A new theory of energy and the economy – Part 1 – Generating economic growth

How does the economy really work? In my view, there are many erroneous theories in published literature. I have been investigating this topic and have come to the conclusion that both energy and debt play an extremely important role in an economic system. Once energy supply and other aspects of the economy start hitting diminishing returns, there is a serious chance that a debt implosion will bring the whole system down.

In this post, I will look at the first piece of this story, relating to how the economy is tied to energy, and how the leveraging impact of cheap energy creates economic growth. In order for economic growth to occur, the wages of workers need to go farther and farther in buying goods and services. Low-priced energy products are far more effective in producing this situation than high-priced energy products. Substituting high-priced energy products for low-priced energy products can be expected to lead to lower economic growth.

Trying to tackle this topic is a daunting task. The subject crosses many fields of study, including anthropology, ecology, systems analysis, economics, and physics of a thermodynamically open system. It also involves reaching limits in a finite world. Most researchers have tackled the subject without understanding the many issues involved. I hope my analysis can shed some light on the subject.

I plan to add related posts later.

An Overview of a Networked Economy

The economy is a networked system of customers, businesses, and governments. It is tied together by a financial system and by many laws and customs that have grown up over the years. I represent the economic network as a child’s toy made of sticks that connect together, but that can, if disturbed in the wrong way, collapse.

Figure 1. Dome constructed using Leonardo Sticks

Figure 1. Dome constructed using Leonardo Sticks

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Oil and the Economy: Where are We Headed in 2015-16?

The price of oil is down. How should we expect the economy to perform in 2015 and 2016?

Newspapers in the United States seem to emphasize the positive aspects of the drop in prices. I have written Ten Reasons Why High Oil Prices are a Problem. If our only problem were high oil prices, then low oil prices would seem to be a solution. Unfortunately, the problem we are encountering now is extremely low prices. If prices continue at this low level, or go even lower, we are in deep trouble with respect to future oil extraction.

It seems to me that the situation is much more worrisome than most people would expect. Even if there are some temporary good effects, they will be more than offset by bad effects, some of which could be very bad indeed. We may be reaching limits of a finite world.

The Nature of Our Problem with Oil Prices

The low oil prices we are seeing are a symptom of serious problems within the economy–what I have called “increased inefficiency” (really diminishing returns) leading to low wages. See my post How increased inefficiency explains falling oil prices. While wages have been stagnating, the cost of oil extraction has been increasing by about ten percent a year, described in my post Beginning of the End? Oil Companies Cut Back on Spending.

Needless to say, stagnating wages together with rapidly rising costs of oil production leads to a mismatch between:

  • The amount consumers can afford for oil
  • The cost of oil, if oil price matches the cost of production

The fact that oil prices were not rising enough to support the higher extraction costs was already a problem back in February 2014, at the time the article Beginning of the End? Oil Companies Cut Back on Spending was written. (The drop in oil prices did not start until June 2014.)

Two different debt-related initiatives have helped cover up the growing mismatch between the cost of extraction and the amount consumers could afford:

  • Quantitative Easing (QE) in a number of countries. This creates artificially low interest rates and thus encourages borrowing for speculative activities.
  • Growth in Chinese spending on infrastructure. This program was funded by debt.

Both of these programs have been scaled-back significantly since June 2014, with US QE ending its taper in October 2014, and Chinese debt programs undergoing greater controls since early 2014. Chinese new home prices have been dropping since May 2014.

Figure 1. World Oil Supply (production including biofuels, natural gas liquids) and Brent monthly average spot prices, based on EIA data.

Figure 1. World Oil Supply (production including biofuels, natural gas liquids) and Brent monthly average spot prices, based on EIA data.

The effect of scaling back both of these programs in the same timeframe has been like a driver taking his foot off of the gasoline pedal. The already slowing world economy slowed further, bringing down oil prices. The prices of many other commodities, such as coal and iron ore, are down as well. Instead of oil prices staying up near the cost of extraction, they have fallen closer to the level consumers can afford. Needless to say, this is not good if the economy really needs the use of oil and other commodities.

It is not clear that either the US QE program or the Chinese program of infrastructure building can be restarted. Both programs were reaching the limits of their usefulness. At some point, additional funds begin going into investments with little return–buildings that would never be occupied or shale operations that would never be profitable. Or investments in Emerging Markets that cannot be profitable without higher commodity prices than are available today.  Continue reading

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How increased inefficiency explains falling oil prices

Since about 2001, several sectors of the economy have become increasingly inefficient, in the sense that it takes more resources to produce a given output, such as 1000 barrels of oil. I believe that this growing inefficiency explains both slowing world economic growth and the sharp recent drop in prices of many commodities, including oil.

The mechanism at work is what I would call the crowding out effect. As more resources are required for the increasingly inefficient sectors of the economy, fewer resources are available to the rest of the economy. As a result, wages stagnate or decline. Central banks find it necessary lower interest rates, to keep the economy going.

