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Why It Won’t Matter If Oil Prices Rebound

Why It Won’t Matter If Oil Prices Rebound

What is the real story of energy and the economy? We hear two predominant energy stories. One is the story economists tell: The economy can grow forever; energy shortages will have no impact on the economy. We can simply substitute other forms of energy, or do without.

Another version of the energy and the economy story is the view of many who believe in the “Peak Oil” theory. According to this view, oil supply can decrease with only a minor impact on the economy. The economy will continue along as before, except with higher prices. These higher prices encourage the production of alternatives, such wind and solar. At this point, it is not just peak oilers who endorse this view, but many others as well.

In my view, the real story of energy and the economy is much less favorable than either of these views. It is a story of oil limits that will make themselves known as financial limits, quite possibly in the near term—perhaps in as little time as a few months or years. Our underlying problem is diminishing returns—it takes more and more effort (hours of workers’ time and quantities of resources), to produce essentially the same goods and services. Related: Resource Dependence Could Prove Fatal For Canadian Economy

We don’t measure our investment results with respect to the quantity of end product produced (barrels of oil produced, liters of fresh water produced, kilos of copper produced, or number of workers provided with sufficient education to work in high tech industries), so we don’t realize that we are becoming increasingly inefficient at producing desired end products. See my post “How increased inefficiency explains falling oil prices.

CostOfExtraction

Figure 1. The way we would expect the cost of the extraction of energy supplies to rise, as finite supplies deplete.

Wages, viewed in terms of the product produced–oil in this case–can be expected to decrease as well. This change isn’t evident in usual efficiency statistics, because some of the workers are providing new kinds of services, such as fracking services, that weren’t required before.

WagesPerWorker

Figure 2. Wages per worker in units of oil produced, corresponding to amounts shown in Figure 1.

Even investment is becoming increasingly inefficient. It takes more and more investment to extract a given quantity of oil or other energy product. This investment needs to stay in place longer as well. The ultra-low interest rates we have been experiencing reflect the poor returns investments are now making. Related: Has The U.S. Reached “Peak Oil” At Current Price Levels?

The myth exists that prices of all of the scarce goods and services will rise higher and higher, as the economy encounters scarcity. The real story, though, is that the inflation-adjusted purchasing power of common workers is falling lower and lower, especially in the United States, Europe, and Japan. Not only can these workers afford to buy less, but they can also afford to borrow less. This means that their ability to purchase expensive goods created from commodities is falling.

At some point, this lack of purchasing power can be expected to affect the financial markets, and the prices of many commodities can be expected to fall. In fact, this already seems to be happening.

The likely impact of such a fall in commodity prices is not good. If low oil prices cannot be “turned around,” they will lead to debt defaults, and these debt defaults are likely to lead to failing financial institutions. Failing financial institutions have the potential to bring down the system, because it becomes very difficult for businesses to continue if they are not supported by a banking system that allows a company to pay its employees. Workers also need the banking system to pay for goods and to save for a “rainy day.”

A big part of what has allowed the economy to grow to the size it is today is increasing debt levels. These rising debt levels play many roles:

  • They make high-priced goods more affordable to consumers.
  • They create greater demand for goods, allowing more end-product goods to be produced.
  • They create more demand for commodities required to make end-product goods, allowing the price of these commodities to rise, so that more businesses have more incentive to create/extract these commodities.

At some point, debt levels stop rising as fast as they have in the past (because of a lack of growth in purchasing power because of diminishing returns in investment), and the whole system tends to fall toward collapse. We seem to have reached this point in the middle of 2014. China was raising its total debt level rapidly up until the early part of 2014, then suddenly moderated its growth in debt level in mid-2014. At about the same time, the US scaled back and eliminated its program of quantitative easing (QE). Oil prices dropped starting in mid-2014, at the time debt levels started moderating. Other commodity prices started falling as early as 2011, indicating likely affordability problems. Related: OPEC Boosting Production To Keep Pressure On U.S. Shale

We are now in the period when many people still believe everything is going well. Oil prices and other commodity prices are low—what is “not to like”? The answer is that the system in not at all sustainable—profits of oil companies and other commodity businesses are down, just as wages of common workers in developed countries are down in inflation-adjusted terms. Companies are cutting back in investment in oil production. Soon oil production will drop. With lower oil supply, the economy will face huge challenges.

