An Economic Theory of Limited Oil Supply

We seem to hear two versions of the story of limited oil supply:

1. The economists’ view, saying that the issue is a simple problem of supply and demand. Substitution, higher prices, demand destruction, greater efficiency, and increased production of oil at higher prices will save the day.

2. A version of Hubbert’s peak oil theory, saying that world oil production will rise and at some point reach a plateau and begin to decline, because of geological depletion. The common belief is that the rate of decline will be determined by geological considerations, and will roughly match the rate at which production increased.

In my view, neither of these views is correct. My view is a third view:

3. An adequate supply of cheap ($20 or $30 barrel) oil is no longer available, because most of the “easy to extract” oil is gone. The cost of extracting oil keeps rising, but the ability of oil-importing economies to pay for this oil does not. There are no good low-cost substitutes for oil, so substitution is very limited and will continue to be very limited. The big oil-importing economies are already finding themselves in poor financial condition, as higher oil prices lead to cutbacks in discretionary spending and layoffs in discretionary industries.

The government is caught up in this, as layoffs lead to more need for stimulus funds and for payments to unemployed workers, at the same time that tax revenue is reduced. There can be a temporary drop in oil prices (as there was in late 2008), as recession worsens, but eventually demand rises again, oil prices rise again, and the pattern of layoffs and increased governments financial problems occurs again.

Without substitutes at a price that the economy can afford, economies will adapt to lower amounts of oil they can afford by worsening recession, debt defaults, and reduced international trade. There may be tendency for international alliances (such as the Euro) to fall apart, and for countries to break into smaller units (Catalonia secede from Spain, or countries break up the way the Soviet Union and Yugoslavia did).

At some point, probably not too many years in the future, the amount of oil extracted from the ground will drop, reflecting a combination of geological and economic factors. The fall may very well be quite steep. While we can’t expect to extract more than geology will allow, there is nothing to say that political and economic factors will allow extraction of this amount. If civil war breaks out in an oil producer, production may drop quickly. Or if oil prices drop because of severe recession, drilling of new fields and wells may drop off quickly, leading to lower production as existing wells deplete, and not enough new supply as added. There may also be disruption in international sales of oil.

What the Economists’ View Misses

The economists’ view misses the fact that it is external energy that makes the economy operate the way it does. (See my earlier posts, here, here and here.) If energy products are higher priced, energy importers can afford less of them, and there is a tendency of their economies to shrink back to what their economies can afford—fewer employed workers and fewer government programs. I talk about the connection between employed workers and energy consumption in The Close Tie Between Energy Consumption, Employment and Recession.

Figure 1. World GDP, oil consumption and energy consumption growth rates, based on data of USDA, Angus Maddison, and BP’s 2012 Statistical Review of World Energy data.

As the growth rate in energy supplies decreases (oil by itself, or in total), the economy tends to shrink back.  Initially (in the 1970s and 1980s), the economy shrinking back looked like it was slowing down – no longer undertaking big new initiatives like interstate highway systems and major electrical grid expansions, and adding new initiatives for taking care of the poor. Then the economy shrinking back morphed into a bigger emphasis on debt financing; less concern about keeping up infrastructure the way it had in the past; and switching from manufacturing of goods to production of services, to keep energy needs lower.

Another way of keeping down energy use was by keeping wages down. Since wages translate to purchase of things that energy can make, lower wages allow an economy to “get by” with less energy consumption. In the US, the quest for lower wages has manifested itself in many ways—the failure of men’s median wages to rise after the mid 1970s, the increasing use of women (at lower average wages) in the workforce, and later outsourcing of jobs to countries overseas with lower wages (and thus less energy consumption by workers).

Figure 2. Per capita oil consumption in countries with recent bank bailouts, based on data of the US Energy Information Administration.

Eventually, the economy shrinking back has become more disruptive. It looks more like recession, with job layoffs, debt defaults, and serious government funding problems. Governments find themselves going deeper and deeper into debt, as tax revenue lags, and there is more need for stimulus funding and benefits for unemployed workers. In such an atmosphere, government stability is at risk. This seems to be where quite a few of the European countries are right now. The United States is not far away either, with many of its problems hidden by deficit spending, “quantitative easing,” ultra low interest rates, and the fiscal cliff.

