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.

How do oil importers reach price limits?

According to most economic theory, oil importers should never reach a price limit. If higher prices occur, as they did in the 1970s and early 1980s (Fig. 2), these higher prices should quickly lead to conservation, plus greater oil extraction and the development of substitutes.

Figure 2. World oil price (Brent equivalent) in 2011$,  based on BP 2013 Statistical Review of World Energy data.

Figure 2. World oil price (Brent equivalent) in 2011$, based on BP 2013 Statistical Review of World Energy data.

In fact, in the late 1970s and early 1980s, high oil price did lead to changes of the expected kind. It was possible to replace oil-fired electric power plants with coal-fired power plants or nuclear electric power plants. It was also possible to replace the very large, fuel inefficient cars that US automakers were making with more fuel-efficient cars, including ones that Japanese automakers were already making. In addition, it was possible to quickly bring additional inexpensive oil on-line, such as from Alaska (Figure 3) and the North Sea. The decline in the 48 states production (excluding tight oil) was never really fixed.

Figure 3. US crude oil production, divided into "tight oil", oil from Alaska, and all other, based on EIA data.

Figure 3. US crude oil production, divided into “tight oil,” oil from Alaska, and all other, based on EIA data.

More recently, there has been much less success in increasing world oil supply. Higher oil prices eventually led to some new production, such as US tight oil (green in Fig. 3). But even with the new US tight oil production, world oil supply has not risen very much  (Fig. 4).

Figure 4. Growth in world oil supply, with fitted trend lines, based on BP 2013 Statistical Review of World Energy data.

Figure 4. Growth in world oil supply, with fitted trend lines, based on BP 2013 Statistical Review of World Energy data.

It is not clear how long the current run-up in tight oil production will continue. Current production is enabled by high oil prices, available credit, and low-interest rates. Even these may not be enough: a recent headline says, Shale Grab in U. S. Stalls as Falling Values Repel Buyers.

What happens when oil prices rise, and no additional supply or substitute is available?

Economists tell us that when oil prices rise, and no additional supply or substitute is available, demand destruction occurs. It turns out that demand destruction for oil corresponds to what most people would call “recession. It is as if the economy shrinks to a smaller size, so that less oil is required.

This economic shrinkage takes place in a number of ways. Higher oil prices make oil less affordable for consumers, businesses, and governments. The indirect result of this is job layoffs, because consumers cut back on discretionary items, such as vacation travel and eating out at restaurants. Governments cut back on projects like road repair, laying off workers. Businesses find they need to raise prices of goods they sell, because of the higher prices they pay for oil. The result is that their products are affordable to fewer consumers, again requiring laying off workers. So the net result is job loss, and continued weakness in hiring, such as the US has seen for several years now.

Governments are particularly affected by high oil prices, because with fewer people working, government tax collections are reduced. More people file for benefit programs, such as unemployment or disability coverage, when they cannot find work. This adds to government funding issues. If banks fail, governments may be called to bail them out, also adding to government expenditures.

There have been academic studies showing that high oil prices tend to create recessionary impacts.  James Hamilton has shown that 10 out 11 post-World War II recessions were associated with oil price spikes. He has also shown that oil price changes in the 2005-2008 period were sufficient to lead to the Great Recession (Brookings Paper). I have also written a related academic paper, Oil Supply Limits and the Continuing Financial Crisis.

Because of these issues, if high oil prices remain after a recession, we should expect continued recessionary impacts, such as an inadequate number of jobs for young people and growing government debt. The government can cover up these issues to some extent with ultra low interest rates. In fact, such low interest rates, together with continued deficit spending, seem to be the reasons the US has been in “recovery” since the Great Recession officially ended in June 2009. However, we still find (Fig. 5) that the big oil importing countries (US, UK, and Japan) have much lower GDP growth in recent years than the rest of the world.

Figure 5. Annual percent change in Real GDP by part of the world, based data of the USDA.

Figure 5. Annual percent change in Real GDP by part of the world, based data of the USDA.

These countries also have much less growth in oil consumption than the rest of the world, indicating that when it comes to oil consumption, citizens and businesses of the US, EU and UK are being outbid by businesses and workers elsewhere.

Figure 6. Oil consumption based on BP's 2013 Statistical Review of World Energy.

Figure 6. Oil consumption based on BP’s 2013 Statistical Review of World Energy.

Workers elsewhere may use less oil per person, but because they have jobs, they are able to purchase new scooters and other goods they want. Their employers also use oil to make and ship goods, keeping their demand high.

