Oil Prices and the Economy
The punch line comes toward the end!
Now that the average price of a barrel of oil on the open market has risen above US $110 there is a lot of chatter in the media about the effects of oil prices on economic growth. It has always been the case that when the price of gasoline or diesel rose significantly (say above US $3.50 for gasoline) then the public takes notice. They have to pay that out of their pockets and they feel the pinch. But the media can use that heightened awareness to go after the real culprit, the price of oil from which the gasoline is refined.
This time around there are many more economists paying attention as well. The price spike in oil in 2008, over US $147 for a while, is now increasingly being recognized as the trigger event that catapulted the global economy into one of the worst recessions in history (second only to the Great Depression). Since then a number of economists have picked up on the theme long known to my colleagues in the biophysical economics discipline, that recessions do generally follow major upward movements in the price of oil. The causal relation is quite simple and I have written about it frequently in these pages. Energy is the root of all costs in the economy. The more the energy costs in dollars, the more costly everything becomes eventually. There is a time lag between the rise in primary energy costs and the propagation of those cost increases through the rest of the economy. Oil represents something like 90% of transportation costs and since we have evolved a global economic system highly dependent on transportation, that sector is generally hurt soon after the rise in oil prices. And soon after the prices of food items starts to push upward because agriculture, food processing, and distribution are all highly dependent on petroleum products of various kinds. Industrial agriculture is dependent on diesel fuel as well as pesticides, herbicides, and fertilizers all derived from oil or natural gas feedstocks.
But that price spike, while the trigger, was not really the cause of the severity or depth of the Great Recession. That was caused by another insidious factor that even now is not understood in terms of oil (or all fossil fuel) costs. The real pain of the 2009 debacle is generally attributed to the burst of the housing market bubble and the associated debt bubble, especially sub-prime mortgages that were magically turned into equities(!). The suddenness with which the financial sector started to implode was breathtaking. We are still not out of the woods in terms of being able to adequately service debts, or in terms of understanding the level of risk that still lay hidden in the books of banks and bonds, etc.
Economists find it easy to explain the economic impact of the bubble bursts, but the real question is why where those bubbles in existence in the first place? I contend that those bubbles as well as several other economic ‘trends’ were a result of the cumulative effect of oil prices rising over the past several decades, and that those price rises can be completely attributed to one factor — the diminishing energy return on energy invested.
As the difficulty of finding and exploiting new oil reserves has increased the energy needed to do so has increased exponentially. It takes many orders of magnitude more investment to drill for oil in the open oceans and especially in deep waters. No major new oil finds are being made on easy to access land. Moreover each new find is really not very large in the scheme of mass oil production. In essence many more oil wells, proportional to the total flow, need to be drilled in order to keep production just ahead of demand. Older, conventional wells are in decline all over the world and so there needs to be greater reliance on unconventional sources. Even the only petroleum product being found on land these days is in the form of tar sands or shale oil/gas. These sources require extraordinary measures and lots of energy to exploit. They also carry a much heavier cost in terms of environmental degradation. Put very simply the amount of energy that needs to be put back into the effort to get the next increment of energy out is growing too rapidly. Just as in a monetary investment, the return on these energy investments is declining more rapidly than most people realize.
And that is why the cost of energy keeps moving upward. But that is only part of the story. In a world in which many countries are attempting to bring their standard of living up to western standards, that is they want to consume more stuff and drive cars just like in the OECD countries, the demand for oil has skyrocketed. At the same time, the decline in old oil production coupled with the increasing energy cost to find and extract new sources has brought us to the point of the economic peak in oil production. Since 2005, by many a reckoning, conventional oil production has been at a plateau and remains there now. However, there are signs that the production rates may be starting to decline.
Net Energy and Prices
What energy is left over after you subtract that needed to extract and refine the gross energy from raw oil (as well as coal and natural gas) is the net of production, e.g. gasoline, electricity, etc. That is the energy that is available to the rest of the wealth-producing economy. That is the energy that is needed to do the work that will create new real wealth, pay down debt and provide for profits to support growth. Net energy, not money, is the true currency of the economy. Money, by itself, does not cause work to happen. All it can do is pay for the energy needed to make the work happen. Labor is energy input. Material inputs are the result of energy being expended to extract and form the inputs to production. There is simply nothing in the economy that doesn't rely ultimately on the inputs of high powered energy flows. So when you start to turn down the spigot of net energy flow you literally start to impede the economy. That net energy flow is being down modulated by the twin effects of peak production and greatly declining energy return on energy invested.
This is why energy, say at the pump, is costing more. This is the one thing that economist theorists got really right. When something is monetized and it is getting scarcer, each unit will be valued more. And when that something is indispensable, as fossil fuel energy is for our modern industrial society, there is not much elasticity in the supply-demand price push. Something critical has to give.
For several decades the corporatized, capitalist, market economic system has been attempting to adjust to the diminishing net energy problem by creating money with debt. In essence the financial system was saying we could borrow against a future when more net energy would flow again and all would be right with the world. After all, throughout history that is exactly what had been happening. We always seemed to have more net energy in each time increment than we had had the time before. Hence we were able to pay back the debt because we actually did produce more real wealth in each subsequent time period. Of course there were bumps along the way, due to any number of factors like wars and animal spirits getting out of control. But since there was always more net energy being pumped into the economy those bumps were transitory. After equilibrium was reestablished we started enjoying the benefits of increasing energy availability and its rewards. We simply have never faced the stark reality of a net energy decline before in history. Now we are.
