Volatility in the Price of Oil since Hubbert's Peak and Investment Risk

Is price volatility since peak oil a cause of the "bad behavior" of the financial industry ?
18 January 2009

Key Words:  oil shock,  inflation, S&P 500, gold, turbulence, shadow banking system, credit crisis.

Summary
This idea is how the interests of certain individuals in the global financial industry may have quickly shifted from protecting shareholders to a wholly self-interested "cashing out" from the mid 2000s. The mechanism proposed is anticipation and confirmation of the consequences of volatility in the price of oil on investment risk. Data and analysis is provided to demonstrate that a distinct and ongoing pattern of pulsed spikes in oil price instability initiated in the mid to early 2000s for which there had been no apparent precedent. This new pattern of price volatility may be a natural process that is caused by being on the down-slope of the production curve since peak oil. Importantly, individual spikes in oil price variance precede similar pulses of instability in the inflation rate, the S&P 500 index and the price of gold - indices strongly tied to the confidence of financial professionals to make accurate predictions about investment outcomes. It is proposed that as evidence for increasing uncertainty in investment risk going forward grew, the necessary and sufficient conditions emerged for: 1) expansion of the "shadow banking system" and 2) unregulated value extraction (i.e. looting) from this sequestered pool of capital.

Introduction
The former chairman of the US Federal Reserve Alan Greenspan provided the following response during questioning about his “ideology” before a committee of the US congress on the 23rd Oct 2008:

Greenspan said: "I have found a flaw. I don't know how significant or permanent it is. But I have been very distressed by that fact...."

A reflexive media and commentators jumped on a bowed Greenspan for the usual depressing reasons. However, was it possible that Mr Greenspan had let his mask slip for a moment ? The attention grabbing part of his sentence was “…how significant or permanent…”. Could it have been that Mr Greenspan was not saying he’d been wrong ? Instead, was he implying that conditions in the economy had changed unexpectedly and fundamentally in a manner that now made his old way of thinking flawed ?

This idea explores the possible causes for Mr Greenspan’s distress. In short, it proposes the outline of a mechanism for how volatility in the price of oil might have contributed to the apparently irrational actions of the financial industry. In particular, it speculates how recognition of the implications of this volatility might have rationally and quickly changed the incentives of certain financial insiders. The idea also proposes that in coming years, unpredictability in the price of oil will  become broadly understood (i.e., infamous) as one of the most serious and pressing threats to our economy and democracy.

Consider the following hypothetical sequence of events:

1. Global oil production peaks around the yr 2000 as predicted by Hubbert.

2. A new pattern of volatility in oil prices emerges shortly thereafter and this pattern continues to build through the present (and into the future).

3. This type of volatility is in the nature of being on the production down slope of a finite resource in great demand (i.e., oil). Variance and occasional very large movements were certainly evident in the upslope of the production curve. However, the frequency and severity of oil price movements that characterize the new pattern on the downhill side of the production bell curve are envisaged to be of a different order of magnitude.

4. Owing to the singular role of oil in the economy, volatility in its price begins to propagate in variable degrees into the volatility of the price of nearly everything else.

5. A general increasing volatility in prices translates into increases in risk of investment - indeed, due to unknowns in future prices and most especially of oil itself, real financial risks across the board are probably rising exponentially relative to price volatilities.

6. A smart, knowledgeable and initially small number of financial insiders anticipate and confirm the implications (as outlined broadly in 1 through 5) of being on the down slope of the global oil production 4-8 yrs earlier than the rest of us. These people don't need to know each other, but do need to have specialized knowledge and be capable of uncommon insight.

7. With financial risk increasing, and a still small, but growing number of insiders coming to understand what is going on, the incentives within markets shift rather quickly from protecting shareholders interests, to figuring out how can to quickly “cash out”. This shift in incentive is the fundamental change (of uncertain permanence) that may be the real cause of Mr Greenspan's distress.

8. The behavior of the primary few spreads within the financial industry. Most of these secondarily affected individuals are probably oblivious to the ultimate cause (i.e., oil price volatility) of their actions. A fin de seicle ethos becomes pervasive. There is an unspoken or perhaps even quietly discussed urgency that time is running out you to make your “nut” (i.e., sufficient money to retire wealthy) and get out. Greed, self-interest and/or stupidity do the rest.

How the "cashing out" occurred is where the idea goes fuzzy. But the story does seem to conclude with tens possibly and hundreds of trillions dollars in mostly worthless ("toxic") assets in the "shadow banking system". It is speculated that the mechanism of "cashing out" did not directly involve the accumulation wealth in the "shadow banking system" per se. Instead, the evidence suggests that extraction of value involved insiders taking fees, salaries, bonuses and other mechanisms leveraged against the "toxic assets" by financial insiders while they were still presumed to have value. Government bailouts of "systemically important institutions" is possibly the last gasp of this use of leverage against the "shadow banking system". Whatever the specifics of the mechanism - we know the rest - credit crisis, stock and housing market crashes, job losses and a looming depression.

Why it is all about oil
A common reaction to this idea, is that its just another liberal attempt to blame everything on oil - the Iraq war, Global warming and so on. Ponder this. The tank of gas that powers your car for a week contains more energy than 6 people doing manual work for a year. It is silly, but imagine paying 6 people to drag your car around rather than using the car's engine. At minimum wage your "car team" would set you back more than $100,000 a year (vs ~$2000 a year for gas), and be slow to boot. You'd need another person  to wave a fan at you to replace your air conditioning. Now multiply what machines powered by inexpensive gas do across the entire economy and you start to get the picture. Think about this $100,000+ next time you feel bummed about paying $40 to fill up. Oil is cheap and makes life easy. It so important that we all but eat the stuff. A barrel of oil has long replaced the gold standard as the guarantor of fiat monetary value. The essential role of oil in finance and powering modern life is why fluctuations in the price of oil have the potential wreak havoc and also why it is front and center factor in the hypothetical mechanism above.