In the US, EU, and Japan, we continue to lose jobs to automation and to outsourcing to low wages countries. As a result, wages are stagnating, and young people are having a hard time getting jobs, making oil less affordable. If only there were more high-paying jobs.  .  . Of course, in a globalized world using coal as a primary fuel, the goods we would make would be too expensive for the world market.

Related financial limits we are hitting

Oil importers around the world are disguising the effect high oil prices are having on economies, through low interest rates and continually rising debt. In doing this, oil importers are able to keep the price of oil that they can afford high. In other words, using these techniques, oil importers are able to keep the blue “affordable by importers” line high in Figure 1.

At some point, there is a limit to how much the adverse impact can be disguised. The following are several areas where limits are now being reached, that will tend to bring down the “affordable to importers” line in Figure 1.

1. Limits on the amount of governmental debt. In the US, the need to raise the federal deficit cap will come up again as soon and October. There will be pressure to try to reduce spending, to reign in the federal deficit. If the economy were growing faster, the debt limit would be less of an issue. But with continued high oil prices, growth is slowed. Debt limits can be expected to continue to be an issue.

2. Slowing growth, and related debt limits, in developing countries. High oil prices affect importers or all kinds, even developing countries that use less oil as a percentage of their total energy consumption. The slowing growth also makes debt harder to manage. News sources are talking about slowing economic growth in China, India, and Brazil.

A recent WSJ article about China is titled, Debt Drags on China’s Growth. According to the article, interest and principle payments on business and household debt currently absorb around a third of China’s GDP. Some debt is being taken on, just to allow interest on past debt to be paid. These high debt levels may cramp future growth in China.

3. Rising longer-term interest rates, because of scaling back or ending quantitative easing. As noted above, low-interest rates are helping to cover up our current issues of inadequate good-paying jobs and inadequate government revenue. If interest rates rise, the government will need to pay more interest on its own debt, leading to a needed tax increase.

Figure 7. Ten year interest rates based on data of the Board of Governors of the Federal Reserve System.

Figure 7. Ten year interest rates based on data of the Board of Governors of the Federal Reserve System.

Another effect of rising interest rates is that the market value of bonds outstanding will fall. This happens because the price of bonds is adjusted so the new owner will get the current (higher) yield to maturity, instead of the original low yield to maturity. Owners of bonds, such as the Chinese and Japanese, are aware of this, and have started selling their treasuries, before prices fall further. (See Reuters: China, Japan lead record outflow from Treasuries in June.) This type of sale of treasuries tends to raise the yield on treasuries, even before the Federal Reserves actually cuts back its monthly purchase of securities under quantitative easing.

If interest rates on 10-year treasuries rise, mortgage interest rates will rise, cutting back on the number of families who qualify for loans for new or resale homes. Last week there were articles saying, “New home sales plunge 13.4%,” presumably from the amount by which interest rates have risen already. If interest rates rise enough, there may also be a decrease in the value of resale homes, because there will be fewer buyers who can afford  move-up homes, lowering demand for homes.

4. Popping of asset bubbles, as a result of rising interest rates. At least part of the rising value of assets of many types (stocks, homes, farms, oil and gas leases) is likely  to related to the very low-interest rates recently experienced. Bubbles tend to occur, because with  debt earning very low-interest rates, borrowers are anxious to earn higher rates of return, however they can. Investors bid up prices using money borrowed at low-interest rates, in hope of making capital gains later. Of course, if interest rates rise, all of this may “turn around”.

One piece of evidence regarding the effect of rising interest rates on stock market prices, versus falling interest rates, for the period graphed in Figure 7, is the following: During the period 1957 between to 1981, when interest rates were rising, the S&P 500 rose by less than inflation. In contrast, during the period 1981 to 2013 when interest rates were falling, the S&P 500 stock market index averaged a gain of about 5% per year, over and above the inflation rate. The difference is in the direction a person would expect, and is quite large.

The Outlook 

As we reach financial limits of many  kinds, further recession, possibly quite severe, seems likely. Some of the limits are ones we have not encountered before, particularly the one with oil prices being too low for exporters, but too high for importers. This makes the situation particularly frightening. At some point, the clash between the price oil importers can afford and the amount oil exporters need could cause oil production to drop dramatically, over only a few years. Such a drop in oil production would likely have a very adverse impact on economic growth.

If oil limits indeed reduce economic growth, this makes models based on the assumption that the future will look like the past invalid. Instead, we need to expect a very changed world. At some point, we may even reach permanent contraction, as oil limits change the nature of the world economy.

