Low Oil Prices – Why Worry?

Most people believe that low oil prices are good for the United States, since the discretionary income of consumers will rise. There is the added benefit that Peak Oil must be far off in the distance, since “Peak Oilers” talked about high oil prices. Thus, low oil prices are viewed as an all around benefit.

In fact, nothing could be further from the truth. The Peak Oil story we have been told is wrong. The collapse in oil production comes from oil prices that are too low, not too high. If oil prices or prices of other commodities are too low, production will slow and eventually stop. Growth in the world economy will slow, lowering inflation rates as well as economic growth rates. We encountered this kind of the problem in the 1930s. We seem to be headed in the same direction today. Figure 1, used by Janet Yellen in her September 24 speech, shows a slowing inflation rate for Personal Consumption Expenditures (PCE), thanks to lower energy prices, lower relative import prices, and general “slack” in the economy.

Figure 1. Why has PCE Inflation fallen below 2%? from Janet Yellen speech, September 24, 2015.

Figure 1. “Why has PCE Inflation fallen below 2%?” from Janet Yellen speech, September 24, 2015.

What Janet Yellen is seeing in Figure 1, even though she does not recognize it, is evidence of a slowing world economy. The economy can no longer support energy prices as high as they have been, and they have gradually retreated. Currency relativities have also readjusted, leading to lower prices of imported goods for the United States. Both lower energy prices and lower prices of imported goods contribute to lower inflation rates.

Instead of reaching “Peak Oil” through the limit of high oil prices, we are reaching the opposite limit, sometimes called “Limits to Growth.” Limits to Growth describes the situation when an economy stops growing because the economy cannot handle high energy prices. In many ways, Limits to Growth with low oil prices is worse than Peak Oil with high oil prices. Slowing economic growth leads to commodity prices that can never rebound by very much, or for very long. Thus, this economic malaise leads to a fairly fast cutback in commodity production. It can also lead to massive debt defaults.

Let’s look at some of the pieces of our current predicament.

Part 1. Getting oil prices to rise again to a high level, and stay there, is likely to be difficult. High oil prices tend to lead to economic contraction.  

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How our energy problem leads to a debt collapse problem

Usually, we don’t stop to think about how the whole economy works together. A major reason is that we have been lacking data to see long-term relationships. In this post, I show some longer-term time series relating to energy growth, GDP growth, and debt growth–going back to 1820 in some cases–that help us understand our situation better.

When examining these long-term time series, I come to the conclusion that what we are doing now is building debt to unsustainably high levels, thanks to today’s high cost of producing energy products. I doubt that this can be turned around. To do so would require immediate production of huge quantities of incredibly cheap energy products–that is oil at less than $20 per barrel in 2014$, and other energy products with comparably low cost structures.

Our goal would need to be to get back to the energy cost levels that we had prior to the run-up in costs in the 1970s. Growth in energy use would probably need to rise back to pre-1975 levels as well. Of course, such a low-price, high-growth scenario isn’t really sustainable in a finite world either. It would have adverse follow-on effects, too, including climate change.

In this post, I explain the reasoning that leads to this conclusion. Some back-up information is provided in the Appendix as well.

Insight 1. Economic growth tends to take place when a civilization can make goods and services more cheaply–that is, with less human labor, and often with smaller quantities of resources of other kinds as well.

When an economy learns how to make goods more cheaply, the group of people in that economy can make more goods and services in total because, on average, each worker can make more goods and services in his available work-time. We might say that members of that economy are becoming more productive. This additional productivity can be distributed among workers, supervisors, governments, and businesses, allowing what we think of as economic growth.

Insight 2. The way that increased productivity usually takes place is through leveraging of human labor with supplemental energy from other sources.

The reason why we would expect supplemental energy to be important is because the amount of energy an individual worker can provide is not very great without access to supplemental energy. Analysis shows that human mechanical power amounts to about 100 watts over a typical laboring day–about equal to the energy of a 100-watt light bulb.

Human energy can be leveraged with other energy in many other forms–the burning of wood (for example, for cooking); the use of animals such as dogs, oxen, and horses to supplement our human labor; the harnessing of water or wind energy; the burning of fossil fuels and the use of nuclear energy. The addition of increasingly large amounts of energy products tends to lead to greater productivity, and thus, greater economic growth.

As an example of one kind of leveraging, consider the use of oil for delivering goods in trucks. A business might still be able to deliver goods without this use of oil. In this case, the business might hire an employee to walk to the delivery location and carry the goods to be delivered in his hands.