Many people believe that oil prices can bounce back up again, but this really isn’t the case, because of growing inefficiency related to limits we are reaching–the need to use more advanced techniques to produce oil; the need for desalination for water in some places; the need for more pollution control equipment that doesn’t really increase the finished goods and services we are producing but instead makes goods more expensive to produce.

Each worker is, on average, producing less and less of the finished goods we really need. Whether we like it or not, standards of living will have to fall. The amount of debt workers can afford decreases rather than increases. This new reality can be expected to manifest itself in debt defaults and increasing financial system problems.

Even if oil prices bounce back up again, it is doubtful that shale oil drillers will be able to again borrow at a sufficiently high rate to increase their production again—what lender will believe that oil prices will remain high indefinitely?

By Gail Tverberg

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  • Brad Clark on April 16 2015 said:
    This one of the strangest posts I have ever seen. It conflates a wide variety of economic phenomena with the entirely expected decline of North American oil production. No one who is familiar with the decline rates for fracked deposits was taken in by the hoopla from faux news.

    The author is working hard make the argument declining oil production is the root of all economic woes. For example, she sites "the inflation-adjusted purchasing power of common workers is falling lower and lower". There has certainly been a dramatic wealth redistribution upwards out of the middle class. But the causes are a combination of advancing information technology and automation, and public policy changes which concentrate wealth and public services with the baby boomer generation. Neither of these are a function of the price of oil. Please remember: correlation is not causation.

    Such petro-centric thinking is characteristic of people who can't tell the difference between technologies and commodities. The prices of commodities are volatile and, since they are ultimately finite, trending upwards. As I look forward I see a world where fossil fuels are increasingly irrelevant as a source of energy. Why? Because they can never be free. Contrast this with renewable energies such as solar. The cost to collect, store, and distribute this energy is still relatively high. But the cost drops year after year. Solar energy technology will just keep getting cheaper because that's what technology does. And the sun is always free.

    The economies of the past were driven by the work accomplished with the chemical energy stored in fossil fuels. The economies of the future will be very different. They will be driven by the work accomplished with electrical energy harvested from renewable technologies. The limiting factors for future growth will be intelligence and creative problem solving. Not by toxic black goo out of the ground.
  • Brian on April 16 2015 said:
    That's a sweet sentiment, Brad. However, renewable technology, like it or not, is still neither economic or scalable and is thus still in its infancy. Meanwhile, energy demand is both huge and growing - particularly among developing nations - so for the next fifty years, aka the rest of our lifetimes, the world will most probably be powered by fossil fuels whether you like it or not, chief.

    ... And North America's "fracked deposits" still have plenty of hydrocarbons in them.
  • Jill on June 17 2015 said:
    Brad, it's 'cite', not 'site'. ^^

    There is a naive innocence to the ideas in your post. You seem to think that solar energy will somehow become free. That's like suggesting that because mobile communications technology has increased in power exponentially over the past decade, making the cost per MB of data/voice cheaper, that talking on the phone or sending a text is free! This is absurd.

    Taking solar as your example, at it's current level of technology, covering the entire roof of your house with solar panels would generate enough energy to heat/cool your home and water and run small appliances - during the day. It would not run your dryer and oven long enough to cook a roast. At night solar cannot light your house, or do anything in fact. Battery technology is also terribly expensive - certainly not free, and never could be. It takes extensive energy and commodities to produce batteries, not to mention the skilled labour, capital and debt servicing requirements of manufacturers.

    So, it takes skilled labour and capital to manufacture solar and battery technologies. Solar also requires large tracts of land, which needs to be purchased or leased on which to install commercial scale solar farms, and the opportunity costs lost as a result of using all this land for solar. Then there is maintenance and continual upgrades requires, not to mention security. The solar and battery industries still operate within the larger capitalist economy.

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