Luke Gromen: "Peak Cheap Oil and the Global Reserve Currency" | The Great Simplification #91

Tying oil to physical gold (not paper gold) through BRICS oil settlement in gold is important for price discovery because when central banks offer credible physical gold settlement of oil surpluses, it creates direct links between the two real assets, breaking the ability of paper markets to manipulate either price.

“by offering credible physical gold settlement of any oil surpluses in yuan at the Gulf Nations in Russia in gold, what you're doing is effectively tying oil to physical gold, physical oil to physical gold, not paper gold, physical, which is important from a price discovery standpoint for gold.”

During World War II, the US Fed capped the 10-year treasury at 2.5% and the 3-month bill at 0.375%, committing to buy whatever the government issued; in nominal terms no one lost money on treasuries, but in real terms they fell sharply after the war when rationing ended, with real rates bottoming at negative 13% (inflation at 15%, nominal rate at 2%).

“And that's exactly what the United States did during World War II. As Japan bombed Pearl Harbor, shortly thereafter the Fed said, 'We're going to cap the 10 year US treasury bond at 2.5% and the three month 3/8th of a percent, and we will buy whatever the government issues.' And nobody lost a dime in their treasuries for those five years in nominal terms. In real terms, those bonds fell sharply, particularly after the war ended and the rationing of goods came off, real rates in the aftermath of World War II shortly thereafter. Real rates are just inflation adjusted interest rates. Real rates in the United States bottomed at negative 13%. In other words, inflation was 15 and your interest rate was two.”

China has been selling off US treasuries, and since 2011 has not bought incremental treasuries on a net basis; their treasury portfolio has not risen since roughly 2011-2013, instead they have deployed those funds into oil supplies, refineries, ports, and gold to store value in energy terms.

“And in fact, China has been selling off their US treasuries recently. Yes? They haven't bought an incremental treasury since 2011. I mean, I'm sure they've bought and sold, but on a net basis, their treasury portfolio has not risen since roughly 2011 or 2013, depending on how you measure it. So things are maturing and rolling off and they're not adding. And they're not adding, and instead they're deploying those funds into things that will much better store value in energy terms, whether that be oil supplies, refineries, ports, gold, et cetera.”

The expanded BRICS group now accounts for over 50% of exportable oil in the world (after internal consumption), not total production, with Russia, Saudi Arabia, and others as major producers, representing a historic shift in global energy control.

“if you add up all the countries now in the expanded BRICS, it accounts for over 50% of the exportable oil in the world, not the production, but what's left after internal consumption is accounted for. And the barrels of oil that are purchasable in the world, 50% or 51% is from Russia, Saudi Arabia, et cetera.”

Gold holdings among central banks have increased by $300 billion since 2014, offsetting a significant portion of the $600 billion decline in treasury holdings, showing a systematic shift in reserve asset preference toward physical gold.

“Gold has gone up 300 billion. We are moving towards that.”

The Ghanaian government has begun using gold as a measure and accepting gold as payment for some obligations; Argentina has taken yuan swaps to repay the IMF; these are examples of emerging markets accelerating de-dollarization in response to currency pressures.

“You've been seeing that the Ghanaian government has done that recently, using again, gold as a measure. Argentina to a lesser extent, and taking yuan swaps to repay the IMF.”

Recent evidence of volatility in treasury and repo markets (the two-year Treasury trading like Dogecoin in March, repo rates spiking from 2% to 10% in one day in September 2019) are previews of the kind of volatility that could occur as the system transitions, and these are assets that historically have never traded with such volatility.

“We've seen little glimpses of the type of volatility that this could spur, and that's in assets that we've never seen or volatility. As you know, as a former bond guy, the Treasury market doesn't trade like Dogecoin. The overnight repo rate that underpins everything else doesn't go from two to 10 in a day.”

The debt-backed fiat currency system as structured since 1971 when Nixon took the US off the gold standard has reached exhaustion due to peak cheap oil, specifically peak cheap energy in terms of the marginal cost of global oil supply.