The fin de seicle ethos
The concept of what is described above as a "fin de seicle ethos" is an important intangible in appreciating how financial insiders interests became uncoupled from the broader economy. To get a sense of this one has to try and remember what you were thinking three or four years ago - a difficult task. For example, I recall commenting to a friend and fellow bike commuter back in 2004, "I believe that we in the US are living in fool's paradise". The friend agreed and replied he had similar worries. My comment was not based on facts or learning, just a feeling of unease about the sustainability of the economic regime. So what would be the difference between me, my friend and financial insiders. Opportunity. Opportunity provided by access to expert knowledge, data and proximity to vasts pools of capital in the "shadow banking system".

So how did this play out ? It is imagined that a small number of knowledgable financial insiders were among the first to deduce that increasing risk was going to make easy money harder and harder to wring out of the system. A larger number of individuals likely subsequently came to intuit the outlines of this looming obstacle to their personal enrichment. Unease about events beyond ones control (i.e., peak oil and associated fluctuation in price), is presumed to be deeply unsettling to the type of ambitious person who dreams of making their "nut" (e.g., millions secured in US treasuries or gold) and retiring early. For such an individual, the palpable sense that as each day passes the chance to "cash out" recedes is presumably a powerful motivator to cut corners. Downstream of the initial inductive agency of increasing investment risk, cynicism and the realization that what is going on is just too crazy and fraudulent to be sustained become additional factors expediting the process. Anticipation of a fast approaching end of business-as-usual and the fear that one may "miss the boat" generates the "fin-de-seicle ethos". Once initiated, wholesale fraud would eventually come to permeate the financial system and collapse would become inevitable. To outsiders, the construct as a whole and its prime actors appear irrational. But, if one starts to imagine the motivations and thought processes over time of inside individuals with opportunity to tap the shuttered riches of the "shadow banking system", this debacle starts to make a good deal more sense.

The hypothetical mechanism imagines a cause for our current economic collapse beyond ordinary human failings such as greed and selfishness. Human frailty is a necessary, but not sufficient factor. Speculating on the cause of this crisis is a weakness of this idea... as it is not so hard to be off track when there are so many unknowns. On the one hand, the workings of complex systems are ineffable....and well...complex. However, even in the most emphemeral of cases, the proverbial butterfly in South East Asia still has to beat its wings to provoke that storm two years later in North Carolina. Some causes are cryptic, but turn out not so hard to be resolve with the right perspective. For example, though not evident until Jared Diamond pointed it out, how the axial geography of Eurasia conspired to give a leg up to certain technological civilizations now seems blindingly obvious to any thinking person. Sadly, the actual mechanisms for many events are lost to the past - owing to various factors including acceptance of the conventional ignorance (i.e, wisdom), the tendency of victors to write the history and so on. Nicholas Nassim Taleb has written beautifully on this topic. Also, as alluded to above, how does one read the thoughts of minds from the past as collective actions were prompted and choices made that determined the course of events. No one is going to admit, or perhaps even remember a point in time 3-4 years ago that they came to understand that the financial system was going to hell in a hand basket and that the only rational thing to do was to fraudulently extract as much value one could for oneself. Monsterous yes, but who would own up to such a thing. Thus, though often hard to locate or hidden there from view, there are always real and ultimate causes for events in the natural world. This we have learned.

It is perhaps worth emphasizing that the hypothesis posed here does NOT require an organized conspiracy to work. Those caught up in the fin-de-seicle ethos do not have to know each other or directly share their concerns. Given the right seed bed, timely ideas propagate like weeds. Simply put, the idea suggests that anticipation and/or confirmation of increasing volatility in the price of oil following its global peak in production provides a key to understanding a rationale  for the current financial crisis. Indeed, pricing unpredictability in this most fundamental of energy sources is suggested to be ultimately the necessary and sufficient factor in the present debacle (and perhaps future ones as well). All else, bad behavior of the Wall Street included, self-organizes and flows downstream from this consideration.

Four propositions that link fluctuations in oil price to bad behavior in the financial markets
Events 1 through 8 of the “hypothetical sequence” outline  propositions for which a certain amount of data can be derived. For example, the “hypothetical sequence” suggests the following:

1. Volatility in the price of oil increased after Hubbert's peak in global oil production.

2. This increase in the volatility of the price of oil is propagating volatility into the price of other goods and services.

3. Increasing volatility in the price of oil and the prices of things general is resulting in increases in investment risk.

4. Anticipation and confirmation of the effects of oil price-induced turbulence on investment risk has provided the necessary and sufficient conditions for; a) expansion of the "shadow banking system (the SBS)" and b) prompted a uncontrolled and wanton level of value extraction from the SBS.

The author refers to these as the 4 propositions of the apocalypse - a sad attempt at playfulness and definitely in poor taste. Nonetheless, in the following sections an attempt is made to derive data to support each of the propositions. It is probably fair to point out at this stage that although propositions 2 and 3 propose mechanistic linkages, the actual data presented will be correlative. This is one step better than providing an opinion not backed up by any facts. However, we are all aware that correlation does not imply causation. Proposition 4 will also be correlative in nature and even more loosely so than 2 and 3. Here, I will explore how anticipation and confirmation may have occurred, paying special attention to what may have been learned from the peak in US oil production in the 1970s. These caveats being said I will proceed and hopefully, you will read on.

Propostion 1. Volatility in the price of oil increased after Hubbert's peak in global oil production
Getting hold of a free source of historical oil pricing data on the internet is surprisingly difficult. There appeared to be packages that could be purchased, but eventually what seemed to be a reliable and free data base was identified at the Illinois Oil & Gas Association website.

http://www.ioga.com/Special/crudeoil_Hist.htm

This site provides complete monthly data from the mid-1980s up until the present on the “HISTORY OF ILLINOIS BASIN POSTED CRUDE OIL PRICES”. Not perfect, but a start.

The chart in Figure 1 is a simple plot of monthly crude “oil price” over a period from 1986 to 2009.

Figure 1 - Monthly Oil Price 1986-2009


The sharp rise and fall in oil at the tail of Figure 1 (i.e., the oil shock of 2008) is a part of this story that is all to familiar to motorists.