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 inadequate supply.
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321 Responses to Oil Prices Lead to Hard Financial Limits

  1. Robert Goldschmidt says:

    Gail,

    I have been looking at the sources of our economic malaise for some time and have concluded that energy is an important but not the dominant factor — although it may very well become so by the end of the decade. What I have found is that rapidly evolving technology which replaces workers together with singular corporate focus on raising short-term earnings is most significant. For the past four decades, line worker wages have flattened while all the productivity gains have been converted into increased corporate earnings and executive remuneration.

    How do you support the growth of an economy where wage-based purchasing power can no longer keep up with increased productivity? With rapidly increasing personal and federal debt. This in turn has grown our financial institutions into the behemoths that throw their weight around Washington these days. Since 1972, payrolls have fallen from 52% to 44% of GDP. This represents $1.2 trillion a year loss in purchasing power or an average of over $10,000 per year for
    each full time worker.

    It has become clear to me that federal intervention will be required to once again “… promote the general Welfare”.

    Your blog provides an invaluable service in understanding the important ramifications of our energy dilemma. However, I believe that we also need to address the growing wage gap problem. Each of us looks at the facts through the lense of our belief system. I hope that I have added some balance.

    • xabier says:

      Much sense in that. The effects of ever-advancing automation and the tilting of most advanced economies towards very low-pay, low-security jobs for the masses is a central issue: to be fair, Gail has always mentioned this among the factors contributing to the financial crisis, but it is certainly not addressed very often, and not at all by politicians (in much the same way that energy is absent from most political and economics discussions.

  2. Don Stewart says:

    Dear Gail and Others
    I have suggested that a kitchen garden for high nutrient but low calorie foods such as vegetables should be high on one’s list of elements for surviving Collapse. With luck, farms will continue to provide us with low nutrient, high calorie, and mostly easily stored and shipped foods. Small animals such as rabbits and chickens can also fit into many home gardens.

    Any novice who starts to garden is likely to run into problems. It simply takes time to understand the ecology of a garden and then get that ecology established. So why do I insist on gardening as a central strategy? I’ve talked about various aspects of gardening, but today George Mateljan (The World’s Healthiest Foods) gives us a good essay on the central importance of non-starchy vegetables. Non-starchy vegetables are some of the most expensive things you can buy in a grocery store (per pound), are usually quite perishable, and lose their nutrients rapidly once they are harvested. In short, perfect candidates for the garden.

    Don Stewart

    Why Vegetables Should Play Center Stage
    More than 60% of Americans are overweight. The amount of money spent on weight loss continues to soar, but is having little effect in curbing excess weight’s contributions to poor health. To restore vibrant health and lose excess weight, my suggestion is, “Eat more vegetables!”

    “Eat your vegetables” is probably the most famous advice in all of nutrition – but we seldom stop to think about what makes vegetables so special or why we need so many each day.

    Since everything we do requires nutrients, the more nutrients we can get for the least amount of calories bodes well for our good health and potential for healthy weight loss. Whether we are awake or asleep, exercising or sitting still, we are staying alive with the help of the nutrients required for our cells’ metabolism. Although some nutrients can be stored in our cells and tissues to a limited degree, most micronutrients cannot be stored. Unless we obtain them daily from our food, we simply don’t have them! The variety of nutrients we need for optimal nourishment is somewhat staggering: we must have numerous vitamins and minerals, plus proteins, carbohydrates and essential fats, and literally hundreds of phytonutrients (including carotenoids like the lycopene found in tomatoes, and flavonoids, like quercitin in onions or genistein in soybeans) to stay optimally healthy.

    Vegetables provide us with an unprecedented array of nutrients. As startling as it might sound, no essential nutrient is missing from vegetables as a group! Proteins, fiber-rich, low glycemic load carbohydrates, essential fats, vitamins, minerals – all are plentiful in the world of vegetables. And so are phytonutrients, health-supporting compounds found only in plant foods. Researchers estimate that at least 10,000 phytonutrients in vegetables will someday be cataloged and understood. Dozens of health-supportive phytonutrients – featuring antioxidant, anti-inflammatory, and other properties – have already been identified in all commonly eaten vegetables. Sometimes these one-of-a-kind nutrients have even been named after the vegetables themselves; spinasaponins in spinach and celerin in celery are great examples.

    The list of nutrients packed inside vegetables includes antioxidants like vitamin C and beta-carotene, which play such a key role in immune support and in protection of cells and blood vessels. Also included in concentrated amounts are B-complex vitamins like vitamin B6, biotin and folate. These B-complex vitamins are essential for energy production, proper formation of red blood cells, and healthy nervous system function. Amply supplied by the green leafy vegetables are minerals like calcium, magnesium and potassium, which are essential for healthy blood pressure and strong bones. And alongside of these vitamins and minerals are abundant amounts of fiber, which helps regulate digestion, stabilize blood sugars, and facilitate weight management. Because many of the above nutrients are not stored in the body in appreciable amounts, and because vegetables aid in the very process of digestion, foods in this remarkable group need to be consumed in generous amounts on a daily basis.

