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

DID OIL PRICE VOLATILITY CAUSE THE FINANCIAL CRISIS?
THERRAMUS 18 January 2009

SUMMARY
A cause for the financial crisis is described that differs from the emerging conventional wisdom. It is proposed a shift in interest occurred within the global financial industry in the 2000s that altered incentives from protecting shareholders to promoting self-interested "cashing-out". The underlying reason for this shift is suggested to be volatility in the price of oil and its downstream effects on investment risk.

Novel data is provided to demonstrate that a distinct series of spikes in oil price volatility initiated in the early 2000s (see Figure 9). These volatility spikes resulted from either sharp rises or falls in price. The oil shock of 2008, when the cost of oil doubled in less than a year (peaking at ~ $140 a barrel), is shown not to be an isolated event. Instead, the oil shock of 2008 contributed to the largest of a series of 7 prominent spikes in oil price variance that occurred in the preceding 6 to 7 years. The multi-year pattern of spiking instability in oil price appears to be unprecedented, is ongoing and may be a natural process that results from being at or starting on the down-slope from "Peak Oil".

Importantly, the individual spikes in oil price variance since 2000 each precede (i.e. are upstream of) corresponding spikes in volatility 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 assessments of investment risk. It is proposed that as evidence consolidated that growing unpredictability in oil price was causing increasing uncertainty to investment outcomes, 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.

Finally, evidence is shown that the "Black Monday" stock market crash of October 1987 could have provided the first unequivocal demonstration that a spike in oil price volatility was sufficient in its own right to induce a sudden increase in investment risk (see Figure 14). Lessons learned on the consequences for market uncertainty of a large transient variance in oil price from the hereto unexplained events of "Black Monday" may have been a factor guiding the avaricious behavior of the financial industry in the lead up to the present crisis.

UPDATES
WAS VOLATILITY IN THE PRICE OF OIL A CAUSE OF THE FINANCIAL CRISIS?

The Oil Drum website published a shorter version of this essay on 8 Dec 2009:

OIL CAUSED RECESSION, NOT WALL STREET

An article on the essay was published 21 January 2010 at:



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 global finance. The idea also proposes that in coming years, unpredictability resulting from sudden movements up or down in the price of oil will become understood to be one of the most serious and pressing threats to our economy and democracy.

Consider the following hypothetical sequence of events:

1. Global oil production begins to peak 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 curve are envisaged to be of a different pattern and 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 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 coming to understand what is going on, the incentives within markets shifted rather quickly from protecting the interests of shareholders, to figuring out how to “cash out” quickly. 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 global financial industry and perhaps beyond. Most secondarily affected individuals are probably oblivious to the ultimate cause (i.e., oil price volatility) of their choices and actions. A fin-de-siecle ethos becomes pervasive. There is an unspoken, or perhaps even quietly discussed urgency, that time is running out to make your “nut” (i.e., sufficient money to retire wealthy) and get out. Greed, fear and/or the survival instinct does the rest. An asymmetric herding behavior takes hold as individuals within the financial industry overwhelmingly place self-interest above the interests of their clients, shareholders and society at large.

How the "cashing out" occurred is a matter of some complexity. But this part of the story does seem to conclude with tens and perhaps hundreds of trillions dollars in worthless ("toxic") assets in the "shadow banking system". It is speculated that the primary mechanisms 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 the taking of fees, salaries, bonuses, stock options and other mechanisms leveraged against the "toxic assets" by the exclusive group that have access to this pool of capital. Government bailouts of "systemically important institutions" is possibly the last gasp of this use of leverage against the "shadow banking system" by insiders. Whatever the specifics of the mechanism - we know the rest - credit crisis, stock and housing market crashes, job losses and the deepest recession of the last 50 years.

The Limits of Conventional Wisdom and the Causes of the Financial Crisis
The hypothetical sequence of 1 through 8 imagines a cause for the financial crisis beyond human failings such as greed and selfishness. Human frailty is a necessary, but not sufficient factor. Speculating on the cause of this economic collapse 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. But, even in the most ephemeral 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 obvious to any thinking person.

The above being said, the cause tagged here is more robust than a wing beat and though in plain sight, we have been curiously blind to it. At its most essential, this narrative is about the primacy of the laws of physics and the sad consequences of magical thinking. It has taken time to piece my story together as it has many intricacies and moving parts. Insights arrived over time, sometimes from unexpected directions. Occasionally startling patterns came sharply into focus. Hopefully, the reader will persist as they are taken through the case step-by-step. But first, put aside the belief that what many call "human weaknesses" had the axial role. Foibles such as hubris, greed, and ambition are recognized as key and necessary factors, but it is suggested that they are not the ultimate determinant of our current unpleasant circumstances.

Another much talked about causal factor is the sub-prime mortgage industry. However, because "experts" keep telling us that sub-prime is the root or ultimate cause of the present difficulties does not necessarily make it so. The workings of oil markets fall outside the experience of most people, but many understand the mechanics of financing a mortgage. Sometimes, familiarity with a subject matter can hinder understanding. The Indian tale of the blind men and the elephant provides a classic fable on the treacherousness of narrowed perspective and half-truths. The fact is that securitization of sub-prime mortgages was just one of the more lucrative facets of a huge and labyrinthine shadow banking system. More on the secondary, but nonetheless key role played by mortgage financing and the SBS in this crisis will be provided later.

Sadly, the ultimate mechanisms guiding 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 insider is going to admit, or perhaps even care to remember a point in the early to mid 2000s that they came to deduce or intuit that the financial system was "going to hell in a hand basket" and that the rational option was to make off like a bandit. Wall Street even has a coded acronym that describes this mind-set  "IBGYBG" - I'll be gone, you'll be gone. For an industry subscribing to IBGYBG as an operating principle, the realization that risks associated with investment in the normal economy were quantifiably increasing was probably deeply unsettling. Given the culture of Wall Street and the wholesale failure of our Government to carry out its regulatory duties, the expansion and looting of the shadow banking system perhaps became all but inevitable.

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-siecle mentality that lubricated this crisis do not have to know each other or openly share their concerns. Given the right seed bed, timely ideas propagate like weeds. Simply put, the idea proposes that anticipation of the economic disruptions that would be wrought by instability in the price of oil following its global peak in production provides a key to understanding the current financial crisis. The pricing unpredictability in this most fundamental of energy sources is proposed to be the sole factor that is both necessary and sufficient to explain the present debacle - and perhaps future debacles as well. All else, bad behavior of the Wall Street included, is suggested to self-organize and flow downstream from the effects of volatility in the price of oil on investment risk.



FOUR PROPOSITIONS THAT LINK VOLATILITY IN OIL PRICE TO BAD BEHAVIOR IN 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 will increase after Hubbert's peak in global oil production (i.e, "Peak Oil").

2. This increase in the volatility of the price of oil will propagate volatility into the price of other goods and services.

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

4. And that information was in place prior to the crisis enabling anticipation that peak-oil-induced volatility would increase investment risk to levels unacceptable to the financial industry.

The author refers to these as the four propositions of the apocalypse - a sad attempt at playfulness and definitely in poor taste. Nonetheless, data will be provided to support each of the propositions. It is probably fair to point out that although propositions propose mechanistic linkages, the actual data presented will be correlative. This is one step better than an opinion not backed up by facts. Nonetheless, one can not infer causation from correlation.

Many commentators have fixated on the pernicious effects to the economy of oil prices hitting new highs. However, this is only half the story. A meaningful index of volatility reflects the magnitude of sharp movements in either a positive or negative direction. Financial unpredictability wrought by a sharp decrease in oil price is likely to be just as economically destablizing as that resulting from sudden increase. The reader should bear this important subtlety in mind as the case in this essay is developed.

The fourth proposition will explore how anticipation may have occurred, paying special attention to what could have been learned from the peak in US oil production in the 1970s and the stock market crash of October 1987 called "Black Monday". Indeed, it is suggested that the mysterious "Black Monday" crash is a key to understanding the present crisis. It is proposed that on this day over 20 years ago, the market learned that spikes in oil price variance are a standalone determinant of investment risk in their own right.

There is one more thing that needs to be written before moving onto the data supporting these four propositions - a look into a possible future. In this essay it will be shown that distinctive series of spikes in oil price variance have recurred as transient phenomena since 2000. Moreover, evidence will be outlined as to how these spikes in volatility propagate their effects downstream into the economy over time. Unfortunately, since these 'variance transients' have now established a repeating pattern, it is likely that economic disruption of the type we have just experienced will occur again (and again) until a new equilibrium is reached.