“the debt backed fiat currency system, as it has been structured and existed since 1971 when Nixon took the US off the gold standard, in our view, has reached exhaustion for peak cheap energy, peak cheap oil in particular reasons”

Political leadership, particularly in the US and UK, has been dominated by 'debt merchants' and 'exporters of debt' (Washington and Wall Street) for 40-50 years, and these interests do not want to hear about the need for currency reform and industrial policy change.

“the political power has resided with the debt merchants, the exporters of debt. You know, who has won in the last 40-50 years in this system. It's been the exporters of debt, which is Washington and Wall Street. And they still have a lot of power, they're not going to want to hear this.”

The US government cannot afford 8 to 10% interest rates on its $33 trillion in debt that rising marginal oil costs would imply, creating a Mexican standoff where the US cannot let rates rise but energy exporters cannot afford to store surpluses in treasuries that do not compensate them for the rising cost of the marginal barrel of oil.

“The problem within that is the US government cannot afford anywhere near eight to 10% interest rates on its 33 trillion in debt... we are now at a situation in the global monetary system... energy exporters globally that first group I talked about would have to be stupid to be blunt, to store surpluses that they earn in dollars in US treasuries at rates that are not compensating them at the rising cost of the marginal barrel of oil”

China, as the world's largest oil importer and trading partner with OPEC, faces a finite FX reserves problem: as oil prices rise and demand grows with economic expansion, China's finite dollar reserves are consumed faster, eventually forcing China to either shrink its economy and imports or find a way to buy oil in non-dollar currencies.

“China's got a finite FX reserves in dollars. China needs to import oil and other commodities to a lesser extent in dollars. China's economy is growing, the price of oil is rising, and as the price of oil rises that consumes dollars fast, finite dollars faster. As China's oil demand goes up to support their growing economy and they're growing debt, the supply of dollars goes down faster. Ultimately, oil imports, if they're only in dollars, will cause China to run out of dollars.”

Historically, wiser policymakers understood the energy-currency-security nexus and used monetary levers (like weakening the dollar) to geopolitically hedge US energy exposure; current leadership lacks this integrated thinking.

“I would say is far wiser than the leadership we have had over the last 25 to 30 years... It's a lever people don't often think about, but I think when we had wiser policymakers, I think they did think about it.”

The biophysical phase shift Nate Hagens refers to is the transition from a society that measured wealth and prosperity primarily in monetary and technological terms to one where energy, ecology, and commodity constraints are primary, with massive implications for financial systems based on digital and paper assets.

“I'm terming what's coming as the biophysical phase shift, which is where society used to measure our wealth and our future prospects pretty much solely in a money and technology sense, and now it's energy and ecology and commodities are going to be primary and that has massive implications for a world that measures our wealth in papers and digits”

The US spending breakdown is: entitlements consume nearly 65% of tax receipts; defense about 25%; and interest payments are now 30% on a proforma basis and rising to approximately 40% as Fed rate hikes fully reset, leaving almost nothing for all other spending.

“the reality is there's only three things big enough to cut, it's entitlements. We're spending call it almost 65% of treasury receipts, record treasury receipts by the way, on entitlements, defense about another 25% of record receipts. And then incredibly in the aftermath of the Fed hikes, we're at about 30% on a proforma basis of treasury receipts is going to go to interest... it's going to be closer to 40%”

In the next decade, inflation will surge in the US and globally to 10-15% on a sustained basis for several years, and real interest rates will be drastically negative during this period; the real value of debt will be eroded in commodity and energy terms, achieving a de facto debt jubilee and bringing debt-to-GDP ratios to more manageable levels.

“I think we are in for a period at some point in the next decade where real interest rates in the United States, inflation surges in the United States, across much of the world and real interest rates are drastically negative for a period of several years. So you go through a period of time where inflation is on a sustained basis in the United States, 10 to 15% for several years at a time, and ultimately the real value of this debt that is ultimately the problem is eroded in commodity terms and energy terms.”

