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Stephen Johnston

Stephen Johnston

Stephen has over 15 years experience as a fund manger - working for organizations such as the European Bank for Reconstruction and Development, Societe Generale…

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January 2012 Update - Can You Spare a Moment for the Real Economy? Part 1

Despite the undoubted, but cheap, appeal of adding to the chatter about which country is thought to be going bankrupt this week or which government believes it can prevent this outcome by the expedient of effectively adding zeroes to amount of its currency in circulation, I thought instead I would try to conduct some analysis of a few trends in the productive economy. Sadly, trying to forecast the next 12 months, or even the next month for that matter, in large part has become a game of guessing how the markets are going to react to political announcements in the land of sovereign debt. How, as people attempting to make rational economic decisions, can we possibly predict the day-to-day actions of markets dominated by non-profit maximizing government and central bankers?

It follows that this may be one of those times when long-term trends are easier to discern than short-term and so today's discussion revolves around some long-term issues in the areas of pensions and energy. I also want to examine another important trend in water resources which I will do in my next briefing.

Pensions (see also Agcapita briefings - Pension Funds and Hobson's Choice & Demographics are Destiny): Pension plans are heading into a challenging period for their ability to pay promised benefits and perhaps for some even for their solvency. At its core, the issue arises because a significant number of pensions assume annual returns in the range of 8% when they are planning how to meet their obligations - at the same time as they are being faced with the Zero Interst Rate Policies ("ZIRP") and boomer demographics. As Ron Chernow points out people are beginning to worry that this might not be a workable investment model "There is a kind of fear, approaching a panic, that's spreading through the Baby Boom Generation, which has suddenly discovered that it will have to provide for its own retirement."

Demographics: It is no secret that the developed world is facing a wave of retirements as boomers move to the end of their productive careers. Just how big is this transition? In 2000, the ratio of Americans between 15 and 59 years old to those over 60 was four to one, according to a United Nations report. In 2050, the ratio will be only two to one. The boomers will need to liquidate assets to fund retirement. However, we can't all cash out at once - pensions are already facing solvency issues and when the boomers start to liquidate this issue will grow in magnitude with poor equity returns as the transmission mechansism. If you don't believe me, here is the bad news straight from the horse's mouth - the US Federal Reserve - an organisation which is much more likely to err on the side of optimism than full disclosure: " Historical data indicate a strong relationship between the age distribution of the U.S. population and stock market performance. A key demographic trend is the aging of the baby boom generation. As they reach retirement age, they are likely to shift from buying stocks to selling their equity holdings to finance retirement. .... P/E* should decline persistently from about 15 in 2010 to about 8.4 in 2025, before recovering to 9.14 in 2030... Moreover, the demographic changes related to the retirement of the baby boom generation are well known. This suggests that market participants may anticipate that equities will perform poorly in the future, an expectation that can potentially depress current stock prices. In that sense, these demographic shifts may present headwinds today for the stock market's recovery from the financial crisis." Poor equity returns indeed!

ZIRP: How does ZIRP also affect my pension you may ask? A large portion of pension portfolios are in fixed income securities that are now yielding a fraction of the returns required to maintain plan benefits. The longer ZIRP continues the worse the problem will become. Ultimately, the combination of demographics and ZIRP is going to mean benefits will have to be reduced and/or large amounts of additional capital in the form of higher contributions will have to be collected. A recent report from the Bank of Canada supports this conclusion. According to the BOC December 2011 Financial System Review "The aggregate solvency of defined-benefit pension funds in Canada is close to an all-time low "(emphasis mine) and further that "According to the Mercer Pension Health Index, the decline in long-term interest rates over the past six months has brought the funded status of Canadian pension funds near the all-time low reached in 2008 (Chart 20). This index declined from 71 per cent in the second quarter of 2011 to 64 per cent at the end of October, indicating that a representative pension plan faces a higher risk of being unable to fully meet its financial obligations." No mention of course that it is exactly the ZIRP policies followed by the BOC that in part are responsible for this problem.

EROEI (see also Agcapita briefing - Start Thinking About EROEI): I have touched on the matter of EROEI on and off over the last year. Put simply, it requires energy to produce energy and the relationship is as Energy Return On Energy Invested. I'd like to take a short-cut and quote from my 2011 EROEI briefing:

"Why is EROEI important? Because we are in the process of transitioning from high EROEI hydrocarbon sources of energy to low EROEI sources - think Saudi Arabia versus the oil sands. Even if you don't believe that peak oil is an immediate issue, I would argue that EROEI decay is most certainly. Discoveries of conventional oil total roughly 2 trillion barrels, of which 1 trillion have been extracted so far, with another trillion barrels to go. However the first trillion barrels was the oil found on shore or near to shore; close to the surface and concentrated in large reservoirs; in politically stable regions - the "easy oil". The remaining oil is far offshore or deep underground; smaller, harder-to-find reservoirs; in politically unstable locations- the "difficult" oil.

I believe an increasingly reliance on 'difficult oil" has some serious consequences for the global economy. The first is that deliverability - the amount produced per year for a given quantity of reserves - will fall, making it harder to increase total production even if reserves remain relatively abundant. The second is that the real cost of extracting the remaining reserves will escalate in terms of the energy inputs required.

Current production is around 86 million BOPD. However an 86 million BOPD oil production profile of high EROEI sources is very different from 86 million BOPD of low EROEI sources. Effectively the net energy left over to drive economic growth is significantly lower in the latter scenario. Here are some very approximate EROEI ratios for various energy sources:

  • 1970s oil & gas discoveries - 30 to 1
  • Current conventional oil & gas discoveries - 20 to 1
  • Oil Sands - 5 to 1
  • Nuclear - 5 to 1
  • Photovoltaics - 3 to 1
  • Biofuels - 2 to 1

Assuming 86 million BOPD composed of 1970s oil & gas - there is around 83 million BOPD net to fuel growth. Assuming 10% 1970s oil & gas, 45% current oil & gas and 45% oil sands then this drops to 76 million BOPD - an 8% reduction. So as we transition to lower EROEI sources of energy - it seems logical that production has to increase faster and faster to generate the same rate of economic growth."

Water: An examination of water resources as they relate to agricultural and industrial output and some practical consequences of water constraints for emerging economies - particularly China and India - will be included in part 2 of this briefing. In the interim I will leave you with some quick agricultural facts you may find interesting:

  • In the United States, approximately 3,000 acres of farmland are taken out of production every day and used for non-agricultural purposes.
  • In the United States, 44% of all farmland is owned by individuals who do not farm the land themselves - they lease it back to farmers. In Canada this percent is significantly lower as financial investors are still relatively new to the market.
  • Saskatchewan has approximately 40% of Canada's farmland - Alberta and Saskatchewan together have approximately 70% making the two provinces the cornerstone of Canadian agriculture.
  • China, with 20% of the world population, has only 7% of the world's arable land.
  • China has lost 20 million acres over the last 10 years, much of this due to construction
  • Wheat demand is projected to increase to 775 million tons by 2020 with 2/3 of this increase coming from emerging economies that will double their imports.



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