projects that have been approved and funded and also you may have better credit risk on the business side, but if you take a look at the rate of change on commercial industrial credit, it is now declining at a rapid rate. So I think on the commercial side, you haven't seen all of the credit implosions as you've seen in the residential and personal side, so I think you’ve got a lag factor here. [19:27]

Hello, Jim and John. This is Frank from Youngstown Ohio. Would you please critique the following solution to our bank insolvency problem? Now, look, I'm not Hank or Ben Bernanke, but why do I get the impression these people are coming at this from the wrong direction? Jim, wouldn't it be better if we cancelled all taxes on savings accounts and CDs and money market accounts? Wouldn't it be better to have liquidity come from that direction to solve this problem instead of throwing good money after bad? Like I said, it's my simplistic view, but I'd like to have you share your thoughts and thank you for the excellent education.

JIM: You know, Frank, eventually, we're going to have to go to a system that encourages savings because in a free market economy, it is the surplus of savings that really determines what interest rates are. And unfortunately, when you have a central bank as we have today that can artificially change interest rates and create money out of thin air, it discourages savings. The more the Fed interferes with real interest rates, the less people save. The lower they drive interest rates below what they should be, the less encouragement there is to save; and then, as you brought up a good point, we tax people for trying to save or invest and we encourage them with tax breaks when they go into debt. That whole paradigm is going to be changed, and it's going to be forced upon – we're going to go back to more of a cash, save and pay system much like we did at the beginning of the 20th Century when this whole thing collapses. [21:09]

Hi Jim and John. Joe from New Jersey. Jim, I wanted your take on principal protected notes and reverse convertible notes. Would this be a good investment for the small investor and is it very speculative? Looking forward to your answer.

JIM: Joe, principal protected notes, unless it's secured with property or something that's tangible, like anything else, you get into counterparty risk. I don't like the idea unless it's specifically backed by an asset. [21:39]

Hi. This is Jim from Michigan. I'm calling with a PowerPoint presentation I thought you'd enjoy. The address forward is www.energybulletin.net/node/23259. And it's about how the USSR was better prepared for a collapse than the US. Thanks.

JIM: All right, Jim, thanks for bringing it to our listeners' attention. [22:01]

Hello. This is Jim from Colorado. I have a margin account with Interactive Brokers and they say they have security backed by a security company up to 500,000 dollars and after that another 500,000 dollars are backed by FDIC. Do I need to worry about my account just in case that company goes out of business, or does margin account and cash account is there any difference between them risk wise? If you could let us know, that would be great.

JIM: Jim, I assume what you're saying is you own a margin account. Most brokerage firms are protected by half a million dollars from fraud or security by SIPC, and that's Security Investor Protection Corporation, and they probably have half a million dollars, as you spoke, with some kind of insurance company. You need to look at the finances of the company. Are they leveraged? What are their financial statements because that tells you how sound their business is and whether they are getting into risky type things, so you need to take a look at the leverage. I'm not familiar with this particular broker. Also, when you do have a margin account, bear in mind that a lot of the securities in your margin account are being loaned out to short sellers, and if any of those short sellers get into trouble as we've seen here, you could get into some counter party risk; some of the risk that you run with a margin account. [23:25]

Hi. Shannon here from Bend, Oregon. How are you guys doing, Jim and John? Appreciate you taking my call. There is a lot of rhetoric going around on the internet about cashing out and the stock market is going to crash. Just wondering if you couldn't touch bases with the gold companies up in Canada and Mexico and some of the others around where we would stand if there is a market crash and how they would hold up? I know we've already took a beating just kind of from your own personal experience where we might end up if something like that was to happen. Any how, awesome show.

JIM: You know, there has been quite a bit of crash in the shares already, and that's what's happened. They are not as liquid, and so when everybody gets risk adverse, plus you've had a lot of naked short selling and short selling itself come in the sector, I think a lot of it's going to depend on the size of the company, the size of the deposit, the experience and access of management to the capital markets, which is going to determine whether these companies are going to survive. But I do think consolidation is coming to the industry. There are a lot of juniors out there that simply aren't going to survive. They are too small, the projects are too small, the management doesn't have the experience or access to the capital markets and many of them will be consolidated in this process. But the large deposits, strong companies with management, a good board, access to the capital markets, I think these are going to be the premiums. And I maintain that in the next couple of years, the two or three million ounce deposits in safe jurisdictions are going to be on the shopping list of a lot of these majors as many of them, from Barrick to Agnico and many others, have already indicated that that's what they are going to be looking at. [25:11]

Hi Jim, this is Denise in California. Several weeks ago, Nick Barisheff spoke on your show about the ETF book and highly recommended it, especially chapter two where he explains the structure of ETFs and differences between mutual funds. Nick said that in the event of a widespread financial collapse, ETF shareholders could lose value because of the way that ETF funds are held. I have read and reread chapter two, but I don't understand why there might be a problem. Can you please explain his concerns about ETFs and do you agree that if there was a widespread financial crash, ETF shareholders could be in danger of losing the value of their shares.

JIM: You know, Denise, I'm not sure if Nick was referring to close-end funds and the difference between closed-end funds and ETFs where there are differences that persist, price differences between the price of the fund and the inter-day value of the securities that compose the fund. You also have sometimes double accounting or double ownership of shares sometimes with the ETFs. And I think maybe that's what Nick might have been referring to. [26:24]

Hi Jim and John, this is Paul from Ohio. I recently purchased SKF, which are the ProShare Ultra Short Financial ETF. I thought it would be a good speculation. Apparently the government thought so too, so much so that they banned short selling in the financial stock. This got me thinking about capital controls. Can you plan a segment on the type of capital controls that you foresee and how to prepare or hedge our portfolios. With the speed of this crisis, we need to contemplate this sooner rather than later.