A further unfortunate fact is that at some point the pattern and attendant disruption will recur with increased ferocity. An aggravating factor in this confluence of misfortune is a failure to assimilate the lessons of the first act of this crisis. The most obvious lesson we have so refused to learn is that tough new regulation of the financial industry is necessary. Re-instatement Glass-Steagall Act and the forced break-up of "too big to fail" banks would be prudent first steps - but more draconian actions will probably be required. Such moves will not halt the fallout from Hubbert's peak, but new prohibitions might provide a bulwark to blunt its effects - especially on the poorest and most vulnerable members of our society. As St Augustine might have said - circumstances will eventually teach us to be "chaste" - but not yet.

PROPOSITION 1. Volatility in the Price of Oil Increased after Hubbert's Predicted 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 &amp; Gas Association website.

Historical oil prices

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 the monthly 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 together with Microsoft Excel was used. 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 right-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. 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 decided that an SD-based index would be better as it reflected absolute, rather than mean normalized, variability in the price of oil.

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 large rise and fall in volatility has the prospect to occur all over again, if and when economic recovery occurs. With tightening supply, cycling variance in the price of oil on the downside of Hubbert's peak will be a stomach churning ride. Policy makers trying to force a recovery by flooding the economy with "stimulus" might consider this unwelcome possibility. The fruit of their efforts may simply be to prematurely spark the next waiting surge in oil price!

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 Oil Price Volatility is Propagating Instabilities 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:

Historical official inflation rate

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- Volatility in the Govt. consumer price index (CPI-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- Trends in volatilities of oil price and Govt. inflation 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":

Historical shadow inflation rate

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 "Honest" inflation rate and inflation volatility since 2000


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 coincident bottoms are 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 these 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 are evident 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 or primary volatility events. There seems to be regularity to the pulses - and thus a temptation to 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 A series of spiked pulses in inflation and oil volatility emerged after yr 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 inflation rate variability, and not vice versa. And not to be boring about it, but these curiously well-organized and co-related patterns, spring up ~3 years 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 9 indicates that the "Katrina-induced" spike in oil price is actually part of a larger pattern of volatility pulses, 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 act as triggers, they are certainly can not be the ultimate cause of, multi-year instabilities of the type illustrated in Figure 9. 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.

A further point regarding the origin of volatility spikes - and this consideration is one of the most appalling of all. The triggers for volatility spikes on the downside from Peak-Oil may increasing come not from familiar events such as hurricanes or insurrections in the Niger river delta, but be much more unpredictable in nature. This will occur as the search for new reserves progressively moves to places where the extraction of oil becomes a tougher and more expensive proposition. One example, of this is in the Middle East. With the decline in Saudi feilds, the US has allocated growing resources to Iraq - a country rich in oil reserves, but possessed of significantly trickier politics than the desert kingdom. The growing expansion of deep sea exploration is another example of a new and risky frontier. Iraq and deep under the sea are examples of places that are rich spawning grounds for the type of unexpected event (i.e. triggers) that lead to rapid swings in the price of oil. With tightening supply and increasing demand, we will have no choice but to go to places that we ought not to be in or at the very least that we are not adequately prepared for.

The volatility index developed here is what is called a positive definitive index. It provides a measure of the level of fluctuation in a variable such as monthly oil price, without regard to whether the changes are positive or negative i.e., increase or decrease over time in oil price. The presumption is that our index provides an empirical means of outlining the pattern of unpredictability faced by the financial industry and in turn, a guide to the forces determining their collective behavior. This being said, how does one create a mental or intuitive picture of what is going on. Grasping the underlying concept of volatility is itself unfamiliar 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 a mental model of the correlation in time 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 9 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 precede pulses of volatility in inflation


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 Is Causing Increased 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&amp;P 500. A measure of risk of investment risk based on the S&amp;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&amp;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&amp;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&amp;P 500. Since October 2008 the S&amp;P 500 has been in enormous flux, building and melting over time intervals of weeks and months. Any reader who transferred 401k monies away from stock-based mutuals in October 2008 and returned in December 2008/January 2009 only to be battered again in February 2009 appreciates the unique perils of an unpredictable market.

Figure 11 Volatility spikes in oil price generally precede pulses of volatility in the S&amp;P 500


Figure 11 is a co-plot of the "smoothened" volatility of the S&amp;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&amp;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&amp;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&amp;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&amp;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 more persuasive case for a tie between the rate of oil price change and investment risk. This plot shows the "smoothened" volatility of the price of gold (as measured from Historical gold price 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 value. By contrast, owing to the acidic affects of inflation, a dollar in 2009 retains only a tiny fraction of its purchasing power to a dollar spent at the turn of the 20th 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 dollar-debasing policies of the Bush and Obama administrations. The perception that gold acts as a store of value confers an interesting property on fluctuations in its price. 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 the level of uncertainty perceived by investors.

Figure 12 Volatility spikes in oil price precede pulses of volatility in gold


As with oil price volatility, fluctuations in the price of gold show 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 our nearly 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 of gold, the S&amp;P 500, inflation and oil are on upward trends


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&amp;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&amp;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&amp;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&amp;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.

One 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 Himalayan 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 second consideration is the destablizing or shock effect of large transient variances in key economic per se. The central role of volatility spikes or variance transients to the unfolding events will be examined further in the following section of this essay.

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 "investment advisors". Namely that such-and-such an investment is good for the long-term. Putting aside well-meaning,self-serving, or just plain dumb "professional advice", the testimony of real-word experience is clear 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 individual 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&amp;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 nearly 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, exploring the alchemy of risk topology 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&amp;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.'

When Black Monday Came
''Occam's Razor - Of several acceptable explanations for a phenomenon, the simplest is preferable. ''

Figure 12 provides evidence that massive hedging in gold was occurring in waves prior to the onset of the financial crisis in spite of the short-term unpredictability of gold as an investment. One reason for this paradoxical phenomenon is that gold is a barometer of perceived investment risk. Proposition 4 examines how it came to be understood that oil volatility was adding unprecedented levels of uncertainty to investment outcomes through the 2000s - as reflected in indices such as the price of gold. Here, the question posed is ...whether specific information was available that could have led to a change in incentive within the financial industry from protecting shareholders to unregulated "cashing out" ?

Exhibit A in Proposition 4 is Figure 14. It may take a while to study and verify this complex chart. However, once you have familiarized yourself with its implications, your view of how economic events in the modern world are shaped may be changed - perhaps not in a happy way. In a nutshell Figure 14 shows that unitary spikes in volatility of the price of oil have occurred immediately downstream to almost all US recessions and stock market crashes since 1966.

Put aside for a moment the explanations trotted out by experts on the vagaries and fortunes of the US economy -- sub-prime, the Fed, interests rates, the business cycle etc etc etc. Figure 14 teaches the single factor common to virtually every US recession and market crash for nearly half a century is that each has been preceded by a prominent transient spike of instability in the price of oil. The one exception with no preceding variance pulse is the shortest recession of this period, which occurred in 2001 in the wake of the so-called dot.com bubble in technology stocks. There is debate as to whether dot com actually met the formal definition of a recession, as it did not comprise 2 successive quarters of negative GDP growth. Semantics aside, it is notable that a volatility spike was coincident with this recession, so the 2001 downturn might be considered as not inconsistent with the general pattern brought to light in figure 14.

Figure 14 - Geopolitical and Economic History of Oil Price Volatility


Looking at Figure 14 in detail, the now familiar recent 6-7 volatility spikes of 2000 to 2008 can be seen at the far right of the plot. Each of these transients in price variance are asterisked and referred to as "primary volatility spikes" on the plot. A new, more recent pulse can be observed to be building in 2009. While this upstroke shows signs of flattening, it has already risen to the point where it is currently the 5th largest spike in oil volatility of the last 50 years.

The left hand of Figure 14 covering the period between 1966 and 1980 provides new food for thought. Against the background of the turbulence of the last 10 years the volatility transients (again asterisked) in this era are almost imperceptible. However, by expanding the Y axis (right hand inset Figure 14) we can see the definite nubs of variance that coincide with the oil shocks of the early 1970s. And these are indeed primary volatility spikes in the context of their era, as they rise above a background which maintained at near-zero levels until ~1980.

It should be noted that the oil markets were heavily regulated by commercial and government interests during this period. Hence, although squelched, volatility appeared to squeak out in spurts when it could no longer be constrained. All the same, two official recessions and a stock market crash can be recognized proximal to and downstream of notable volatility spikes between 1966 and 1979.