Unfortunately, with stagnant or lower wages, consumers find that goods from the increasingly inefficiently sectors are increasingly unaffordable, especially if prices rise to cover the resource requirements of these inefficient sectors. For most periods in the past, commodities prices have stayed close to the cost of production (at least for the “marginal producer”). What we seem to be seeing recently is a drop in price to what consumers can afford for some of these increasingly unaffordable sectors. Unless this situation can be turned around quickly, the whole system risks collapse.

Increasingly Inefficient Sectors of the Economy 

We can think of several increasingly inefficient sectors of the economy:

Oil. The problem with oil is that much of the easy (and thus, cheap) to extract oil is gone. There seems to be a great deal of expensive-to-extract oil available. Some of it is deep under the sea, even under salt layers. Some of it is very heavy and needs to be “steamed” out. Some of it requires “fracking.” The extra extraction steps require the use of more human labor and more physical resources (oil and gas, metal pipes, fresh water), but output rises by very little. Liquid extenders to oil, such as biofuels and coal-to-liquid operations, also tend to be heavy resource users, further exacerbating the problem of the rising cost of production for liquid fuels.

I have described the problem behind rising costs as increasing inefficiency of production. The technical name for our problem is diminishing returns. This situation occurs when increased investment offers ever-smaller returns. Diminishing returns tends to occur to some extent whenever resources of any kind are extracted from the ground. If the extent of diminishing returns is small enough, total costs can be kept flat with technological advances. Our problem now is that diminishing returns have grown to such an extent that technological advances are no longer keeping pace. As a result, the cost of producing many types of goods and services is growing faster than wages.

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Ten Reasons Why a Severe Drop in Oil Prices is a Problem

Not long ago, I wrote Ten Reasons Why High Oil Prices are a Problem. If high oil prices can be a problem, how can low oil prices also be a problem? In particular, how can the steep drop in oil prices we have recently been experiencing also be a problem?

Let me explain some of the issues:

Issue 1. If the price of oil is too low, it will simply be left in the ground.

The world badly needs oil for many purposes: to power its cars, to plant it fields, to operate its oil-powered irrigation pumps, and to act as a raw material for making many kinds of products, including medicines and fabrics.

If the price of oil is too low, it will be left in the ground. With low oil prices, production may drop off rapidly. High price encourages more production and more substitutes; low price leads to a whole series of secondary effects (debt defaults resulting from deflation, job loss, collapse of oil exporters, loss of letters of credit needed for exports, bank failures) that indirectly lead to a much quicker decline in oil production.

The view is sometimes expressed that once 50% of oil is extracted, the amount of oil we can extract will gradually begin to decline, for geological reasons. This view is only true if high prices prevail, as we hit limits. If our problem is low oil prices because of debt problems or other issues, then the decline is likely to be far more rapid. With low oil prices, even what we consider to be proved oil reserves today may be left in the ground.

Issue 2. The drop in oil prices is already having an impact on shale extraction and offshore drilling.

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Eight Pitfalls in Evaluating Green Energy Solutions

Does the recent climate accord between US and China mean that many countries will now forge ahead with renewables and other green solutions? I think that there are more pitfalls than many realize.

Pitfall 1. Green solutions tend to push us from one set of resources that are a problem today (fossil fuels) to other resources that are likely to be problems in the longer term.  

The name of the game is “kicking the can down the road a little.” In a finite world, we are reaching many limits besides fossil fuels:

  1. Soil quality–erosion of topsoil, depleted minerals, added salt
  2. Fresh water–depletion of aquifers that only replenish over thousands of years
  3. Deforestation–cutting down trees faster than they regrow
  4. Ore quality–depletion of high quality ores, leaving us with low quality ores
  5. Extinction of other species–as we build more structures and disturb more land, we remove habitat that other species use, or pollute it
  6. Pollution–many types: CO2, heavy metals, noise, smog, fine particles, radiation, etc.
  7. Arable land per person, as population continues to rise

The danger in almost every “solution” is that we simply transfer our problems from one area to another. Growing corn for ethanol can be a problem for soil quality (erosion of topsoil), fresh water (using water from aquifers in Nebraska, Colorado). If farmers switch to no-till farming to prevent the erosion issue, then great amounts of Round Up are often used, leading to loss of lives of other species.

Encouraging use of forest products because they are renewable can lead to loss of forest cover, as more trees are made into wood chips. There can even be a roundabout reason for loss of forest cover: if high-cost renewables indirectly make citizens poorer, citizens may save money on fuel by illegally cutting down trees.

High tech goods tend to use considerable quantities of rare minerals, many of which are quite polluting if they are released into the environment where we work or live. This is a problem both for extraction and for long-term disposal.

Pitfall 2. Green solutions that use rare minerals are likely not very scalable because of quantity limits and low recycling rates.  

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