The most concerning thing about the next decade is the poor strategic foresight and decision-making of Western leadership, particularly in Europe over the last 18 months, which risks leading into catastrophic tail-risk outcomes.

“the thing that's scary, the most concerning thing to me, I don't want to say scared but most concerning thing is the intelligence and foresight, strategic foresight of Western leadership leading us into a, what I still think is a tail risk, really bad outcome... The Europeans in the last 18 months, to me, stunningly, stunningly bad leadership. Like galactically, stunningly bad leadership.”

The system will likely change suddenly without much warning, maybe 5-7 years off, making it critical to educate people about the money-energy nexus and have them start planning now rather than waiting for the crisis to force action.

“we're not going to get a lot of warning. It may be five or seven years off, but we're not going to get a whole lot of warning”

Young people should pursue their passions, fall in love, start families, and pursue careers aligned with their values rather than being paralyzed by the economic and environmental crises on the horizon; the ability to reach large audiences and do meaningful work is more available now than ever before.

“It's going to sound cheesy, but fall in love, start a family, go to an art museum, find what you're passionate about. Because, yes, on one level it's very scary. On another level, that opens up lots of opportunities for doing and talking about things or engaging in things that you can do as a career, as a life's purpose, that otherwise wouldn't be available to you. Just me talking to you, hopefully hundreds of thousands of people or millions of people will listen to this around the world, and that type of reach was simply unavailable even 10 years ago”

Stock-to-flow ratio is a simplified way to think about the number of 'shells in a shell game'—a commodity with 1.1-1.3 stock-to-flow like oil cannot separate physical fundamentals from price for long because there aren't enough shells to hide shortages, while a commodity with 65 stock-to-flow like gold has 65 shells per physical unit and can have price manipulated through paper claims.

“So the stock to flow ratio can be simplified down to the number of shells in a shell game, right? So if you have a commodity with a stock to flow ratio of 1.1 to 1.3 like oil, you can't separate physical fundamentals from price for very long, because the stock and flow ratios are so small it's going to show up, right? So you have 1.1 to 1.3 shells per p. If the stock to flow ratio of gold is 65, there's 65 shells per p. And so, they can play games by creating paper unallocated supply”

A barrel of oil represents 10,000 to 25,000 hours of human labor equivalent, making energy the real currency of life and the fundamental measure of economic activity, not money.

“you often write that a barrel of oil has 25,000 man-hours of labor in it. I would handicap that, I say 10,000 because we're more efficient at getting the muscle power, but still it's like years of our work is in a barrel of oil”

A 1980 quote from Jelle Zijlstra, chairman of the Bank for International Settlements, stated that 'a third oil crisis could not be survived by the international financial system because the inflation would make it impossible to recycle the petrol dollars to oil importing countries with any hope of repayment in real terms,' and we are now in that third oil crisis.

“this quote was written in 1980 by the chairman of the Bank of International Settlements, Jelle Zijlstra, and it said 'its second oil crisis could be worked through slowly, but the international financial system could not survive a third oil crisis. The inflation would make it impossible to recycle the petrol dollars to the oil importing countries with any hope of repayment in real terms, in oil terms. Trade would crumble and the system would be brought to its knees.'”

The Biden administration's reshoring, increasing investment in the electrical grid, and domestic industrial policy is in direct contradiction to the global monetary system as structured since 1971, where the US's job was to run deficits and import goods to supply dollars to the world; if reshoring is to continue, a neutral reserve asset is required and the global system must change.

“we are seeing the Biden administration run this reshoring, the increasing investment in electrical grid, all this domestic infrastructure, this basically industrial policy... that is in direct contradiction to the global monetary system as it has been structured since 1971. In other words, since 1971, the US' job is we run deficits and if we need to shut down our manufacturing and import it from elsewhere to run more deficits to supply the dollars, that's what we do. So if we're actually bringing stuff back, relocalizing, that means the global system is changing. That means the global monetary system is changing. And if that is going to continue to happen, you have to have a neutral reserve asset.”

There are significant complexity risks between current state and Gromen's energy-driven revaluation scenario—many supply chains depend on just-in-time delivery and interconnected global production networks that could break, causing cascading failures.