The period between 1980 and the early 1990s is fascinating. Within this time, frame three recessions and one stock market crash occurred. Again the "one on one" and upstream relationship of primary volatility spikes to economic events is maintained. Perhaps the most interesting event of this period is the stock market crash known as "Black Monday". The crash that began on Tuesday the 19th of October 1987 appeared to come out of nowhere, occurring during a period of steady gains in growth in the US economy. While "Black Monday" remains the greatest single-day loss that Wall Street has ever experienced, no convincing answer to what caused it has ever been forthcoming. There are speculations on the role of computer trading, herd behavior by market players and derivatives.

In the historical perspective provided by Figure 14 it can be seen that an overlooked factor is a large oil volatility transient that peaked shortly prior to this market crash. This spike was caused by a failure of OPEC to stabilize prices owing to "cheating" by cartel members on production quotas. The honorable Saudi's tired of their role as a production "buffer" to counter misbehavior by OPEC siblings and temporary chaos (and hence volatility) ensued in the oil markets.

"Black Monday" may turn out to be one of the most significant lessons in the dark arts of the markets ever. It came as if a meteor in a time before telescopes or knowledge of heavenly bodies. Its singularity and inexplicably is just the "exception that proves the rule" that good scientists are always on the look out for. The unexpectedness of this stock market crash spared it a tidy accounting by the press and the mendacities of conventional wisdom. In the context provided by Figure 14, that "Black Monday" was the immediate downstream product of an unusually large spike in oil volatility now becomes a totally reasonable proposition. Indeed, it may be the only explanation that makes any sense. A precipitous induction of investment risk by an oil variance pulse in the absence of an economic downtown. In other words, OPEC gave us an experiment on the effects of a primary volatility spike controlled for the confounding influence of declines in US quarterly GDP (US quarterly GDP).Sweet. No need to invoke the God's of randomness to explain "Black Monday" then - ergo Occam's razor.

It is speculated that inquiring minds watching the events that unfolded over 20 years ago on October 19th 1987 may have become early adopters of the conclusions regarding transient instablities in oil price and investment risk outlined in this essay. The insights provided by the oil shock's of 1970s probably laid out the principle for anyone awake and motivated enough to recognize the pattern. Similarly, oil volatility pulses at the beginning of the 1980s and the 1990s provided further confirmation of the correlation. But in these latter cases, one could still have argued that the poor investment environment resulted from the economy being in bad shape. But "Black Monday" sealed the deal, by showing that a primary spike in oil price variance was sufficient, in it own right, to inject uncertainty into investment markets, even during a period of steady growth in GDP. Students of "Black Monday" likely now hold some of the most senior and influential positions in the Global Financial Industry.

Here another curious thing. The arrow hanging over "Black Monday" on the chart proper is actually an error. It got accidentally left there whilst Figure 14 was being prepared in Photoshop. But I'm going to leave the "hanging" arrow there as in the "The Omen". You know...there were those creepy blurred lines that hovered over pictures taken of the doomed priest.

Figure 15 - Primary Oil Price Volatility Spikes 1966-2009


In the penultimate step of the data section of this essay, an attempt will be made to "drag the beast" into the "light of day" as fully as possible. The root cause of our economic woes is postulated as to what the essay now refers to as primary volatility spikes - large, transient variances in the price of oil. It is suggested that primary volatility spikes can be thought of as a class of discontinuous phenomena in their own right within the broader category of volatility. The focus here is on oil, but as has already demonstrated, other economic variables (e.g., inflation) over the last 6-7 years have also displayed similar discrete spikes.

The ability of large variance transients in oil price to cause economic shock appears to some extent to be dependent on the era in which they occurred. For example, relative to those of the last decade, the absolute magnitude of spikes in the early 1970s were small (e.g., inset Figure 14) - nonetheless the dire economic ramifications of these shocks are all too well remembered by anyone over the age of 45. In the following paragraphs, a simple arithmetic device will be used to provide a visual representation of the relative impact and frequency of primary volatility spikes over the last half century.

The top panel of Figure 15 again shows the plot of oil price volatility (darker red line) from 1966 through to 2009, though this time with a 60-month moving average (thick pink line) co-plotted on the same axes. This pink line provides the mean level of volatility within rolling 5 year time frames as a backdrop to appreciate individual peaks in oil price variance against. We can take this a step further, by expressing each time point along the darker red line as a function of the moving average at that same time. This is called normalization and a plot of normalized volatility can be seen in the lower panel of Figure 15.

"Normalization" brings into the "light of day" some 30 primary volatility spikes. For the first time we now are able to gain a sense of the magnitude and unitary nature of spikes in oil price variance from era to era - albeit imperfectly. The spikes within the 43 year time span are clustered into 5 groups (Figure 15). The first cluster of spikes is in the early 1970s, corresponding to the period in which US "Peak oil" occurred, the second, third and fourth clusters are centered on the 1986 "Black Monday" spike and the fifth is the largest and most recent group that has been the main focus of this essay.

One surprise outcome of "normalization" is that it provides evidence that the latest (i.e.,fifth) cluster of instability in oil pricing may have initiated in the mid 1990s, rather than in the early 2000s as was indicated from earlier charts in this essay. If this earlier onset is the case, it has interesting implications. For example, if the new pattern of volatility seen in cluster 5 is diagnostic of the aftermath of Hubbert's peak, then it could infer that the worldwide crest in oil production occurred prior to 2004.

The actual timing of Hubbert's peak will only be settled by a future economic historian with retrospective data in hand. All the same, if one were hedging bets, a safe-ish guess is that "Peak oil" probably occurred sometime between 1997 and 2007. It would certainly have been a remarkable piece of prognostication if Dr Hubbert turns out to have hit the mark both times in in his 1956 prediction that 1970 and turn of the millenium would correspond to when the US and world reached their respective maxima in crude oil production.

Figure 16 - Primary Oil Price Volatility Spikes and Gold Price Movements 1966-2009


Figure 16 returns us to the theme of this essay. Namely, the effect of volatility in the price of oil on investment risk. Gold was fingered earlier on as both a store of value and an extremely sensitive indicator of perceived market risk by sophisticated investors. Figure 16 provides a beautiful illustration of how primary volatility spikes presage and accompany surges in the price of gold. Using this chart it is straightforward to guess which is the "horse" (Theramus suggests the volatility spikes) and which is the "cart" (gold) of the pair. Interestingly, a small upward blip in gold price (yellow arrow, Figure 16) can even be seen to occur toward the end of 1986, prior to the "Black Monday" stock market crash. But consistent with the hypothesis outlined in this essay, this small surge in gold price and the large market crash of the following October, both occurred after the initiation of the 3rd cluster of oil price variance spikes.

Finally, note how the start of the fifth and most recent cluster of volatility in the late 1990s precedes the kick-off of a relentless climb in the value of gold over most of the 2000s. If you're curious about what happened to money lost during the financial crisis, then one perhaps does not have to look too much further than this veritable mountain of gold with its foothills nestling in the year 2000. If you wish to recover the money back from your dropping house value or evaporating 401k plan, one place to turn your attention too would be the vast amount of wealth that has been accumulated in gold over the last 5 or so years by certain individuals. Good luck with that, by the way : &gt;)

'In summary, based on the data of this and preceding sections, the concept of a "primary volatility spike" or "variance transient" is introduced. It is shown that primary volatility spikes in the price of oil show an uncanny proximal and upstream correlation with all major US recessions and stock market crashes since 1966. Of specific interest, the stock market crash of "Black Monday" may have provided a controlled experiment demonstrating that a primary volatility spike was sufficient to cause a major induction in investment risk independent of other factors. Lessons learned over the last 40 years on the effect of oil variance transients on investment risk are suggested to have guided the response of the global financial industry to the present crisis. In particular, this information may have provided the rationale for shifts in incentive that led to: '

1) the uncoupling of the interests of the financial industry from the broader economy, 

2) the expansion and looting the shadow banking system and 

3) the aggregation of wealth by prescient actors in "value stores" such as gold.

DISCUSSION OF THE IMPLICATIONS OF THE FOUR PROPOSITIONS
NB - This discussion remains a work in progress

This sections needs intro para - brief summary of data and then outline of structure of discussion.



