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The Economics of Peak Oil PDF Print E-mail
Thursday, 28 April 2005

Not all economists are of the ‘flat-earth’ variety! Those not indoctrinated with the liberalist free-market mantra are as likely as any other open-minded person to accept the concept of a peak and decline in global oil production. Economics is the study of human behaviour and the allocation of resources, and as such may even shed light on the issue of peak oil. Geologists plot Hubbert’s peak based on physical extraction data, but the way that supply interacts with the global economy and market expectations tweaks the shape of that bell curve. This will marginally improve things, or make the situation a whole lot worse.

But first, a short alternative history of modern industrial progress to show how oil and the economy are so closely entwined. The material standard of living we enjoy today is a result of technological advances in transport, communications and productive capacity, fuelled by fossil fuels, firstly coal and then oil (gas played second fiddle to these two giants). The process of rapid globalisation started in the nineteenth century and, following the upheavals of two damaging world wars, continued with renewed vigour over the second half of the twentieth century. The source of this vigour was an international free-trading system coupled with stable financial system, considerable population growth, and increasing supplies of oil. All of which in turn led to rapid technological innovation. For example, in 1930 a three minute phone call from London to New York cost more than £150 but today costs as little as a few pence.

The post-WWII period was truly a golden age for much of the world economy. Between 1946 and 1973 there were growth rates worldwide that made the achievements of the coal-fired nineteenth century seem modest. The U.S. saw per capita GDP growth averaging 2.4% per annum between 1950 and 1973, Germany 5%, and Japan more than 8%. Inflation was low, unemployment was low, and incomes rose at their fastest ever pace. Policy-makers, scientists, international bankers, and corporate businesses all like to take credit for this golden age, but fundamentally it was pretty much all down to one factor: oil. For without oil these growth rates would have been impossible to achieve. The graphs of global oil production and global GDP can be fitted over one another: during this golden age period oil production grew exponentially and so did the global economy.

This exponential growth was physically unsustainable and oil use would have slowed in the late 1970s even without political intervention in the market. As a result of the 1970s oil crises the global economy stalled and then retrenched. Demand for oil actually fell for the first time in history. Without this fall we would have been in the current situation during the mid-1990s. Recovery was slow over the decades following the 70s oil shortages, with variable economic recoveries in the western industrialised nations and measured economic collapse in the Communist Bloc. However, economic progress was rapid, though punctuated with financial calamity, in the developing nations of East Asia. The most recent global economic boom has seen increasing demand for oil from both the western industrialised nations and these industrialising nations of East Asia. Without a miracle new energy source this current global economic growth will not be able to continue.

So what happens next? There is a geological upper limit to oil production. Plotting production curves, as undertaken by ASPO, provides a timeline of events based on this geological limit. However, this is only half of the story. The ways in which supply and demand for oil interact in the global market place also have to be considered.

An important factor in determining the initial impacts of reaching peak is whether the global economy is expanding at the point that oil output slows or whether the economy is already contracting for other reasons (such as the economic slowdown that resulted from the dotcom crash). In the latter instance, where global demand for oil is already declining, the severity of the initial shock would be reduced, and the plateau might also be extended as a result of slowed production. However, global oil depletion would initially be masked by declining demand and already well underway before anyone was aware of the situation.

If, on the other hand, the global economy had been growing strongly, as it has over the last couple of years, then the supply shortfall would be more keenly felt. With regard to the timing of impacts in this case it is possible that the nature of modern commodity markets would induce an economic slowdown on the approach to the oil production peak. Market reaction may well be some time in advance, since if the rate of oil production slows on the approach to peak and cannot keep up with robust growth in demand for oil, then rising prices will spark interest in the issue of future supplies (as is the case now). As soon as one major oil trader 'suspects' that peak is close at hand then market panic could ensue, even if, in fact, we are still a few years away from the peak. Short-term panic in the market could lead to oil prices doubling overnight, leading to a swift global economic crash similar to that in 1979-81. The end result being that the financial impacts of peaking may start some time pre-peak.

Even without market panic, at best there will be a steady rise in oil prices as buyers attempt to secure supplies of oil at what they believe will be below market value at some point in the future. Future prices are almost impossible to predict with any accuracy, and the task gets more difficult further into the future. An analysis which is being used by the Canadian Imperial Bank of Commerce looks at the potential oil supply shortfall and what price would be needed to close the projected shortfall by destroying demand. They estimate the supply shortfall increasing from about one million barrels a day (b/d) in 2006, which they believe can be closed by oil prices rising to around $60 a barrel, to 2.8 mb/d the year after, when oil will rise to $70. In 2008 they have oil at $80, in 2009 they predict $90 oil, and 2010 oil rises to around $100 a barrel. This would probably result in a gradual slowdown in the global economy as it slips into major recession in 2008 or 2009.

