Oil Limits and the Economy: One Story, Not Two

The two big stories of our day are

(1) Our economic problems: The inability of economies to grow as rapidly as they would like, add as many jobs as they would like, and raise the standards of living of citizens as much as they would like. Associated with this slow economic growth is a continued need for ultra-low interest rates to keep economies of the developed world from slipping back into recession.

(2) Our oil related-problems: One part of the story relates to too little, so-called “peak oil,” and the need for substitutes for oil. Another part of the story relates to too much carbon released by burning fossil fuels, including oil, leading to climate change.

While the press treats these issues as separate stories, they are in fact very closely connected, related to the fact that we are reaching limits in many different directions simultaneously. The economy is the coordinating system that ties together all available resources, as well as the users of these resources. It does this almost magically, by figuring out what prices are needed to keep the system in balance—how much materials of which types are needed, given what consumers can afford to pay.

The catch is that the economic system is not infinitely flexible. It needs to grow, to have enough funds to (sort of) pay back debt with interest and to make good on all the promises that have been made, such as Social Security.

Energy use is very closely tied to economic growth. When energy consumption becomes slow-growing (or high-priced—which  is closely tied to slow-growing), it pulls back on economic growth. Job growth becomes more difficult, and governments find it difficult to get enough funding through tax revenue. This is the situation we have been experiencing for the last several years.

We might think that governments would be aware of these issues and would alert their populations to them.  But governments either don’t understand these issues, or only partially understand them and are frightened by the prospect of what is happening. The purpose of my writing is to try to explain what is happening in terms that people who are used to reading the Wall Street Journal or Financial Times can understand.

I am not an economist, so I can’t speak to the question of what economists are saying. I do know that what economists say tends to change from time to time and from researcher to researcher. For example, in 2004, the International Energy Agency prepared an analysis with the collaboration of the OECD Economics Department and with the assistance of the International Monetary Fund Research Department (Full Report, Summary only). That report said, “.  . . a sustained $10 per barrel increase in oil prices from $25 to $35 would result in the OECD as a whole losing 0.4% of GDP in the first and second year of higher prices. Inflation would rise by half a percentage point and unemployment would also increase.” This finding is consistent with the issues I am concerned about, but I expect that not all economists would agree with it. Oil prices are now around $100 per barrel, not $35 per barrel.

The Tie of Oil and Other Forms of Energy to the Economy

Oil and other forms of energy are used to power the economy. Historically, rises and falls in the use of oil and other types of energy have tended to parallel GDP growth (Figure 1).

Figure 1. Growth in world GDP, compared to growth in world of oil consumption and energy consumption, based on 3 year averages. Data from BP 2013 Statistical Review of World Energy and USDA compilation of World Real GDP.

Figure 1. Growth in world GDP, compared to growth in world of oil consumption and energy consumption, based on 3 year averages. Data from BP 2013 Statistical Review of World Energy and USDA compilation of World Real GDP.

There is disagreement as to which is cause and which is effect—does GDP growth lead to more oil and energy demand, or does the availability of cheap oil and other types of energy power the economy? In my view, the causality goes both ways. Oil and other types of energy are needed for economic growth. But if people cannot afford oil or other types of energy products, typically because they don’t have jobs, then energy use will drop. And if oil prices drop too low, we will be in real trouble because oil production will stop.

How Oil Limits Work

People tend to think of limits as working in the same manner as having a box with a dozen eggs. Once the last egg is gone, we are out of luck. Or a creek dries up from lack of rainfall. The water is no longer available, so we have lost our water source.

With the benefit of the economy, though, limits are more complicated than this. If we live in today’s economy, we can purchase another box of eggs if we run short of eggs, assuming markets provide eggs at a price we can afford. If the creek runs dry, we can figure out a different approach to getting water, such as buying bottled water or hiring a tanker to get water from a source at a distance and bringing it to where it is needed.

