Why Do Prices Go Up?
I've hammered on this issue many times, but it seems that it needs even more exposure now. Oil price has been hovering around the $90 - $95 price range for several months now. That range isn't really hard since there are many grades of oil (light sweet to tar sands gunk) that have a range of prices based on the desirability, a function of how easy it is to refine the oil to high demand products like gasoline and diesel fuels. I haven't seen anything resembling a weighed average price, by type and volume say, but you can see the general trend by tracking prices of any of several sources. For example Brent Blend (North Sea source) was running in the high $90s a few days ago. Tapis crude (from Malaysia and traded in Singapore for Asian markets) was running over $100 on that same day. And West Texas Intermediate (USA, most often quoted benchmark price) was running just over $90. Here is the problem. The price of oil is a major cost factor in everything else in the economy.
Way back in March of 2008, when the price of WTI went over $100 I wrote What's wrong with this picture? in which I dissected the cost accounting of a supply chain from a basic material extraction (from natural resources) through intermediate processing and component forming, up through final product production. What I was trying to show is that while energy costs recorded for each enterprise in the chain were relatively small in dollars, that the fact is every stage along the way energy inputs were necessary to get to a final product. In point of fact all work must have energy inputs, and thus all inputs to production ultimately resolve to energy. This includes labor, materials, and overhead, which allocates costs to historical expenditures for physical plant assets as well as current operating expenses. Extractive industries are generally very energy intensive even when the energy is that of human labor (e.g. miners).
The energy costs (in joules or BTUs if you prefer) accrue at every stage. In this blog I want to explicate this aspect just a bit more and examine the way in which rising costs of fossil fuels propagate throughout the economy and contribute to inflation, i.e., the rising costs of all products, not just, say, gasoline. But, insidiously, inflation is not the only impact we will see from rising energy costs. These are just a natural reflection of a simple biophysical economic fact. The supply of net energy to do all useful work is already in decline. This is because the amount of energy that is consumed in the extraction of fossil fuels has been steadily increasing while the rate of production (esp. of oil) has been decreasing. We have already passed the peak of net energy, so we are able to do less real work (as opposed, say to fantasy financial services work done on Wall Street and by gambling bankers - not all bankers, just the greedy ones). It appears now that we have passed the global peak of extraction of conventional oil, and we have certainly reached the point where new production is only for high energy cost oils (e.g. from deep water drilling or tar sands). Readers would do well by reading postings in The Oil Drum and The Energy Bulletin for starters. You will find other blog pointers in my blog roll to the left. All of these are examining the peak oil phenomenon and exploring the implications for macroeconomics.
The graph below, supplied by Wikipedia (have you made your donation yet?), shows the general trend of WTI prices from 1996 to 2008. As can be seen in the graph, oil prices basically increased by five times in that period. Eventually it reached a top of $147 and some change and then tumbled back down to $40+ when the demand for oil plummeted and triggered the 2009 recession. For a good overview of the oil production vs. price history see Gail Tverberg's “Will 2011 be a rerun of 2008?” on The Oil Drum.
Graph 1. WTI price trends 1996 to 2008 (1994 is a typo - source Wikipedia.
Clearly the price signal has been on a more or less steady climb for the decade. There is no oil embargo to explain this, only the twin effects of peaking production and falling energy return on energy investments (EROI) which translates into higher costs of production.
But the really bad news is that oil is an input to everything else in the economy, either directly or indirectly. Its cost increases are most readily and quickly felt in the transportation sector. But oil is also used as chemical feedstock for plastics and other derived products. It is simply everywhere in one molecular form or another. As I said transportation systems rely very heavily on oil in the form of gasoline and especially diesel. The latter is a major input to the extraction industries, even for coal (I've been trying to assess the magnitude of this relationship as it might have a great impact on coal production costs).
One of the most sensitive sectors that gets impacted almost immediately is food production. Food is the necessary energy input to human labor. Though the energy content of food is derived from sunlight, the organization and operations of food production — the modern industrial agricultural operation — runs on diesel and electricity (much of which is produced by coal-fired plants). Artificial fertilizers are absolutely mandatory in order to maintain high yields per acre and that is necessary to feed the urban populations. Fertilizer components, fixed nitrogen, phosphates, and potash (potassium) have to be manufactured or mined and shipped to the point of production, then the product shipped to the point of use. It has been estimated by various energetics analysts that one calorie of sunlight in food costs ten calories of fossil fuel to produce and deliver.
Inflation is the increase in asset (or services) costs over time. There are two real causes of inflation. The first is the biophysical increase in costs due to shrinking availability of net energy, which leads to less real work and fewer assets being produced. The dollar costs of what does get produced goes up (as does the price of the energy inputs). The second is due to not adjusting the currency value in accordance with the shrinkage of real assets. This would be done by reducing the amount of currency in circulation. But, of course, this is exactly the opposite of what the US Fed is doing (see quantitative easing). Way back in 2008 I wrote about the dual problem that we are about to face, contraction along with inflation (not just stagflation but Contractflation).
