Oil Prices Lead to Hard Financial Limits

We live in a finite world.  Clearly, a finite world has limits of many kinds. Yet economists and other researchers use models that assume that these limits are unimportant for the foreseeable future. They have certainly not stopped to think that any of these might be very hard limits that are difficult to get around, and furthermore, that we might be reaching them in the next year or two.

What are the hard limits we are reaching? One of the main ones is that at some point, there is a clash between the oil prices importers can afford, and the amount oil exporters require.

Figure 1. Author's view of conflict in required oil prices

Figure 1. Author’s view of conflict in required oil prices

In fact, there can even be a conflict between prices producers in a non-exporting country like the US or Brazil need, and the prices citizens can afford to pay.

Why Oil Exporters Need Ever-Higher Prices

Oil exporters need ever-higher prices, partly because the cost of extraction continues to rise, and partly because oil exporters use taxes from oil to fund public works projects and to keep their many unemployed citizens pacified. The Arab Petroleum Investment House estimates this combined cost for OPEC countries to be increasing by 7% in 2013. Required prices by oil exporters are already in excess of current market prices for some countries, making the situations in these countries less stable. Examples of countries needing higher oil prices than current prices to balance their budgets include Nigeria, Venezuela, Iran, Iraq (APIH report) and Russia (Deutche Bank estimate).

There is evidence that the collapse of the Former Soviet Union in 1991 occurred when oil prices dropped too low. The Soviet Union was an oil exporter, but with the low oil prices, it could not afford to make investments in new productive capacity. It also could not afford to fund government programs. The collapse did not happen immediately, but happened after low prices had sufficient time to erode funding. Ultimately, the central government collapsed, leaving the individual state governments. See my post, How Oil Exporters Reach Financial Collapse. Continue reading

Stumbling Blocks to Figuring Out the Real Oil Limits Story

The story of oil limits is one that crosses many disciplines. It is not an easy one to understand. Most of those who are writing about peak oil come from hard sciences such as geology, chemistry, and engineering. The following are several stumbling blocks to figuring out the full story that I have encountered. Needless to say, not all of those writing about peak oil have been tripped up by these issues, but it makes it difficult to understand the “real” story.

The stumbling blocks I see are the following:

1. The quantity of oil supply available is primarily a financial issue.

The issue that peak oil people are criticized for missing is the fact that if oil prices are high, it can enable higher-cost sources of production–at least until these higher-cost sources of production prove to be too expensive for potential consumers to buy. Thus, high price can extend oil production for longer than would seem possible, based on historical patterns. As a result, forecasts based on past patterns are likely to be inaccurate.

There is a flip side of this as well that economist have missed. If oil prices are low (for example, $20 barrel), the economy is likely to be very different from what it is when oil prices are high (near $100 barrel, as they are now). Continue reading

Oil Limits Reduce GDP Growth; Unwinding QE a Problem

We know the world economic pattern we have been used to in years past–world population grows, resource usage grows (including energy resources), and debt increases. The economy grows fast enough that paying an interest rate a little higher than the inflation rate “works”  for both lenders and borrowers. Borrowers are able to handle the required interest rate, because their wages are rising fast enough to buy homes and cars at prevailing interest rates. Unemployment is not too much of a problem because jobs grow with population and resource usage. Governments do fairly well, too, because they can tax the growing wages of the population sufficiently to get enough taxes to pay the benefits they have promised to constituents.

This model “works” fairly well, as long as the economy is growing fast enough–population continues to grow and resource extraction continues to grow as planned. In a finite world, we know that this model cannot work forever. At some point, we can expect to start reaching limits.

What do these limits look like?  I would argue that in the case of resource extraction, these limits look like increasingly high cost of extraction. We need to extract resources from increasingly deep locations, in increasingly out-of-the way places, using increasingly more energy intensive techniques. For a while, improved technology is sufficient to keep costs down, but eventually the cost of extraction begins to rise. Some of the rising cost may even be taxes, because the country where the extraction is located needs higher taxes to keep a growing population properly fed and housed, so they do not rebel and disrupt production.

When the cost of extraction begins to rise, it is as if we are pouring more manpower and more resources of many types (steel, fracking fluid, jet fuel, electricity, diesel fuel) into a deep pit, never to be used again. When we put more resources in, we get the same amount of resource out, or even less than in the past. If we want to continue to increase the amount we extract, we have to further increase the quantity of resources used in extraction. I have referred to this issue as the Investment Sinkhole problem. Obviously, if we put more manpower and other resources into this pit, we have less for other purposes.

A recent example of resources hitting limits is oil. World oil prices started increasing about 2004 (Figure 1). Analysts say that these rising prices are related to rapidly increasing production costs. Oil company presidents say that we extracted the cheap to extract oil first, and most of it is now gone. Recent reports of major oil companies say profits are dropping, despite high oil prices.

Figure 1. World crude oil production and Brent spot oil price, both based on EIA data.

Figure 1. World crude oil production and Brent spot oil price, both based on EIA data.

Oil is an important commodity because it represents about 33% of the world’s energy supply. It is the world’s primary transportation fuel. It is a very important fuel in agriculture, operating farm equipment, transporting fertilizer, running diesel irrigation pumps, making herbicides and pesticides, and transporting goods to market. Therefore, if oil prices rise, food prices are likely to rise well. In fact, since nearly all goods are transported, an oil price rise affects nearly all goods and quite a few services.

There are really two issues when the cost of oil extraction rises:

1. If the sales price of oil rises, to what extent will this increase adversely affect the economic growth oil importing economies? Rising oil prices mean that the salaries of workers do not go as far, so they must cut back on discretionary goods. Profits of companies will also fall, because it is hard to raise prices of goods, without reducing the quantity sold. In my view, the run-up in oil prices since 2004 explains pretty much all of the “Great Recession’s” impact on oil importing economies. See my article Oil Supply Limits and the Continuing Financial Crisis. In the next section, I show evidence that oil price increases have had a very adverse impact on GDP growth of oil importers.

2.  While the cost of oil extraction is expected to continue to rise, can the sales price of oil really increase to match this higher extraction cost? If oil price can’t rise because of affordability issues (low salary growth, low growth in debt, or cutbacks in government transfer payments), then there is likely to be a crisis of a different kind. Oil exporters will find that oil prices are not high enough to cover their costs, and will cut back drilling to what is profitable. In fact, countries that are producing oil mostly for themselves, such as the US, are also likely to see their oil production drop, because prices will not be high enough to justify new investment. In such a situation, both oil importers and oil exporters are much worse off, because most of our systems are dependent on oil, and less oil will be available.

The Federal Reserve now is discussing the possibility of stopping quantitative easing. If this is done, I expect it will have a very adverse economic effect: long-term interest rates will rise and asset prices are likely to fall. If commodity prices fall as well, then we could find ourselves in the scenario outlined in the preceding paragraph, in which oil prices drop lower than the cost of production for many producers.

Continue reading