Oil limits are a kind of limit we often hear concerns about. Being able to drill oil wells at all and refine the oil into products of many kinds requires a complex economy, one that can educate engineers working in oil extraction and can build paved roads, pipelines, and refineries. The economy needs to be able to produce high tech equipment using raw materials from around the world. Thus, there must be an operating financial system that allows buyers at one end of the globe to purchase materials from the other end of the globe, and sellers to have the confidence that they will be paid for contracted products.

If a company wants to extract oil, it can almost always figure out places where this theoretically can be done. If a company can gather together all of the things it needs—trained workers; enough high tech extraction equipment of the right type; enough pollution-fighting equipment, to prevent oil spills and spills of radioactive water; and leases on land where drilling is to done, then, in theory, oil can be extracted.

In fact, the big issue is whether the extraction can be done in a sufficiently cost-effective manner that the whole economic system can be supported. Even if the cost of extraction “looks” fairly cheap, such as in Iraq, or in some of the older installations elsewhere in the Middle East, the vast majority of the revenue that is generated from oil extraction (often as much as 90%) goes to support the government of the country where the oil is extracted (Rogers, 2014). This revenue is needed for many purposes: desalination plants to provide water for the people; food subsidies, especially when oil prices are high because food prices will tend to be high as well; new ports and other infrastructure; and revenue to provide jobs and programs to pacify the people so that the government will not be overtaken by revolt.

A major issue at this point is the fact that most of the easy-to-extract oil is already under development, so companies that want to develop new projects need to move on to locations that are more difficult and expensive to extract (Bloomberg, 2007). According to oil industry consultant Steven Kopits, the cost of one major category of oil production expenses increased by an average of 10.9% per year between 1999 and 2013. In the period between 1985 and 1999, these same expenses increased by 0.9% per year (Kopits, 2014) (Tverberg, 2014).

When production costs are higher, someone loses out. It is as if the economy is becoming less and less efficient. It takes more people, more energy products, and more equipment to produce the same amount of oil. This leaves fewer people and less energy products to produce the goods and services that people really want, putting a squeeze on the economy. The economy tends to grow less quickly because part of the goods and services available are being channeled into less productive operations.

The situation of the economy becoming less and less efficient at producing oil is called diminishing returns. A similar problem exists with fresh water in many parts of the world. We can extract more fresh water, but it takes deeper wells. Or we have to ship in water from a distance, using a pipeline or trucks. Or we need to use desalination. Water is still available but at a higher per-gallon price.

Diminishing Returns is Like a Treadmill that Runs Faster and Faster

There are many ways we can reach diminishing returns. One easy-to-illustrate example relates to mining metals. We usually extract the cheapest-to-extract ores first. An important cost consideration is how much waste material is mixed in with the metal we really want–this determines the ore “grade.” As we are gradually forced to move from high-grade ores to lower-grade ores, the amount of waste material grows slowly at first, then dramatically increases (Figure 2).

Figure 2. Waste product to produce 100 units of metal

Figure 2. Waste product to produce 100 units of metal

We know that this kind of effect is happening right now. For example, the SRSrocco Report indicates that between 2005 and 2012, diesel consumption per ounce of refined gold has doubled from 12.7 gallons per ounce to 25.8 gallons per ounce, based on the indications of the top five companies. Such a pattern suggests that if we want to extract more gold, the price of gold will need to rise.

The economy is affected by all of the types of diminishing returns that are taking place (oil, fresh water, several kinds of metals, and others). Even attempting to substitute “renewables” for nuclear and fossil fuels electricity production acts as a type of diminishing returns, if such substitution raises the cost of electricity production, as it seems to in Germany and Spain.

If the total extent of diminishing returns is not very great, increased efficiency and substitution can act as workarounds. But if the combined effect becomes too great, diminishing returns acts as a drag on the economy.