    You actually have to hunt in order to find nutrients that are very difficult to obtain in ample amounts from vegetables. Vegetables even supply the omega-3 fat called alpha linolenic acid, but the omega-3 fatty acids, EPA and DHA, and certain amino acids are better supplied by other types of foods. For overall nourishment though, you can’t beat vegetables.

    And as for weight loss, vegetables as a group, with the exceptions of starchy vegetables such as potatoes and corn, are the foods that are not only among the most nutrient-rich, but are also the lowest in calories.

  3. xabier says:

    Jody and don

    On Wives, Husbands and Questions: a chap I know passed by as his wife was typing an email: ‘Who are you writing to?’ As he glanced at the screen (very ill-advised to do so) the words ‘ totally useless idiot’ happened to catch his eye. So he looked closer: she was describing him to a friend! Even worse, it’s true, he’s a hopeless case……..

  4. xabier says:

    Jody

    I agree that Europe is not where one would ideally choose to be: mined-out, depleted soils, simmering racial and religious tensions due to mass immigration without consent of the older settled populations over the last decade, fragile woodland (or simply not enough for greatly expanded populations created by the oil boom), mass unemployment, and importing nearly all oil and gas from not particularly friendly regions.

    Against that one can set having to negotiate smaller distances than in, say, the US or Australia, pedestrian-friendly towns and cities, and the public transport infrastructure (but it’s generally expensive). However, what one saves in oil use, one loses in the high cost of everything. Formerly cheap countries like Spain are cheap no longer. My Polish friends envisage no problem with finding land with plenty of wood and water, but oil and gas remain a problem for them: without Russia, they freeze.

    Still, it looks better than the Middle East, for now.

  5. Robert,

    You bring up some interesting points. Unless we have good paying jobs, we lose purchasing power. Technology experts were touting the great improvement in productivity from replacing assembly line workers with robots. But robots don’t buy much goods and services or pay taxes. Yes, they do require energy, parts, and a few highly trained technicians to maintain and operate them, but I wonder how this affects our economy compared to the workers (and their families) the robot replaced.

    There is talk in Washington and elsewhere about our need to create better paying jobs for Americans. How do we do this when companies like Apple believe “Made in the U.S.A.” is no longer a viable option for most Apple products. http://www.nytimes.com/2012/01/22/business/apple-america-and-a-squeezed-middle-class.html?pagewanted=all&_r=0

    As our population becomes poorer we are no longer a viable consumer market. We have already lost most of our manufacturing business. Much of the merchandise we import is cheaply made crap! How can we create jobs if business can find consumers? As the financial sector and corporate executives take larger and larger shares of shrinking profits, they are hollowing out wager earners as well as our business sector. I compare it to the game of Monopoly. When one person has all the money the game is over.

    As our economy went through the period we call the Great Recession, workers lost jobs and benefits. As the Great Recession passed, low and middle income earners have not made up the lost ground. Employers are eliminating full time positions and creating temporary ones in order to avoid paying benefits. Even as the unemployment numbers are declining, a significant number of the jobs being created aren’t’ as good as the ones that were lost. And if we look at the details of the unemployment figures reported by the Bureau of Labor Statistics http://www.bls.gov/news.release/pdf/empsit.pdf, we see numbers that are more worrisome than rosy picture of the downward trend in “unemployment”. It all depends on how the government defines and counts people out of work.

    There were 169,000 non-farm jobs created in August (for some reason farm workers aren’t counted in employment statistics). The official unemployment number was 11.3 million people, of which 4.3 million have been unemployed for more than 6 months (38%)–problem #1. In addition, there were 2.3 million “marginally attached” people who are out of work but hadn’t actively searched for work in August (government doesn’t count you as unemployed if you aren’t looking for work).–problem #2. Of this group 866,000 were categorized as “discouraged” workers, people who have given up searching for work because they no longer believe they can find a job. If we actually counted all the people out of work our unemployment rate is closer to 8.—problem #3.

    In addition to the unemployed, marginally attached, or discouraged workers there were 7.9 million people employed part time but wanting full time work (called involuntary part-time workers). This means we have another 5% who probably need but can’t find full time work, or are working 2 part-time jobs, which doesn’t qualify as full time work!—problem #4.