The next problem was how to calculate an index in the volatility of oil price based on these data. It was reasoned that this index of volatility should reflect the spread or variability in price over successive months. To acheive this a straightforward approach based on parametric statistics used together with Microsoft Excel. The index was calculated as follows. The monthly oil prices for Jan, Feb and Mar of 1986 were $22.50, $16.00 and $14.00 respectively. First  the standard deviation (SD) of the first 2 numbers (i.e., $22.50 for Jan 1986 and $16.00 for Feb 1986) was calculated as an index of their spread. This SD was 4.60. Next, the standard deviation of the 2nd and 3rd numbers for (i.e., $16.00 for Feb 1986 and $14.00 for Mar 1986) was estimated to give an SD of 1.41. These calculations were carried out for successive pairs of months for all 276 months from Jan 1986 down to Dec 2008.

The chart in Figure 2 plots the index of “Oil Price Volatility” in red in the left hand Y-axis along with the monthly oil price plotted in blue (now in the left hand Y-axis). Eyeballing the "seismograph-like twitchings" on this chart suggests that volatility has been increasing, particularly since 2002. Something that is particularly intriguing about this chart is a progression of increasingly larger "peak twitches" that appear to rise notably above a lower background of variance in the volatility index (see small arrows on Figure 2). This could be noise, but these higher amplitude pulses do seem to have pattern which looks as though it may be meaningful. More on this later.

Figure 2 - Oil Price Volatility has Risen Since 2000 - A


A few notes on Figure 2 and its underlying assumptions. First, one has to worry about deviance from normality etc. The approach used is not perfect. However, the aim was not to clear the forest, but to cut a narrow path through it. For this purpose, using SD as a proxy for spread seemed sufficient for now. Second, it is understood that variance (i.e., SD squared) is the preferred method by statisticians for estimating the spread of a sample population. Variances were calculated for the list of SDs and these calculations tended to accentuate the trend seen in red in figure 2. However, it was decided that the simpler SD calculation did the job, so it was stuck with. Third, calculating SD for 3 or 5 successive months was also carried out. The same overall pattern resulted from these calculations as was found for the 2-monthly calculations in figure 2. As this was the case, the calculations from monthly pairs was used as it was surmised that what would be lost in noise by using bimonthly figures would be made up with increased signal from a calculation based on higher temporal resolution. The thinking was that the robustness of approach was not so much in the individual bimonthly calculations of SD, but in the trend that emerged from them over the period between 1986 and 2009. Fourth, it would have been great to get one's hands on daily, rather than monthly, oil price data to do the calculations – but as mentioned, such data is hard find on the internet. Finally, coefficient of variance (i.e., average for the 2 monthly numbers over their SD x 100) was considered as another parametrically based index of volatility. However, on reflection  it was deduced that an SD-based index would be better as it would reflect absolute, rather than mean normalized changes, in the price of oil. Absolute volatility in price is surmised to be a best estimate of the factor propagating instability into the prices of other goods per the “hypothetical sequence”. Mean normalized SD (i.e., coefficient of variance) would be a dampened index relative to a measurement based on the absolute variability in oil price. And in turn, it was surmized the SD of oil price volatility (not coefficient of variation) would be more proximally related to increasing investment risk also as per the “hypothetical sequence”.

Qualitatively, the underlying trend in oil price volatility over time in Figure 2 appeared non-linear. Microsoft Excel was used to calculate a 3-factor polynomial fit to the scatter plot. This trend as represented in the pink non-linear regression line overlaid the “red” price volatility data in Figure 3. The R squared of the regression line is statistically significant and so on as provided in the chart. Interesting features of the pink regression line include that it starts to move notably from around year 2000 (i.e., Hubbert’s predicted production peak as in the "hypothetical sequence"). It also climbs in what appears to be an exponential manner from this time to the present (i.e., Jan 2009).

Figure 3 - Oil Price Volatility has Risen Since 2000 - B


The trend in oil price volatility is isolated in Figure 4. From this it can be seen that volatility based on the calculation approximately doubled between yrs 2000 and 2004 and then approximately doubled again between 2004 and 2006. What happens next is an interesting question ? A clue to this might come from a smaller bump in volatility occurring during the 1990s (see Figure 4). Based on this pattern it is speculated that the current exponential rise will flatten as time proceeds and eventually becoming a second bump, albeit of higher amplitude than that occurring during the 1990s. After completion of the current bump, one imagines that a rise and fall in volatility has the prospect to occur over again, if and when economic recovery occurs. With a tightening supply, cycling variance in oil price could be a stomach churning ride.

Figure 4 - Regression of Oil Price Volatility Trend 1986-2009


The regression line in figure 4 was recalculated for different time frames in an attempt to figure out when in the past the trend line would have indicated a significant uptick in oil price volatility. This was done to test a speculation in point 6 of the “hypothetical sequence” in which it was posed that data on rising oil price volatility and its implications on investment risk  may have been available to financial insiders 4-5 yrs ago. This was achieved by removing yr 2008 and then calculating the regression line, and then doing the same with yrs 2008 and 2007 removed from the regression and and so on. Doing this, it emerged that the signal for the rising trend in oil price volatility was faintly evident (in an empirical sense) from the end of 2003 and continued to build over successive years from that time. Prior to 2003 it would have been very tough to pick up the rising trend signal from the approach taken here.

'In conclusion, looking back from 2008 there is quantitative evidence for a rising trend in the volatility of the price of oil that commenced from around year 2000 coinciding with Hubbert's predicted global peak in oil production. The signal confirming the start of this upward trend in volatility would have been evident 4 to 5 years ago from around the end of 2003.'

Proposition 2. Increases in the volatility of the price of oil is propagating volatility into the price of other goods and services
As a first step, the monthly year-to-year inflation rates between 1986 and 2009 were used to derive an index of general price volatility in goods and services. Unfortunately, there is evidence that the Government may "monkey" with statistics on inflation. One would imagine that under-reporting inflation has benefits for the "powers that be" that would include making them look good or "rigging the table" on payouts of inflation-proof bonds and so on. While it may be easier to manipulate absolute levels of an index, it is assumed that cloaking the pattern of a second order variable such as volatility is more difficult for would be cheats - more on this later. So, one won't be ungracious. The authorities are taken at their word on their monthly inflation calculations - at least to start with.