Oil Increases are Already Higher than the Economy Can Comfortably Absorb

For oil, we can estimate the historical impact of increased efficiency and substitution by looking at the historical relationship between growth in GDP and growth in oil consumption. Based on the worldwide data underlying Figure 1, this has averaged 2.0% to 2.4% per year since 1970, depending on the period studied. Occasional years have exceeded 3%.

The problem in recent years is that increases in the cost of oil production have been much higher than 2% to 3%. As mentioned previously, a major portion of oil extraction costs seem to be increasing at 10.9% per year. To make this comparable to inflation adjusted GDP increases, the 10.9% increase needs to be adjusted (1) to take out the portion related to “overall inflation” and (2) to adjust for likely lower inflation on the portion of oil production costs not included in Kopits’ calculation. Even if this is done, total oil extraction costs are probably still increasing by about 5% or 6% per year—higher than we have historically been able to make up.

According to Kopits, we are already reaching a point where oil limits are constraining OECD GDP growth by 1% to 2% per year (Kopits, 2014) (Tverberg, 2014). Efficiency gains aren’t happening fast enough to allow GDP to grow at the desired rate.

A major concern is that the treadmill of rising costs will speed up further in the future. If it is hard to keep up now, it will be even harder in the future. Also, the economy “adds together” the adverse effects of diminishing returns from many different sources—-higher electricity cost of production, higher metal cost of production, and the higher cost of oil production. The economy has to increasingly struggle because wages don’t rise to handle all of these increased costs.

As one might guess, when economies hit diminishing returns on resources that are important to the economy, the results aren’t very good. According to Joseph Tainter (1990), many of these economies have collapsed.

Why Haven’t Governments Told Us About these Difficulties?

The story outlined above is not an easy story to understand. It is possible that governments don’t fully understand today’s problems. It is easy to focus on one part of the story such as, “Shale oil extraction is rising in response to higher oil prices,” and miss the important rest of the story—the economy cannot really withstand high oil (and water and electricity and metals) prices. The economy tends to contract in response to a need to use so many resources in increasingly unproductive ways. We associate this contraction with recession.

We have many researchers looking at these issues. Unfortunately, most of these researchers are focused on one small portion of the story. Without understanding the full picture, it is easy to draw invalid conclusions. For example, it is easy to get the idea that we have more time for substitution than we really have. Financial systems are fragile. The world financial system almost failed in 2008, after oil prices spiked. We are still in very worrisome territory, with many countries continuing a policy of Quantitative Easing and ultra low interest rates. We may have only a few months or a year or two left for substitution, not 40 or 50 years, as some seem to assume.

Of course, if governments do understand the worrisome nature of our current situation, they may not want to say anything. It could make the situation worse, if citizens start a “run on the banks.”

The other side of the issue is that if governments and citizens don’t understand the full story, they may inadvertently do things that will make the situation worse. They certainly won’t be looking long and hard at what collapse might look like in the current context and what can be done to mitigate its impacts.

489 thoughts on “Oil Limits and the Economy: One Story, Not Two

  1. Dear Gail and All

    Yesterday I noted the publication of the book The Soil Will Save Us. It may be useful to put some of the numbers into perspective. I have previously noted that photosynthesis provides roughly 10 times the energy supplied by fossil fuels (from Lenton and Watson). The following numbers are from Tyler Volk’s books Gaia’s Body and CO2 Rising..

    Pg 109 Gaia’s Body “This mutual influence between soil and life has prompted the Dutch soil scientist N. van Breemen to call soil a ‘biotic construct favoring net primary productivity’ ”

    Pg 79 CO2 Rising:

    Carbon emissions from fossil fuel burning, per year, circa 2008 is 8 billion metric tons per year.
    Photosynthesis uptake of carbon is 60 billion tons per year
    Land use changes are estimated to release 1.5 billion tons per year (with considerable uncertainty) e.g., plowing and deforestation

    Pools of carbon in billions of metric tons:
    Atmosphere 800
    Land Plants 600
    Ocean Life 2
    Ocean Surface 800
    Deep Ocean 25,000
    Soil 2,000

    Pg 122 and preceding, Gaia’s body
    ‘Computing over a depth of just ten centimeters (where most of the action of life occurs) and for a moment neglecting the clay, I derive a surface area index equiavlent to 2000 Earth areas. Adding the bacteria-sized clay particles boosts this number to 11,000 Earth areas. To calculate a full meter of depth, multiply these numbers by 10.’

