Putting the Real Story of Energy and the Economy Together

What is the real story of energy and the economy? We hear two predominant energy stories. One is the story economists tell: The economy can grow forever; energy shortages will have no impact on the economy. We can simply substitute other forms of energy, or do without.

Another version of the energy and the economy story is the view of many who believe in the “Peak Oil” theory. According to this view, oil supply can decrease with only a minor impact on the economy. The economy will continue along as before, except with higher prices. These higher prices encourage the production of alternatives, such wind and solar. At this point, it is not just peak oilers who endorse this view, but many others as well.

In my view, the real story of energy and the economy is much less favorable than either of these views. It is a story of oil limits that will make themselves known as financial limits, quite possibly in the near term—perhaps in as little time as a few months or years. Our underlying problem is diminishing returns—it takes more and more effort (hours of workers’ time and quantities of resources), to produce essentially the same goods and services.

We don’t measure our investment results with respect to the quantity of end product produced (barrels of oil produced, liters of fresh water produced, kilos of copper produced, or number of workers provided with sufficient education to work in high tech industries), so we don’t realize that we are becoming increasingly inefficient at producing desired end products. See my post “How increased inefficiency explains falling oil prices.”

Figure 2. The way we would expect the cost of the extraction of energy supplies to rise, as finite supplies deplete.

Figure 1. The way we would expect the cost of the extraction of energy supplies to rise, as finite supplies deplete.

Wages, viewed in terms of the product produced–oil in this case–can be expected to decrease as well. This change isn’t evident in usual efficiency statistics, because some of the workers are providing new kinds of services, such as fracking services, that weren’t required before.

Figure 3. Wages per worker in units of oil produced, corresponding to amounts shown in Figure 2.

Figure 2. Wages per worker in units of oil produced, corresponding to amounts shown in Figure 1.

Even investment is becoming increasingly inefficient. It takes more and more investment to extract a given quantity of oil or other energy product. This investment needs to stay in place longer as well. The ultra-low interest rates we have been experiencing reflect the poor returns investments are now making.

The myth exists that prices of all of the scarce goods and services will rise high and higher, as the economy encounters scarcity. The real story, though, is that the inflation-adjusted purchasing power of common workers is falling lower and lower, especially in the United States, Europe, and Japan. Not only can these workers afford to buy less, but they can also afford to borrow less. This means that their ability to purchase expensive goods created from commodities is falling.

At some point, this lack of purchasing power can be expected to affect the financial markets, and the prices of many commodities can be expected to fall. In fact, this already seems to be happening.

The likely impact of such a fall in commodity prices is not good. If low oil prices cannot be “turned around,” they will lead to debt defaults, and these debt defaults are likely to lead to failing financial institutions. Failing financial institutions have the potential to bring down the system, because it becomes very difficult for businesses to continue if they are not supported by a banking system that allows a company to pay its employees. Workers also need the banking system to pay for goods and to save for a “rainy day.”

A big part of what has allowed the economy to grow to the size it is today is increasing debt levels. These rising debt levels play many roles:

  • They make high-priced goods more affordable to consumers.
  • They create greater demand for goods, allowing more end-product goods to be produced.
  • They create more demand for commodities required to make end-product goods, allowing the price of these commodities to rise, so that more businesses have more incentive to create/extract these commodities.

At some point, debt levels stop rising as fast as they have in the past (because of a lack of growth in purchasing power because of diminishing returns in investment), and the whole system tends to fall toward collapse. We seem to have reached this point in the middle of 2014. China was raising its total debt level rapidly up until the early part of 2014, then suddenly moderated its growth in debt level in mid 2014. At about the same time, the US scaled back and eliminated it program of quantitative easing (QE). Oil prices dropped starting in mid-2014, at the time debt levels started moderating. Other commodity prices started falling as early as 2011, indicating likely affordability problems.

We are now in the period when many people still believe everything is going well. Oil prices and other commodity prices are low—what is “not to like”? The answer is that the system in not at all sustainable—profits of oil companies and other commodity businesses are down, just as wages of common workers in developed countries are down in inflation-adjusted terms. Companies are cutting back in investment in oil production. Soon oil production will drop. With lower oil supply, the economy will face huge challenges.