The Myth of Substitution

A big part of the economists’ problem in figuring out the problem with limited cheap oil supply is their assumption that energy is not very important. It doesn’t cost very much, so why worry about it? Certainly, there should be substitutes. For example, if we can’t afford to make goods, we should be able to switch to the production of services, since these don’t require as much energy to produce. This might be a method of substitution.

But think about this. In our own life, our own energy comes from food. If someone told you that we were having a problem with food supply, but the economists said not to worry, we would find a substitute, how convinced would you be that economists really knew what they were talking about? Do you feel less hungry after a haircut, or a trip to get a loan at a bank (two standard types of services)? Perhaps they were underestimating the importance of food.

Something like that happens with other forms of energy as well. It is virtually impossible to substitute away. There is a little substitution over time of one form of energy for another, just as there is substitution of wheat for corn. But in general, each type of energy has its own uses, and it is hard to substitute one type for another. A car runs on gasoline. It is possible to substitute up to 10% or 15% corn ethanol in the gasoline, but unless significant changes are made, it is not possible to run the car on natural gas or on coal.

A big part of economists’ problem with overestimating the role of substitution is their missing the adverse impact of high oil prices (or other high energy prices) on the economy. As I have explained previously, when oil prices rise, both the cost of food and cost of commuting tend to rise. Workers cut back on discretionary spending, so as to have enough money for commuting and food expenses, leading to layoffs in discretionary industries. Housing prices stagnate or drop, as people cut back their expectations of moving to a higher priced home. Governments find themselves in increasingly poor financial condition, trying to fix these problems, with lagging tax revenue. All of this creates substantial economic problems, which cannot be overlooked.

The comment a person often hears is, “As soon as the price of oil rises high enough, _______ will substitute for it.” This doesn’t work for a couple of reasons: (1) By the time the price rises that high, the economy will be “in the tank” anyhow; a high-priced substitute doesn’t fix the problem. (See my post High-Priced Fuel Syndrome) (2) Substitutes generally use oil in their production, either directly or indirectly, so when the price of oil rises, the price of the substitutes tends to rise as well, although probably not as much as the oil price rise.

Substitution to date is not taking place very quickly. On a worldwide basis, 87% of current energy use comes from fossil fuels, based on BP’s 2012 Statistical Review of World Energy Data. The remainder is divided as follows, in the year 2011:

▪               Nuclear amounted to 5% of the total;

▪               Hydroelectric amounted to 6% of the total, and

▪               Renewables (including wind, solar, biofuels, wood, waste, geothermal, and others) come to a total of 2% of world energy supply.

There has been some substitution away from oil for a long time, because oil is high priced. Often, this occurs through electrification of various processes. The electricity used in this process is today mostly from natural gas and coal, with lesser amounts from nuclear, hydroelectric, and other renewables.

The speed with which substitution of electricity for oil is taking place varies, with stationary applications working best, and transportation being slow to change. According to the US Energy Information Administration, in 2011, only 0.3% of US transportation fuel was electricity. The rest of transportation was divided as follows: Oil, 92.7%; Biofuels, 4.3%; Natural Gas, 2.7%.

Another application which is a significant user of oil, but for which little substitution toward electricity is readily available, is in food production. Oil is used in operating farm machinery, in making herbicides and insecticides, and in transporting food to market. This is a reason why many people are interested in local food production, using techniques that use less oil.

What the Peak Oilers Missed

If a person goes back and looks at M. King Hubbert’s 1956 paper, Nuclear Energy and the Fossil Fuels, they will discover that Hubbert talks about a very optimistic scenario: the use of nuclear energy rising, before the use of oil and other fossil fuels begins to decline. See my post, Will the decline in world oil supply be fast or slow?

Figure 3. Figure from Hubbert’s 1956 paper, Nuclear Energy and the Fossil Fuels.

Elaborating further on this idea, Hubbert, in his 1962 paper, Energy Resources – A Report to the Committee on Natural Resources, writes about the possibility of having so much cheap energy that it would be possible to essentially reverse combustion–combine lots of energy, plus carbon dioxide and water, to produce new types of fuel plus water. If we could do this, we could solve many of the world’s problems–fix our high CO2 levels, produce lots of fuel for our current vehicles, and even desalinate water, without fossil fuels.