Either way, the result is recession. The pain, though, will not be felt equally around the world. Net oil exporters, such as Venezuela, Nigeria, Russia, Saudi Arabia, and Iran could benefit from higher revenues, whilst maintaining domestic supplies at the existing lower price. Inflation would rise with energy prices in importing countries and initially central banks may raise interest rates to further slow demand and gain control over inflation. Unemployment is likely to rise, with those hit hardest working in jobs reliant on discretionary spending. Bankruptcies would mount and house prices would drop. In some areas of the economy there would be rapid inflation, in others deflation. Some nations such as the UK have fuel taxes that would soften the impact of higher oil prices and could be lowered to off-set the higher price of crude (although this would reduce government revenue). Other nations, such as the US, would feel the full force of the price rises and experience higher levels of inflation. Exporters would also be hurt, especially those to the US. These are the initial impacts, from here it is possible to argue that two scenarios would unfold:

Scenario One. If, as is likely, there is an over-correction in demand due to the higher oil price, then the global recession will reduce demand for oil to a level below supply. If production is still at the plateau (a big ‘if’) then the pressure on oil prices would ease temporarily as a consequence, allowing a short economic recovery. This will provide a possibly once-only opportunity for far-sighted policy-makers to implement a radical transformation of the economy, encouraging viable renewable energies as well as energy-efficient technologies and working patterns. This would entail greater re-use of materials, lower overall consumption of resources reliant on oil, limits on the use of cars, and greater local resource self-sufficiency. If this programme is implemented rapidly enough in the major economies, with non-essential economic activity curtailed, then a steady reduction in oil demand would allow the restructuring to continue for longer. Government control of almost all economic activity would be required during the restructuring. If, however, political leadership is weak and the effort is half-hearted, or depletion picks up speed, then, within a relatively short period of time, oil production will once again reach the physical resource limits and managed economic decline to a sustainable path will be much more difficult.

Scenario Two. It could be very possible that declines in oil production post-peak will be faster than depletion rates suggest, as, once aware of the global peak, some producer nations (such as Venezuela, Russia and Iran) may value oil's export opportunity cost for use in their own economy (e.g. to build an alternative energy infrastructure for themselves) and restrict output below the maximum. With rising oil prices oil producers’ incomes from crude sales can be maintained without having to maintain production at the same level. A second reason to restrict production is if the future price of oil is expected to rise (and this increase is greater than the ‘discount rate’ of money), then it is better to hold on to oil and export it at a later date for a higher price (or whatever it is that you want) rather than sell it immediately for less. In countries that decide to adopt this path expect to see re-nationalisation of oil companies, the expelling of foreign oil companies (or a more subtle hampering of their investments in production), and in time the rewriting of existing supply agreements. The result of such an approach is that oil exports would decline and the daily global supply of oil would be reduced even faster. With rapidly declining oil supplies the global recession may quickly become a second Great Depression. Energy prices could continue to climb even with a shrinking global economy if available oil supplies (i.e. on the market as opposed to geologically available) fall at a faster rate than economic activity. With actual shortages of oil occurring in some nations governments would have to enforce strict energy conservation, however, this would probably not prevent their economic collapse.

The difference between the outcome of each scenario is not just economic survival. In the scenario of withheld oil supplies use of military force to secure the oil needed to maintain an individual nation’s material comfort becomes much more likely. How have we come to be in such a potentially perilous situation? The world was wrong to allow markets to price oil. Markets have a short-term outlook and, anyhow, need reliable information to function properly. Oil was priced too low to reflect the finite supply. OPEC and the oil companies have ensured that the world will shortly experience the biggest market failure in history. Mainstream economists still insist that the rising price of oil will solve our problems through the magic of markets. However, none of these economists understand the concept of ERoEI, though they will before long. One silver lining to peak oil could well be the demise of uncritical acceptance of the free-market ideology and all that it entails. In this new post-peak world a new type of economic analysis will be needed, one based on energy rather than money. However, this is only my perspective, and, as is well known, if you ask three economists a question you will get four answers, so please don’t base your investment or lifestyle decisions on any of the above!

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