Many people believe that oil prices can bounce back up again, but this really isn’t the case, because of growing inefficiency related to limits we are reaching–the need to use more advanced techniques to produce oil; the need for desalination for water in some places; the need for more pollution control equipment that doesn’t really increase the finished goods and services we are producing but instead makes goods more expensive to produce.

Each worker is, on average, producing less and less of the finished goods we really need. Whether we like it or not, standards of living will have to fall. The amount of debt workers can afford decreases rather than increases. This new reality can be expected to manifest itself in debt defaults and increasing financial system problems.

Even if oil prices bounce back up again, it is doubtful that shale oil drillers will be able to again borrow at a sufficiently high rate to increase their production again—what lender will believe that oil prices will remain high indefinitely?

The China Connection

I have been trying to put the real story of energy and the economy together over a period of years. Prof. Lianyong Feng of Petroleum University of China, Beijing, hired me to put together a short course (eight sessions, each lasting about 1.5 hours) on the nature of our current problems for students majoring in “Energy Economics and Management.” The course would be open to everyone choosing this major, including freshman, so I needed to assume a fairly low level of background knowledge. Actual attendees included a number of graduate students and faculty, attending the course without credit.

I put together a series of lectures, which I gave during the second half of March 2015. PDFs of my lectures are also now available on my Presentations/Podcasts page.

These lectures were videotaped by Prof. Feng’s staff, and I am in the process of making You Tube Videos from them, in addition to the original MP4 format. (YouTube videos cannot be seen in China.) My current plan is to give a brief discussion of these lectures, in future posts.

Following the lecture series, I visited several places in China, to see how the economic slowdown is playing out in China. This included visits to Northwest China (Hohhot and Hardin), Northeast China (Daqing and Harbin), and Southeast China (Wenzhou area). In Wenzhou, I visited three different companies attempting to sell electrical equipment on the world market.

From these visits, we could see how the world economic slowdown is affecting China, and how China’s own slowdown in debt growth is adding to the world slowdown. We could also see that the slowdown has not yet run its course China–growth in housing continues, even as the need for it seems to be slowing. College students are finding it difficult to find high-paying jobs in oil and other commodity sectors. The lack of growth in high-paying jobs will provide downward pressure on housing prices as well.

I plan to write a post about this situation as well.

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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486 Responses to Putting the Real Story of Energy and the Economy Together

  1. Kulm says:

    These are what the future will be.

    > We’re in a greater-moderation of no downturns and monotonically increasing growth, which will continue for what will seem like forever. Policy makers have conquered the business cycle; they have conquered the rate hike; and they have conquered the bear market. Next comes the type 1 civilization transition, the singularity, a theory of everything, mind uploading, a halo ring that will encircle the earth, space colonies, a matrix, and much more.

    Actually, I do think these will be obtainable with what energy remaining now, after about 90% of the world’s population is reduced to somalian refugee status requiring very little energy to maintain.

    • Tolstoy's Degenerate Grandson says:

      When this hits you will be one of those people staggering around as if you’d been caught in a road side bomb blast, observing the misery and death around you, and wondering how you got your prediction so wrong.

      • Kulm says:

        Actually there were two extremely famous Chinese poets who experienced something like this during AD 8th century, Du Fu and Li Bai(Li Po), when a rebellion shook the dynasty which was extremely rich and powerful.

        Li Bai was a favorite poet of the Emperor, which means he was somewhat like Steven Spielberg or George Lucas of the day. Du Fu was a low-level govt employee, although because he was such a good poet he was acquainted to Li Bai.

        Both survived the rebellion, which killed about half of the people alive in China at that time. When the rebellion ended the GDP fell to maybe 1/3 of what it used to be.

        Although Li never regained the wealth lost during the rebellion he still retained his fame, and was always able to find someone to sponsor his poetry. Du, having retreated to the family farm (which was protected from the mobs because he was an official, no matter how low ranking ) was as poor as what he was throughout his life, but both found enough strength to compose poetry about the death and miseries around them. Starving people do not write poems, which need ink and pens which tend to be expensive during scarcity.

        • Tolstoy's Degenerate Grandson says:

          Nobody has ever experienced the situation that is headed our way. When this hits the entire world will stop.