The Biophysical Economy — i.e., Reality
Real wealth ultimately comes down to two biophysical stocks: physical assets and biomass! The former means all of the physical objects, including the ones representing knowledge assets like bits in a computer file. The latter includes the totality of human beings, their pets, and their non-food plants (e.g. ornamental plants). Of these, of course, the total mass of humanity is what we are primarily concerned with. For a more complete explanation of the assets/biomass breakdown see my tutorial, “Work, Exergy, the Economy, Money, and Wealth”.
Figure 1 greatly simplifies the overall picture found in Figure 3 of the above tutorial. Here I have just included the two stocks (actually as active processes, oval shapes in the systems diagramming lexicon) and the sources of material and energy that enable their construction (including biological reproduction) and maintenance.
Figure 1. A condensed macroeconomic view of reality. All of humanity is represented by the biomass subsystem. There are two main streams of flows from the natural world that support the continued creation of biomass. The first is the parallel extractions of energy, one in the form of extrasomatic energy. Fossil fuels make up the largest single part of this energy flow (> 80%). Hydroelectricity and nuclear make up most of the rest with very small contributions from wood and other vegetable matter and even smaller contributions from high-tech, so-called, renewables like wind and solar. The second energy extraction is from solar energy to food production. This is made possible on large scales by the supplement of fossil fuel energy from the first energy extraction (red arrows). The second flow is material extracted from nature and formed into usable assets (which includes more energy extraction equipment!) Humans provide energy flow feedback to all of the other processes in the form of labor (including intellectual labor).
The key concept in all of this is the flow of energy, assumed to be in the proper form after extracting raw energy and converting it to the forms that drive our work engines (e.g. food or gasoline or electricity, etc.). Energy is the prime input to every single activity in the economy.
Figure 2 depicts the situation which I called contraction. As energy sources diminish, post peak oil, combined with the rapidly declining energy return on energy investment (i.e. higher costs for extracting energy) there is a necessary shrinkage of net energy available to do the useful work in the economy. Ergo, both biomass and assets shrink since their production rates and maintenance are curtailed.
Figure 2. This figure shows the situation of the biophysical economy subsequent to the increase in energy costs to extract energy (larger red arrow feeding back into the energy extraction process) and the shrinkage or depletion of the fossil fuel energy resources (e.g. sometime after peak oil). The net energy available to run the rest of the economy is shrunk so that asset production as well as biomass production (after shrinkage in food production) must decline in response. Worse yet, the reduction of net energy flows means losing the ability to maintain current stocks of biomass (increased death rate) and assets.
This is what is staring us in the face right now. We have reached, by all reasonable indications, the peak of oil production in total barrels pumped. We seem to be on what is called a bumpy plateau rather than a definitive peak owing to the response of the economy (contraction or recession) that lowers demand for energy and thus slows the pumping rate temporarily. As the economy has seemed to pick up growth momentum (don't try to sell that to those whose jobs went missing or lost their homes to foreclosure of course) the speculation of higher demand and a non-ability to actually increase production over what the likely peak number was appears to be elevating the futures price for oil and thus we find ourselves back at the 2008 situation once again.
There is every likelihood that the $85+ price level is putting a tremendous drag on every global economy, even, or especially the Chinese and Indian economies. If the price of oil stays at that level for much longer, say two more months, I would not be surprised to see us in what economists call a double dip recession, but where the next low will be much lower than that of 2009. As the oil further depletes there is nothing but upward pressure on prices even as recessions seem to temporarily cause a decline in short-term prices. The daily, even weekly ups and downs of oil prices are just market jitters — noise. The long term trend (as in Graph 1) is terribly clear.
Compounding this issue is the fact that new oil finds have been getting smaller and smaller as far as field size goes. And they have been happening in more remote, and hence more costly, locations like deep water. Or the oil is actually not found in pools but embedded in shales and tar sands which require extremely expensive extraction methods and technologies. So the likelihood of bringing more capacity on line as a result of higher prices is getting smaller and smaller over time. The net payoff of investments in new oil production is approaching zero. The marginal returns are already in decline.
There is no solution to the fundamental problem. There will be contraction even if we were to somehow find the resources to invest massively in alternative energy projects. The latter simply cannot scale up to meet the same level of demand as is currently met by fossil fuels. If the rate of depletion of the latter is high, then it becomes unlikely that we would even be able to muster that investment since it means diverting a substantial amount of energy from even necessary asset production/maintenance (forget about discretionary spending). The Chinese government, with their more autocratic abilities, seem to be trying this now. They are investing more energy into alternative sources, but as they do they are having to substantially increase their imports of oil and even coal. Not that many years ago we told stories about how much coal China and the US had to provide energy for perhaps several centuries. But that was just a story and not a very good one at that.
I have been writing a lot about the need to ramp up (from the grass roots) our approaches to food security by learning and practicing permaculture. Up until now it has been as much an exercise in intellectual musing about the application of systems science to localized living. I have been exploring some possibilities, but frankly have found the potential sources of financing not ready to hear the message. Now I wonder if I'm too late for myself and family. Given the rates of energy reduction I am witnessing I would say it is now time to act. If you have the ability to go full bore into starting a permaculture community now is the time to make it happen. Choose your site wisely. And good luck.