Of course, economists and capitalists have not really thought about it in those terms. Instead they simply think in terms of profits and growth. They do not see that the real growth is in the production of real wealth, per se. They do not recognize the role of energy in work processes and as the currency of economics. So consequently they did not have the language of energy to reason with. If they had, they might have made very different decisions.
The debt bubble that has been building in the global economy for a number of decades is a direct result of declining net energy. At first the impetus to rely on borrowing to create the illusion of wealth was due to the mere deceleration of net energy production. The western economies responded by trying to find cheaper labor pools, those that did not have high energy life styles to support such as were found in the developing world (at the time, of course this was the undeveloped world but with potential to provide labor!). Globalization was very much a reaction to the increasing constrictions on energy flow that (see below) drove prices of all other inputs higher. The housing bubble in this country (and other OECDs like Ireland and Spain) was really just an attempt to create money (not real wealth) by treating houses as investments that would pay off down the road. The problem, of course, is that people started treating their houses as if they were automated teller machines when in fact they were little more than slot machines. And just like in Vegas, the odds were against the gamblers. The bankers, of course, not wanting to be left out began to take on riskier and riskier bets (er, loans) in the form of sub-prime mortgages (and who knows what else). The recent deregulation of financial markets made it easy to create securitized instruments out of these mortgages. And everyone in the financial sector was soon on the bandwagon of risky behavior because the payoffs in dollars was getting really huge. When the oil price spike of 2008 hit, the whole system collapsed. Marginal mortgage payers couldn't both service their debt and afford to get to work (at low paying jobs). Soon the whole house of cards came tumbling down and the pain was felt all round.
Until, that is, the US government (and through its leaning on other OECD governments) stepped in to ease the pain. Bailouts, quantitative easing, you name it. The US government has gone deep into hock to try to keep the economy moving (that is growing). And right at the moment, if you listen to President Obama, it is working. But I guarantee you that won't be for long. All the US and OECD countries have done is trade one kind of debt for another. They have not addressed the central issue of increasing net energy flow and that is precisely why the jobs situation is still pathetic. Take note that even the so-called encouraging jobs creation reports coming out of Washington are really about low-pay, service oriented jobs or jobs that used to pay higher wages but are being replaced by low-salary employees. The raw numbers mean nothing until you weight them with salary data.
The prices of primary energy, oil, natural gas, coal, nuclear, and hydroelectricity will continue to climb. The former (fossil fuels) is due to declining EROI and peak production. The latter will also increase because, believe it or not, they depend on cheap oil to keep producing! In the long run the economy will continue to slide and no amount of Keynesian spending by the government will put it right, no matter what the Paul Krugmans and Robert Reichs have to say about it (as an aside it seems that these two are starting to grasp the significance of peak oil concepts! Maybe hope for them yet!)
There is nothing that is going to replace fossil fuels, and we had better start coming to grips with that fact. The laws of thermodynamics will not be beaten by technology. No amount of fix can be applied to convert an inherently weak source of real-time energy (solar in all its manifestations on Earth's surface) into the power needed to run our economy as it stands. I am abhorred by the suggestions from many scientists that their pet technology will somehow fix the energy situation. For example those scientists who are promoting algae-based oil production know very well that it would take many orders of magnitude increase in the efficiency of photosynthesis to compensate for what many millions of years of realistic plant photosynthesis needed to produce the same power concentration we find in fossil fuels. I understand their motivation to suggest the ‘possibilities’ in their grant proposals. They want to get funded. But the level of intellectual dishonesty is ghastly.
There is no magic technological bullet that is going to replace fossil fuels. Period. And that means that we will be seeing a continuing contraction in economic output for many decades, perhaps even centuries, to come unless starvation, diseases, and conflicts help kill off the population first.
Facing reality, what might we expect in the coming weeks, months, and years? Right now many people are concerned about the price of oil and its immediate impact on the economy. They are, of course, asking the wrong questions since they should be worried about the long term. Nevertheless here is the answer. It isn't the absolute price of oil that is the killer. What really counts now, and actually has always counted, is not the peak price that might obtain (say in a panic), but the cumulative cost of oil over time. In math terms it is the area under the curve (plot of oil prices over time) that really matters. The amount of time that oil spends in the plus $85 range it is robbing the economy of a capacity to do work. What is really happening is that the net energy from oil is declining and will decline at a rate proportional to the amount of time that the price is so elevated.
In cybernetics (control theory), this is known as integral control. The feedback that controls the economy (in this case the flow of net energy into the work that produces real wealth) is seen in the diminishing return on monetary investment. In other words, the world goes into a recession because it cannot produce. One very clear and immediate response is the layoff of workers (labor is an energy input into production) who, in our consumeristic society, can no longer purchase stuff which merely exacerbates the whole problem. Demand for energy then goes down and investments in new energy production go down correspondingly.
The only thing that could possibly break this downward cycle is the discovery of new, much higher, energy return on energy invested sources. If you take any time to look at the data on EROI for all of the current proposed sources, alternative/renewable sources, you find that they are way too low for maintaining an industrial society such as ours. Perhaps there is yet to be discovered a wonderful new source of energy that has an EROI equivalent to oil back in the 1950s (roughly 30-40 to 1). I sincerely hope so. I am not, however, holding my breath.