Supply chains require super-linear energy

Wednesday, 13 July 2022 — Albert Park

[7 min read]

Dear Reader,

Jim Rickards has explained before one of the concepts that can have unintended consequences for supply chains — efficiency.

Today, Jim focuses on the other E: energy. The problem is that supply chains need super-linear energy.

And now that we have a better understanding of the supply chain crisis, we can look at who the winners and losers might be. This is vital reading for your investments.

Regards,

Callum Newman,
Editor, The Daily Reckoning Australia

Dear Reader,

In my last editions, I’ve covered the first E — efficiency. This brings us to the second problem — energy.

All systems run on some form of energy. It can take the form of electrical energy from nuclear power plants, hydroelectric generators in dams, natural gas plants, coal-fired plants, or renewable sources such as wind and solar. Energy can also be provided in the form of human labour, which is fuelled by food.

Money is a form of energy. It takes energy to produce profits in the form of money. Money is a store of value, which can be used in the future to release energy through the purchase of electricity, buying inputs, or paying wages. Money is like a battery for storing energy between the input and output stages in the supply chain.

Complex dynamic systems such as the supply chain run on energy. The problem is that the energy inputs rise in a super-linear fashion relative to the scale of the system. In plain English, this means that if you double the scale of a system, you may increase the needed energy (electricity, money, or labour) by a factor of five. If you double it again, you increase the energy inputs by a factor of five again. This means that after doubling the scale of the system twice, the scale is four-times larger, but the energy inputs are 25-times larger.

When the profits from increasing the scale of the system are high and energy costs are low, these lopsided ratios of scaling functions may still be profitable on net. Yet, when profits start to shrink (because of competition from disruptive technologies) and energy prices start to rise (because of government regulation and inflation), the impact of energy input costs on a highly leveraged supply chain network becomes a constraint on the operation of the system as a whole.

The rising cost of energy inputs is exacerbated by outright energy shortages, as are now emerging in China and Germany. China has coal shortages — coal accounts for more than 50% of their electricity generating capacity. Germany has natural gas shortages, which may grow worse if Russia invades Ukraine and the US imposes sanctions on Russia. These energy shortages are slowing output in both countries right now. Both are export powerhouses.

Other factors weighing on the supply chain today include the pandemic and geopolitical stress. Major trading nations such as Australia and China pursued the ridiculous goal of a Zero-COVID policy, or no new outbreaks of the infection. This is impossible. It’s tantamount to pursuing a policy in which no one catches a cold. The goal is absurd, but the costs are real.

On 13 December, China closed dozens of manufacturing plants in the city of Shaoxing based on 173 reported cases of COVID. Most such cases are mild and non-fatal. Shaoxing is next to the port city of Ningbo, which is the world's third-largest port based on container volume. More than 50,000 people in the Shaoxing–Ningbo area have been placed under quarantine.

The combination of manufacturing shutdowns and the likelihood that port operations in Ningbo will be disrupted soon will send ripples through the global supply chain. Inside the containers waiting to be shipped from Ningbo are parts needed to meet supply chain requirements at manufacturers, retailers, and distributors all over the world.

Geopolitics are another factor, as Russia invades Ukraine, China threatens to invade Taiwan, and Iran works overtime on building a nuclear weapon, with possibilities of violent retaliation, the imposition of economic sanctions, and a global restriction of free trade.

Global supply chains are already stretched to the breaking point. These geopolitical confrontations could cause the supply chain system to break down entirely, as happened in the 1930s.

The winners and losers from the crisis

There’s no easy solution to the supply chain breakdown. Complex systems collapse in a cascading fashion. Each problem leads to a larger problem downstream. The ripple effects fan out, but they cannot be reversed. The river doesn’t flow backwards.

Efforts to solve particular problems by hoarding, overordering, or seeking new sources of supply only make the situation worse. Those remedies come at the expense of someone else in some other supply chain. It’s a zero-sum game. The overall situation grows more dire, even if Band-Aids provide temporary relief to some.

If you consider supply chains as belonging to each company that participates or even to groups of companies in the chain (the ‘enhanced supply chain’), you’re missing the bigger picture. The global supply chain is a system of systems. Each separate supply chain system is complex, but the system of systems is immeasurably complex. Trying to model this complexity would require a processing power greater than the entire computational capacity of the planet. We call this system of systems the ‘meta supply chain’.

Increasing output doesn’t help when the transportation lanes are blocked. Marshalling more transportation lanes doesn't help when the warehouses are full. Getting some deliveries to manufacturing centres doesn’t help when other critical deliveries are late. Profits are eaten alive by higher energy costs, higher labour costs, higher inventory costs, and lost sales.

US government policy is trying to increase oil and natural gas costs in order to enhance the attractiveness of wind and solar energy. These Green New Deal policies will fail. While wind and solar have a place, such intermittent sources of energy can’t maintain the output levels needed to run a modern power grid and can’t scale fast enough to meet rising energy demands. Meanwhile, higher costs for gasoline, jet fuel, diesel, and natural gas will exacerbate existing problems in the supply chain.