    The official unemployment rate of 7.3% doesn’t tell us the disparity between groups based on age, ethnicity, gender, or education level. Economists talk about the “lost generation” the young people that can’t find work after college and miss a valuable time to start their career. But there is also the large number of teenagers that don’t finish high school or if they do, go on to college. For example, if we look at the data in Table A2, teenagers (anyone ages 16 to 19) unemployed Caucasian/White is 20.5%, African American/Black 38.2%, and Hispanic 28.4%. Overall the Asian unemployment rate is only 5.1%.

    How are these young people going to start a family, buy a house, afford health insurance, pay taxes? Most end up still living at home past the age of 25, or become criminals and are incarcerated, at which time they are no longer counted in the statistics for unemployment.

    I don’t see any way to reverse this trend, or any possibility that our government could agree to do anything to reverse it.

    You said that “since 1972, payrolls have fallen from 52% to 44% of GDP”. That is interesting when one realizes that consumer spending in 2011 was 72% of GDP. Does this mean that consumers are buying 28% of their purchases with credit? I suppose home mortgages could make up a large portion of this since houses are too expensive for most people to buy without a mortgage. Lots to think about. Few answers.

    regards,

    Jody

    • Scott says:

      Jody, One last comment on this thread since Gail put out an interesting new article which I am about to study…. But just wanted to mention buying a home without a mortgage was one of the hardest we ever did and only after working 30 years, It should be a goal for all but a tough one for sure. So easy to get trapped in the credit world in the west especially a few years back when they were handing out money on credit like candy and it has happened to me when I was younger too. So a worthwhile goal to pay off one’s main home. After that just watch out for the taxman…

      Scott

      • Scott,
        Yes, I see Gail has a new post that I am interested in reading. I wanted to comment about buying a home without a mortgage. If I was old enough to withdraw from my retirement accounts without a penalty I would do so. I think what you’ve done was very sensible.

        My husband and I have never had enough money saved up to buy a home without a mortgage, but we saved enough money to make a very good down payment (35% on our first home and 20% on our second). This meant that we didn’t have to have mortgage insurance, a fee that banks charge when you don’t have a down payment. We also borrowed less than what the banks said we could qualify for. I found that the “maximum” one qualifies usually means payments will stretch you so far you can’t afford to make extra principle payments.

        We pay extra principle each month, which significantly reduces the life of the mortgage. Our first home had a 30 year mortgage but we paid it off in 7 years. Our second home had a 15 year mortgage and after 9 years we refinanced, and took out some of the principle to pay for the solar PV system and geothermal systems. Our new mortgage is 10 years, but we expect to have it paid off in 7 years. Because of our investment in renewable we have only a $10/month electric bill (the base one has to pay just to be hooked up to the grid), phone, and DSL. We don’t subscribe to cable t.v. We no longer have propane because we heat with geothermal, run by solar P.V. I recycle 95% of our household waste and what little garbage we need to dispose of I take to the transfer station where I pay $1.50 per bag. We generally dispose of 6 bags a year. Water is from our well. Sewage is septic tank.

        My husband and I have a similar approach to finances, which makes for a happy marriage! We have always saved money, paid off credit cards each month, researched our purchases so that we get the best quality for the money we spend, and kept our wants reasonable (i.e. be frugal). Living this way has allowed us to make many good investments in our home and personal property, giving us a very comfortable lifestyle. We started transitioning towards energy conservation, renewable energy, and home food production about 10 years ago. But we still live a modern lifestyle and enjoy many of the benefits of our current economic system.

        Regards,
        Jody

        • Scott says:

          Hello Jody, All of those things that you are doing they do cost money and you made an investment and it will be paid in less that ten years which is great. I think many of us are a bit uncertain to make investments on a new solar panel or large power systems although we desire them and this is because of the uncertainty in the world.

          You have made your stand and sounds like a wise investment. We do have a rental home that needed a roof this summer and that place still has a loan on it for seven years, but our main home is paid off so in hard times we may have to let that rental just go or do something with it.

          If we cannot invest in a solar PV system we can at least get a few small panels, some batteries and AC/DC converters to run a few things in our homes.

          I kind of think of collapse like camping, those items would be needed as if you were camping and perhaps those in home with a wood stove with a pot of soup may fair a bit better. So I have kind of stocked up on some camping stuff including old fashioned Oil Lamps and oil and cooking gas and of course lots of firewood which is easy to get here in Oregon.

          Depending on where you are you should prepare accordingly, but we had to move to feel safer from the city to the small mountain town we now live in. But I had to wait years until I could retire just as most people are locked into their jobs and it is tough to move to a better area.

          Scott

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