The problem that arises if we don’t have such a substitute for fossil fuels is a severe one. How do we keep our current economy operating, if oil prices, or fossil fuels in general, become high priced, and start interfering with the economy? At some point, the interference will become so great that recession will set in, in many major oil importing nations. Oil prices will drop, and oil producers will not be able to extract oil at those prices. There may be major financial impacts as well—governments dropping out of the Euro, the US government facing a financial cliff, and other countries (Japan, Britain, and China, for example) facing difficulties as well.

In my view, the shape of down slope in oil production is likely to be steeper than the pattern by which oil supply increases. Geology determines the maximum amount of extraction, but it doesn’t determine how much will actually be extracted.  Economic conditions need to be right for the extractions to take place. Low oil prices by themselves could cause political upheaval in some oil exporting nations. If there are huge international trade problems, this could reduce demand as well.

Why International Trade Can Be Expected to Contract

Huge economic growth since World War II has been enabled by increased international cooperation and increased globalization. It is now possible to make many high-tech goods using trained specialists who travel around the world and raw materials imported from countries that will put up with high levels of pollution. These high-tech goods can be very cheap, if they are assembled in a country such as China with cheap labor.

Once countries start operating in a mode of “not enough energy to go around,” the model of global cooperation starts disintegrating. If unemployment becomes an increasing problem, then countries are no longer be willing to let in cheap labor from lesser-developed countries. We can see this happening in the United States, with respect to workers from Mexico.

If oil is becoming a problem, we will see more spats, of the type recently occurring between Japan and China, leading to lower trade. There may even be more resource wars. Large countries encountering financial problems will see individual units wanting to go their own way, with the parts that are doing better economically wanting to disassociate themselves from the have-nots.

Figure 4. Oil as a percent of total 2006 energy consumption for European countries, based on BP’s 2012 Statistical Review of World Energy

High oil prices are likely to lead to more defaults on loans. In fact, Figure 4 shows that the countries most at risk of defaulting tend to be the ones that imported the largest percent of their energy from oil in 2006, before the recent crisis begin. As the world encounters more and more loan defaults, this too can be expected to erode interest in foreign trade. Such trade will likely not disappear, but may be carried on to a greater degree between trusted partners, or on more of a barter basis. For example, a certain quantity of oil may be traded for goods that the oil-producing country can use.

Businesses, Governments and Consumers form a Networked System

The way the world operates today, each business is added to the existing web of governments, businesses and consumers that exists today. Some businesses succeed, while others fail. Success or failure depends the laws that are in effect, the resources that are available, what competition there is, and the purchasing power of customers.

If energy is in short supply, more and more governments and businesses will fail, and increasing numbers of consumers will find themselves without jobs in the traditional economy. Banks may be overwhelmed by debt defaults. At some point, supply chains will become so disrupted that it will be hard for anything other than small local businesses to succeed.

This will correspond to what Joseph Tainter talks about as moving to a state of lower complexity. We don’t know exactly when or how this will happen, but it appears that we are already moving in this direction. The next years seem likely to be challenging ones!

This entry was posted in Financial Implications, Oil and Its Future and tagged , , , , by Gail Tverberg. Bookmark the permalink.

About Gail Tverberg

My name is Gail Tverberg. I am an actuary interested in finite world issues - oil depletion, natural gas depletion, water shortages, and climate change. Oil limits look very different from what most expect, with high prices leading to recession, and low prices leading to financial problems for oil producers and for oil exporting countries. We are really dealing with a physics problem that affects many parts of the economy at once, including wages and the financial system. I try to look at the overall problem.

