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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Oil Price Slide – No Good Way Out

The world is in a dangerous place now. A large share of oil sellers need the revenue from oil sales. They have to continue producing, regardless of how low oil prices go unless they are stopped by bankruptcy, revolution, or something else that gives them a very clear signal to stop. Producers of oil from US shale are in this category, as are most oil exporters, including many of the OPEC countries and Russia.

Some large oil companies, such as Shell and ExxonMobil, decided even before the recent drop in prices that they couldn’t make money by developing available producible resources at then-available prices, likely around $100 barrel. See my post, Beginning of the End? Oil Companies Cut Back on Spending. These large companies are in the process of trying to sell off acreage, if they can find someone to buy it. Their actions will eventually lead to a drop in oil production, but not very quickly–maybe in a couple of years.

So there is a definite time lag in slowing production–even with very low prices. In fact, if US shale production keeps rising, and Libya and Iraq keep work at getting oil production on line, we may even see an increase in world oil production, at a time when world oil production needs to decline.

A Decrease in Oil Prices May Not Fix Oil Demand

At the same time, demand doesn’t pick up quickly as prices drop. We are dealing with a world that has a huge amount of debt. China in particular has been on a debt binge that cannot continue at the same pace. A reduction in China’s debt, or even slower growth in its debt, reduces growth in the demand for oil, and thus its price. The same situation holds for other countries that are now saturated with debt, and trying to come closer to balancing their budgets.

Furthermore, the Federal Reserve’s discontinuation of quantitative easing has cut off a major flow of funds to emerging markets. Because of this change, emerging market demand for oil has dropped. This has happened partly because of the lower investment funds available, and partly because the value of emerging market currencies relative to the dollar has fallen. Again, a decrease in oil price is not likely to fix this problem to a significant extent.

Europe and Japan are having difficulty being competitive in today’s world. A drop in oil prices will help a bit, but their problems will mostly remain because to a significant extent they relate to high wages, taxes, and electricity prices compared to other producers. The reduction in oil prices will not fix these issues, unless it leads to lower wages (ouch). The reduction in oil prices is instead likely to lead to a different problem–deflation–that is hard to deal with. Deflation may indirectly lead to debt defaults and a further drop in oil demand and oil prices.

Thus, oil prices are likely to continue their slide for some time, until real damage is done, perhaps to several economies simultaneously.

The United States’ Role in the Oil Over-Production / Under-Demand Clash 

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Eight Pieces of Our Oil Price Predicament

A person might think that oil prices would be fairly stable. Prices would set themselves at a level that would be high enough for the majority of producers, so that in total producers would provide enough–but not too much–oil for the world economy. The prices would be fairly affordable for consumers. And economies around the world would grow robustly with these oil supplies, plus other energy supplies. Unfortunately, it doesn’t seem to work that way recently. Let me explain at least a few of the issues involved.

1. Oil prices are set by our networked economy.

As I have explained previously, we have a networked economy that is made up of businesses, governments, and consumers. It has grown up over time. It includes such things as laws and our international trade system. It continually re-optimizes itself, given the changing rules that we give it. In some ways, it is similar to the interconnected network that a person can build with a child’s toy.

Figure 1. Dome constructed using Leonardo Sticks

Figure 1. Dome constructed using Leonardo Sticks

Thus, these oil prices are not something that individuals consciously set. Instead, oil prices reflect a balance between available supply and the amount purchasers can afford to pay, assuming such a balance actually exists. If such a balance doesn’t exist, the lack of such a balance has the possibility of tearing apart the system.

If the compromise oil price is too high for consumers, it will cause the economy to contract, leading to economic recession, because consumers will be forced to cut back on discretionary expenditures in order to afford oil products. This will lead to layoffs in discretionary sectors. See my post Ten Reasons Why High Oil Prices are a Problem.

If the compromise price is too low for producers, a disproportionate share of oil producers will stop producing oil. This decline in production will not happen immediately; instead it will happen over a period of years. Without enough oil, many consumers will not be able to commute to work, businesses won’t be able to transport goods, farmers won’t be able to produce food, and governments won’t be able to repair roads. The danger is that some kind of discontinuity will occur–riots, overthrown governments, or even collapse.

2. We think of inadequate supply being the number one problem with oil, and at times it may be. But at other times inadequate demand (really “inadequate affordability”) may be the number one issue. 
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WSJ Gets it Wrong on “Why Peak Oil Predictions Haven’t Come True”

On Monday, September 29, the Wall Street Journal (WSJ) published a story called “Why Peak Oil Predictions Haven’t Come True.” The story is written as if there are only two possible outcomes:

  1. The Peak Oil version of what to expect from oil limits is correct, or
  2. Diminishing Returns can and are being put off by technological progress–the view of the WSJ.

It seems to me, though, that a third outcome is not only possible, but is what is actually happening.

3. Diminishing returns from oil limits are already beginning to hit, but the impacts and the expected shape of the down slope are quite different from those forecast by most Peak Oilers.

Area of Confusion

In many people’s way of thinking, the economy is separate from resources and the extraction of those resources. If we believe economists, the economy can grow indefinitely, with or without the use of resources. Clearly, with this view, the price of these resources doesn’t matter very much. If one kind of resource becomes more expensive, we can substitute other resources, once the scarce resource becomes sufficiently high-priced that the alternative makes financial sense. Incomes can rise arbitrarily high–all it takes is for each of us to pay the other higher wages. And we can fix any problem with the financial system with more money printing and more debt.

This wrong version of how our economy works has been handed down through the academic world, through our system of peer review, with each academic researcher following in the tracks of previous academic researchers. As long as new researchers follow the same wrong thinking as previous researchers, their articles will be published. Economists were especially involved in putting together this wrong world-view, but politicians helped as well. They liked the outcomes of the models the economists produced, since it made it look like the politicians, with the help of economists, were all-powerful. All the politicians needed to do was tweak the financial system, and the world economy would grow forever. There was not even a need for resources!

Peak Oilers’ Involvement 

The Peak Oilers walked into a situation with this wrong world view, and started trying to fix pieces of it. One piece that was clearly wrong as the relationship between resources and the economy.  Resources, especially energy resources, are needed to make any of the goods and services we buy. If those resources started reaching diminishing returns, it would be harder for the economy to grow. The economy might even shrink. Dr. Charles Hall, recently retired professor from SUNY-ESF, came up with one measure of diminishing returns–falling Energy Returned on Energy Invested (EROEI).

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