There is a lot of oil about. A lot left in the ground and a lot being produced. It is easy to forget, amidst all the rhetoric, that Peak Oil is called Peak Oil because we will never be more awash in the black stuff as we are right now. The current abundance of oil also makes the job of Peak Oil deniers so much easier. "Oil shortage!", they say, "What Shortage?" - as if this were the problem.

Peak Oil is in many ways a symbolic marker. Like reaching the year 2000, the Queen passing her 50th jubilee or getting half way through a pint of beer. A notable point, but in the long run perhaps not significant in itself. What really matters are the untoward manifestations that will accompany Peak Oil, many of which we have not paid attention sufficient too.

In this essay a phenomenon I refer to as a primary volatility spike is identified. Because of my background as a biologist, I visualize primary volatility spikes as a self-organizing phenomena akin to action potentials in neuro and cardiac biology. Like the action potential responsible for the heart beat which "fires" after reaching a threshold, I picture volatility spikes in oil price "sparking" and then conducting their downstream effects into economic variables such as inflation rate and investment risk. To continue the analogy, like a rare ectopic heart beat that sometimes can fire out of sequence and cause a heart attack, the mysterious "Black Monday" stock market crash of 1987 may have been caused by a temporary, but large run-up in oil price that occurred in 1986.

On time scale of the 24-hour news cycle, primary volatility spikes develop slowly and are hidden from view. They are a type of phenomena that we humans are poorly equipped to recognize and respond to. The hypothesis I pose here is that an increase in oil price volatility since 2000 caused the financial crisis in 2008 by propagating repeating pulses of pricing uncertainty into financial markets over the last 7-8 years. To most of us, this process was too ponderous and below the radar to consciously register its progression. But to the dynamic ,interwoven construct that is the global economy, these pulsed waves of volatility may have seemed like repeating blows of a wrecking ball slamming into the foundation of our financial markets.

Why this is all about oil
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 energy-dense, cheap and makes life easy.

The loss of a predictable oil supply has implications far beyond stable energy supply. The chemical by-products of hydrocarbons are cornerstone of modern life. Oil provides a raw feedstock for plastics, paint, chemicals, rubbers, and asphalt to name but a few key materials. Imagine a transportation industry without either car tires or tar-seal to surface roads or an agricultural industry deprived of the fertilizer and herbicide spray required for the vast production of corn necessary to feed America. Oil is so important that we all but eat the stuff.

In my opinion, oil has also long replaced the gold standard as the guarantor of fiat monetary value. The essential role of oil in finance and powering modern life is also 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 shadow banking system itself is a child of oil. What else could have underwritten the expansion of this pool of sequestered value that at its peak came to equal many multiples of the GDP of the entire planet ? What else but the greatest material prize in history - the oil reserves of the world.

Readers may be taken aback by the apparent assumption in the essay that "Peak Oil" has already occurred. However, it was never the author's intention to convey that this was a given. Care has been taken to emphasize that the timing provided of ~year 2000 in the hypothetical sequence (i.e., 1 of 1 through 8) is based on a prediction. This starting point came from M. King Hubbert's famous paper presented to the American Petroleum Institute in 1956 where he provided a mathematical analysis that indicated that the worldwide peak in oil production would occur around half a century from 1956. Hubbert's authority was later cemented when his prediction of the peak in US domestic oil production in the early 1970s turned out to uncannily accurate. This being said, the emergence of a new pattern of volatility shocks initiating from ~1997 as shown on Figure 15 (i.e., cluster 5) suggests that global "Peak Oil" could have occurred sometime in the decade between 1997-2007.

NB this section needs to modified to add Steve from Virginia's concept of Peak Oil availibility.

Volatility in the Price of Oil is a Natural Consequence of Hubbert's Peak
This idea wiki began in January 2009. At the time, the cost of a barrel of oil had receded to around $40, after reaching a peak of over $140 some months earlier. When this sub-section of the essay was first being drafted in May 2009, oil had crept up to just under $60 a barrel. Now, as of early July, price is falling again and a new variance transient has climbed to the point that it is now the 5th largest primary volatility spike since 1966. Not the monster of 2008, but nothing to sniff at by the same token.

The chart of daily oil price over the last 2 years traces an eye-catching internal momentum. The line describing its prominent surges and falls appears to follow a tight curvilinear trend over the weeks and months. Naturally there are wobbles, but the oil price chart progresses as if under a geometric law. The reason for this conformity probably has a simple explanation. The daily price of oil is being determined by the same endogenous mechanism that governs the multi-year pulses in variance (i.e., cluster 5 of Figure 15) brought to light earlier in this idea.

Unpleasant as it is, the state of affairs that we now find ourselves is likely to be part of a natural process – hence the reference to an “endogenous mechanism” above. The type of volatility occurring is in the nature of being on the down slope of a finite resource in great demand (i.e., oil). Cyclic fluctuation in the value or availability of a resource (especially non-renewable ones) is characteristic as that resource becomes depleted. "The oil drum" website has some great discussions on this topic. Examples include the whipsaw changes in the price of whale bone in the 19th century as this material used for hooped dresses, corsettes etc became more and more scarce (19th Century Whale Bone Prices). In a more recent example, Atlantic cod numbers landed off New England have shown similar surges and falls over time in response to over fishing. The potential for ups and downs in oil price also has interesting parallels to the interlinked changes in predator-prey numbers in the wild.

It is argued in this idea, that human fraility is a necessary, but not sufficient causal factor in the financial crisis. To conclude that greed and hubris is at the center of gravity of the crisis is an error of reasoning not so far from the rationale for sacrificing virgins for a good harvest, blaming homosexuals for Katrina, or the evening news assigning a specific cause to the day’s movement on the Dow Jones Industrial Average. Such actions and utterances make emotional connections - but they often have no basis in objective reality. The process that is currently unfolding may be more about the laws of physics than it is directly about us. What we are experiencing is characteristic of a resource depletion curve and is a pattern of volatility that would follow inevitably from Hubbert’s peak.

There May be Few Historical Parallels for the Current Economic Crisis
The idea that the present economic crash has much in common with previous speculative "bubbles" is a widely held point of view. Supporters of this camp note parallels in a lineage that can be traced back to the Dutch tulip mania of the 1600s and before. A certain wise and beloved Father-in-law opines that "What is happening now has happened before and will happen again. People forget. Folk will be folk". There is much truth to the particulars of this statement. This being said, the evidence suggests that the unpleasantness of late may have features that have not been encountered before. The scale of the crisis is off the map in comparison to every other preceding downturn. The Great Depression of the 1930s was also a global event, but in terms of the amount of wealth involved and lost it can not hold a candle to the level of deleveraging that we are currently experiencing.

Perhaps the most troubling distinguishing characteristic is that it is difficult to see where the energy to power new growth will come from. In the 1980s, Mr Reagan turned to the giant Saudi oil fields as a substitute for declining US production. Iraq is thought to sit on the world's second largest oil reserves. But it remains to be seen whether Mr Cheney's actions in "cordoning-off" and altering the political arrangements in Iraq mitigates the situation. The cost of ensuring a stable flow of energy from the Middle East for the West has increasingly been shouldered by the US and its military. This task becomes a harder and bloodier slog with each passing year. The lack of a reliable source of new fuel for economic growth makes the outcome of the present crisis unique in its uncertainty. And if there is one thing that the “animal spirits” of the market can not and will not stand for it is uncertainty.

Warren Buffet, famously observed that "“You only find out who is swimming naked when the tide goes out”. A seaside aphorism might also used to make an observation on the failure of honest reflection on the causes of the present crisis. A tidal wave of oil volatility washed over us in 2008, yet nearly everyone is still standing on the beach wondering why they're wet. In fairness, the oil shock of 2008 appeared to be an isolated and unexpected event that occurred after the visible onset of the financial crisis in 2007. This sequence of events may have led to an impression that the 2008 surge in oil price was a product of the financial crisis, rather than vice versa. However, Figure 9, reveals that the large price increase of 2008 is actually the largest of a series of at least 6 pulses in oil price volatility, the first of which appeared to have initiated toward the end of 2003. The swell of a new 7th primary volatility spike has evidently built during the initial part of 2009. Pontificating on sub-prime, lack of regulation or sighing and wisely intoning on the wretched greed and excess of Wall Street may work for a while, but at some point insouience will have give way to a recognition of an unpalatable truth. Growing unpredictability in the price of oil is probably at the root of our problems.

NB .. This section needs to have data on 1919-1930 and 2000-2008 barley prices added per the TOD comment section - e.g., demonstration of a previous bubble (1929 crash) that didn't show commodity volatility transients similar to those seen over last decade.