JIM: You know, Paul, we probably will address something like that because certainly we're seeing unusual things happen. You know, you think you want to hedge your portfolio and go short and the next day the government changes the rules. And as we've seen this government do, and especially in this crisis (and remember we're not out of the woods yet with this crisis, it can get much much worse) you're going to see the rules change as we go along because in other words, you take a look at the Lehman bankruptcy, the government thought “well, they dodged a bullet” and they let that one go under and then it spilled over into the derivative, the credit default swap market and the money market funds. And the next thing they had to react to it by back-stopping money market funds. So, yeah. That's probably a good idea that we're going to be talking about that. One of the things – you may not be able to move money out of the country. You may be restricted in terms of what things you're going to be going in. In other words, if people short, we may ban short selling. The only thing you’ll do is buy and sell but you won't be able to short, or periodically they'll come in and put some controls on shorting. We're going to have to get quite a few experts on here because there are a lot of things happening right now that are just – we're in a new era right now and the government is doing and breaking all kinds of rules as we go along. [28:11]

Hi Jim, this is Michael calling from Taiwan. My question is that I read that the potential CDS market is at a staggering 62 trillion US dollars. And if it collapses, it's likely that it will be almost a complete wipe out of the financial institutions in the USA. Personally, I have invested a lot of my holding in the Taiwan equity market, mainly in the oil refineries and commodity sectors. But my question for you is: 1) do you expect a wipe out of US financial institutions; and 2) should during a time like this should I reduce my equity holding in the Taiwan market even if they are in the commodity sectors. It will be great if you can answer the question for me.

JIM: I know, Michael, if the credit default swaps implode, as I believe they are going to start doing next year, AIG, a good example, it's not just US institutions. If you take these credit default swaps, the main players in this market were the banks. And I'm talking about banks, international banks that you can count on two hands. They are all interlocked and intertwined with each other. Japanese banks, European banks, US banks, Swiss banks, all of these banks are tied together. That's why when you’ve seen in this credit crisis, and remember last August, it erupted with banks and funds in Europe where it first emerged and then came across the pond over here to the US. So this whole thing is interlinked and it's global. But I think hard assets, hard resources of tangible type assets as money loses its value with all governments inflating. But if you're 100 percent in stocks right now, that's not a good diversification. You might want to have some kind of cash instruments in strong currencies and also bullion. [30:09]

Hi Jim and John. This is Mike from Miami. Great show you guys. I'm a long time listener, first time caller here. I've got a question about inflation-deflation and looking to Japan for historical guidance on what happened over there in the 90s. So despite this massive inflation bail out, money printing effort we've got going on, in Japan a similar thing happened in the 90s with the bust of the real estate bubble there and then the subsequent bad loans and bailouts for the banks; and, well, we can look at the charts and history to see what all of that led to. And my question is: What is different in our situation? Why do you think we're going to deal with inflation versus like in Japan deflation declining stock markets and recession after recession. I'd like to get your take on that, and well, good luck in these troubled times everybody.

JIM: You know, Mike, I answered that in a earlier caller. A lot of it has to do with money velocity and savings. Also remember in Japan and the US which had deflationary experiences were creditor nations. In other words when the United States experienced it's problem it was a creditor nation versus a debtor nation. The experience of debtor nations are much different, but a lot of it has to do with money velocity and hoarding. If you listen to a caller earlier in the Q&A section, by the time I've gotten yours, you've probably already heard that answer to one of my earlier callers dealing with inflation and deflation. [31:34]

Hi. This is David calling from Vermont. I'm confused. Spider Gold GLD holdings were reported to rise to a record 724 tons on September 24th. However, spot gold prices are low. I wonder if you can explain how the spot price is set and why it remains low when there is this tremendous buying power going on right now.

JIM: You know, David, to try to explain this in the time remaining would take a long time, but I'm going to recommend that you google ‘spot price’ and there is Wikipedia. It explains the difference between spot price and future prices and forward contracts in terms of coupon curve and the spot curve. It also talks about the difference in terms of how these items can trade differently at different periods of time. In other words, the spot can be lower than the future or the spot can be higher than the future. When you go to the Wikipedia, there is a whole number of links on forward prices and pricing in terms of how all of this works. It would take me probably about five minutes to get into that and explain how it works, but there is a good example or reference point. You just go to Wikipedia, type in spot price and it’ll give you everything you need to know. [32:54]

JOHN: Quite an interesting week. I guess that's an understatement, but we have to close out with something. That closes out the program for today. Let's preview what's coming up in the next few weeks assume that we don't have to jump in and do emergency intervention on the Financial Sense Newshour.

JIM: Next week my guest will be Frank Holmes. He manages the US Gold Fund. He's also coauthor of a new book called The Goldwatcher. On October 18th, John Waggoner Bail Out will be with us and we're working on some special programs right now, and this is changing as it goes, just as there is so many things that are happening in our financial markets right now. We're trying to get some guests on that are going to have some relevance to the things we're seeing happen in the financial markets and in Washington, and that's coming up.

So on behalf of John Loeffler and myself, we'd like to thank you for joining us here on the Financial Sense Newshour. Until you and I talk again, we hope you have a pleasant weekend.