“I can see that, but it depends what global and US oil production are. And it also depends bigly on the complexity risk between here and there. Because there are so many different supply chains and contracts and little spark plugs that are made somewhere.”

The US and Western nations' inability to easily override an OPEC/BRICS-imposed gold price stems from the fact that most people do not yet understand the primacy of energy and oil relative to financial assets, so they underestimate BRICS leverage.

“because people don't think about the primacy of energy of oil relative to the financial assets, they don't see this yet by and large. Some, it's a small minority that sees it, but I think a lot more people are going to see it when it hits them over the head in coming years.”

Tragedy of the commons problems (environmental externalities not priced into goods) will get worse as peak cheap oil reduces society's ability to pay for environmental remediation, and the proper remedy is to price environmental damage, but politically this is unpopular because it requires people to pay more.

“It's a tragedy of the commons problem, right? Ultimately, in terms of because nobody pays for the externalities, here we are. So again, it comes down to what's the right thing to do is to better reflect what the real price is... peak cheap oil is going to make society's ability to pay more tougher.”

Leveraging gold in a hyperinflation scenario (like Weimar Germany) is actually very dangerous; even as the gold-to-Reichsmark price rose from 10 to a trillion Reichsmarks, the month-to-month volatility was extreme, and leveraged longs were taken out multiple times in five years as prices crashed, meaning the optimal strategy is not to leverage into gold but to stay under-levered and maintain anti-fragility.

“Let's take it to the extreme, right? Extremes inform the means. One of the great hyperinflations of all time was in Weimar, Germany from 1918 to 1923... So basically, gold goes from 10 Reichsmarks to a trillion Reichsmark over five years... if there's going to be a debt jubilee, if there's going to be high rates of inflation, the optimal strategy is borrow a bunch of money, buy that asset on leverage and then just let the inflation go. Personally, I had thought that myself, too. I'd only ever seen that version of the chart. Then I saw this chart from my friend, Dan Oliver... it shows the month-over-month price change... What it shows is that if you were levered, levered long gold... You were taken out. In the greatest hyperinflation in history, you lost all of your money four or five separate times in five years.”

Blue-collar workers and skilled trades workers may benefit from Gromen's scenario, as 10-15% inflation might coincide with 10-15% wage growth in these sectors as economies reshore and production increases, while their long-term fixed-rate mortgages (locked at 3%) become cheaper in real terms.

“When you see UPS drivers getting 170,000. When you see around me, plumbers making 300 to 350,000 in Cleveland, Ohio, when a nice house is 250, 300,000, maybe 350,000. There is a rebalancing that will take place. It will require in a lot of cases, flexibility. But to the extent you are a laborer, skilled trades, et cetera, it's very possible in that 15% inflation, depending on your area, you may be seeing 10, 15, 20% wage inflation at a time when your 30-year mortgage is three.”

The blue states in the US subsidize the red states, with blue states as surplus states and red states running deficits within the US union; in the scenario Gromen describes, this relationship would reverse, with red states (energy and food producers) subsidizing blue states (financialized, asset-producing regions).

“we have the blue states and red states and we've all seen the map. And if you look at the map, blue states, red states, we've seen these articles that have highlighted that essentially the blue states subsidize the red states, right? The blue states are your surplus states, and the red states run deficits... the blue states, which tend to be much more highly financialized than the red states, subsidize the red states. What this world would look like is effectively reversing of that, where your red states are producing oil and food and goods”

Personal resilience and anti-fragility are more important than trying to time the market; people should invest in relationships, health, and communities, and avoid over-leverage while building productive skills.

“I would say invest in maintaining and building personal relationships, personal health, anti-fragility in your life, in your finances. Stay under-levered. Don't go out and borrow a bunch of money... Those are the things that really matter... invest time with my family. Invested time with my children, pursuing a passion.”

No credible energy productivity miracles are visible on the research horizon that won't require yield curve control implemented by the Fed to monetize industrial production.