Monthly numbers on historical inflation rate (calculated from the so-called CPI-U) were obtained from:

http://inflationdata.com/Inflation/Inflation_Rate/HistoricalInflation.aspx

Figure 5 shows a co-plot of monthly inflation (orange as calculated from the consumer price index - CPI-U), the index of inflation volatility based on bimonthly SD (green), and the trend in the inflation volatility index (light green line) over the period between Jan 1986 and Jan 2009. Bimonthly SD was calculated as an index of volatility of CPI-U/inflation exactly as was described above for the index of oil price volatility. As was the case for oil price volatility, a trend line was also calculated by Microsoft Excel as a 3-factor polynomial fit to the CPI-U/inflation volatility data (equation and R square value are provided on the chart).

Figure 5 Government Statistics on the Consumer Price Index (CPI) Suggests that Volatility in Inflation has Risen Since 2000


The pattern for CPI-U/inflation volatility is different in subtle ways from that of oil price volatility. Nonetheless, a commonality of increasing volatility from the late 90s rising until the present is evident. The dark green line indicating the CPI-U/inflation SD switches with increasingly greater amplitude over this period. The lighter green regression line confirms the trend.

Figure 6 The Trends in Oil Price and Government Provided Inflation Rate Volatilities Appear Not to Coincide


In Figure 6 the trends in monthly oil price and inflation (CPI-U) volatility are plotted together on the same time scale (i.e., Jan 1986-Jan 2009). A rise from the late 1990s to the early 2000s in the trends for both indices is apparent. However, an important problem is that the inflation SD trend appears to reach it lowest point in 1997, slightly earlier than the oil price SD trend (which as discussed above bottoms around 2000). This feature is referred to as a "non-coincident bottom" on the plot. This lack of coincidence in the lowest trough of the two plots is problematic for the "hypothetical sequence" in which it is implied that oil price variance should causally underlie inflation volatility. It is also an issue from the point of view of suggesting that some sort of coincidence occurs between the timing of Hubbert's prediction of global peak oil (i.e., yr 2000) and inflation volatility kicking off. One can perhaps account for this "non-coincidence" as a statistical error, the effects of more than one time-dependent factor on inflation, the result of government manipulation and so on. Nonetheless, this discrepancy is a concern and further clarification is required.

What happens with if "honest" numbers on inflation rate are used ?
There is much question as to whether the "official" US inflation figures reflect the actual rate of inflation in this economy. An interesting website that provides alternate calculations of inflation is "John Williams Shadow Government Statistics":

http://www.shadowstats.com/

At this site, inflation numbers are calculated using methodologies that were utlized in 1980s. A site newsletter indicates that this "Alternate Consumer Inflation measure, reverses the methodological gimmicks of the last 25 years". In other words, the site suggests that Government "cheating" on inflation has been removed from estimates so that the true variance in inflation over time can be seen. Interestingly, a strong advocate for the current "monkeyed with" Govt. version of inflation calculation was none other than Mr Alan Greenspan of the current distress. Unfortunately, shadowstatistics.com does not provide its numbers free, and as there was no money or desire to purchase  said data, the numbers were interpolated from a plot helpfully provided at the website. I might add that if I been caught by my partner paying just under $200 "for just some numbers off the web!"... there would have been serious repurcussions. Though the coming "the end of the world as we know it" is being reflected upon here, the author has no wish to sleep alone with the cats during the interim. The plot below in Figure 7 provides the fruits of the effort to (re)generate data on "honest" inflation and inflation volatility from publicly available information. And MAN... it is a doozy !

Figure 7 Plots of the "Honest" Numbers of Inflation Rate and Inflation Rate Volatility


What we see from the "honest" numbers in Figure 7 is that volatility is now picking up slightly later into the 2000s than calculated from the official Govt. stats. Indeed, it appears that shadow inflation rate volatility does not start a new pattern of more vigoruous "twitching" until after 2000. The light green plot of the volatility trend confirms a low point for the shadow numbers occurs from around the year 2000. Figure 8 co-plots the trend for oil price volatility and shadow inflation (CPI-U) volatility and from this it can be ascertained that the pattern of variance of the two indices since the mid 1990s is very similar. The non-linear exponential rise in the inflation volatility curve is now apparently lagging a little behind the rise in oil price volatility. Most importantly, the low point of the two trends curves now share a "coincident bottom" and a coincident bottom is a lovely thing.

Figure 8 The Trends in Oil Price and "Honest" Inflation Rate Volatilities Coincide


A feature of the plot for inflation are larger twitches or pulses of volatility (Figure 7). Similar, though somewhat less distinctive pulses were noted earlier on the plot of oil price volatility (Figure 2). To improve resolution of these larger twitches by reducing noise, 3-month moving averages of the inflation and oil price were calculated (Figure 9), and then the volatility indices for inflation and oil price were re-calculated based on thee moving averages. These plots reveal fascinating patterns. Prior to 2000, spiking in the two "smoothed" indices occurs, but it is rather irregular. However, after 2000 the spiked pulses of volatility appear to assume an organization. In particular, 6 distinct pulses in inflation volatility occur in the period (green arrows on top panel) between 2004 and 2009, the most recent of the 6 occurring ~December 2008, being particularly large. An early seventh uptick in inflation rate instability is also marked on the chart that peaks in 2001-2002. Although a possible harbinger, it is not clear whether this 2001-2002 peak is truly part of the 2004 to 2009 series, as it is not as sharp as the subsequent 6 pulses. There seems to be regularity to the pulses - and thus a temptation assume that the sequence is an oscillating wave. However, if one looks at the spaces between the green arrows marking the pulse tops, they are NOT consistent. The interval between the spikes gets shorter and shorter as one approaches 2009. If this is an oscillating wave, it is rather complex.

Figure 9 Emergence of a Distinct Series of Spiked Pulses in Volatility of the "Honest" Inflation Rate and Oil Price Since 2000


Now... if one looks at the "smoothened" oil price volatility index over the period between 2004 and 2009, almost the same pattern is seen (lower panel Figure 9). A distinct series of pulsed spikes (red arrows), each spike being separated by increasingly shorter intervals of time. It should be noted that the words "almost the same" are used in the prior sentence. The reason for this becomes apparent when the plots for the oil and inflation indices are overlaid between 2000 and 2009 (Figure 10). Although the two patterns are very similar, individual "pulse" peaks for inflation and oil price do NOT show precise alignment in time. Instead, in 5 out of 6 of the spikes in the series between 2004 and 2009, a pulse in inflation volatility lags slightly behind a leading pulse in oil price volatility. The exception being the first inflation spike in the sequence occurring at the beginning of 2005, which precedes (albeit by a hair), rather than follows, a pulse in oil price volatility. A further notable feature of the plots is that the amplitude of the volatility spikes, and in particular those of oil,  show progressive increase over time.