    • Tolstoy's Degenerate Grandson says:

      “Policy makers have conquered the business cycle; they have conquered the rate hike; and they have conquered the bear market.”

      I would love to agree with you but that would mean that Bernanke invented a perpetual economic motion machine and this makes the logical part of my brain have seizures.

      If it were so simply what I am left wondering is why in the hell didn’t someone come up with this strategy a long time ago? And why doesn’t Somalia adopt these policies?

      Perhaps it’s like a lot of inventions — the concepts are often so simple that you kick yourself saying why in the hell didn’t I think of that.

      Ben Bernanke for God I say.

  2. Tolstoy's Degenerate Grandson says:

    This is truly frightening.

    CAT is perhaps the most important indicator of global growth because their gear is ubiquitously used in construction projects globally.

    http://www.zerohedge.com/news/2015-04-22/caterpillar-its-second-great-depression#comment-6019426

    We are very very close to the end game. The only thing keeping this company from collapsing is the QE that they are taping for ZIRP cash that is being used to prop up their shares.

    Anyone still think that QE ZIRP is about helping billionaires? It is the blood (filled with toxins) that is keeping Frankenstein alive.

    • gerryhiles says:

      @TDG
      The Baltic Dry Index is another fundamental good/bad indicator and it is stuck at very low levels.

    • edpell says:

      Holy Crap, you are right, this is frightening. 8% per year “deleveraging”. (/scarc on) In about 120 months we will be positioned for growth. (/scarc off)

    • I visited three companies in China that are selling electrical equipment. One was small and selling only to Chinese small businesses. The other two were trying to sell in the international market. There were having a terrible time. No one wanted/could afford new long distance transmission equipment. If electricity is not growing, it is pretty clear that the world economy has a problem.

      • Tolstoy's Degenerate Grandson says:

        Not sure if I mentioned but a friend who is a partner in a law firm that relies primarily on China business told me recently that business is absolutely horrible, primarily because shipping volumes have been off massively in recent months.

        I have been speaking with people with extensive business networks in China, primarily consumer products, and it is a bloodbath.

        Where is the driver of the global economy now that China is going to pieces?

        if we make the end of the year without a major problem that would be a surprise. Can’t see how we get through to the end of 2016

        • That is my fear–that the end is not too far away, if China is now shrinking rather than growing. I may have mentioned before that the China Daily, while I was over there, was speculating that first quarter growth would be reported at less than 7%. This didn’t happen, but someone at the newspaper must have thought that the economy wasn’t really growing very much.

  3. edpell says:

    Hello Jan, I do not know if you are a man or a woman (those two choices are listed alphabetically). I had been thinking weather beaten 70 year old Swed but a post said “she” so now I do not know. Are you Mr. Jan or Ms. Jan? Thanks. Mr. Ed

    • Jan Steinman says:

      I had been thinking weather beaten 70 year old Swed

      Hey, suits me! Run with it if it feels right! For some reason, people I’ve conversed with for years online are surprised when they first hear my lack of foreign accent.

      Having endured merciless teasing as a schoolkid, I rather enjoy being gender-ambiguous sometimes. I got assigned to girls’ gym in high school, but they stopped me at the locker room door.😦

      This can be especially fun on-line, as someone in this thread tried to tell me all about myself, while getting this one key fact wrong! It tends to bring out latent sexism in guys, who often seem to feel emasculated by women who know stuff other than cooking, cleaning, and having babies. One time, after patiently explaining facts contrary to someone’s belief system, I was accused of “being on the rag.” I once had a public offer of marriage from a guy who lacked a taste for demure women.

      I’m a bit over a decade shy of 70, and my heritage is Swiss/English, not Swedish, but at least you nailed the gender.

  4. Don Stewart says:

    Dear Gail and Finite Worlders

    BC has made an interesting post at Ron Patterson’s blog related to some of Gail’s conceptual graphs in her post. BC’s words are also related to those of BW Hill, in the comments here. Partial quotation:

    http://peakoilbarrel.com/opec-tight-oil-and-russia/

    ‘What few will say at this point, i.e., they won’t be paid if they do, is that an increasing majority share of US “oil” extraction since 2012 was consumed in order to extract the unprofitable incremental supply at $75-$100/bbl that is not affordable to the rest of the economy to burn and grow real GDP per capita AND sustain unprofitable “oil” extraction at today’s $45-$55/bbl.