    My note: the significance of surface area traces back to the fact that surfaces are where exchanges and thus life happen. For example, a leaf exchanges carbon dioxide and oxygen. Root hairs are where the action is in the soil. The point is that Life creates enormous surface areas which have profound influences on the cycles of Nature. For all of you cursing the clay in your lawn, keep in mind that clay particles are also biologically active in ways that sand grains are not.

    Those who look at biological farming and gardening as our potential saviors look at the enormous fluxes and the size of the reservoirs and the enormous power of the biologically active surface areas and ruminate about the ways we might nudge Nature in ways that benefit humans.

    Don Stewart

    • Don

      Alas, the power in Nature is not that which gives our ‘leaders’ and masters their kicks in life.

      • Dear Xabier
        Many years ago I heard the novelist Larry McMurtry talk. McMurtry was born in Texas, and wrote a lot of stories about the frontier. Texas was an independent country from 1835 to 1845. It needed a capitol building, but had no money. So it got some Scottish investors to agree to build a capitol building, and in return gave them millions of acres of land which was overrun with Comanches, at the time. After the Civil War, the US Cavalry either killed the Comanches or drove them to Oklahoma. So western Texas became the land of gigantic ranches on vast grasslands. For about 10 years, there were no fences. It was called ‘open range’ and cows were branded with the insignia of a specific ranch. Then, the ranchers figured out that perhaps they could make more money with fences.

        McMurtry said that the ranchers realized pretty quickly that they had destroyed ‘Eden’, but they could not figure out a way to go back, once they had done the dirty deed. I believe that greed is still classified as a deadly sin, but few people want to think about that anymore.

        When I contemplate the enormous fluxes of energy and materials that Nature provided for the early humans, and see how humans managed to turn that into slave labor in coal mines and textile mills and now into fraudulent banking maneuvers, it always reminds me of McMurtry’s comments. Even a little bit of reflection would lead one to the conclusion that we went very wrong. But we can’t figure out how to get back to Eden.

        On a more optimistic note, I think it is interesting to see how small changes in the fluxes could help us immensely with some of our problems.

        Don Stewart

  2. Pingback: The People I Turn To Re: Energy Issues by Richard Ha | Ahualoa Community Association

  3. Could it be that predictions of future shale gas and tight oil production by the Energy Information Administration (EIA) may diverge significantly from actual production?

    I wrote a paper awhile back illustrating their poor prediction for North Sea oil production from the late 1990s (see http://www.resilience.org/stories/2011-04-19/look-back-north-sea-oil-production-projections). I’ve also shown that their predictions for the Gulf of Mexico and Mexican oil production were also not very good (http://www.resilience.org/stories/2012-02-17/how-reliable-are-us-department-energy-oil-production-forecasts and http://peak-oil.org/2010/01/mexican-oil-production-continues-to-dive/). Unfortunately, nobody in the media looks back at EIA oil production predictions.

    In terms of tight oil production in the U.S., it appears to me that the EIA prediction may diverge significantly from actual production rates in the future. Most of the oil production increase in the U.S. since 2010 has come from Bakken and Eagle Ford shale formations. In 2011 I predicted that Bakken would peak in 2014 +/- 1 year. Recently international petroleum geologist Jean Laherrere predicted Bakken would peak in the fall of 2014. Also, David Hughes, who has done an extensive analysis of Bakken, has revised his predicted peak to 2015.