The fin de seicle ethos
The concept of what is described above as the "fin de seicle ethos" is considered to be an important psychological element of how the interests of financial insiders probably became uncoupled from the broader economy over the last decade. To get a sense of this try remembering whether you had worries about the economy four to five years prior to the onset of the crisis in 2007/2008 - not an easy task. For example, I recall commenting to a friend, and fellow bike commuter. back in spring 2004, "...that it seemed to me that we were living in a fool's paradise". The friend agreed, replying that similar concerns had been gnawing at him as well.

My "fools paradise" conversation with my friend was not based on facts or learning, just a joint feeling of unease about the sustainability of the economic arrangements of the country. Times seemed prosperous, but I believe my friend and I were not alone in this "hard to put ones finger on the origin of our discomfort. For example, one also now hears stories of the deep unease felt by homeowners as they observed house prices rocket in certain markets in the early-mid 2000s. These increases occurred in what appeared to the best of times - Heloc loans flowed like milk and honey. But smart observers watched (and maybe even participated in) unfolding events, all the while sensing that something was profoundly wrong.

What would be the difference between the intuitive feeling that something was not right that I was experiencing in 2004 and similar intuitions held by certain financial insiders? Opportunity. Opportunity provided by proximity to expert knowledge and gossip, the focus that comes from being a financial professional and access to the "shadow banking system".

One could go further. The role of intuition, and how it affected self-preservation instincts en masse has been largely ignored. The lack of thought and discussion in this area occurs for understandable reasons. The private, fleeting thoughts and fears of individuals are impossible to quantify. Scientifically determining who was thinking what and when over time spans of years, how people acted on these thoughts and whose actions were consequential is not something that any historian is going to get at anytime soon. The problem of reconstructing the process in retrospect in large populations is thus like medical epidemiology based entirely on guess work.

Anecdotes such as that cited between my friend and I provide provocative, though less reliable reference points. In another example, I had a thoughtful note from a retired oil industry executive who had read this essay. He concurred with much of the analysis and also saw the role of intuitive anticipation in the process as important. He mentioned that in 1980 a Texas oil tycoon had told him that “...oil would be the cause for all the earth shattering events you will experience young man”. This wily Texan new the score in 1980, but clearly this thought-seed had also been planted in my correspondents head from that time on as well.

So, what is my best guess at how events might have played out over the 2000s in the financial industry ? It is imagined that a small number of knowledgeable insiders were among the first to intuit or deduce that increasing risk was going to make easy money progressively harder to wring out of the system (i.e., investment risk was rising). Subsequently, larger numbers of individuals came to deduce or intuit the outlines of this looming obstacle to their personal enrichment. Unease about events beyond ones control (e.g., peak oil), are presumed to be unsettling to the ambitious "type" who dreams of making their "nut" (e.g., millions secured in gold) and retiring early. For such a person, the palpable fear that as each day passes the chance to "cash out" recedes is presumably a powerful motivator. In its culminating stages, the "fin de siecle ethos" is presumed to have come to infect larger and larger numbers of individuals within the financial industry, most of whom were likely oblivious to primary causation i.e., the effect of oil price volatility spikes on investment risk.

Downstream of the agency of increasing investment risk, cynicism and the realization that what was going on was just too crazy and fraudulent to be sustained became additional factors expediting the process. Anticipation of an approaching end to business-as-usual and the fear that one may "miss the boat" drove the "fin-de-siecle ethos". At the peak of this epidemic of bad behavior, wholesale fraud came to permeate the entire economic system and collapse was all but inevitable. To outsiders, the construct as a whole and its actors appeared to be irrational. But, if one starts to make educated guesses at the probable motivations and thought processes over time of the circles of individuals who had the opportunity to tap the shuttered riches of the "shadow banking system", the nuts and bolts from which the financial crisis were fashioned start to make more sense.

In the last data section, I highlighted the 1987 stock market crash as historically the most clean evidence for a mechanistic linkage between an oil price volatility transient and heightened investment risk. This remains correlative observation, but as mentioned earlier, interpretation of "black Monday" was unconfounded by an accompanying period of negative US GDP. This being said, it is probably to simplistic to assign this event as the primary cause of intuitive anticipation except for the most astute and connected actors. For example, the fuzzy sense of unease I felt about the economy in 2004 occurred completely independently of this knowledge - I was still 5 years away from observing the relationship between the OPEC-induced oil price spike of 1986 and the stock market crash in the following year. The fin-de-siecle ethos was in the air and I, and others, were presumably responding to it.

Finally, I shall close this section by digressing from this important, but somewhat airey-fairey discussion of the concept of the fin-de-siecle ethos and the triggering of "asymmetric herding" by the financial industry to a more tangible subject. The concept of peak oil has been common knowledge for over 30 plus years now. Indeed, it would not be surprising to find out in a future presidential archive release that the prospect of peak oil and its potential for disruption to the US economy were front and center of Mr Cheney's hush-hush energy task force in 2000. Auspiciously, the energy task force began convening in the second week of the Bush II Presidency. In any case, the existence and timing of Hubbert's peak is no secret. Its more a matter of whether one is prepared to think realistically about its consequences or not. It is also no mystery that the some of the smartest and most aggressively realistic individuals are to be found are in the upper echelons of the global finance industry.

The Expansion of the Shadow Banking System and Hubbert's Peak
That the uber opportunists of the global financial industry have behaved unacceptably in the face of the current predicament remains to be confronted. Their greed has been truly exceptional. These statements may seem contradictory given the "natural process" line argument made above. However, to reiterate, it is proposed here that the expanding and looting of the shadow banking system (i.e., the bad behavior of the financial industry) is a knock-on from the effect of oil volatility on investment risk - a downstream consequence of starting on the oil resource depletion curve. The prescient and avaricious few that have taken advantage of this situation have unfortunately ensured that the ride down from peak oil will be much more difficult than it would have otherwise been.

The crooked progeny of the human imagination that has most exacerbated this crisis is the "shadow banking system" (SBS). Shaped in large part by the urges that we are least proud of as a species - fear, greed, deceipt - the SBS became the voice and tool of the "fin-de-seicle ethos" that led to the near collapse of the global economy. For a good part of its operation over the last 20 or so years, the function of many of the instruments of the SBs was to reduce risk. In one example, airlines could buy oil in so-called futures contracts to make the costs of jet fuel more predictable, thereby easing business uncertainty. However, from around the year 2000 the SBS began metamorphizing into something darker. From the turn of the millenium its instruments began to be used as a cover, enabling powerful and secretive interests to aggregate what amounted to the wealth of the entire planet.

"Expert" commentators on the SBS tend to focus on its individual components - its devilishly complex derivatives and investment vehicles. The securitization of mortgages within instruments such as collaterized debt obligations (CDOs) is one of the more important and popularly discussed elements of the construct. There is a tendency to treat the SBS and its parts with an awe resembling that we reserve for great science - as if it comprised a set of discoveries akin to molecular biology or quantum theory. However, the brilliance of the mathematics which underpin its individual components is entirely beside the point. What is missed by those trying to come to grips with the causes of the financial crisis is that the SBS is more than the sum of its individual parts. The malign evolution that the SBS underwent from a set of useful hedges to the main lever of a vast fraud can only be appreciated if one steps back and examines its composite architecture as a whole.

The first and most important of the meta-level characteristics of the SBS is that it expanded to a huge sum of money – one half quadrillion to one quadrillion dollars by reliable estimates. One quadrillion is a 1 with FIFTEEN 0s after it ! By comparison, the GDP of the world in 2008 was only ~ one twentieth of this at around $ 60 trillion. Hold up a minute and think about this. What these numbers mean is that the SBS had a cash equivalent in it equal to 10 to 20 times the annual productivity of all humans presently living and working. Mother Earth was evidently not big enough for these people – their needs run to the annual output of at least 10 planets.

Second, there is a curious mindset that the obligations of the SBS are somehow more theoretical than actual. An interesting manifestation of this is that one often hears the evasive qualifier "notional" placed in front of estimates held within the SBS. However, as speculated previously, the SBS came to assume functions that were not foreseen at its inception. Of these roles, the one of primary interest to financial insiders was the use of the SBS to extract salary, bonuses, fees, stock options and other very real monies leveraged against its now famous "toxic assets". This use of the SBS appears to have taken place mainly prior to the onset of the financial crisis in 2007, when the guillible could be convinced that "toxic assets" retained value. Thus, the window of time in which the largest extraction of real money by insiders occurred has long since past.

