Wednesday, September 28, 2011

Peak Oil: The New (Old) Reason For Business Cycles

Chris Sebrowski argues that whether or not we’re coming up against geological peak oil, we’re likely to come up against economic peak oil first (excerpts, emphasis from source):

A Brief Economic Explanation of Peak Oil

For a number of years there has been an arid debate between economists and geologists about Peak Oil. The geologists maintain that Peak Oil (maximal production) is a geological imperative imposed because reserves are finite even if their exact magnitude is not, and cannot be, known.

In contrast many economists maintain prices will resolve any sustained supply shortfalls by providing incentives to develop more expensive sources or substitutes. The more sanguine economists do concede that the adaptation may be slow, uncomfortable and economically disruptive.

The reality, I believe, is that both groups have part of the answer but that Peak Oil is, in fact, a complex but largely an economically driven phenomenon that is caused because the point is reached when: The cost of incremental supply exceeds the price economies can pay without destroying growth at a given point in time. While hard to definitively prove, there is considerable circumstantial evidence that there is an oil price economies cannot afford without severe negative impacts.

The corollary is that if oil prices fall back to and sustain levels that do not inhibit growth, then economic growth will resume, with both recoveries and downturns lagging oil price changes by 1-6 months.

The current failure of most western economies to achieve anything more than minimal growth this year (2011) is most likely because oil prices are already at levels that severely inhibit growth. Indeed, research by energy consultants Douglas-Westwood concludes that oil price spikes of the magnitude seen this year correlate one-for-one with recessions...

...For most OPEC producers oil and gas revenues are their principal source of income and government revenues. There is much literature to show that when oil prices rise, producer government expenditures rise and absorb most if not all of the gain very quickly.

The so-called ‘Arab Spring’ has added a further twist to this process. Governments in a number of OPEC countries and some non-OPEC producers have dramatically boosted government expenditures to reduce the risk of social upheaval leading to their being overthrown. Increased military and security expenditures feature alongside greater hand-outs and benefits to the population...

...This means that, whatever the public statements, most OPEC members now require oil prices around $100/barrel to balance their books and will seek to secure higher prices by restraining supply if necessary. However, under sufficient economic pressure oil prices would fall with severe impacts on Opec budgets....

...Thus the geologists are right that the depletion of low-cost oil will produce Peak Oil but it will not be caused by a shortage of oil resources.

The economists are right that there is no shortage of oil resources or oil substitutes but have so far failed to recognise that there is an oil price which cannot be afforded and this constraint will create and define an economic Peak Oil to be differentiated from a geological Peak Oil...

...But all these countries are ultimately hostage to Chinese demand. By itself, China represents about half of demand growth for most commodities in a typical year. The growth of the Middle Eastern economies and commodity suppliers like Brazil, various African countries, as well as Australia and Canada are largely derivative of China’s growth…

…What price, then, can China bear? The historical record shows tremendous volatility, but in general, it would appear the country can afford to spend 6.3%-6.7% of its GDP on crude oil expenditures, or approximately $100-$110/barrel. When prices are above this level, both China’s oil consumption and GDP growth tend to fall. This is a good bit higher than the $90/barrel estimated as the bearable price for the US and Europe.

Why is China’s tolerance higher? Because the value of oil is higher there. For example it is fairly clear that the economic benefit of the first car in a family is much greater than that of the third. Similarly the productivity gain from the first truck in a commercial fleet is greater than that of the twentieth. This observation suggests that rapidly industrialising economies such as China and India have a higher marginal productivity from an incremental barrel of oil than in more developed economies.

This in turn poses a terrifying question: Would this higher price tolerance mean developing economies could keep developed economies in growthless stagnation by paying oil prices that were just above those that bring developed economies to an economic halt?...

...The dating of Peak Oil using this economic approach gives almost identical results to calculations based on net incremental supply (new capacity minus depletion) with both approaches showing 2014/2015 as the crunch point. This coincidence is not surprising as most of the remaining oil development projects are high cost (Deepwater, Tar sands, Arctic).

This is a fascinating analysis of the current situation…and a frightening preview of the next 5 years. If this is correct, then the main constraint on global growth will not be structural imbalances, governmental paralysis or even debt, but volatility in the price of oil.

If you want a historical overview of the impact of oil prices on economies, check out this paper by James Hamilton of Econbrowser.

One way to avoid the nightmare scenario laid out here is not mentioned – what happens if China hits a growth wall? There’s more than a little potential for that to happen, for two reasons. First is the possible hangover from the credit binge China indulged in during the crisis, which may be nearer than we expect. Second is that China’s demographics suggest a rapid slowdown in growth some time in the next ten years, as the population ages – despite being still a developing country, China’s demographics (due to the One Child Policy) looks more like that of a mature economy, and that has implications for its long term growth path.

What about Indian demand? As an economic growth story, I like China over the short term, but India’s current fundamentals look lousy. But the story shifts over a longer term horizon – India has more potential from both a demographic standpoint and in terms of shifting to industrialisation. Yet I don’t think India’s oil demand will be anything close to China’s current gargantuan appetite for commodities of all sorts.

But that only pushes back the probable timeline for economic peak oil, not derail it entirely.


  1. bro hishamh

    there's another development

    If this is adopted on a global level we may see different price levels. The bulk of trading activity in the market is not for physical delivery hence the relation with real supply constraints is slightly distorted.