It's the Area Under the Curve

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.

Comments

[Phil Henshaw]

Well, saying "the only thing that could possibly break this cycle..." is assuming your various assumptions. I think we may indeed see fuel prices double and hold a couple more times, to $16/gallon or higher perhaps, having already doubled a couple times I think from the effective $1/gal we designed our economy around. But what are the other assumptions that might change?

Do you think we might finally have a serious discussion about why our economy is only stable if it is consuming depleting resources as growing rates?? Do you think it would become possible to discuss how that is directly connected to the similar need to generate $'s at ever growing rates?

These are physical system questions that even the physical system economists seem loath to try discussing, very oddly. It seems to strike much too close to home or something. So, I ask us all, why are we so averse to that discussion, that is so very central to the survival of our culture and society?? Is it just because it seems like it might hide embarrassing complicity, or that we'd find things that would make us change, have no solution anyway, or unleash culture wars that would get out of control?

Personally, I've looked at the problem inside and out from many directions, checking out all those and lots of other possible hazards. It seems that the one risk that fits is discovering our "good will mistake". Our culture has been misunderstanding the natural processes of the economy and people in every sector have been showing good will in trying to fix things they basically didn't understand.

It would of course involve change to deal with that, but might be exciting too. Would the hazard of discovering a way to understand the problem, as our solution, be really so threatening?

[Peter Cranstone]

Spot on. The area under the curve is the "pay no attention to the man behind the curtain". Oil is the issue. The second law of thermodynamics is clearly at play and overcoming entropy is not for the weak or feeble.

We sure do live in interesting times.

[Robin Datta]

Excellent as usual, but regrettable in the futility of the wish that it was somehow mistaken somewhere.

The Powers That Be are either willfully misleading (amounting to malevolence) or woefully ignorant (amounting to incompetence) and in either case unfit for their role.

[Nigel Goddard]

Do you mean exergy or "available-work" rather than energy? In which case making production of goods and services more efficient can help to mitigate the reduced availability of net primary energy, although there are limits.

[Oz]

The decrease-over-time of ERoEI certainly seems a likely candidate to explain much about economic bubbles, trends and the current ongoing and accelerating decline, but I think it's a mistake to assert it explains everything. As is often the case, things are more complex.

For example, take a glance at what's happened to the value (in purchasing power) of US$1 since 1913, when the (privately owned) Federal Reserve took over the monetary system (throw in FDR and Nixon's abandonment of the gold standard), and you have another primary contributor. Oil is, after all, measured in the USD - a fiat currency created via debt and manipulated for upwards of 100 years such that is has lost over 95% of its value. Surely, this decline in monetary value has played a role in conjunction with the decline in ERoEI.

In a sense, the Fed policy of the last century may have served as an aggravating factor to your thesis (i.e. it's even worse than you describe). It has effectively hollowed out the 'real' economy (which is why the government now fraudulently measures economic output via GDP - a non-credible, thumb-on-the-scale measure of *consumption* rather than production), rendering it exquisitely vulnerable to a decline in ERoEI coupled with the demand for ever more energy. The surge in debt, it seems, masks a multitude of sins - not just net energy declines, but purchasing power declines as well.

Incidentally, the Keynesians and Monetarists both miss this monetary piece. The Austrian school (and I wish more biophysical economists were familiar with the work of von Mises and Rothbard) gets it. The Austrians also are the only school which vociferously agrees with you that "real growth is in the production of real wealth, per se."

What this means is that, even absent declining net energy, we were already in big trouble, economically speaking, because both monetary and fiscal polices over many decades - and accelerating over the past three - have done serious damage to real economic growth and the prospects for it.

However, even the Austrian school fails to "recognize the role of energy in work processes and as the currency of economics" - and so do not grasp the import of declining net energy, which the biophysical school does.

Maybe you guys should get together. :)

So I see this as essentially a double whammy. An economic system which must grow or die is now experiencing not only declining net energy (and thus an impassable obstacle to sustainable growth), but also the poisonous fruits of decades of monetary mismanagement and manipulation (which has sapped the economic resiliency and vitality which would have been so useful in days to come as we tumble along Hubbert's downslope).

It seems to me that if you combine the economy/ERoEI thesis as you have outlined it here, the Austrian school understanding of the impact on an economy (Main St, not Wall St) of a privately controlled, debt-based fiat currency, and J Tainter's views on declining marginal returns as a society grows ever more complex (itself closely related to energy), well, that's easily a PhD dissertation, though not one that would ever get presented at Jackson Hole.

[George Mobus]

Phil,

Do you think we might finally have a serious discussion about why our economy is only stable if it is consuming depleting resources as growing rates??