A coincident bottom is one thing, but agreement at six points ? If this were a crime scene finger print, one would reasonably assume that a match was likely. Moreover, inflation pulses tend to be downstream, from the spikes in oil price volatility. This would be consistent with, although not confirmatory of, oil price variance determining that of inflation, and not vice versa. And not to be boring about it, but these curiously well-organized and co-related patterns, spring up after 2000, Hubbert's predicted year for peak oil.

Pulse 2 in oil price volatility is interesting. Its initiation toward the end of 2005 corresponds roughly to Hurricane Katrina. Many in the US will remember the sharp rise in oil prices at the time and how conventional wisdom (especially in the media) noisily focused on the hurricane as the primary causal factor in the sharp ascent of gas prices. However, the big picture view provided in Figure 10 clearly indicates that the presumed "Katrina"-induced pulse in oil price is actually part of a larger pattern of volatility spikes, including one that preceded it by a year and the third pulse in the sequence that followed roughly a year later. As with 2005, 2004 also had an active hurricane season. However, 2006 was comparatively quiet. The point is that while events such as Hurricane Katrina may be triggers, they are certainly can not be the ultimate cause of, multi-year instabilities of the type illustrated in Figure 10. To believe otherwise would be a classic "missing of the wood for the trees". Or is it trees for the wood ? - never can get that one straight.

How does one analogize these phenomena to create a mental picture of what is going one here. Grasping the underlying concept of volatility is itself unfamililar territory for most. Imagine a flag gently fluttering in a steady breeze, a single volatility event could be pictured as the flag suddenly being flapped vigorously back and forth by a strong gust of wind. Or how about a running tap plumbed into an artesian well ? When the well head is high, water runs smoothly from the tap. But when the well is running dry, air gets into the water line causing flow to splutter and choke. How about the temporal correlation between the behavior of variance in oil price and inflation ? One analogy could be the relationship between bioelectricity and the heart beat. The heart beat literally results from a traveling electrical impulse (think oil volatility spike) that triggers a reactive twitch in the muscle of the heart (think inflation rate spike ). Taking the analogy a little deeper, the electrical impulse originates from instabilities (i.e., volatility) in the bioelectrical properties of the heart's pacemaking cells which coalesce at regular intervals to form the impulse. Astute readers will be thinking, but the heart beat is regular. Well, yes it is - except just before a heart attack. The pattern of variance shown in Figure 10 has a scary resemblance to an electrogram trace of a beating heart becoming chaotic and entering ventricular fibrillation !

Figure 10 Volatility Spikes in Oil Price Since 2000 Precede Spikes of Volatility in the "Honest" Inflation Rate


These findings are gratifying in the sense that a case can now be made from the data that the pattern of volatility in general pricing (as reflected by the shadow inflation (CPI-U) volatility plots) is plausibly downstream from oil price volatility, at least since peak oil. However, there are caveats that must be born in mind. First, close and convenient correlations in the timing and shape of the two patterns of variance is not proof of causality. Second, by accepting the shadow statistics inflation over those of the Government, multiple errors are possible. For example, the mistake of confirming one's own preconceived ideas has to be watched for. When building a story from a tableau of similar, but subtly differing facts it is all to easy to assume that the data variant that best seems to fit the narrative is the data that must be right. Also, the Govt. may NOT be lying. Yes, yes, I know.... but one must keep an open mind. However, even if the inflation numbers have been "monkeyed" with, it is hard to conceive that the intent of the change in the 1980s was to uncouple the appearance of a connection between volatility in inflation and oil price that would occur some 20 years later. Even  Maestro Greenspan could not have such prescience. The "monkeying" in the 1980s was likely done for more mundane reasons. All the same, the effects of this messing with the inflation numbers provides a salutory lesson. Never fuck with the fabric of reality, as it may stop you from seeing something else that is unexpected and really, really important ! 'In conclusion, it is cautiously proposed that there is evidence of a correlative link between volatility in the price of goods and services, as reflected in the shadow CPI-U, that coincides with increasing volatility in the price of oil from year 2000. The strongest support for this link comes from a distinct and unprecedented series of pulses in oil price instability that occurs over the period between 2004 and 2009. Each pulse in this series is matched by a coincident or downstream twitch in volatility in the inflation rate  '

Proposition 3. Increasing volatility in the price of oil and the prices of things general will result in increases in investment risk
Deriving an accurate measure of investment risk is  hard. How does one get at such an intangible ? Certainly not in real time or in the future - otherwise one would be wealthy. To look back at how investment risk may have varied over the last decade or so a leaf was taken from the preceding sections. It seems silly to say it, but first let's accept that stock markets reflect investment activity. One of the broadest and deepest stock indices is the US S&P 500. A measure of risk of investment risk based on the S&P 500 would be its volatility over time. Certain readers are now thinking. There he goes again - on and on about volatility. To a hammer, everything looks like a nail (such an irksome cliche) and so on. But stick with it, if you can.

Imagine that the S&P had been on a gently rising trend with very few ups and downs over an extended period of months. With such a pattern in place, most investors could safely bet that tomorrow the index would still be on this same unwavering trend. In this environment the day-to-day risk of investment, if a number could put on it, would assumed to be low. By contrast, if there were a great deal of turbulence in the S&P 500, then one would be much less certain that an investment made today would look wise tomorrow. This would be a high risk environment, a situation that unfortunately reflects the current reality of the S&P 500. Since last October the S&P 500 has been in enormous flux, building and melting (mainly melting) over time intervals of weeks and months. Any reader who transferred 401k monies away from stock-based mutuals last October (2008) and returned in December 2008/January 2009 only to be  battered again in February 2009 appreciates the perils of the last 6 months.

