EROEI: Economics Without the Money

by Chris Mayer, Daily Reckoning

“For some years now,” Tim Morgan writes in Life After Growth:

“Global average EROEIs have been falling, as energy resources have become both smaller and more difficult (meaning energy-costly) to extract.”

You may have heard of this concept called energy return on energy invested (EROEI). It looks at how much energy we expend in relation to how much energy we extract. Some, like Morgan, think this is very important.

Consequently, falling EROEIs have become the basis of a variety of dire forecasts…

Be skeptical of anything that seeks to analyze our economy by taking money out.

In these scenarios, we spend more and more energy just getting energy, and we have less and less for other discretionary items. As Morgan writes:

“If EROEI falls materially, our consumerist way of life is over.”

I’m writing to you today to slay this flawed EROEI concept.

I have to say I used to be taken in by this argument. I wrote an issue of my Capital & Crisis newsletter a couple of years back with the headline “Crack This Code: EROEI – Why It Matters Now and What to Do About It.” I included a list of approximate EROEI ratios for various energy sources:

• 1970s oil and gas discoveries: 30-to-1
• Current conventional oil and gas discoveries: 20-to-1
• Oil sands: 5-to-1
• Nuclear: 4-to-1
• Photovoltaic: 4-to-1
• Biofuel: 2-to-1

I noted that such ratios were falling and concluded that a lower mix of EROEI sources means higher prices for many commodities, because “it will take more energy to produce them.”

It means nothing of the kind.

I would like to right my old error and convince you why EROEI is fatally flawed, so you don’t fall for it. I’ll use Morgan as the foil, because he is an articulate and strong proponent of the idea in his new book.

Morgan’s crucial assumption appears on page 5: “The economy is not primarily a matter of money at all. Rather, our economic system is fundamentally a function of surplus energy.”

This is the key to the whole EROEI argument. Morgan repeats it often. And it is completely wrong.

You can’t take money out of the equation! Money is what it’s all about. It is the essence of the economic life. It’s at the center of decision making. As economist Hyman Minsky said:

“Money isn’t everything. It is the only thing.”

Be skeptical of anything that seeks to analyze our economy by taking money out. Households and firms make decisions based on money. They certainly don’t use EROEI, nor should they.

When a firm decides to drill a well or not, it does so on the basis of estimated costs and profits. It makes a decision based on some expected return – as measured in money. They are not the same. High-EROEI projects can be losers. Low-EROEI projects can be winners – as measured in profits and return on investment in money terms.

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According to Morgan’s logic, you wouldn’t bother generating electricity…

Here is Robin Mills, currently with Manaar Energy (and once a petroleum manager for the Emirates national oil company in Dubai):

“Generating electricity, usually at a thermal conversion efficiency of less than 50% plus transmission losses, has an EROEI of much less than 1, but is still rational and economic because electricity is such a useful form of energy.”

Put another way, the money costs of the inputs are less than the money prices of the outputs. It works because… it’s profitable! People value electricity more than they value the inputs. Looked at through an EROEI lens, though, it doesn’t make sense.

You can build any scary resource scenario you want if you exclude money prices. If, say, falling ore grades were predictive of prices, then we would see continually rising prices for copper and other resources. Clearly, this isn’t the case. But this does not prevent people (usually geologists) from taking these moneyless concepts to make economic forecasts of higher prices.

A general rule of thumb: If it doesn’t take into account money prices, then it isn’t about the real-world economy as it exists today.

That’s my biggest objection to EROEI. But I’m not making a comprehensive case against EROEI here. That would take too long. I won’t get into how EROEI is calculated: there is no agreement and when you think about it, maybe it’s impossible to know with any accuracy worth relying on.

In the end, I think Morgan doesn’t really get modern money. He repeats an old myth about its origins. He doesn’t seem to know why fiat currency has value. (He says money is a “claim on real goods and services,” which only begs the question: Why do people accept dollars in exchange for real goods?) He doesn’t seem to understand the primacy of making a monetary profit in a market economy.

Contrary to Morgan, you can’t take money out and hope to understand the modern economy. You have to study money. And in markets, you have to make a money surplus (a profit) – or you are out of the game before long. I can’t say the same is true for EROEI, which is perhaps the best I can say against it.

You can ignore EROEI, but you can’t ignore money.