Stock options appear to be among the most important and pernicious means of value extraction from the SBS pre-2007, when the share prices of many institutions were at their most fraudulently bloated. As such stock options will be given consideration in the following couple of paragraphs.

Options were given under the premise that they induced "alignment of interest" with shareholders. On this basis, numerous stock options were handed out by Boards of Directors. However, shareholders should have paid more attention to the numbers of options being distributed and their vesting schedules. If they had done so, they would have noticed that extraordinary amounts of value were being given away at their expense. For all practical purposes, the hypothesis that the recipients of stock options underwent a beneficial "alignment of interest" has been falsified by the events of the financial crisis.

One might go further in pointing at the noxious role played by stock options in the crisis. purpose of stock options was never to promote alignment with shareholders, instead they were mainly used as a tool by senior management in their goal of self enrichment. The lions-share of options always went to those in the upper strata of companies. The crumbs that remained were sprinkled over those lower down company food chain. Contract provisions were in place to enable the retraction of stock options the moment an employee acted in a manner judged by executives to be out of line. Confiscation of options was especially rapid when employees were caught acting in the interest of shareholders at the expense of management. Ironically, stock options have been a major reason that so few whistleblowers emerged as the fraudulent structure of the SBS grew to gargantuan proportions.

Be that it may that the shadow banking system is now a hollowed out shell, it is noteworthy that in 2008 when AIG was used by the Bush Treasury as a conduit to funnel billions of tax payers dollars to settle credit default swaps (CDSs) with Goldman Sachs et al., the CDSs were valued at the definitely non-notional rate of 100 cents on the dollar. Also, the change in so-called mark-to-market accounting rules allowed by the present administration enable banks to continue the fantasy that their "toxic assets" are worth more than expired lottery tickets.

It might also be argued that both the Bush and Obama administrations have abetted this potential fraud by using taxpayers money in attempts to take the "toxic assets" off the books of so-called "too big to fail" financial institutions. If the hypothesis posed in this essay has merit, one has to admire the "double dare" audacity of the financial industry. First, engineering the expansion and looting of the SBS and then convincing the powers-that-be that the implosion of the SBS caused by a fraud that they had instigated necessitated taxpayer-funded bailouts.

The third key meta-characteristic is that the labyrinths of the shadow banking system operated in secrecy. Even the financial press largely ignored its significance until 2007. Anyone now awake enough to notice, has become alarmed to discover that the sum value of its various instruments, came to dwarf traditional investment vehicles. The fact is that investments ordinary people considered prudent, such as stocks and bonds, were viewed as a “chumps’ game” by financial insiders. Meanwhile, the CDSs, SIVs, CDOs and the rest of the SBSs constituent alphabet soup were used to quietly aggregate a monumental stash. Only the annointed few had access to this private "piggy bank". Without most people knowing what had happened, the financial industry changed the rules of the game and then took the ball away.

Fourth, the shadow banking system was unregulated by the authorities. This part of the tragedy is so grand, one has to weep and laugh in turns. But “look not on the mote in your brother’s eye” for the sins of omission and commission that lead us to this place. All of us share blame for not saying STOP. Perhaps one noteworthy factor here was our passivity in buying the theory that campaign contributions are a form of speech protected by the constitution - i.e., as opposed to actual bribery. Acceptance of this idea allowed access for financial and banking interests to lobby for, and in some cases actually write the law changes that led to this fiasco. This interpretation of the speech provisions of the constitution enabled compliant politicians to take the money in good conscience.

To pull back from the sermon a little here, the net effect of the SBS not being policed was that a small group within the global financial industry engineered the largest unregulated transfer of wealth in the history of mankind. Did anyone do anything illegal ? Probably not. "Path smoothing" was seen to by a string of politically connected fixers over years, including Messrs Gramm, Summers, Greenspan, Rubin and Paulson. The necessary law changes were bought and paid for under the guise of "protected speech" from Congress.

Now that the shadow banking system has collapsed, ordinary folks have had the punctured ball handed back. The money that evaporated from the value of your house decreasing by 25 to 60 %, the amount lost when your 401k dropped by a half, your job and future employment prospects, those crushing interest rates that you'll soon be paying and the taxes that you and our children will fork over to cover Government deficit spending – guess where it all is going or went. To pay the tab ran up on the shadow banking system. Realize also that the losses so far are but a down payment on the debt incurred. House prices and stocks have further to fall. Taxes, interests payments and inflation resulting from the excess of the greedy few will increase to consume a good chunk of what is left of your savings and to garnish the earnings of our children and their children.

Moreover, as large as President Bush and Obama's bailout spending seem, their efforts are modest compared to the giant vortex of "notional" obligations that have been created within the shadow banking system. A class 2 tornado of Govt. spending compared to a category 5 hurricane of "toxic assets" on the books of financial institutions. This is why the initial incarnation of Mr Paulson's TARP plan was never going to work and why Mr Geithner's PPiP program is stumbling. The pols can stiff the taxpayer from here to kingdom come and there still probably would not be enough money to repair the damage done to bank balance sheets. This is also the reason that the current President's "stimulus" is struggling. The SBS continues to churn at the center of the economy - a huge black hole from which neither matter nor light escapes.

To summarize: 1. The shadow banking system quietly expanded to a huge fortune equal to many times the wealth of the world, 2. Its secret operation is not policed, 3. The only people that have access to this fortune are denizens of the global financial industry and 4. This giant black hole is stifling economic recovery. The common sense of folk tales dictates what pirates do when they find themselves in a secret cave filled with a vast treasure. The immaculate logic of the fairy story also teaches us what pirates will do when told.... ''Me 'arties there be but a day or two before the treasure is swallowed up into the bowels of the earth. Aaaarrrg...PLUNDER!'' The tremors of volatility in oil price were the portent that this day is coming and the devil has already taken the hindmost. The wiliest pirates are long gone lugging what booty they could manage. The slower or perhaps more audacious villains are still busy accepting bailout monies courtesy of the US taxpayer.

The Global Financial Industry has Acted Immorally
The current version of capitalism has a fatal flaw. Its general rule has been that it is every man for himself. But at some point the case arose that the only rule became that it's every man and woman for themselves. And most efficient it has been in operating in this manner. The speed with which its most ardent practitioners sniffed out the coming oil-induced economic collapse and rounded up as much of world's wealth as they could manage to gather for themselves was remarkable. Future generations will no doubt regard us as profoundly foolish for allowing a small clique to gather and fence off value equal to the entire wealth of world and then subject it to a 10-fold leverage. Being at the tail end of one hundred years of oil has coddled us into thinking that we are special. Time to think again.

Most reasonable people do not object to free enterprise, but they do draw the line at licentious enterprise. Sensible adults are also aware of socialism's great failings. Despite the efforts of demagogues on the radio and TV, it is a phoney exercise to cast the issues here in terms of capitalism vs socialism. Ultimately, the case of the shadow banking system is not that complicated. It is not about dead or dying political ideologies, it is about decency vs indecency. What has happened is a deep moral failure. A violation of fairness and natural law. Good people in the US and across the world have been disgusted by the pandemic of immorality that appears to have taken place. Many are no longer buying that the financial crisis is too complex for them to understand. They know right from wrong - their Mama and Papa taught them so.

Judge Richard Posner in a 2009 book makes the point that the banking and financial industry... "was only doing what the market and consumers expected them to do". This argument is wet, to say the least. Posner was wrong before in his untrammeled support of big capitalism. To rationalize his previous positions he now compounds his error by failing to acknowledge that in the pursuit of self-interest sentient beings have a duty to act as moral agents. For social animals such as ourselves, "nature red tooth and claw" is balanced by "fair’s fair". Fair is fair is not the meek code of losers. The anger of the righteous is a counterveiling force that has consistently mitigated the excesses of powerful elites. When on trial - "I was just doing what I was told to do" or that "I was simply doing what everyone else was doing" is not a defense. It should also be recognized that the jurors will not necessarily be our peers - it will be our children (in the Judge's case his grandchildren) who prosecute the hard questions.