Figure 11 Co-Plot of Volatility Indices for the S&P 500 and Oil


Figure 11 is a co-plot of the "smoothened" volatility of the S&P 500 stock index (calculated as for inflation and oil in Figure 9) and oil price volatility over the period from 2000 to the present. It has to be said that the correlation in the peaks of volatility is not as nice as that seen between oil price and inflation volatility over the same period (e.g., Figure 10). Between 2000 and 2004, there is turbulent "froth" in the S&P that presumably corresponds to the recession in the aftermath of the tech boom of the late 1990s. However, between the all important 2004 and 2009 period, the same general pattern observed previously applies. There are coincident spikes in volatility in the S&P 500 (blue) and oil price (red) between 2004 and 2009, with pulses in the oil-based index generally leading surges of volatility in the stock index. There are exceptions. A spike in the S&P occurs between pulses 3 and 4 that appears to have no matching spike in oil price change (indicated by a question mark on Figure 11). Perhaps there is an abortive uptick at the base of the "question-marked" spike. Also, pulse 5 in the S&P is more a shoulder on pulse 6, than a distinct spike in its own right. So, on the basis of Figure 11, squinting a little and using one's imagination - you may convince yourself that the idea has not quite fallen apart.

An analysis of the subsequent Figure (12) provides a juicier meal. This plot shows the "smoothened" volatility of the price of gold (as measured from http://www.lbma.org.uk/stats/goldfixg - gold in USD) over the period from 2000 to 2009 (gold line). The gold index is co-plotted with the trusty, jagged plot of "smoothened" oil price volatility (red line). Gold is an interesting commodity. In days gone by it provided the foundation of the means of exchange i.e., it was regarded as money. Gold may well return to this status. However, for the moment, and over the last 60 or so years, evidence is strong that oil supplanted gold as the primary guarantor of value around the world. Many professional economists point to the Bretton Woods conference or President Nixon, as fixed events or personalities that occasioned the decoupling of gold and paper currency. However, it seems that such these were may have been mere "anchor" events that acknowledged a changing reality where oil had supplanted gold as the new king. King oil may be spluttering and dying, but king it remains.

The above being said, reading the economic literature, one comes across charts of the inflation-adjusted price of gold which suggest that over the last 150 to 200 years gold has continued to hold its real value rather constant. By contrast, owing to the the acidic affects of inflation, a dollar today retains only a tiny fraction of its purchasing power to a dollar spent at the turn of the last century. For this reason gold is treated as a safe haven by investors wishing to protect against inflation. For example, a scan of smart finance websites like the "marketoracle.com" are presently full of exhortations by various "experts" to buy gold as a hedge against the inflationary and potentially US dollar debasing policies of the Bush and Obama administrations. This use as a store of value or fixed value asset confers an interesting property on fluctuations in the price of gold. The vigorousness of its movements up and down reveal the sentiment of people of means who are able to buy gold to offset investment risk. In other words, volatility in the price gold provides an index of how safe or risky sophisticated investors judge the investment environment to be - a measure of investor nervousness if you will.

Figure 12 Co-Plot of Volatility Indices for Gold in US Dollars and Oil


As with oil price volatility, fluctuations in the price of gold shows a general rising trend over the period between 2000 and the present. Looking at the detailed geometry of the ups and downs within this trend, it can be seen that Pulse 1 in oil price volatility is matched by a downstream peak in the gold index. What comes next is a shocker. BANG ! Pulse 2 in oil price volatility (the Hurricane Katrina pulse) appears to ignite a huge surge in gold price variance. Its almost as if the pulse 1 was a warning shot and then a second confirmatory slug of oil price turbulence convinces a bunch of savvy investors to run for cover - big time. Pulse 3 in oil occurs and there follows a modest surge in gold price variance. Then the more dramatic pattern repeats. With the rise of pulse 4 in oil volatility, there is second a dramatic and sharp run up in variance associated with gold price. This huge spike in the gold index coincides with the first swallows (vultures ?) of the credit crisis: Bear Stearns collapse, Bernanke assuring us that the sub-prime market is contained and so on. The cycling pulses in oil price volatility 5 and 6 follow, with all too predictable downstream spikes in gold volatility.

The patterns in Figure 12 are astonishing. Volatility in the price of oil genuinely appears to be leading investor sentiment - each pulse heralding large changes in fluidity in the gold market. Again, it must be reiterated that it can not be concluded that actual investment risk is rising based on Figure 12. This gets back to the "through a glass darkly" problem in measuring investment risk in real time alluded to at the opening of proposition 3. But what we can say is that the type of people with resources and knowledge to "play" the precious metal markets, the gold bugs, are certainly acting as if they believe that investment risk has risen over the last 5 years. It should also be noted that if one eyeballs the area under the curve of the gold plot, around 50 % of total activity occurred prior to early 2007. This strongly suggests that there was a cohort of smart people who were expecting BIG TROUBLE long before the rest of us had ever heard of a credit default swap or indeed AIG. This needs to be reflected on for those who hold the position that continues to be promulgated by the all but useless news media that, "No one saw this coming".... or (Imagine comely female news anchor) "Nouriel Roubini. You are one of the few people that predicted this...".... "blah..blah...blah". Well, the gold data suggests that a whole bunch of savvy people anticipated what was coming and many of these individuals are probably now doing very nicely, thank you.

Figure 13 Volatility Trends for Gold, the S&P 500, "honest" Inflation rate and Oil Price


The data analysis section initially focused on comparison of volatility regression trends. However, as we have gotten deeper in, the multi-pulse pattern in oil price volatility and downstream fluctuations in gold, inflation and the S&P 500 have taken precedent. The theory, as we elaborate in the paragraphs above, is that the pulses or spikes provide reference markers in time, that enables interpretation of relationships between different variables in greater temporal detail. For example, pairwise analysis of the "smoothened" volatility plot for oil indicates 6 pulses of variance between 2004 and 2009. Each pulse in the oil plot stands as a staging post for a subsequent unitary spike of heightened fluidity in inflation rate, the S&P 500 stock index and gold price.