As noted, collapse is unidirectional. Once water goes over the waterfall, you cannot push it back up the falls. The meta supply chain will have to find a new level. It will be slower and more costly but perhaps more robust to future failure.

The biggest loser will be China, because it’s the source of many inputs in the broken supply chain that will be abandoned. The biggest winner will be the US, because it has the greatest capacity to onshore broken links and build replacements for lost capacity elsewhere.

Still, reconfiguring the meta supply chain will take 5–10 years to accomplish. In the meantime, investors should expect empty shelves, higher costs, and slower growth in companies that are most affected by the breakdown. I’ll be highlighting those winners and losers in future editions…

All the best,

Jim Rickards,
Strategist, The Daily Reckoning Australia

This content was originally published by Jim Rickards’ Strategic Intelligence Australia, a financial advisory newsletter designed to help you protect your wealth and potentially profit from unseen world events. Learn more here.

Dear Reader,

‘“In August 1971”, writes Dan Denning in his “Dollar Report”, “French President Pompidou sent a French destroyer to New Jersey to collect French gold held in custody by the Federal Reserve. This was the end of the post-World War II Bretton Woods system, where the US dollar was the global reserve currency, but backed by gold at a fixed price of $35/ounce.”’

Last week, we looked at the causes of today’s financial turmoil. The worst stock market…worst bond market…worst inflation…worst six months for a standard, 60/40 (bonds/stocks) portfolio ever — how did we get here?

It’s like an archaeological dig…going down…down…down through the layers of mistakes, delusions, and wishful thinking.

Was it because the French destroyer went back empty-handed?

Or because Putin invaded Ukraine? Or because Eve took the apple at the beginning of time?

The problem with digging is knowing where to stop. You keep putting in the spade and you end up in China.

And yes, China is where we’re going today.

Soft dollars

The US switched to a ‘soft’ dollar in 1971. It was a dollar that looked for all the world like the 1969 dollar. But it was different. It was no longer convertible to gold, it was a technocrat’s dollar — flexible, adjustable, and prey to temptation. It was a dollar the French couldn’t redeem for gold at a fixed rate.

New dollars are conceived in the credit market. When banks lend, they don’t actually reach into their vaults to draw down their depositors’ savings. Instead, they just create the money ‘out of thin air’, as a bookkeeping transaction. It doesn’t matter if there are any savings or not.

Conception is the most popular part of the human life cycle. Money is no different; everybody smiles when a new dollar is born. Thus, as borrowing grew, 1971–2022, the money supply grew…and aged. As we saw on Friday, from 1971 to today, federal debt grew three times faster than GDP. And soon there was a big pile of grumpy, old debt that needed to be repaid.

As long as the dollar was tied to gold, there were limits. Ultimately, dollars were redeemable for gold. And there was only so much gold. But without the link, the sky was the limit.

In addition to normal bank lending, the Fed could also ‘print’ dollars and use them to buy bonds. This ‘quantitative easing’, QE, had the effect of putting whole legions of new dollars into service…and driving down interest rates so that even more people wanted to borrow.

Ben Bernanke would crow that he had had ‘the courage to act’ when he used QE to stop a financial correction in 2009. But the result was a US$30 trillion (total new debt 2009–22) increase.

It was a circus of imbeciles — who thought you really could get rich by printing money. And the imbeciles were right.

Inglorious elites

It was no coincidence that most financial assets are owned by the elite — the richest segment of the population. These were the people who run the Fed, dominate both houses of Congress, and the White House too. No wonder they were happy with the new money program. Between 1971 and 2022, it boosted their wealth — real estate, stocks, bonds, private businesses — by an estimated US$72 trillion.

But with all this money printing going on, how come consumer prices didn’t go up alongside asset prices? And what about the 80–90% of the population that didn’t own stocks and bonds?

That’s where the Chinese come in. One of the elite doctrines of the late 20th century was the ideal of ‘globalisation’. New York Times columnist Tom Friedman wrote a book celebrating it — The Earth Is Flat.

In 1979, China decided it was time to join the world economy. ‘To get rich is glorious’, said Deng Xiaoping. Soon, China was covered in glory. Almost overnight, factories sprouted like bamboo shoots…and some 300 million peasants made their way to urban centres to work in them. With so many very cheap Chinese on the assembly lines, who needed to pay American wage earners more money; who needed them at all? And as Chinese factories turned out gadgets by the millions, why should prices go up?

A life of its own

And so, the great trans-pacific trade routes grew crowded. Ships from China rode low in the water, freighted with TVs, toaster ovens, and refrigerators bound for American consumers. The ships going the other way were almost empty. The Chinese made valuable goods. Americans printed up the money to buy them. And by December of 2021, the trade deficit with China had soared to more than US$94 billion for the single month.

That trend appears to have peaked. May 2022’s trade deficit with China fell to only US$78 billion. Why? There are few peasants left to exploit. And Chinese factories are paying more for their copper and zinc and oil and other raw materials.

So now, with its own labour and raw materials costs rising, China is no longer enabling US money printers. Consumer prices are rising everywhere. And inflation takes on a life of its own.

Stay tuned...

Regards,

Bill Bonner,
For The Daily Reckoning Australia