156 thoughts on “An Economic Theory of Limited Oil Supply

  1. A few thoughts about what Sandy should teach us.

    (1) The notion that Our World is Finite is absolutely true. Wealth, once destroyed, is just gone. The Keynesian/Cornucopian notion that wealth is disposable because we can always just create some more is revealed to be quite hollow. Yet the illusion persists that ‘if its good for GDP, then it’s good for the USA’.
    (2) Turning seacoasts into suburbs has been a huge misallocation of resources. I don’t know if the Fiscal Cliff provides for the termination of federal flood insurance. If it does, it might be worth while. More broadly, going through a Fiscal Cliff experience might be the wake-up call we need to decide what we want to be when we grow up.
    (3) Sharon Astyk’s new book Making Home is hot off the press. I haven’t read it all as yet. But what I have scanned I have liked. For example, one of the people she talks to says ‘other people see limbs down from storm damage, I see firewood’.
    (4) Sharon includes some profiles of people she has met and admired. One is Michelle, in Chicago. ‘Few people have done as much to convince me that cities have a sustainable future as Michelle, who made a passionate case in their favor. Now I was seeing Chicago’s future through Michelle’s eyes. In her mid-fifties, Michelle looks a decade younger. She is an immigrant from South Africa…she showed me the gardens of her neighbors, immigrants from a dozen countries, and the community garden she and others are building in their area and how it fits into a larger picture of food security for the city…I saw the beauty of an urban homestead, from the solar panels on her roof to the beehives on her second-floor balcony…makes use of every inch of space’. Everyone should hang around with some immigrants–they see opportunity everywhere.
    (5) Sharon identifies the ability to work with others on common needs as one of the bottleneck skills we have to develop. While the TV may be showing fist-fights in New Jersey at the gas stations, what I am hearing from neighbors who have children in NY/NJ is overwhelmingly neighbors helping neighbors. Wall Street has not yet beaten the cooperative impulse out of everyone…as yet.
    (6) Climate change is having effects that we did not suspect a decade ago. Doubtless we have more surprises in store Sharon’s advise to stay home more and use less fossil fuels is right on target. As a bonus, maybe you can contribute to greatly reducing Rex Tillerson’s bonus.

    Don Stewart

    • Just a couple of comments. I think insurance of all kinds has contributed to a lot of bad decision making. Part of it is the give-away Federal Flood Program. But even “wind insurance’, which are written by private insurers (and state like Florida try to make as underpriced as possible) lead to a lot of bad decision making. Health insurance seems to lead people to believe that doctors can fix anything–there is no need for personal responsibility in preventing disease. Also, health insurance has helped support the huge share of GDP currently being spent on medical care in the US–with poorer health outcomes than in many other countries.

      Sharon often has a lot of good ideas. Maybe I can find a chance to look at her new book.

    • Huppert’s theory has gone the way of Malthus, and anyone who doesn’t know that must be living under a rock. The one thing this crowd (and sadly, you too Don), is that you don’t know everything. We aren’t all staving now as Malthus predicted because smart people invented tractors, fertilizer, and hybrid seeds. We won’t run out of oil because smart people invented 4D geologic mapping and ways to dril horizontally 10,000 feet below the surface. And folk will still be swimming at the Jersey Shore 100 years from now, because by then, we’ll have a fix for whatever is needed to make sure of it. The only thing finite in this world is your imaginations!

  2. It seems to me that some current comments by intelligent, well-meaning people outline some of the important questions.
    (1) Numerous people think that life is going to be awful and there is nothing to be done about it. There will be mass starvation, epidemics of disease, violence, etc.

    If I believed this, I don’t know what I would do–perhaps drink a lot.

    (2) Lester Brown’s current article on wind power is a good example of those who think we can transition pretty seamlessly to renewables:

    If I believed Lester, I would join the crusade for industrial strength renewables.

    (3) Sharon Astyk, in Making Home (page 14) states ‘Now consider the reality. In fact, our carbon problem is very simple. We can’t burn all the carbon we do have, and we don’t have enough to build our way out of burning it. We have to use less….Climate change will not come equitably to every place, but it will come everywhere. Energy depletion too will come unevenly, but it will come, and so will the financial consequences of both. The ways to mitigate them are the exact opposite of running away to discover what we should have known already–we need to appreciate what we have here, and slow down further.’

    If I believed Sharon, then I would get about making my home as resilient and pleasant as possible and pay a lot of attention to personal relationships with people in the neighborhood. If I were extremely optimistic, I might try to persuade my neighbors to enroll in the Voluntary Simplicity movement. The subtitle to Sharon’s book is ‘How Settling for Less can Mean Having More’.