The trend analysis nonetheless remains a valuable tool. Figure 13 plots regression lines for the trends in volatility of oil, gold, the S&P and inflation indices between 2000 and 2009. The Y axis values for each variable was normalized (highest measurement to 1) to enable plotting on the same graph. The most striking and obvious feature that can be drawn from Figure 13 is that volatility in all 4 indices display exponentially rising trends. The non-linear trend in "honest" inflation rate bottoms coincidently, or perhaps even a little after that of oil (as indicated previously). In turn, the S&P 500 demonstrates a recent nadir that occurs subsequent to both inflation and oil price volatility.

So far, so good. The trend data for oil, inflation and stock prices concur with the hypothetical sequence. The exception is the gold volatility index. The regression trend for variance in gold price genuinely seems to bottom out around yr 2001, a time preceding the other 3 indices, including oil. However, to reiterate, the "pulse" analysis governs. When volatility is examined at higher resolution (e.g., as in Figure 12), it is seen unequivocally that over the last 5 years individual pulses in oil price fluctuation precede those of gold. The interpretation of what is going on here harks back to the special status of gold as a safe haven. The early rise in fluidity of the gold market after yr 2000 perhaps reflects the anticipation of the coming age of turbulence by a number of keyed-in individuals. It suggests the existence of prescient actors who, despite the presence of clear confirmatory signal, the traditional stomach churning up and downs of the gold market and the existence of manifold lucrative and less risky opportunities for investment elsewhere (at least prior to 2007), were systematically hedging wealth with gold in increasing amounts.

A final word and a return to caveats associated with estimating investment risk. The most damnable thing is that the further into the future one goes, the less accurate the estimate of risk becomes. Anyone who has ever extrapolated a regression trend understands how error bounds bloom the longer the line goes into uncharted territory. Its not only a vexing problem for this analysis, but also generates a paradox that unsettles the advise given by many an investment advisor - namely that such-and-such an investment is good for the long-term. The further one goes into the future, the likelihood that something completely unexpected will wipe out a specific investment increases. Indeed, over long enough time frames (e.g. generations) it becomes almost certain that most investments will go to zero value. A limitation of the approach used so far in proposition 3 is that it is restricted to estimates of short-term variation over monthly sequences. Obviously, it may help the robustness of the analysis that the S&P is comprised of many opportunities rather, than a single investment. However, if there is one thing that the financial crisis has taught us, the assumed protections of portfolio diversity can rapidly evaporate when everything starts moving in the same direction i.e., precipitously down. One approach that may be worth exploring is to use the historical data to generate what is imagined as 3D surface of risk volatility trends between investments separated by varying lengths of time ....but this will be for another day.

'In summary, evidence is provided for a correlative link between volatility in the price oil and two indices of investment risk. Fluctuations in the S&P 500 stock index and the price of gold. Again, six pulses in oil price instability are seen to be matched by unitary twitches of volatility in the stock index and gold price over period between 2004 and 2009. The detailed correspondence between the oil and gold indices is particularly striking. It is concluded the environment for investment over the last 5 to 9 years has been marked by risk that is increasing in a non-linear, perhaps even exponential manner.'' '''

Proposition 4. The effects of oil price-induced turbulence on investment risk were anticpated and acted upon by fincancial insiders
NB Prop 4 - this section is a work in progress. Please add your own notes on developing this discussion - Therramus

Link from gold - gold vol index an anticipatory index

What signal confirmatory ?

Debate on timing of Hubbert's peak

Whale bone price plot from 1800s

Predator prey flubber... Oil drum

Paper on investment risk and oil price in Asian markets

1972 Energy crisis - oil price and inflation - what we learned

The actual size of the SBS - maybe 1 quadrillion dollars... no one talks about this

Gordon Brown... gets it -

The necessary and sufficient conditions for expansion of the "shadow banking system (the SBS)" and b) Prompted the extraction of value from the SBS by financial insiders

Concluding meditation on the meaning of the four propositions
NB This section is also a work in progress. Please add your own notes to those below for developing discussion - Therramus

Mechanism...mechanism...mechanism.

...and care that balance maintained in this section. On the one hand, the imposition of a natural forces beyond human control - i.e., increasing turbulence post-peak oil... human fraility a necessary, but not sufficient causal factor. but once recognition of what is under way has taken place our response takes on ethical dimension... we as a moral creature - first revulsion at those whom have acted indecently in face of this crisis... next correction of wrong doers ... then hard choices will have to be made.

For those who don't realize it yet - what is going on is the largest transfer of wealth (some might call it theft) in history. Did anyone do anything illegal ? For most part (likely) technically not - the necessary enabling rule changes and "path smoothing" were seen to by individuals including Messrs Gramm, Summers, Greenspan, Rubin, Paulson their helpmates (e.g., lately Mr Geithner) and puppetmasters.

But were there unparalleled breaches of the Golden Rule, morality and the breaking of bounds that enable people of goodwill to live in peace their neighbor? Yes. Will this immoral selfishness contribute to unnecessary misery and death ? Probably. Bear in mind though the end of oil will likely be source of considerable suffering in it own right... but this will not help.

Capitalism's fatal flaw. In general, its every man for himself, until the situation arose that the only rule remaining was... its every man and woman for themselves.

Most sensible people do not object to free enterprise - but they do draw the line at licentious enterprise. Reasonable people are also aware of socialism great failings. The capitalism vs socialism debate....is in reality dead ... this debate has as much life in it as the Norwegan blue. This is about decency vs indecency. What has happened here is widely viewed as a deep moral failure. A violation of fairness and natural law.... good people everywhere are revolted by the pandemic of immorality that appears to have taken place.

The financial industry now can not prevail in its every petition that what's good for them is good for the economy. This proposition has been proven demonstrably to be false. Indeed, j'accuse worse. The industry's place men in Govt. need. to be shown the door e.g. the tax cheat Mr Geithner and Mr Summers - a key architect of current mess - who also seems to have been making inexplicably large amounts (~$5m by some accounts) of money working as a hedge fund shill. Mr Volcker seems to be the only great man of economics left in Govt. - surely must have trusted proteges if  needs to spend his dotage fishing. Also can't help myself - but the gentle Mr Bernanke (utterances about the great moderation aside) seems a decent man. Although Mr Bernanke may ultimately need to burn his thesis on the great depression....

If some people don't like the word Nationalization for what has to happen to certain large, irresponsible and insolvent banks lets call it something else... e.g., bankruptcy.