    What some call a “glut” of “oil” is actually an unprofitable supply at which neither the shale “oil” sector can afford to produce and consume to produce “growth” of supply that the economy can afford to consume and “grow” real GDP per capita.’

    Don Stewart

  5. Don Stewart says:

    Dear Finite Worlders

    When things are tough, it is especially important not to make things worse by our own actions. I participated in a Webinar with Kelly McGonigal, the Stanford psychologist last evening on the broad topic of Willpower. If we know something is good for us, but don’t actually do it, or if something is bad for us, and do it anyway, and never give much thought to what it is we really want, then it pays to listen to Kelly and other researchers. I will give you just a couple of the things I noted in last night’s discussion.

    Willpower is not a virtue, and lack of willpower is not a vice. Willpower is a muscle that we can train and make stronger. Willpower resides in a constellation of locations in the prefrontal cortex. We seem to have extraordinary willpower capabilities because our very complicated social relationships require that we share and cooperate and minimize fighting. When we are well connected to our social society, we have more willpower.

    We have one brain, but two minds. One mind is concerned about ‘wise action’, while the other mind is concerned about ‘instant gratification’.

    Stress drives us in the direction of ‘instant gratification’. Guilt is a form of stress, which drives us likewise to ‘instant gratification’. Young women who were made to feel guilty about eating a doughnut subsequently ate twice as much candy.

    There are two ways to train the brain:
    A. Train the biological response
    B. Strengthen the brain for specific challenges: e.g., quitting smoking

    Training the biological response can be done with a 5 minute meditation exercise. It is best if you are a bad meditator, trying to focus on your breath rather than all those chaotic thoughts. As you struggle to refocus on the breath, you exercise all the neural muscles that you need to also exercise willpower in general. After 5 minutes, the biology of the body changes and makes you less susceptible to the lures of ‘instant gratification’.

    Another response is to adopt the habit of Pause and Plan. This is a more sophisticated version of the Count To Ten advice you probably got from your mother.

    When we are successful, our heart rate variability increases, which is a sign of balance in the autonomic nervous system. If you learn to shift your heart rate variability, then lots of good things happen to your biology.

    A still contentious topic is glucose (blood sugar) and willpower. Roy Baumeister at Florida State did some experiments which seemed to prove that willpower was a depletable resource. Using willpower used up blood sugar, which caused us to be more subject to additional temptations. However, recent research tends to show that the brain monitors blood sugar. If the level is fluctuating, the brain figures that the supply is not dependable, and will tend to try to conserve blood sugar in the face of stresses. Therefore, the solution is to eat a diet which supplies a steady supply of sugar (which would also prevent diabetes, my note). The dietary enemies would be those things which cause a surge in blood sugar, followed by a crash.

    Research shows us that wanting something and liking it after we get it are two completely different brain systems. Wanting something very badly is a poor indicator of actual enjoyment of it after we get it. My note: most all of commerce is about taking advantage of our desires. The Internet, for example, is supported by the advertising which attempts to capitalize on our wants. Since wants have little direct relationship to long term satisfaction, we are vulnerable as consumers. Back to Kelly: the mindful experiencing of the want defuses it, and returns control to our better angels. Sarah Bowen at the University of Washington is a leading researcher on this topic.

    We hate to feel guilty about our bad behavior. Dieters turn to junk food and procrastinators turn to playing solitaire on their computers because they hate to admit that they have been eating badly and procrastinating. When a psychologist intervenes in an experiment where people have fallen off the wagon with soothing words of forgiveness (e.g., everyone does it once in a while, let’s try again), behavior can improve remarkably.

    Secure Attachment ( a term of art) is the best foundation for willpower a parent can give a child. Secure Attachment is not coddling a child. It is instead characterized by a parent giving a child a safe place to come back to after going out into the world and taking risks and learning from successes and failures. It is not about self-indulgence, nor about guilt trips.

    Feeling Like It comes after we Start Doing It. Action changes feeling—courage and willingness rise to the challenge.

    Don Stewart
    PS No transcript, trust me.

  6. Jan Steinman says:

    Play nice in the sandbox, folks. Godwin’s Law means I might be getting out my moderator’s hat.

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