    (4) Albert Bates writes about his pleasant experience in Mexico living a month without electricity:

    If I believed Albert, I might very well look for some place where, as a friend put it, ‘entropy is less advanced than it is in the U.S.’ Albert certainly didn’t suffer down there in Yucatan living on a tiny fraction of the energy that Americans take for granted. I will also note that 40 years ago Albert moved from NYC to The Farm in Tennessee and found ‘home’.

    (5) Sharon Astyk writing about Wendell Berry (pg 17): ‘how many of them were prepared to live with about half as much electricity? Some undoubtedly were. Wendell Berry, for example, has tried for decades to convince Americans that the pre-electric past was not hell.’

    If I believed Wendell and Albert, I would make some local arrangements for living with a combination of non-grid tied electricity and non-fossil fuel generation of light and heat. I wouldn’t put much faith in the industrial solutions favored by Lester Brown. Nor would I wait for Government to offer me solutions.

    (6) Sharon Astyk writing about Dmitry Orlov (pg 214): ‘I was struck by Dmitry Orlov’s observation…about the way the people of Russia responded to the collapse of the Soviet Union. In a crisis, he says, education isn’t less important but more. You may end up digging ditches, but if you also know poetry or music and have a head full of ideas, you can live in your mind while your body works.’

    If I believed Dmitry, then I would continue my own liberal education and do my best to spread the idea of liberal education in a world awash in narrowly focused goals. A local craft school established in the 1920s thought that their ideal student would ‘sing behind the plow’. I might try to become a better story teller–my singing is hopeless.

    As I sort through the issues, it seems to me that a few jump out:
    (A) Is Sharon correct that we have enough fossil fuels to roast us but not enough to escape roasting?
    (B) Given that each of us needs daily support from neighbors, how can we maximize the chance of getting this support?
    (C) How can each of us increase our self-reliance and decrease our dependence?
    (D) How can each of us and our neighbors enjoy an expanding cultural horizon in a world of shrinking physical horizons?
    (E) What energy sources are realistic in a time frame of one decade? two decades? three decades? five decades? What, exactly, do we need to do to utilize those energy sources?

    Some of these questions are primarily quantitative, some are primarily qualitative, but most contain some mixture. Given that we are dealing with a complex system and complex systems tend to resist forecasts, I doubt that we will ever come to universal agreement. It seems to me that question A is foundational. I think that Gail believes that we will not have enough fossil fuels to roast ourselves, that Sharon believes what I have stated, and that Lester Brown believes we have enough time and resources to change. If we, as a society, are going to make any progress at all, I think we have to get a better quantitative understanding of question A.

    Don Stewart

    • Don, that’s a really great summary.

      Not enough people have the perceptiveness to put all of those factors into a matrix like that. And that’s I think why Gail’s site is so invaluable, in that it tries to bring together all of those elusive factors, and make meaning of the whole.

      I spend my life in green circles and find most of my colleagues think of the future in too simplistic terms, nearly all focus on electricity, as if solar panels and wind turbines were some sort of fix all, and a fairly easy one at that. There’s not enough appreciation of the extent to which liquid fuels are solidly imbedded in our infrastructure and production of essential goods and services.

      That said, there are good people out there pushing each of those lines of inquiry that you mention and although each on has its severe limitations it is people like yourself that can help to bring about a higher level of maturity regarding the choices and possible futures that can come out of the matrix of thought processes.

    • It is very complacent to believe that we will not have enough fossil fuel to roast ourselves. The planet moved from ice-age to interglacial without any fossil fuel extraction industry whatsoever. If we pass a tipping point, and some scientists believe that it might already be too late, then it will not matter if we stop buring fossil fuels immediately, the temperature will simply climb to a new stable state. It is not certain that that state will support human life or not. I am surprised that Gail should be so unaware of positive feedback mechanisms and their attendant dangers.

    • You are right–I think resource issues will cause huge disruption very soon, especially in the financial area. This will make it very difficult to “build our way out” of our problems. I don’t think we can know in advance exactly how this will all play out, but I expect that in various ways, supply lines will break, so it will be more difficult to build our way out of today’s situation. I think Lester Brown is badly mistaken as to what is possible.