Culture of deliberate stupidity - among smart educated people - don't rock boat...avoid culpability, being in a willful state of denial make malfesance so much easier.

Charles University, Czech Republic-motto - rough translation - "The truth struggles - but eventually it comes out".

Danger of assuming that basic reasons for all financ. crashes are similar. Posit - disagree, each upheaval has its own character. Is this crisis unique... ??? Conventional wisdom is sold on the idea that this crash is like  previous ones.... traces a lineage  to the Dutch tulip mania of the 1600s and before... etc etc...  greed, hubris, fear, panic, boys-will-be-boys, the human condition, madness of crowds etc...  latest attempt to align economics to science this time via  anthropolgy, pop psychol, chaos theory... major current pre-occupation in media/press...  putting it all down to hoodoo and ungovernable forces... But is  this a cop out ?...  what say the present crisis is unique, maybe  animal spirits are not wholly and conveniently to blame and maybe we won't be back to business as usual shortly... this over scientification of economics a bad fit... lost connection to its base in moral philosophy...

As a pure scientific discipline, economics is at best a bad imitation of biology. Economists may understand macho concepts such as competition, predation and specialization....the role of chance,. But fail to appreciate the other many clever regulatory processes/mechanisms that Mother Nature has found necessary to invent and/or exploit e.g. compartmentalization, redundancy, compensation, signal transduction networks, negative and positive feed back loops, predator prey relationships, division of labor, commensualism, outlier vulnerability, and so on and so on in one interdependent, heavily regulated, mean reverting, sticktogetheration after another. No doubt if capitalisms' true believers did understd. what Nature has discovered it takes to survive and prosper in this world, they would find its diverse and elegant strictures anti-free market, anti-free-trade, anti-globalization, pro-union... and downright Un-American.

Yes, we humans are greedy, foolish and violent - in many ways rather ordinary mammals. But can be extraordinary too. Given sufficient cause and evidence we react with revulsion to immorality. In times of great stress turn our ears to teachers of new rules - e.g. the Golden Rule - Confucious, Bhudda, Mahabharata, Hillel, Jesus, Muhammad, and Miss Karen Armstrong. Many do strive to be their brother's keeper. We also capable of repentance, forgiveness and learning to change our ways. There is hope.

Speculations on other Future Consequences of Volatility in the Price of Oil for Politics and Freedom
There is a another set of worrying questions on how we respond to rising oil price volatility in the future. It is argued above that the type of instability in oil price we're now seeing is a natural manifestation of being on the down-slope of the production curve since peak oil. But so what ? And what now ? The political class appears to have taken the position that technocrats like Mr Bernanke and Mr Geithner have the knowledge and tools to "get the economy back on track". But the reassuring fiction that smart folks have the situation under control will likely be blown away by the next run-up in oil price. Foolish commentators will no doubt attribute daily wobbles during this coming surge to irrelevant or bogus causes - e.g., OPEC, Nigerian terrorists, unexpected changes in the oil inventory, and so on. But all of us will know in our hearts that such things are as pin-pricks to a leviathan. What is coming at us is relentless, indifferent and unstoppable as the incoming tide. So, rather than charging around willy nilly spending money on stimulus and bailouts, wise leaders might pause and ask themselves: Where is this going ? How do we prepare for what may be truly hard times ahead ? and What does this weird dream about seven fat cows eating skinny cows mean ?

In the longer term, what becomes of our present democratic-capitalist model with its emphasis on the invisible hand of the market, maximizing individual freedom of choice and relying on enlightened self-interest ? Is this model equipped to deal with the unpredictable consequences of pulsing waves of oil price volatility ? In this "brave new future" "will realizing your dreams", "having it all", "reaching for the top" etc be possible for most. Probably not, at least in the material sense. How will we organize ourselves politically ? Will waves of volatility-induced economic disorder result in more centralized and regulated control by the authorities or chaos. What becomes of political freedoms in such a world ? Perhaps in the same manner oil price volatility could propagate instability into prices and increases investment risk, could other knock on effects include lability in liberal social mores and ethical principles ? Could we see the return of unpleasant, albeit longstanding human practices such as slavery ? With the demise of oil, back-breaking labor will still need to get done. Indeed, if one thinks about it, there are uncomfortable parallels in the callous economics of how fossil fuels and slavery (historically) have used been used to do work.

Recent manifestations of oil price volatility induced instability in our democracy might include the election of our first black President (as outstandingly qualified as President Obama may be - he is a notable anomaly), the comic behavior of the congress as "it misses the wood for the trees" reflexively reacting to each "new" crisis, unilateral preemptive acts of war by democracies (e.g., US in Iraq, Russia in Georgia, Israel in Gaza), increased use of unregulated surveillance by the state and the vile justifications for the use of torture as a tool by certain elected authorities and some in the media. Admittedly, the timing of a number of these manifestations do not fit the time line illustrated in the figures above. Nonetheless, the shocks caused by the ongoing effects of fluctuations in oil pricing could make possible other hereto unthinkable changes to the way things are done and soften us up to accept new draconian impositions. I heard a Democrat politician say "never waste a good crisis" recently - an unfortunately callow statement given the magnitude of the calamity facing us. That being said, this individual may be spoiled for choice in future emergencies available for charraling the flock.

On the more hopeful side, a realization of the consequences of oil price volatility in economics could provide individuals who consider themselves "conservative", in the peculiar sense it is presently defined in US politics, a rationale for a fundamental change in their thinking. It also would give urgency to the majority of self-identified "moderates" and/or "liberals"  who pay noisy lip service to the idea of "addiction to oil" but don't do anything meaningful about this addiction. When it becomes understood that that volatility in the price of oil is: 1) absolutely ruining our economy, 2) disrupting our governance systems, 3) rending the fabric our cultural and religious institutions, and 4) doing so long before we pump all oil wells dry or burn sufficient amounts of it to kill our beautiful planet, then calculations  in all parts of the political spectrum could change quickly and fundamentally. To put this another way, a beneficial effect of the coming widespread misery induced by price turbulence could be a collective choice to urgently explore  how end to our dependence on oil. This call to action could be far more efficient in changing behavior than less immediate threats such as global warming and the eventual depletion of the resource.