Low Oil Prices: Why Worry?

Most people believe that low oil prices are good for the United States, since the discretionary income of consumers will rise. There is the added benefit that Peak Oil must be far off in the distance, since “Peak Oilers” talked about high oil prices. Thus, low oil prices are viewed as an all around benefit.

In fact, nothing could be further from the truth. The Peak Oil story we have been told is wrong. The collapse in oil production comes from oil prices that are too low, not too high. If oil prices or prices of other commodities are too low, production will slow and eventually stop. Growth in the world economy will slow, lowering inflation rates as well as economic growth rates. We encountered this kind of the problem in the 1930s. We seem to be headed in the same direction today. Figure 1, used by Janet Yellen in her September 24 speech, shows a slowing inflation rate for Personal Consumption Expenditures (PCE), thanks to lower energy prices, lower relative import prices, and general “slack” in the economy.

Figure 1. Why has PCE Inflation fallen below 2%? from Janet Yellen speech, September 24, 2015.

Figure 1. “Why has PCE Inflation fallen below 2%?” from Janet Yellen speech, September 24, 2015.

What Janet Yellen is seeing in Figure 1, even though she does not recognize it, is evidence of a slowing world economy. The economy can no longer support energy prices as high as they have been, and they have gradually retreated. Currency relativities have also readjusted, leading to lower prices of imported goods for the United States. Both lower energy prices and lower prices of imported goods contribute to lower inflation rates.

Instead of reaching “Peak Oil” through the limit of high oil prices, we are reaching the opposite limit, sometimes called “Limits to Growth.” Limits to Growth describes the situation when an economy stops growing because the economy cannot handle high energy prices. In many ways, Limits to Growth with low oil prices is worse than Peak Oil with high oil prices. Slowing economic growth leads to commodity prices that can never rebound by very much, or for very long. Thus, this economic malaise leads to a fairly fast cutback in commodity production. It can also lead to massive debt defaults.

Let’s look at some of the pieces of our current predicament.

Part 1. Getting oil prices to rise again to a high level, and stay there, is likely to be difficult. High oil prices tend to lead to economic contraction.  

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How our energy problem leads to a debt collapse problem

Usually, we don’t stop to think about how the whole economy works together. A major reason is that we have been lacking data to see long-term relationships. In this post, I show some longer-term time series relating to energy growth, GDP growth, and debt growth–going back to 1820 in some cases–that help us understand our situation better.

When examining these long-term time series, I come to the conclusion that what we are doing now is building debt to unsustainably high levels, thanks to today’s high cost of producing energy products. I doubt that this can be turned around. To do so would require immediate production of huge quantities of incredibly cheap energy products–that is oil at less than $20 per barrel in 2014$, and other energy products with comparably low cost structures.

Our goal would need to be to get back to the energy cost levels that we had prior to the run-up in costs in the 1970s. Growth in energy use would probably need to rise back to pre-1975 levels as well. Of course, such a low-price, high-growth scenario isn’t really sustainable in a finite world either. It would have adverse follow-on effects, too, including climate change.

In this post, I explain the reasoning that leads to this conclusion. Some back-up information is provided in the Appendix as well.

Insight 1. Economic growth tends to take place when a civilization can make goods and services more cheaply–that is, with less human labor, and often with smaller quantities of resources of other kinds as well.

When an economy learns how to make goods more cheaply, the group of people in that economy can make more goods and services in total because, on average, each worker can make more goods and services in his available work-time. We might say that members of that economy are becoming more productive. This additional productivity can be distributed among workers, supervisors, governments, and businesses, allowing what we think of as economic growth.

Insight 2. The way that increased productivity usually takes place is through leveraging of human labor with supplemental energy from other sources.

The reason why we would expect supplemental energy to be important is because the amount of energy an individual worker can provide is not very great without access to supplemental energy. Analysis shows that human mechanical power amounts to about 100 watts over a typical laboring day–about equal to the energy of a 100-watt light bulb.

Human energy can be leveraged with other energy in many other forms–the burning of wood (for example, for cooking); the use of animals such as dogs, oxen, and horses to supplement our human labor; the harnessing of water or wind energy; the burning of fossil fuels and the use of nuclear energy. The addition of increasingly large amounts of energy products tends to lead to greater productivity, and thus, greater economic growth.

As an example of one kind of leveraging, consider the use of oil for delivering goods in trucks. A business might still be able to deliver goods without this use of oil. In this case, the business might hire an employee to walk to the delivery location and carry the goods to be delivered in his hands.

A big change occurs when oil and other modern fuels become available. It is possible to manufacture trucks to deliver goods. (In fact, modern fuels are needed to make the metals used in building the truck.) Modern fuels also make it possible to build the roads on which the truck operates. Finally, oil products are used to operate the truck.

With the use of a truck, the worker can deliver goods more quickly, since he no longer has to walk to his delivery locations. Thus, the worker can deliver far more goods in a normal work-day. This is the way his productivity increases.

Insight 3. Growth in GDP has generally been less than 1.0% more than the growth in energy consumption. The only periods when this was not true were the periods 1975-1985 and 1985-1995. 

This is an exhibit I prepared using data from the sources listed.

Figure 2. World GDP growth compared to world energy consumption growth for selected time periods since 1820. World real GDP trends for 1975 to present are based on USDA real GDP data in 2010$ for 1975 and subsequent. (Estimated by author for 2015.) GDP estimates for prior to 1975 are based on Maddison project updates as of 2013. Growth in the use of energy products is based on a combination of data from Appendix A data from Vaclav Smil's Energy Transitions: History, Requirements and Prospects together with BP Statistical Review of World Energy 2015 for 1965 and subsequent.

Figure 1. World GDP growth compared to world energy consumption growth for selected time periods since 1820. World real GDP trends for 1975 to present are based on USDA real GDP data in 2010$ for 1975 and subsequent. (Estimated by author for 2015.) GDP estimates for prior to 1975 are based on Maddison project updates as of 2013. Growth in the use of energy products is based on a combination of data from Appendix A data from Vaclav Smil’s Energy Transitions: History, Requirements and Prospects together with BP Statistical Review of World Energy 2015 for 1965 and subsequent.

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