    There is increasing evidence that a Bakken peak will be coming soon. It’s important to note that about 90% of Bakken oil production in North Dakota comes from 4 counties: Mountrail, McKenzie, Williams and Dunn. The reason for that is because that is where the oil is. Initial production rates in Bakken counties outside of the top four counties drops off significantly which I recently showed (see http://peak-oil.org/2013/11/analysis-of-well-completion-data-for-north-dakotas-bakken-formation/).

    The general assumption concerning Bakken and Eagle Ford is that if the number of new wells continues to increase, production will increase until the play is totally saturated with wells. My argument is that as the fruitful area gets saturated with wells, I expect production to decline because wells outside of the core area will not be as productive. Based upon my calculations and assuming 500 acres/well, the core area will be pretty well saturated with wells by the end of this year.

    Compounding the problem of less productive wells in the future is the fact that tight oil wells decline rapidly (see http://peak-oil.org/2013/11/analysis-of-well-completion-data-for-north-dakotas-bakken-formation/). There are more and more wells that are in decline so an increasing number of new productive wells have to be added to negate the declining wells. If the new wells decline in initial production, that just means more wells have to be brought on-line more rapidly. At some point, the new wells can’t keep up.

    Based upon data in the Bakken Weekly, 964 wells were completed from the week of Jan. 1 through the week of March 17 of this year and the sum of the initial productions was 588,539 b/d. That compares to 586 wells and 465,877 b/d for the same period in 2013. The ratio of 2014/2013 wells is 1.65 and the ratio of 2014/2013 initial production is 1.26. That indicates that initial production/well is declining. For the month of March, the ratio of 2014/2013 wells was 1.69 and the ratio of initial production was 0.86.

    There have been several media articles recently stating that oil companies are losing money on tight oil projects and that oil companies are starting to cut back. If that indeed happens, that would make it even more likely that tight oil production will decline in the near future.

    Recently I read an article which stated that wildcatters were leaving the Bakken region and going to east Texas to look for oil. If there were a lot of fruitful areas to drill in the Bakken region, why would wildcatters want to leave North Dakota?

    What I’ve stated about Bakken applies to Eagle Ford as well. Production ramped up a little later in Eagle Ford but the intensity of the drilling activity has been higher than in the Bakken region so I expect a peak there in 2014/2015. It won’t be long before we find out if that is correct.
    The oil industry has drilled wells in the best shale plays as fast as humanly possible and production ramped up rapidly. The down side of that is that production can also decline rapidly after the peak. Jean Laherrere projects that Bakken production will decline ~80% by 2020 from its peak. David Hughes projects that Bakken production will be essentially zero by 2035, 21 years from now.

    • You are quite right–EIA estimates are likely high. They have a definite high bias. We are likely not far away from peak in the Bakken and Eagle Ford, for several different reasons–poorer well productivity, financial difficulties, can’t keep borrowing because banks won’t lend more.

  4. Oil markets certainly have a large correlation with economic growth and performance, and analysis of the correlation between the past 11 recessions and oil prices supports that claim. I think the idea that we are running out of oil is exaggerated, but I do think we have peaked in cheap oil. As we continue to develop more expensive ways of extraction, oil prices will increase. Oil price increases will increase the incentives of oil producers to continue to find new ways to get oil and we get a continuous cycle. The instability of oil markets is dangerous to any economy, especially economies that are on the edge of growth/recession. Developing more secure supplies is crucial, whether it be from more reliable producers of oil or domestic production. Decreasing our risk by reducing our dependence on volatile markets while developing alternate strategies to replace is oil is a good place to start.

    • Actually that is not the case – Exxon and Chevron last month announced capex reductions because they cannot make money even with oil at $100 or so.

      And the consumer is unable to deal with $100 — so the economy cannot tolerate even higher prices.

      4 articles for reference:

      Why peak oil signals the world’s end, or at least the one we know – Author Steen Jakobsen, Chief Economist & CIO, Saxo Bank

      This is old story and, as the world still goes around, one could dismiss all this analysis. However, what is new is that business conditions are becoming more challenging for the oil majors as figure 7 suggests.

