We have all heard the story about oil supply supposedly rising and falling for geological reasons. But what if the story is a little different from this–oil production rises and falls for economic reasons? If this is the issue, it doesn’t really matter how much oil is in the ground. What matters is if economic conditions are “right” for continued and rising extraction. I have shown in previous posts that oil prices that are too high are a problem for oil importers while oil prices that are too low are a problem for oil exporters. As a result, oil prices need to be in a Goldilocks zone, or we have serious problems, of one sort or another.
As long as the price of oil keeps rising, there is at least some chance the amount of oil extracted each year will keep rising, because more oil resources will become economic to extract. The real problem arises when oil price falls back from a price level it has held, as it has done recently, and as it did back in July 2008. Then there is a real chance that investment will become non-economic, and because of this, oil production will fall.
Figure 1. World crude oil price and production, based on monthly EIA data.The corresponding price in late April is approximately $100 barrel, so is even lower yet.
Oil prices play multiple roles:
- High oil prices encourage extraction from more difficult locations, because the higher cost covers the additional extraction costs.
- High oil prices allow exporters to have adequate money to pacify their populations, even if their oil exports have been declining, as they have been for many exporters.
- High oil prices allow funds for investment in new oil fields, as old ones deplete.
- High oil prices tend to put oil importing countries into recession, because it raises the costs of goods and services produced, without raising the salaries of the workers. In fact, there is evidence that high oil prices lower wages (both directly and through lower workforce participation).
- High oil prices make countries that use large amounts of oil less competitive with countries that use less fuel in general, and less oil in particular.
When oil prices decline, it is evidence that Items 4 and 5 above are outweighing Items 1, 2, and 3. This tips the scale in the direction of a fall in oil production.
Debt also affects oil prices. As long as investors have faith that businesses can make money, despite high oil prices, they will continue to borrow to expand their businesses. This additional debt helps drive up demand for goods and services of all kinds, including oil, so oil prices rise. Also, if consumers are able to borrow increasing amounts of money, this also drives up demand for goods that use oil, such as cars. But once the debt bubble bursts, it is easy for oil prices fall very far, very fast, as they did in 2008.
If we look at the 2008 situation, oil limits were very much behind the overall problem, even though most people do not recognize this connection. It was the fact that oil limits eventually led to credit limits that caused the system (including oil prices) to crash as it did. High oil prices led to debt defaults and bank write offs, and eventually led to a huge credit contraction in economies of the developed world. This credit contraction affected not just oil demand, but demand for other energy products as well.
The problems of the 2008 period were never really solved: the lack of growth in world oil supply remains, and this lack of growth in world oil supply continues to hold back world economic growth, particularly in developed countries. We recently have not been feeling the effects as much, because with deficit spending, the problems have largely moved from the private sector to the government sector.
The situation remains a tinderbox, however. The financial situation is propped up by ultra-low interest rates, continued government deficit spending, and Quantitative Easing. In a finite world, debt growth cannot continue indefinitely. But if debt growth permanently stops, and switches to contraction, we would end up in an even worse financial mess than in 2008. In fact, such a change would very likely to would lead to a contraction of “Limits to Growth” proportions.
In this post, I will explain some of these issues further.