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How is an oil shortage like a missing cup of flour?

If I bake a batch of cookies and the recipe calls for two cups of flour, but I have only one, it is pretty clear that I can’t bake a full batch of cookies. All I can make is half a batch. I will end up with half of the sugar, and half of the eggs, and half of the shortening that I originally planned to use left over.

Liebig’s Law of the Minimum applies in situations like this. In agriculture, it says that growth is controlled not by total resources available, but by the one in scarcest supply. If a baker does not have enough of one necessary ingredient, he will have to make a smaller batch. I wonder if it isn’t a little like this with oil and the economy.

Oil seems to me to be a necessary “ingredient” in our economy. If for some reason oil is not available (perhaps because the buyer cannot afford it), then to some extent other “ingredients” in the economy, like human labor and new houses and stores in shopping malls, are less-needed as well. That is why as oil consumption decreases, there are so many lay-offs, and the effect multiplies and affects all areas of the economy, even housing prices and demand for business property.

If worldwide oil price is on the high side (like it is now), customers are faced with a choice–should they buy the full amount of high priced oil, or should they cut back in some way. For example, a state transportation department might find that asphalt (an oil product) is high priced. They might decide to buy less and fix fewer roads. If they do this, they won’t need as many workers to spread the asphalt, so they may lay off some workers. With less demand, refineries that make the asphalt won’t need to process as much oil, so some of the older refineries can be closed, and their workers laid off.

The laid off workers will have less money to spend, so they will cut back–go out to restaurants less, take fewer trips, and wait longer between haircuts. And of course, there will be little need to build new refineries, or to buy new trucks for spreading asphalt, so these changes will impact workers in the construction business and in the manufacturing of trucks. A laid off worker may miss mortgage payments, and this will trickle through the economy in other ways. Housing prices may drop from lack of demand because some workers have lost their jobs, and because foreclosed houses are on the market at low prices.

In some cases, there may be the possibility of substitution–in this example, switching to concrete or gravel roads instead. But even in this case, there might be layoffs–less need for refineries, for example. Also, spreading gravel might take fewer workers. Concrete roads might last longer, and therefore affect employment in years to come.

Let’s take another example. If oil prices rise, airlines will need to raise their prices to cover the cost of fuel. Because of  higher prices, businesses cut be expected to cut back on travel, and less-wealthy vacation travelers may stay home. The reduction in travel can be expected to lead to layoffs in the airline industry. There will be less demand for new airplanes (unless an inventor can truly figure out a way to make a more fuel efficient airplane!), and less demand for workers who build the airplanes. Fewer travelers will pass through the airport, so airport restaurants and shops are likely to lay off workers.

As a third example, if oil prices rise, grocery stores will raise the price of the food they sell because oil is used in food production and transport, and stores will need to pass the higher costs through to the customer. While customers are likely to “trade down” to the less-expensive items offered, in total, they are still likely to spend more on groceries than in the past. To compensate, customers can be expected to cut back on their discretionary expenditures elsewhere. A few may even miss mortgage payments.

How can this problem of layoffs, debt defaults, and falling housing prices be avoided when oil prices rise? I am not sure that it can be.

If a government has a huge amount of money for oil subsidies, perhaps it can subsidize oil prices, so the effect isn’t felt throughout the economy. Usually, it is only the oil exporters who can afford such subsidies.

Or a government can make a rule that companies can’t lay off workers, no matter how much demand drops. Unfortunately, such a rule is likely to result in many bankrupt companies. If they continue making goods few can afford, they will end up with a lot of excess inventory as well.

Or governments can try to cap oil prices. But now we are running short of oil that can be extracted from the ground at low cost, so capping prices has the perverse effect of reducing supply. Governments can also raise taxes on oil companies, but to some extent this also has the effect of reducing supply. The fields that had marginal profitability before the tax hike are likely to be closed.

If the government wants to keep employment up, somehow it needs to find less expensive alternatives to oil, so as to stop this vicious cycle of higher oil prices sending the economy into a tail-spin. Higher priced substitutes are not helpful–they just make the situation worse! This is why most of the alternatives now under consideration are dead ends, unless the costs can be brought way down, say to $50 or $60 barrel. Even electric cars need to be inexpensive, to really help the economy.

Too many people don’t really understand where the economy is running into trouble, and are proposing solutions that can’t fix the problem. Our real problem is that the economy cannot afford high priced oil; it is not that there is too little (high priced) oil in the ground.
We have always assumed that we can have cheap and available ingredients for our societal “recipe” for how our current economy functions. Now this assumption is coming into question.

By. Gail Tverberg

Gail Tverberg is a writer and speaker about energy issues. She is especially known for her work with financial issues associated with peak oil. Prior to getting involved with energy issues, Ms. Tverberg worked as an actuarial consultant. This work involved performing insurance-related analyses and forecasts. Her personal blog is ourfiniteworld.com. She is also an editor of The Oil Drum.

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Leave a comment
  • Anonymous on February 03 2011 said:
    With higher price oil, production can be maintained if other factors of production accept a reduction in their remuneration. Other factors of production means employees, and since they are not going to play this game, output comes down, and some of these employees become redundant.Its really quite simple. If the oil price keeps going up, somebody is in trouble. Professor James Hamilton's theory - and mine - is that the high oil price was a key factor in the macroeconomic meltdown of the last few years is absolutely correct.
  • Anonymous on February 04 2011 said:
    Sorry, but I forgot something in my above comment. This is an excellent article. I hope that it has maximum circulation, because it says something that everybody should know.
  • Anonymous on February 04 2011 said:
    This is the nub of the energy crisis we now face. Our civilization is based on cheap energy for transportation, food, health and employment. Just look at the graph of population growth vs oil production. Wealth may trickle down but impoverishment is pouring down. The only remedy would be a new, inexpensive and rapidly deployable source of energy, whch seems unlikely. More likely is the devouring of every last scrap of resources by the oil enabled population overshoot.
  • Anonymous on February 05 2011 said:
    Well done Gail! It seems you have written an economics article that is enlightenimng, informative and that needs to be read. I might not understand all of it (yet), but if Fred Banks likes it, that's good enough for me.

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