      Indeed since 2009, the capital expenditures of ExxonMobil, Royal Dutch Shell and Chevron have increased by 39-89 percent while their production has stalled. This is the balance-sheet-based proof that the peak-oil is happening now.

      Indeed, according to Kopits, total upstream industry spendind since 2005 has been USD 4 trillion (about USD 2.5 trillion spent on legacy crude oil production), and legacy oil production has declined by 1 mmb/d since 2005. By comparison, between 1998 and 2005 the industry spent USD 1.5 trillion on upstream development and added 8.6 mmb/d to total crude production.

      This declining energy return in energy production, which is nothing but the by-product of declining/exhausting oil reserves and the very fact we are experiencing the peak-oil, drives the whole economy down.

      So how all this relates to the “secular stagnation” scenario and all the fall in total factor productivity. Well, this is where things get a little bit technical and where our tale comes (finally!) to an end:


      ExxonMobil, like Chevron and Royal Dutch Shell, will cut spending in 2014 after spending heavily over the past few years. That will make it tough to reverse last year’s decline in production.

      Oil and gas behemoth ExxonMobil (NYSE: XOM) upset the market on March 5 when it told analysts it would cut spending this year. The news was not well-received, and the company’s shares fell hard on the day of the announcement. ExxonMobil is tightening its belt this year, and there are clear worries that there’s a lack of suitable investment opportunities out there for the taking.

      Reduced capital expenditures is a recurring theme going on right now across the oil and gas industry. Other global super-majors including Chevron (NYSE: CVX) and Royal Dutch Shell (NYSE: RDS-B) are adopting similar strategies this year, so it’s not as if this is an ExxonMobil-specific issue.


      THE DECLINE OF THE WORLD’S MAJOR OIL FIELDS: Aging giant fields produce more than half of global oil supply and are already declining as group, Cobb writes. Research suggests that their annual production decline rates are likely to accelerate. http://www.csmonitor.com/Environment/Energy-Voices/2013/0412/The-decline-of-the-world-s-major-oil-fields

      The Saudis have also made public plans to start injecting carbon dioxide into the world’s largest oil field, Ghawar, no later than 2013. CO2 injection is what you do when an oil field starts yielding progressively less oil. It gooses the output…for a little while) http://www.forbes.com/sites/greatspeculations/2011/03/04/the-truth-behind-saudi-arabias-spare-capacity/

    • The issue is that wages do not rise, even as the cost of oil extraction rises. If oil prices rise too much, we end up in recession. If oil prices don’t rise enough, drillers quite and go home. We are very close to this problem. We need cheap energy sources that can use the same devices we have today, so we don’t have the cost of building new cars/trucks/airplanes/farm equipment/building equipment. We really don’t have many alternate strategies to choose from. They are all more expensive than we can afford.

  5. Interesting graph: http://upload.wikimedia.org/wikipedia/en/7/7c/Ultimatereserveoilprojections.gif
    It shows (assuming a 2% growth rate in oil consumption) that even if one assumes there is twice as much oil as Colin Campbell estimated (with a peak having occurred in 2010) that only pushes the peak 14 years out. Harper (Harper who? I’m not sure graph doesn’t say) assumed 50% more economically recoverable reserves than Campbell which only pushes peak out 5 years (2015).

    • I would argue that in nothing says the shape of the curve will be as shown, though. A whole host of bad effects give rise to the peak. The actual shape will be much more downward that the graph claims.

      • I absolutely agree. I was thinking about this the other night, it will look more like your “shark fin” collapse. The way I envision it, society will desperately “pull forward” production so the graph will have an undulating plateau, the peak decline will begin later than expected, and then the amount of economically feasible reserves will suddenly drop as the civilization around it collapses. In other words I think the amount of economically recoverable reserves is grossly overestimated.

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