(Or: Why I am looking for a defensive Super Fund.)

Well the Peak Oil game is over. It is time for me to post something serious. So I am thinking about my Superannuation and how investments are likely to do in the economic conditions ahead....

I am on record (in an article in The Australian newspaper, about 18 months ago) as saying we can expect a boom, followed by a severe bust. The bust will be comparable with The Great Depression, or alternately, with Russia after the collapse of the Soviet Union. My estimate for the length of the boom was 10 years, but I have since revised that down a little. There are three causes for the downwards revision: Firstly resources are tighter than I thought (a lot of proven reserves have been revised downwards recently), secondly  "above ground" political factors are moving faster than I thought and finally, but most importantly, I failed to factor in the rather obvious fact that demand destruction occurs in non-exporting countries first (exporters service their own market first, then export the excess).... and the sources of the boom (China, India, to a lesser extent the US, etc) are net resource importers, not exporters, so they are likely to suffer from this effect (at least somewhat).

However, as a resource exporter I think Australia is well positioned to weather the bust. 

My supporting argument is based on this premise:-

Resources (led by oil and gas) are becoming expensive. While there is still a lot out there, the "low hanging fruit" is gone. As a result, we are seeing the demand curve diverge slightly from the supply curve and this is driving the increase in resource prices across the board.

The consequences are this:-

Countries with excess resources tend to consume their own resources and only export the excess. So when the demand curve diverges from the supply curve for a given resource the need of the exporting country is met first and the countries without the given resource tend to suffer disproportionately, as they only get the leftovers. Obviously, this is a simplification, the market does tend to balance things by escalating the price, but if the local market can pay (which they probably can, since they are getting a good price for their left-over resources) then the local market will be serviced first.

Oil production was steady last year (at around 84+ million barrels a day), but oil exports dropped by about 1% - despite record oil prices and thus a record incentive to export.  

Conclusion:-

I suggest that this drop in exports was caused by the fact that oil producing nations serviced their own market first and had no capacity to service the importing nations at the level demanded (hence the huge increase in oil prices as supply and demand diverged).

If there is a gap between the supply and demand curves, then the drop in exports that started in January 2006 is a symptom of this problem. The slope of this graph is tiny - there is slightly more than a 3% per year difference between the historic growth trend (upwards 2%) and the export trend in 2006/2007 (down 1%) , but the implication is profound. Instead of demand being met by increased exports,  substitution must occur to supply the demand increase, and a compounding 1% destruction in demand must be found each year to cover the decline in exports.

The pattern seems to be that substitution is covering the increase in demand by developed countries (using ethanol, LPG, etc), while the reduction in exports is being met by demand destruction in impoverished nations.

The trend could be simplified by assuming that the use of ethanol and LPG will increase by 2% each year in the years to come (this is perfectly in line with George W Bush's call for "20% ethanol by 2010") and another fragile nation implodes each year to cover the 1% decline in exports. A nice, neat solution. However this simplification is unlikely to be reflected in reality.   

This geographic demand destruction is a complication that I did not originally consider:- despite globalisation, the world can't be treated as one discrete market.

As an example:- As any economist can tell you, demand destruction occurs as prices rise. This demand destruction is happening already (at least for oil), but only in some geographic areas. If you live in Australia, you get a bit miffed at paying $1.30 per litre, but it has little impact on your habits. But if you live in a country that is already marginal (due to bad government or whatever) a tripling in the price of a barrel of oil leads to complete destruction of demand. People substitute or do without. This is currently occurring in several African nations (and to a lesser extent in parts of Asia and India).

People in Zimbabwe in particular have gone almost completely without oil for the last few months (the government there is particularly incompetent, making their economy very marginal). This complete demand destruction will probably lead to some African nations collapsing, as industry is unable to continue in these countries without oil, and without oil for transport food is simply not making it onto the shelves in the cities. We perceive the cause of this collapse as bad government (and it is), but it is worth noting that with the tripling of the cost of a barrel of oil, complete demand destruction is starting to occur in locations made fragile by local factors. 

Many other resources are showing similar rises in price, and substitution is occurring for many of them. However most non-energy resources (eg copper) are qualitatively different from oil. Resources  such as copper are not consumed when they are used. So, as copper (or any similar resource) goes up in price it becomes attractive to pull it out and re-use it more profitably somewhere else. This ability to re-use the resources elsewhere makes it possible to strip resources of this type from the infrastructure of an impoverished or failed nation and add them to the infrastructure of a wealthy nation.  Resources such as this are also obvious targets for theft - It is impossible to guard a thousand kilometres of copper power line. If the price of resources goes up far enough, infrastructure is likely to be threatened, particularly in less wealthy nations. The economic implications of constant infrastructure breakdown are obvious.