"Don't you know you can't run away from trouble?"
One of the oldest Universities of Europe, Charles University in Prague has a motto that roughly translates as - "The truth struggles sometimes, but usually it comes out". A lovely example of the Czech talent for understatement. This motto more authentically captures the emergent nature of truth than say the bombastic, "You shall know the truth and the truth shall set you free" attributed to Jesus of Nazareth. Another appropro saying - this time from John Kenneth Galbraith. "Wealth is the relentless enemy of understanding". Perhaps not always a "relentless enemy", as knowledge is occasionally useful to wealth, but a foe nonetheless. How about Saul of Tarsus ? "Stand firm then, with the belt of truth buckled around your waist, with the breastplate of righteousness in place, and with your feet fitted with the readiness that comes from the good news (gospel) of peace". Where is the like of St Paul now that such a person is really needed ? Finally, among the wisest of them all, Uncle Remus to Brer Rabbit. "Don't you know you can't run away from trouble?... There ain't no place that far."

OK. I'm "beating around the tar-baby" and for good reason. I am afraid. No mistake should be made. There is trouble ahead over the path that the US will take and the shape of a new world to come.

At this point you might be expecting that Theramus is going to lay out the battle lines as he sees them. Demonizing the financial oligarchy, providing helpful suggestions on how to stand up to theses bullies and so on. Well I am going to do this - in my own way. But first, let me approach the issue from another direction. How did we let this happen ? What was the flaw in our system (and perhaps in us) that enabled this vast fraud to occur ? Increasing numbers of citizens now find themselves to be little better than serfs, indentured by debt and paying tribute to a burgeoning aristocratic kleptocracy. In many respects, a historical circle has been joined. The ideals of Republic appear to have been turned on their head.

In the following sections I am going to try and understand how we came to be were we're at. It will be from an American perspective. The crisis has its main genesis in our unique social structure and economic arrangements. We consume a good fraction of the world's oil and our brand of democracy is pre-eminent. I will take multiple routes, but hopefully will eventually draw the strands together into a coherent analysis of how we find ourselves at this place at this time. Also please forgive an increasing polemic tone - some of what follows was written with an angry heart. It is my intent to weed out most of the passion in the essay with iterated editing over time. I do not want readers distracted by my stomping about, screaming and shouting. Well... there may be a little impassioned stomping about.

First a few disclosures about myself. I am an American by personal choice, career and the imperative of a growing American family. Born in the Malaria-belt of Africa, raised in the South Pacific, trained in Europe - I arrived as an immigrant to the US in mid-life. It has taken sometime even to begin to understand the workings of this country - but now after many years, it is slowly starting to seep through a skull of thickened bone and scar tissue.

One moment of understanding came while enjoying the Disney movie "High School Musical" with my children. My initial reaction to High School Musical was to think- the old bard has done it again. Shakespeare's tale, Romeo and Juliet, revived from Medieval Italy to be re-told in a 21st century school in Arizona. But the more I thought about it, the more my focus strayed from the leads - the Astairesque Troy Bolton and the toy goddess Gabrielle. What came to catch my attention were the factions caricatured by the movie - the "jocks", the "mathletes", the school "dance and drama set" and so on. I asked myself - were these groups manufactured for the purpose of narrative tension? Are High Schools in the US really as clannish as this ? I recalled the cliques of my own secondary school days in another part of the world. But, these were limp compared to the assertive, rigid groupings of American students that provided the taught backdrop for the story of our two young lovers.

Another revelation came from the Google Dow message board. What I judged as a more than averagely thoughtful poster opined that the US was a "socialist country" and the main aider and abetter of this tendency of late had been the Republicans. One can imagine the opprobrium prompted by this observation. I was agnostic on rightness or wrongness of the opinion expressed - but again what interested me was how the posted responses sorted into definite groupings, each with its own set of postures and shared internal language.

The last example of formative experience is a swimming club my children are associated with. One does not wish to go into too many details on this other than to observe that I have learned more about American political culture than I perhaps cared too from an innocuously named entity called a "booster club". The seriousness with which some American parents take childrens' athletics is quite remarkable. It is all too easy for an outsider to make fun of - but this crucible for parental ambition is the real thing. Not a laughing matter at all.

Now, of course the Google Dow Board is available to anyone who wishes to post from around the world. Also, one is aware that real High School life in the US is not as played on TV. Nonetheless the Google board, High School Musical and various other inputs of the last 15 years crystallized the following important realization about America for me. My epiphany was that the fundamental unit of social and political organization of the US is what one might loosely describe as a group of people sharing a common interest or purpose. The American experiment has many unique characteristics - but it is this nation's exaption of groups and their interests into the very core of its political structure that is one of its most novel and basic features.

America was founded, and continues to be comprised from aggregations of people brought together under various rubrics, that of ethnicity, church, state, municipal, sporting, business, and so on. It is built from the ground-up by a heterogeneous patchwork of such interests - aggregating, disaggregating, jostling, co-operating, fighting, ascending, and descending. Many natural born Americans reading this are now probably smiling to themselves... it took this "nub" 15 years to learn something that obvious. Well, I'm sorry - but, yes it did.

The apparent genius of the American system - as written into its founding documents - the Constitution and the Bill of rights etc is that it codified a new system of governance that built directly on the oldest of human social institutions - the tribal group. Sorry to those who were expecting hear the virtues of the nuclear family extolled. Unfortunately, like many widely held fantasies about origins - the scientific record teaches that Mum, Dad and the kids were not particularly apt to survive as an isolated group in this cruel old world. Secretary Clinton said it well- it takes a village to raise a child.

The new tribal collectives that make up America were a clear break from the past, in that group cohesion was now not necessarily determined by genetic, familial or ethnic affiliations. We can thank our "founding fathers" for encoding this structure into the very DNA of American political organization. These men, and likely many women, understood that maintenance of a balance between competing interests provided a robust and stable social fabric. It was also realized that factors prompting large and cohesive aggregations of people - such as a state controlled church or an all powerful ruler - had to be avoided like the plague. Hence the enactment of sensible constitutional provisions such as "separation of church and state" and the "separation of powers".

This also explains the visceral reaction of many Americans to their understanding of socialist government. It was learned or intuited that if certain "tribes" became too big or powerful, then the stability of our system of governance was put in peril. When citizens now rail against the power of "special interests" it should be realized that this is what we are all about - "special interests" are tribal interests and these groupings are very much part of the American way.

The desire to suppress the growth of over-powerful interests is also the reason we Americans have never seen and indeed, are unlikely to see Govt.-sponsored universal health care. For all the blood and venom spat at President Obama - his modest attempts to regulate the health insurance industry are a pale avatar of the types of Government run health care that can be seen in Europe, Canada or Australasia. Indeed, what has come to be known Obamacare would be viewed as quite right-wing in most other advanced economies.

The problem for US polity is that a truly nationalized health system similar to a European model would represent an efficient means of aggregating the interests of a new supra-middle class grouping. A political faction potentially wealthier, larger and more unified in outlook and purpose than has ever occurred in this country. The President understands this and so do his Republican enemies. But for all its gentile allure, the emergence of a state-dependent Bourgeouise grouping as occurs in many industrialized countries, will be resisted ferociously by the right. It is also probably 50 years to late to catch this boat. It is an irony that the phrase "middle class" is bandied about in the media as if it defined a single socio-economic category in the US. But I have observed no such coherent group in America - at least as I understand the term "middle-class" as it applies to nearly everywhere else in the first world.

It might be noted that thus far the importance of individual freedom and its protection by law has not been broached. Many Americans will quickly offer these as the foremost considerations when asked what makes the US of A an exceptional country. One does not want to downplay liberty and all that. However, an objective reading of the course of events since the American revolution suggests that in practice the freedom of individuals, and the legal protection of their personal liberties in the US is somewhat overstated. If the embodiments of the constitution protecting individual rights did govern as the overriding consideration, then there would have been no slavery, no civil war, no reconstruction, no Trail of Tears, no Jim Crow laws, no war-time internment of Japanese-Americans, no need for the civil rights movement and US would not incarcerate its citizens at a rate four times that of any other industrialized nation.

One could go on and on reciting other examples that refute the primacy of the individual in the US political system. In the recent past we saw President Bush attempting to set aside Habeas Corpus in the jailing of prisoners in the "War against Terror", including, in one instance we know about, an American citizen. In 2008, the Supreme court re-asserted this ancient right (inherited from the English judicial system) to seek relief against being detained indefinitely without due process.