A big change occurs when oil and other modern fuels become available. It is possible to manufacture trucks to deliver goods. (In fact, modern fuels are needed to make the metals used in building the truck.) Modern fuels also make it possible to build the roads on which the truck operates. Finally, oil products are used to operate the truck.

With the use of a truck, the worker can deliver goods more quickly, since he no longer has to walk to his delivery locations. Thus, the worker can deliver far more goods in a normal work-day. This is the way his productivity increases.

Insight 3. Growth in GDP has generally been less than 1.0% more than the growth in energy consumption. The only periods when this was not true were the periods 1975-1985 and 1985-1995. 

This is an exhibit I prepared using data from the sources listed.

Figure 2. World GDP growth compared to world energy consumption growth for selected time periods since 1820. World real GDP trends for 1975 to present are based on USDA real GDP data in 2010$ for 1975 and subsequent. (Estimated by author for 2015.) GDP estimates for prior to 1975 are based on Maddison project updates as of 2013. Growth in the use of energy products is based on a combination of data from Appendix A data from Vaclav Smil's Energy Transitions: History, Requirements and Prospects together with BP Statistical Review of World Energy 2015 for 1965 and subsequent.

Figure 1. World GDP growth compared to world energy consumption growth for selected time periods since 1820. World real GDP trends for 1975 to present are based on USDA real GDP data in 2010$ for 1975 and subsequent. (Estimated by author for 2015.) GDP estimates for prior to 1975 are based on Maddison project updates as of 2013. Growth in the use of energy products is based on a combination of data from Appendix A data from Vaclav Smil’s Energy Transitions: History, Requirements and Prospects together with BP Statistical Review of World Energy 2015 for 1965 and subsequent.

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Deflationary Collapse Ahead?

Both the stock market and oil prices have been plunging. Is this “just another cycle,” or is it something much worse? I think it is something much worse.

Back in January, I wrote a post called Oil and the Economy: Where are We Headed in 2015-16? In it, I said that persistent very low prices could be a sign that we are reaching limits of a finite world. In fact, the scenario that is playing out matches up with what I expected to happen in my January post. In that post, I said

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

This mismatch between rising costs of oil production and stagnating wages is what has been happening. The unaffordability problem can be hidden by a rising amount of debt for a while (since adding cheap debt helps make unaffordable big items seem affordable), but this scheme cannot go on forever.

Eventually, even at near zero interest rates, the amount of debt becomes too high, relative to income. Governments become afraid of adding more debt. Young people find student loans so burdensome that they put off buying homes and cars. The economic “pump” that used to result from rising wages and rising debt slows, slowing the growth of the world economy. With slow economic growth comes low demand for commodities that are used to make homes, cars, factories, and other goods. This slow economic growth is what brings the persistent trend toward low commodity prices experienced in recent years.

A chart I showed in my January post was this one:

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 price of oil dropped dramatically in the latter half of 2008, partly because of the adverse impact high oil prices had on the economy, and partly because of a contraction in debt amounts at that time. It was only when banks were bailed out and the United States began its first round of Quantitative Easing (QE) to get longer term interest rates down even further that energy prices began to rise. Furthermore, China ramped up its debt in this time period, using its additional debt to build new homes, roads, and factories. This also helped pump energy prices back up again.

The price of oil was trending slightly downward between 2011 and 2014, suggesting that even then, prices were subject to an underlying downward trend. In mid-2014, there was a big downdraft in prices, which coincided with the end of US QE3 and with slower growth in debt in China. Prices rose for a time, but have recently dropped again, related to slowing Chinese, and thus world, economic growth. In part, China’s slowdown is occurring because it has reached limits regarding how many homes, roads and factories it needs.

I gave a list of likely changes to expect in my January post. These haven’t changed. I won’t repeat them all here. Instead, I will give an overview of what is going wrong and offer some thoughts regarding why others are not pointing out this same problem.

Overview of What is Going Wrong

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How Economic Growth Fails

We all know generally how today’s economy works:

Figure 1

Figure 1

Our economy is a networked system. I have illustrated it as being similar to a child’s building toy. Ever-larger structures can be built by adding more businesses and consumers, and by using resources of various kinds to produce an increasing quantity of goods and services.

Figure 2. Dome constructed using Leonardo Sticks

Figure 2. Dome constructed using Leonardo Sticks

There is no overall direction to the system, so the system is said to be “self-organizing.”

The economy operates within a finite world, so at some point, a problem of diminishing returns develops. In other words, it takes more and more effort (human labor and use of resources) to produce a given quantity of oil or food, or fresh water, or other desirable products. The problem of slowing economic growth is very closely related to the question: How can the limits we are reaching be expected to play out in a finite world? Many people imagine that we will “run out” of some necessary resource, such as oil, but I see the situation differently. Let me explain a few issues that may not be obvious.

