The Peak Oil Side of Volcanoes

This Icelandic volcano is not just a quaint story about some faraway place. We need to keep an eye on Iceland and its grumpy volcanoes. The historic record is filled with Icelandic volcano blasts that wrecked European civilization. It goes back at least to the days of the Roman Empire. There’s evidence that an Icelandic eruption in A.D. 405 led to a harsh winter the next year, in which the Rhine River froze. This allowed the barbarians cross in numbers sufficient to defeat the Roman Legions.

In A.D. 934, there was a massive lava flow from Iceland’s Eldgja fissure system. It unleashed the largest basalt flood in recorded history. An ash cloud blanketed Northern Europe and weakened many political structures. This eruption helped keep the Dark Ages dark, and in particular harmed the English political system. It’s no coincidence that William, Duke of Normandy, conquered England a century or so later, in 1066.

Then there was the Laki eruption in 1783, with another immense outpouring of lava in Iceland. This eruption emitted large volumes of poisonous gas, including fluoride and sulfur dioxide chemicals that poisoned half of Iceland’s livestock. The gas cloud blew over Scandinavia as well, causing many deaths and hardships that included a long famine.

There were many deaths further south in Western Europe, as well, in 1783. Then came several years of extreme weather. Among other problems was a shortfall in farm output. This led to a drop in tax receipts for governments across the continent. In France, King Louis XVI eventually had to summon the Estates General to ask for new taxes. Instead, he wound up with the French Revolution.

Do not discount the immediate or long-term human, economic and social effects of natural phenomena. I hope that the Icelandic volcano goes back to being dormant. But it’s nothing that anyone can control.

One way or the other, the Icelandic volcano is important to you as an investor. This situation is bad for the European economy. It helps explain why the euro dropped in value last week, while the dollar strengthened. Also, note that as the dollar rose, the price of gold fell, retreating from an otherwise bullish advance.

And what about energy concerns?

The most immediate, and most public, effect of the Icelandic volcano is that transatlantic flight has reverted to the pre-Charles Lindbergh days. Basically, there is no more flying to and from Europe across the North Atlantic. (OK, maybe you can route through Spain, but you get my point.)

Right now, for example, one of the world’s largest carriers, Lufthansa, is completely grounded. Most other European carriers are likewise not operating, or running a drastically reduced schedule. The airline industry is losing about $200 million in revenues per day, while stranding millions of passengers.

According to Eurocontrol, which operates the airspace in Europe, about 20,000 flights per day are canceled. By my back-of-the envelope calculation, that translates into about 1.5 million barrels of jet fuel per day that’s not being burned to power airliners. That’s just shy of 2% of total daily world oil demand. So with this fast hit to demand, it’s no wonder that the price of oil has dropped about $4 per barrel in the past week.

Right now the volcano is creating a “peak airspace” condition that is driving down the price of oil…but which almost perversely mimics the effects of Peak Oil. How’s that for irony? Sure the price of oil is dropping as a consequence of the eruption. But this same scenario of curtailed world trade is what will result when the price of oil rises and forces world trade to slow down.

But it’s not as if jet fuel is the only cost for airlines. There’s a lot of fixed overhead, whether the jets fly or not. Now there’s discussion of the need for a bailout for European, and some U.S., carriers. Oh, great. Another bailout. Anybody have any spare money lying around?

Meanwhile world trade is indeed suffering. Perishable items, from flowers to exotic fish and fruits, are rotting on the loading docks. High-value items like computer chips and diamonds are sitting in secure warehouses. Much other airfreight is just stacking up on the pallets. FedEx and UPS together carry about $1.3 billion of goods per day between North America and Europe. Right now, it’s almost all shut down.

The ripples are global. For example, Chinese auto assembly lines are slowing down due to lack of electronic components from Germany. There are reports of mass layoffs in nations as far apart as Kenya and Colombia, due to the inability to export goods via airfreight to Europe. Then consider all the personal and business disruptions and expenses from casual and business travelers unable to fly.

Can the world economy take this hit? British newspapers are claiming that the economic crunch is worse than right after Sept. 11. Indeed, the airline hit alone has already lasted longer than the post-Sept. 11 groundings. And it’s going to continue for how long? Nobody knows. Or put another way, do YOU want to be on the first airliner to fly through an ash cloud?

Is this really an air safety problem? Or is it a government regulatory problem? According to NATO officials, an F-16 suffered severe engine damage over the weekend while flying through the ash cloud. Finnish officials also announced that one of that country’s F/A-18s suffered massive engine damage during a routine test flight, due to the ash.

For another opinion, we go to Giovanni Bisignani, director general and CEO of the International Air Transport Association. He believes that European governments have been far too reactive to the Icelandic volcano. There’s “no risk assessment, no consultation, no coordination and no leadership,” he told The Washington Post.

Not sparing any sugar, Mr. Bisignani adds that “Governments must place greater urgency and focus on how and when we can safely reopen Europe’s skies… This crisis is costing airlines at least $200 million a day in lost revenues and the European economy is suffering billions of dollars in lost business.”

My inner geologist has, on occasion, pondered the implications of natural disaster on world trade. Consider the effect of earthquakes. In historic and current times, we’ve seen horrendous examples of disaster all across the world, from wealthy nations like the U.S. and Japan, to developing countries like China, to impoverished places like Haiti.

The San Francisco earthquake of 1906, for example, caused many banks and insurance companies in the U.S. and Britain to fail. This led to the Panic of 1907. The Panic of 1907 led directly to the creation of the U.S. Federal Reserve in 1913.

OK, so creating the Federal Reserve wasn’t quite the same thing as the barbarians crossing the Rhine and defeating the Roman Legions. But even if the Iceland volcano calms down tomorrow, say, and the airlines get back to “normal” in a week or two, what then? Just carry on with business as usual? Or will your worldview change?

Until we meet again,
Byron King
Whiskey & Gunpowder

April 22, 2010

The Daily Reckoning