Not sure who the "we" includes. I believe this is the conversation that "we" biophysical economists have been having unless I misinterpret your meaning here (I have yet to go deeper into the e-mail you sent which might have cleared this up).

When I said that the only thing that could break the cycle was a new energy source with a high EROI I meant that it was the only thing simply because "we" humans are incapable of doing what is actually necessary, let alone have any conversations. By that I refer to the average human with average sapience. It takes a lot more wisdom than the average person has to even recognize the problems let alone think about solving them. That is why I am also interested in sapience.

-----------------------------
Peter & Robin. Thanks for the notes. So noted.

-----------------------------
Nigel,

I have written before about the meaning of exergy and its relation to the economy. Yes, the net energy flow into the economy is exergy in the technical sense. But since most readers may not have a good understanding of the term, I tend to stick with net energy to do useful work (more words, but probably better understood).

------------------------------
Oz,

Thanks for the reminders of just how complex the economic system is. There is quite a lot unsaid behind my claims. I tend to look at the human manipulations as unconscious (mindless) attempts to compensate for what is happening in the energy realm! So all of those manipulations (good and bad, but mostly bad) on the monetary/fiscal sides have been responses to a grander scale of declining net energy flow per unit of energy extracted. This has actually been going on for a very long time. It was the case with coal before oil started taking on the heavy lifting. Indeed, had it not been for diesel fuel, coal would be many times more expensive today. Now it is oil's turn and the decline in net energy per unit of raw energy has been noticeable since just after WWII.

In my view the problems with the gold standard to which Nixon responded, were caused by the accumulated mismatch between money's nominal value and the declining real wealth value that it should have represented. And that latter is based on the amount of useful work that could be done, or in other words, net energy.

So in sum, and I know this short explanation is not going to really do the job, I think there is good reason to believe that the kinds of decisions and manipulations of the economy (esp. debt reliance) have been reactions to the underlying situation with respect to net energy. Those reactions were conditioned by our general belief that growth in wealth should go on forever and was the normative model of economics. Ergo, people have been trying to keep that illusion going by any means possible. It was somewhat possible as long as there was increasing production of oil even as the net per unit declined. We were losing on each unit but making it up in the volume! But now that peak production has set in, even that means for perpetuating the illusion is gone.

PS. Joe Tainter is going to be at the next BPE meeting in April (15/16).

Regards

George

[Robin Datta]

Something complementary to sapience?
TED Talks
David Brooks: The social animal
http://www.ted.com/talks/david_brooks_the_social_animal.html

[George Mobus]

Robin,

Every once in a while David comes up smelling a lot better than other times! I caught his article in the NYT this weekend. Will take a look after finals week is dead and gone.

George

[Ken Arent]

I see a potential flaw in the notion that fossil fuels will not be replaceable by renewable energy sources, because the latter represents millions of years of stored solar energy. The amount of solar energy that was captured and converted into fossil fuel sources was a minuscule fraction of the total solar energy input into the biosphere over that period of time. It is at least theoretically possible that we could have all of our energy needs met by solar power. The technological barrier of actually capturing and storing that energy may or may not be surmountable.
It seems at least possible that we could chain together renewable sources of energy to mitigate some of their deficiencies. For example wind or geothermal power could be used to operate biofuel plants using cyanobacteria (more promising than algae). Such operations could be scaled up readily. Not requiring fertile soil they could but point in desert regions mitigating their environmental impact. If combined with technology that improved energy efficiency, couldn’t society work around the declining EROI?

[George Mobus]

Ken,

The amount of solar energy that was captured and converted into fossil fuel sources was a minuscule fraction of the total solar energy input into the biosphere over that period of time.

I'm not seeing how this is a flaw int argument.

It is at least theoretically possible that we could have all of our energy needs met by solar power.

Well we could in the sense that we reduce our energy requirements to just those that can be met by real-time flow. But if you are thinking that we can power our current level of BAU (and especially if you allow the development of the rest of the underdeveloped world to our standard) then I have to reiterate that that is a pipe dream.

The rest of your comment is really a restatement of the conventional "green" wisdom (leaving out only the part about high paying green jobs!). They make these claims but provide no substantial evidence. Whereas modelers and biophysical economists like myself keep showing that by thermodynamic considerations (ultimate controlling laws!) that this is not feasible. Statements like:

Such operations could be scaled up readily.

cannot be substantiated. They are wishful thinking at best.

Finally,

If combined with technology that improved energy efficiency, couldn’t society work around the declining EROI?

It turns out that technology that improves the efficiency of one process is often bought at a greater net energy cost than what is saved locally. For example to make solar PV more efficient requires scarce rare earth dopants that require considerably more energy to extract and refine than they produce in greater conversion efficiency. We need to get this simple fact through our skulls: There is no free lunch!