1. Our economy is like a pump that works increasingly slowly over time, as diminishing returns and other adverse influences affect its operation. Eventually, it is likely to stop.

As nearly as I can tell, the way economic growth occurs (and stops taking place) is as summarized in Figure 3.

Figure 3. Overview of our economic predicament

Figure 3. Overview of our economic predicament

As long as (a) energy and other resources are cheap, (b) debt is readily available, and (c) “overhead” in the form of payments for government services, business overhead, and interest payments on debt are low, the pump can continue working as normal. As various parts of the pump “gum up,” the economic growth pump slows down. It is likely to eventually stop, once it becomes too difficult to repay debt with interest with the meager level of economic growth achieved.

Commodity prices are also likely to drop too low. This happens because the wages of workers drop so low that they cannot afford to buy expensive products such as cars and new homes. Growing purchases of products such as these are a big part of what keep the economic pump operating.

Let me explain some of the pieces of the problem that give rise to the slowing economic growth pump, and the difficulties it encounters as it slows down. Continue reading

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Nine Reasons Why Low Oil Prices May “Morph” Into Something Much Worse

Why are commodity prices, including oil prices, lagging? Ultimately, the question comes back to, “Why isn’t the world economy making very many of the end products that use these commodities?” If workers were getting rich enough to buy new homes and cars, demand for these products would be raising the prices of commodities used to build and operate cars, including the price of oil. If governments were rich enough to build an increasing number of roads and more public housing, there would be demand for the commodities used to build roads and public housing.

It looks to me as though we are heading into a deflationary depression, because the prices of commodities are falling below the cost of extraction. We need rapidly rising wages and debt if commodity prices are to rise back to 2011 levels or higher. This isn’t happening. Instead, Janet Yellen is talking about raising interest rates later this year, and  we are seeing commodity prices fall further and further. Let me explain some pieces of what is happening.

1. We have been forcing economic growth upward since 1981 through the use of falling interest rates. Interest rates are now so low that it is hard to force rates down further, in order to encourage further economic growth. 

Falling interest rates are hugely beneficial for the economy. If interest rates stop dropping, or worse yet, begin to rise, we will lose this very beneficial factor affecting the economy. The economy will tend to grow even less quickly, bringing down commodity prices further. The world economy may even start contracting, as it heads into a deflationary depression.

If we look at 10-year US treasury interest rates, there has been a steep fall in rates since 1981.

Figure 1. Chart prepared by St. Louis Fed using data through July 20, 2015.

Figure 1. Chart prepared by St. Louis Fed using data through July 20, 2015.

In fact, almost any kind of interest rates, including interest rates of shorter terms, mortgage interest rates, bank prime loan rates, and Moody’s Seasoned AAA Bonds, show a fairly similar pattern. There is more variability in very short-term interest rates, but the general direction has been down, to the point where interest rates can drop no further.

Declining interest rates stimulate the economy for many reasons:

  • Would-be homeowners find monthly payments are lower, so more people can afford to purchase homes. People already owning homes can afford to “move up” to more expensive homes.
  • Would-be auto owners find monthly payments lower, so more people can afford cars.
  • Employment in the home and auto industries is stimulated, as is employment in home furnishing industries.
  • Employment at colleges and universities grows, as lower interest rates encourage more students to borrow money to attend college.
  • With lower interest rates, businesses can afford to build factories and stores, even when the anticipated rate of return is not very high. The higher demand for autos, homes, home furnishing, and colleges adds to the success of businesses.
  • The low interest rates tend to raise asset prices, including prices of stocks, bonds, homes and farmland, making people feel richer.
  • If housing prices rise sufficiently, homeowners can refinance their mortgages, often at a lower interest rate. With the funds from refinancing, they can remodel, or buy a car, or take a vacation.
  • With low interest rates, the total amount that can be borrowed without interest payments becoming a huge burden rises greatly. This is especially important for governments, since they tend to borrow endlessly, without collateral for their loans.

While this very favorable trend in interest rates has been occurring for years, we don’t know precisely how much impact this stimulus is having on the economy. Instead, the situation is the “new normal.” In some ways, the benefit is like traveling down a hill on a skateboard, and not realizing how much the slope of the hill is affecting the speed of the skateboard. The situation goes on for so long that no one notices the benefit it confers.

If the economy is now moving too slowly, what do we expect to happen when interest rates start rising? Even level interest rates become a problem, if we have become accustomed to the economic boost we get from falling interest rates. Continue reading

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