Even in wealthy nations, if the price of these resources keeps rising, our infrastructure is likely to be subject to disruption due to theft.

So demand destruction occurs in a geographically staggered sequence, with the most marginal areas suffering from demand destruction first. Where the country affected is already marginal, that country collapses.

Each year another 1% in demand destruction needs to occur. My prediction would be that this would lead to a series of rolling collapses of the world's more seriously "failed states". Where the nation is not marginal, substitution or "making-do" will lead to a depressed economy for a while, then ingenuity will (I presume) lead to a new, robust economy based on new techniques and technologies.

So my prediction would be that a truly global collapse of the economy will not occur (despite the Malthusian predictions to the contrary), but that a rolling series of problems could cause a sustained economic downturn. This will culminate when the economic drivers of the boom (China, India, etc), who are net resource importers, are constrained by resource unavailability. This constraint will be obvious to net exporters, thus mitigating somewhat against the constraint, as exporters will be motivated to find ways to export to the drivers of their economy. 

Eventually, new drivers will emerge. The new drivers will probably not be nations, the drivers will emerge from new energy technologies.

This emergence may be complicated by some problematic economic precursors: the asset bubble, the US deficit, the demise of the "petrodollar" leading to the demise of the $US as a unipolar fiat currency, while simultaneously we have the demise of the US as a unipolar world superpower (and the rise of China and resurrection of Russia),  etc. These factors are significant because they can cause some economic hiccups in the near term. These hiccups are problematic because while (as you say) substitution is a possible approach when resources are constrained, there is a problem - substitution frequently requires different (or extra) infrastructure. If the economy is suffering from a series of hiccups, then investment in infrastructure is difficult. This creates another constraint to growth further down the road (as infrastructure of this type often has a 5-10 year lead time).

These constraints can (and will) be overcome. But if these events occur, then we can expect a very rocky road for a number of years before the solutions arrive.

Hence, I want to be financially insulated against this possibility. There are three final obstacles to prediction:

1. Anybody who thinks they can predict outcomes ten years from now needs to increase the dosage of their medication.

2. Other people can predict too and this changes the outcome, frequently shortening timeframes (due to the "self-fulfilling prophecy" effect).

3. Specific political responses to resource constraints appear to be emerging. The US appears to have decided that controlling some Middle East oil is a good risk-management strategy - but this may have backfired, accelerating the problem rather than solving it. Meanwhile Russia is ramping up rhetoric. Associated with the hawkish rhetoric are some internal changes in Russia that look a lot like a move to extreme Nationalism, or even overt Fascism. Both China and Russia are modernising their armed forces and equipping them with technologies that may negate the US technological advantage. Both Russia and China are extending the borders of their claimed territory to include resource-rich areas. Other nations are disputing these claims. If this trend continues and deteriorates into localised belligerence or limited war (direct or by proxy), then it is really hard to guess where this will lead. In Australia, the effects may be limited. It might even be good for Australia.

So, to summarise the model:

1. We face resource constraints due to the emergence of developing markets combined with increased difficulty in extracting resources (most of the low hanging fruit has been harvested).  This has led to a slight divergence between supply and demand, which in turn has driven prices for resources up.

2. As this divergence of supply and demand proceeds, the resource constraints are likely to disproportionately affect net resource importers.

3. Sadly, the drivers of the current economic boom are net resource importers.

4. For this reason, resource constraints represent economic constraints as the resource constraint constrains the source of the economic boom.  (However, for reasons of pure self-interest, the exporters are likely to search for ways to support exports to the nations that are drivers of the economic boom, so this problem will be somewhat mitigated.)

5. These economic constraints do not effect everywhere equally. The first impacted areas will be the most marginal economies. The next affected areas will be the nations that are net importers that do not drive the economic boom (the non-boom nations get lower priority for imports).

6. Because geographic areas are impacted sequentially, a global breakdown won't occur (despite the doomsayer's predictions), but a sustained downturn is possible as a result of economies sequentially suffering from a downturn.

Oh.... and the final bit of the model:

7. If resource wars become widespread, all bets are off.

Is the model flawed? Yes. Because I have not talked about the people that need to die as part of “demand destruction”. And I am not going to. It depresses me.