      I also think that those who have built climate models are badly mistaken as to what is possible. In the future, supply lines will be broken (through international trade problems, banking problems, lack of long distance air flights, etc), and these broken supply lines will mean that a lot of what looks like extractable fossil fuels today will not be extracted. (We may already be past some tipping point with respect to climate anyhow, so perhaps this is irrelevant.) I am not convinced that there is a whole lot we can do, one way another, to affect climate. The Maximum Power Principle of H. T. Odum basically says that if there is energy available (including fossil fuel energy), organisms will figure out a way to use it, as efficiently as possible. If you and I decide not to use some of the available fossil fuel energy, there will be others in the system who will choose to use it instead. Thus, the fact that you and I decide not to use some of the fossil fuels does not leave the fossil fuels in the earth forever; it just transfers the availability of those fossil fuels to someone else. The critical point is really the breaking of supply lines that makes fossil fuel extraction possible, and we don’t have much control over when the system breaks. I expect the breakage of those supply lines will happen mostly in the next few years. Even with the breakage of supply lines, there may still be some coal near the surface that can be mined without modern techniques, and this extraction will continue. The amount of coal extracted without the benefit of modern techniques and transportation will likely be tiny compared to today, however.

      There are different ways of dealing with the downslope, and you have mentioned some folks with good ideas in this regard. Certainly, most of us can get along with less than we have today, and this is part of any solution. If we look around the world, there are a lot of people living without electricity, in homes they have built from local materials. Many of them are quite happy with their circumstances. We don’t think we could live that way, but throughout history, that is the way most people have lived.

      Workers in India harvesting rice

      Another part of the solution is that we all have some “stuff,” and it won’t evaporate immediately. These things would include clothes, a place to live, books, and various types of tools–shovels, pencils, pens, paper, books, etc. Our problems will get worse, as these things start to wear out, if we haven’t figured out how to make replacements with local materials. There will be unneeded things we can recycle, and that will help for some years as well.

      You say,

      (1) Numerous people think that life is going to be awful and there is nothing to be done about it. There will be mass starvation, epidemics of disease, violence, etc.

      If I believed this, I don’t know what I would do–perhaps drink a lot.

      Even if that does turn out to be true, I am not sure that drinking is a good solution. If nothing else, even if it is true, the extent to which it is true is likely to vary greatly by location, so we don’t know that it will be true for ourselves. All we can do is take one day at a time, and see how things work out.

      There are many people who are in hospice, or otherwise know the ends of their lives are approaching. Most of us are healthy, so have advantages over them. Often, the people in hospice use the time they have available to visit again with family, and do other simple things that give them pleasure. Even if we expect things will be terrible in the future, we can do thing now that give us pleasure, and build relationships with others. Also, if we change our focus so “stuff” isn’t so important, whether or not someone steals things from us is less of a problem. Even if things get bad, we have some control over our lives–our thoughts, if nothing else.

      • Dear Gail
        Thanks for the detailed response. Perhaps I have been inattentive–I think I now understand better your concern with supply lines.

        If I might add a few words along those lines. Chris Martenson sent out a note today (it is proprietary, so I won’t quote it) expressing a lot of pessimism about the political situation and the financial situation and the backdrop of resource depletion. In addition, he sees social dysfunction in the US–quoting with approval some words of Matt Taibbi:

        ‘So all this freaking out and vicious invective-trading looks nuts from the outside: it looks like we’re making up reasons to hate and fear each other, summoning the language of violent civil unrest with a hedonistic zeal that only people who haven’t experienced the real thing could possibly enjoy.’

        So what some very smart people see is that the system is stretched like a rubber band and any little thing can snap it and finance fails (as it did in 2008, but from a now much worse initial condition) and global trade fails so that supply lines fail and our ability to physically produce an awful lot of stuff fails.

        Consequently, debating whether we run out of fossil fuels first due to depletion or run out of environment first due to unbearable climate change is likely to be irrelevant. The system will have failed before either happens.

        I wonder if I could buy the grass shack Albert Bates uses for his writing?

        Don Stewart
        PS I am reconsidering the drinking plan. Instead, I plan to get a gypsy to read some tea leaves and tell me exactly when the sky will fall. Then I will order lots of goodies on the credit card so that they get here before the crash. But then, the following week, the post office will stop delivering bills and I will never have to pay. Of course…all that stuff might make me a target for bandits?

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