George

[Ken Arent]

I agree that PV will never be scalable, because of the limitations of rare earth elements. However, cyanobacteria do not have these requirements. Using wind farms to generate the input power for cyanobacteria based biofuels is what I’m saying is scalable. Not necessarily rapidly scalable. I am not denying that a population bottleneck is a high probability as well. In fact losing much of the population from the third world regions of the southern hemisphere (due to climate change, and resource exhaustion) will probably be required for a the world to come to grips with the enormity of the challenges we face. That being stated, only tragedies of this scale will provide a common enemy for humanity to rally against.

I’m also a fan of Tainter’s work (if one can celebrate such darkness), but his analysis is incomplete on many fronts. I recommend Peter Turchin’s work on cliodynamics (a demographic-structural theory), in particular his book “Secular Cycles.” The problem with Tainter (Turchin only hints at this) is that he sees a ceiling on complexity. Societies crumble at vastly different scales of overall complexity. This is related to their ability to maintain an adequate energy and resource subsidy, but I don’t think that is the whole of the answer. Tainter rejected the notion that societies collapsed based on environmental catastrophe, and I agree with his reason. He argued that some societies withstood similar insults from the environment and still remained intact. I would argue that societies have also faced energy and resource shortfalls and maintained their integrity (of course not without suffering) while they found supplementary sources and technologies.

I argue that all complex systems break down (be they civilizations, biological organisms, or whatever else) for the same reason: a loss of the weak links that maintain their small-world network architecture.

I’ll have more to add later, but I must say that I love the work you’re doing here.

[George Mobus]

Ken,

I talked with Joe Tainter about your thoughts. He is familiar with Turchin's work and I guess they are mutually not impressed! Joe does not think his work implies a limit or ceiling to complexity. The limit is determined by the limits of net energy flow (which is why Joe speaks at the Biophysical Econ meeting!)

WRT: societies that maintained their integrity in spite of reductions in net energy flow, I would like to have some examples. Joe talks about the forced simplification that the Byzantine Empire underwent to avoid complete collapse. But by his description it would be hard to assert that they had maintained, say, their cultural integrity. They became a shadow of their former selves, so to speak, but reverted to localized economies that were able to survive after Byzantium rule over outlying regions collapsed.

The point about loss of weak links is interesting. In my network flow analysis of complex systems there are issues with competition between flow paths as energy declines. I suppose one could argue that some flow links lose energy as a result of this competition and that they are, de facto, weak.

Look forward to future comments you have.

George

[Ken Arent]

Turchin and Tainter are mutually antagonistic for certain. I think this is to the detriment of finding a coherent theory however. Sometimes big boys, with big theories can behave like big petulant children. Tainter’s critique of Turchin can be found here in a review that appeared in Nature called Plotting the downfall of society (Turchin has it posted on his site, but I can’t access it right now). In the review Tainter also rejects the work of CS Holling, from your recommendation of Hommer-Dixon I think you are a bit more sympathetic to Holling.

My point in considering a synthesis between Turchin, Tainter, Holling, and network theory, is that I think it demonstrates that the problem solving capacity of a civilization doesn’t decrease linearly with increasing complexity. My argument is that as complexity increases and resources become scarce the network transitions from a small-world (moderately sized hubs with adequate weak link stabilization) to a star network (fewer larger hubs with an increase reliance on strong links, and increased cascading synchronization), when this phase change happens problem solving capacity decreases rapidly and catastrophically. See the book Weak Links: The Universal Key to the Stability of Networks and Complex Systems by Peter Csermely for elaboration. I think that this rapid decrease in problem solving capacity prevents a society from finding a supplementary energy subsidy (in historic societies) or adjusting to existence with reduced net energy (in modern society).

On the modern green energy debate offshore wind (possibly integrated with wave power) provides pretty good EROEI. For the problems of storing, transporting, and intermittence of the power generated using the wind as input to cyanobacteria based biofuel generation could increase the energy quality. I know building the infrastructure makes it challenging, but thorium could be a bridge fuel. With reasonable quality uranium theoildrum.com puts nuclear between 10-20 for EROEI. The thorium fuel cycle would eliminate much of the energy for mining (we already have so much mined, and we get even more from mining rare earth’s), for fuel fabrication (if a LFTR is used), and waste disposal. It seems plausible that thorium could double uranium’s EROEI.

[George Mobus]

Ken,

You might be interested in this. I am trying to launch a research project to investigate the flow of energy on the generation of complexity in a classical cellular automata lattice. I've also considered doing something similar in a more general network framework. Grid models with energy (e.g. climate models) have been around for a while, but I have never seen any attempt to link complexity evolution with energy flow.

Now, what funding agency might be interested!

George
PS. Thanks for the lead to Csermely

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