“The short answer is no, not that won't require basically yield curve control implemented by the Fed to monetize industrial production.”

The energy productivity miracle required would need to be in liquid fuel specifically, not just any energy technology, because liquid fuel is the transport vector of the global system; alternatively, small fission commercialization with battery material abundance could theoretically replace liquid transport fuels.

“it's not specifically energy productivity in this case because we could have a miracle in some energy technology that has nothing to do with liquid fuel that is the transport vector of the global system. So, it's kind of got to be a miracle in that arena as well, right? Yes, basically or it's equivalent. So, you commercialize small fission and build the infrastructure and now all of a sudden you actually can... And you don't have battery material constraints, and so now we can run EV cars and trucks to replace those fuels.”

It is possible that the US and Western governments could try to vilify and restrict gold use (as the US did in the 1930s), but there are elements in the US defense and intelligence community that understand the need for a neutral reserve asset as part of reshoring industrial policy.

“I think it's very possible they could. How much of the world's gold reserves do the United States have... So a quarter? Yeah, so very well represented. And so number one, that's part of the reason why I'm not convinced that they will, because it actually will be in the interest of the United States for the price of gold to rise. It recollateralizes the system, it weakens the dollar, it will free up more oil supplies”

The US SPR (Strategic Petroleum Reserve) drawdown last year was a choice between using price as an incentive to drive conservation and production (the strategic long-term approach) versus suppressing prices to support the treasury bond market (the short-term approach); the US chose the latter.

“When oil went up a bunch, great. Let's take the strategic approach and use the price incentive to drive consumption savings, to drive investment in production. Or let's sell the SPR down to get oil down and just stuff all those problems that are real problems back under the rug for a second, because the Treasury market's getting upset. And of course the US leadership being US leadership chose the Treasury market and the short-term expedient”

When China and Russia sanctioned the US oil exports in 2003 by invading Iraq for access to oil, Chinese leadership interpreted the seemingly insane Iraq War as a sign that US leaders were recognizing a problem with global oil supplies; China then began a 20-year effort to address its Malacca Problem (the vulnerability of 5 million barrels of oil per day to US Navy blockade through the Straits of Malacca).

“in '03 when the United States said, 'And now we're going to invade Iraq because they have WMD and they supported Al-Qaeda,' despite very we'll say minimal evidence to support that. Chinese leaders, she said, 'Took that as a sign that there was something wrong with global oil supplies,'... Their Malacca problem was 5 million barrels a day of oil plus goes through the straits of Malacca, which can be shut down very easily by the US Navy. And so, they got to work on it.”

An energy productivity miracle would offset the dynamics that peak cheap oil is putting in motion by allowing the world to maintain faith in the real value of sovereign debt relative to energy inputs without needing to change the monetary system.

“an energy productivity miracle would basically offset the dynamics that peak cheap oil is putting in motion. So basically, to the extent that the world is concerned about the real value of sovereign debt and treasuries, specifically relative to their needed energy inputs now and in the future, that would allow them to say, 'Oh, okay. I'm not going to run out of energy. The real value of debt is not going to collapse against energy.'”

Policymakers should recognize the need to shorten supply chains and reshore key production for resilience and anti-fragility, and this is advice Gromen gives to people thinking about these systemic changes.

“Yes, it is advice I would give them. I think there has been some recognition of that among policymakers. I think you raise a great point too, as it ties back to the prior point of, 'Can US and western policy makers constrain gold in that world?' And if the bottleneck is energy as we think it will be relative to dollars, treasuries, paper, financial assets, that ties back to why I think it might be so important about the BRICS... implement industrial policy to build resilience, to build anti-fragility, to build re-localizing supply chains.”

The price of gold in oil terms has risen almost 4x since 2008, from 8-9 barrels per ounce to nearly 30 barrels per ounce, but the nominal dollar price of gold has not risen proportionally because synthetic paper gold supply has been created and expanded to suppress the gold price.

“the price of gold in oil has risen almost 4x since 2008. The gold to oil ratio has gone from eight to nine barrels an ounce to almost 30.”