Aside 2 Feb 2010 - Most of this section written 6 months ago. As if on cue the Supreme Court, January 2010 issued its ruling that corporate (read tribal) interests have the same rights of speech as individuals. This was largely pushed through by the Catholic block vote (Roberts, Alito, Scalia, Thomas, Kennedy) that now dominates the court. Sotyrmayr voted against, but she brings the number of Catholics on this 9 person body to an eye popping 6. One does not have to look too far for the reason that the majority found themselves on the corporate side of the argument. The Catholic church in which these folk were raised is the oldest and most successful corporation that has ever existed. But the Supreme Courts' move is a step too far. The hard-men of the Republic, many of whom trace their origins to Protestant Scots-Irish immigrants, may go along with the ruling for the moment, as it presently perceived to have the superficial marks of conservative branding. However, the red-necks will eventually catch on to the deeper implications for what they view as their liberties. These folk will not be trodden on and will not let this foolish piece of judicial activism stand.

Now here is the point I'm coming to. At least co-equal in importance to individual liberties then, and perhaps unique in its centrality to the workings of the American political system, are the various provisions under US constitutional law that ensure freedom of association. The ability to form swim teams, militias, or that matter a Wall Street firm in a manner that is not unduly encumbered by the state, incorporates the central nervous system of this nation. The consideration of the individual and their rights in law are critical, but in affect it is suggested that individual perogatives have worked more like a conscience with a loud voice, and when necessary, gnashing teeth in our unique political arrangement.

A frank reflection on the record of history indicates that groups have tended to to hold sway in the US, with the re-assertion of individual rights acting to correct the excesses of powerful interests. It is the maintenance of the dynamic balance between the conflicting interests of "tribal" groups and the rights of the individual has been a key part of the equation that has made us the most materially successful nation that the world has ever seen.... until now, that is.

The Fork in the Woods
The unique American way of organizing a human society is now under serious assault and it is the old problem identified by the founding Fathers: Imbalance wrought by a too powerful interest. The Wall Street tribe has placed the Republic in peril. Moreover, it is not hyperbole to suggest that the potential for constitutional conflict approaches the significance of church-state separation.

The proportion of GDP contributed by the finance and banking sector has doubled since the 1980s and in 2008 approached 10 % of US GDP. The ongoing concentration of wealth resulting from the so-called "financialization" of the US economy has resulted in development of oligarchic clans with influence almost unrivalled since the inception of our Nation. The locomotive-strength forces that these folks are capable of mustering first came out of the shadows during the craven response of President Bush's administration in the first year of the financial crisis. With the body politic, and every regulatory authority at their beck and call, the financial industry saw to it that tax payer resources at a level not mobilized since the second world war were brought to bear.

I do not make the comparison to WWII lightly. In fact, it makes my blood boil with rage. When one thinks about the sacrifices made by millions of young men during WWII (family members included), I am truly sickened. The astronomical numbers required for the financial bailout and its parallel to war spending does provide one service. It puts the damage wrought by the financial industry into perspective. WWII was the largest crisis faced by the US of the last 100 years. The imperative was the defeat of the Nazi's and their allies. In addition to waging total war, the murderous adherents of Nationalist Socialism were slaughtering Jews, Gypsies, homosexuals, mental patients, and any other "unwanted" soul within their remit. When one thinks about what Wall Street has done in the perspective of what it took to wage WWII, it is not so easy to blow off. Indeed, the huge amounts of tax payer monies required to bailout Wall Street indicate that their malign influence is now one of the major issues facing the Republic. Not addressing this imbalance places the US in clear and present danger.

Unfortunately, by their combined actions the Republican and the Democratic leadership have thus far rejected the founding principles of the Republic at every opportunity. The path that these people have taken is so comprehensively un-American that it is difficult to imagine that a Japanese, British or for that matter a New Zealand Government would have done it any differently. In our system favoritism towards a specific group, no matter how powerful is forbidden. The American way should have no place for concepts such as "too big to fail" or "risk of systemic failure". Success should be rewarded, and if imprudence has occurred, it should be punished with alacrity. Unless a process of correction is initiated quickly, no matter how hard, we do not learn from our mistakes. This tight feed back loop between cause and effect is what made us strong in the past. If there are extreme circumstances in which it is too difficult for us to follow the remedies laid out at the institution of the Republic, then our nation never had a purpose that set it apart in the first place.

Again, one emphasizes, as has been done ad nauseaum in this essay, that the root of our problems is grand, rooted in the natural process of oil depletion and of a historical scale that perhaps surpasses a human lifetime. All the same, the thing that should have been within our grasp from the outset was the response of our over-schooled political class to the crisis. The correct course of action required no insight into the grand forces at work here. No need to acknowledge Peak oil or root out the potency of a primary volatility spike in unleashing system wide fraud- all that could come later. Instead of looking to guidance in the US Constitution, our leaders held their noses, as they have poured money into a corrupt financial sector - uttering such things as ...."that much as this is against my free-market principles, I'm doing what has to be done". There are no atheists in fox holes. Well, apparently these days there are no one who believes in free enterprise either.

The actions of the Bush and Obama administrations to this crisis has been a cynical betrayal of the American people - those living now and those who came before us over the previous 230 years. Mr Bush's administration did what has always apparently done as a matter of personal habit. Took the easy way out. Punted, thoughtlessly leaving a mess for someone else to clean up... but this time it was too big for even Dad to make good. W and his foreign entanglements.... that big lovable lug Unfortunately, President Obama's primary focus appears to be on continuing the process started by the previous administration, ensuring, for the moment, that the needs of the "tribes" of Wall Street are seen to first.

Personally, I admired what I saw of Mr Obama as he campaigned and then entered the first part of his presidency. He seemed in control and as as smart as a whip. Unfortunately, as time as gone on I have come to the view that the President may be out of his depth. His consistent elevation of corporate interests, whether they be of the financial, health insurance or oil industries, over the interests of ordinary and powerless folk, have followed depressingly familiar arc. The moment of greatest cringing and regretful reflection by me came as President Obama, in prime time, informed us (in the wake of the BP Deep Horizon disaster) that he believed industry experts who told him that drilling for oil in the Gulf of Mexico at 5000 feet below the sea level was safe. I think a lot other people heard this and asked themselves what possessed the President to make such an unsettling remark. If he is telling the truth then he is revealed to be naive, dumb or both. If he is misrepresenting his credulousness, then he is a lier and a thin-skinned, buck-passer to boot. Whomever of the Presidential staff that read his speech and did not point-blank say to the President I am begging you not to say this - should be fired now.

For me and I believe many others, President Obama "anger" at those who told him deep sea drilling was safe, whether it came from candor or naivete, represents a watershed. Obama needs to become a quick study. His moment to decide whether he will truly emulate Lincoln or shuffle off the stage has arrived. Welcome to the return of history Mr President. Fate, talent and ambition placed you on this stage. What are you? Tragic hero or dithering weakling? Cesar or Pilate. Lear or Hamlet? One way or another your name will be remembered in 1000 years. How, is the choice you must now take.

Time is running out for the rest of us as well. More that two centuries in the making, our unique political experiment in the US has come to a fork in the deepest part of the woods. In one direction is the path well trodden by other nations...

To be continued...

Future Consequences of Oil Price Turbulence for Politics and Freedom
There is a another set of broader societal 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 major run-up or collapse in oil price. The spike of 2009 could develop further, the next big one may be another year or two away. Whatever the case, another dramatic surge of unpredictable change in the price of oil is on its way.

Foolish commentators will no doubt attribute daily wobbles during this new spike to irrelevant or bogus causes - e.g., OPEC, oil speculators, 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 further lability in 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 legal figures and some in the media.

Admittedly, the timing of a number of the manifestations listed not fit the time line illustrated in the figures provided in this essay. 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 also soften us up to accept new draconian impositions. Mr Rahm Emmanuel, a Democrat politician recently said, "...never waste a good crisis" - an unfortunately callow statement given the magnitude of the calamity facing us. This being said, our political leaders may be spoiled for choice with future emergencies that will be available for charraling the flock.

On the more hopeful side, a realization of the consequences of oil price volatility could provide individuals who consider themselves "conservative", in the 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 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.

In conclusion,
madness came to global financial markets. However, it is proposed that the monumental level of bad behavior that occurred was not irrational. Instead, it is suggested that increasing fluctuation in oil price following Hubbert's peak (1997-2007?) is the ultimate explanation of the economic crisis. Those with the wherewithall to understand and respond to instabilities in oil price seem to have gathered available resources - positioning themselves for whatever is next. Unless Mr Greenspan among this avaricious few, his distress may be significant and permanent.

Theramus

About Therramus
Therramus is a neutered Tom. His avatar is a US Medical School Professor and Biologist. New Zealander by accent, education and upbringing, he presently lives with his gorgeous wife and lovely family in beautiful Charleston, South Carolina. He is an outsider to the oil industry ...



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