Why oil prices can’t rise very high, for very long

Oil prices are now as high as they have been for three years. At this writing, Brent is $74.14 per barrel and West Texas Intermediate is at $68.76. These prices aren’t really very high, if a person looks at the situation from a longer term point of view than the last three years.

Figure 1. EIA chart of weekly average Brent oil prices, through April 13, 2018.

There is always a question of how high oil prices can go, and for how long.

In fact, we have many resources, of many kinds, whose prices of extraction keep rising higher. For example, obtaining fresh water for the world’s population keeps getting more and more expensive. Some parts of the world need to resort to desalination.

The world economy cannot withstand high prices for any of these resources for very long. Certainly, it cannot withstand high prices for a combination of necessary resources, because people need to cut back on other purchases, in order to afford the necessities whose prices are rising. This article is a guest post by another actuary, who goes by the pseudonym Shunyata. He explains in a different way why high resource prices cannot last, whether they are for oil, or natural gas, water, or even fresh air.

Dear Readers:

As you are no doubt aware, Gail has created a fantastic portfolio of blogs that explore our energy/financial/economic system, blogs that reveal many hidden or misunderstood aspects of our situation. I have found these discussions invaluable and share them wherever I am able; to solve our societal problems we need to develop a societal understanding of these issues.

The problem I face is helping other people, like my grandparents, get a foothold in this complex discussion. They can understand why oil might “run out,” but trying to understand the problematic financial situation is more difficult. I like metaphors to explain things – metaphors that allow my grandparents to understand the major elements of the situation. The metaphors I am using are to the oil industry. My grandparents have been following the oil situation for a long time. If a person has been following the oil industry, they may be helpful.

Below you will see how I explain Gail’s detailed writing to my grandparents in three short chapters. I hope you find this outline helpful in your own discussions, and I welcome your suggestions for improving the transparency of the story.

PRODUCTION COST

What if air had to be produced from wells and purchased by businesses and families to conduct their normal affairs?

If air is readily available in the ground, we can always extract what we need, making it easy for businesses and families to operate, or even to grow.

What happens if air becomes harder to extract? Perhaps the easy air is gone and we are increasingly looking at extracting deep water air, or air dissolved in shale stone.

Technology may be able to help; sometimes it can help a lot. But there is an immediate production cost shock in funding the development of that technology. This cost shock occurs whether we are talking about conventional air or solar-based renewable air.

There is a lower but permanent increase in production cost, both to fund the complexity of the technology (a deep water air rig just costs more to operate than a land rig) and to pay off any debt needed to build the new technological infrastructure. This cost increase occurs whether we are talking about conventional air or solar-based renewable air.

This cost increase is a permanent drag on the economy. Wages don’t rise to compensate for the higher cost of air. There is no substitute for air, and air simply isn’t available in the quantities the economy previously enjoyed – unless we stop doing things that we were doing before and redirect those resources toward producing the same amount of air we used to have.

DEBT

In a modern financial system, we use “money” as a proxy for economic activity. In a barter system, I can obtain goods and services by trading my work product for your work product. But carting around packages of finished goods is unwieldy, so we use “money” as a medium of exchange. If you and I are both willing to trade our finished goods for a symbolic piece of paper, then I can trade my goods and services for paper, bring that paper to you and trade it for your goods and services. This medium of exchange makes it easy to trade complex goods and services over long distances, or at different points in time.

How would lending work in this barter system? Someone could produce many finished goods, trade it for symbolic paper, but not immediately trade it for other goods, and “save” their paper for later. Debt is a process of borrowing someone else’s saved symbolic paper to purchase goods and services for themselves. This is helpful when I need to build a deep water air rig but don’t have the money myself. I can borrow someone else’s money and pay them back later, after my rig is bringing in revenue.

This simple borrowing process only works if some people aren’t consuming goods and services in the economy, and are instead allowing others to “borrow” their ability to consume. What if there isn’t enough saving to make large borrowing possible? What if I want to maximize economic activity and don’t want people to defer their own individual consumption?

If we want more funding than barter can provide, this can be done in more than one way:

[a] Money can be loaned into existence. This happens every day, when people decide to buy a car, and take out a loan for that purpose. Or people buy something with a credit card, and decide to carry a balance, rather than pay it off immediately. Nearly all loans today represent new money to the system.

[b] Governments can also obtain money by issuing bonds. Or they can simply issue money certificates without having any backing for the money.

Let’s call the process of adding funding to the economy, over and above what would be available by debt, “money printing.” In each of these cases, symbolic paper is added to the economy without previous work having been performed.

[1] Money printing can be helpful when it represents an investment in growing the overall economy. Investment in deep water air rigs will make air more available in the economy and will spur an expansion of economic activity. In this case the goods and services in the economy eventually “grow into” the amount of money that has been printed and the extra economic activity in the future is used to repay the debt.

[2] Money printing is unhelpful when it simply becomes someone’s savings (i.e. growing wealth inequality). The economy is still obligated to repay the debt (usually through taxes) and economic activity becomes sequestered in wealthy people’s savings, without ever creating demand for someone else’s product.

[3] Money printing is also unhelpful when it is used to fund more air consumption without any investment in air production. For example, a family that borrows money for an air vacation (or for basic daily air subsistence):

  • Now has a debt–repayment of which will reduce future air consumption
  • Has created no permanent demand for air and does not require permanently expanding air production for the economy–so their vacation air demand tends to increase the cost of air for all other consumers.

PRICE
What happens when we put these two chapters together? When air becomes more difficult to extract:

[1] Production cost goes up permanently.

[2] Economic activity is redirected to maintain air production, and overall economic activity is reduced. With reduced overall economic activity there is a reduced need for air, resulting in excess air supply and a temporary reduction in air price.

[3] If air consumers spend their available money on air and defer other purchases, there is an additional reduction in economic activity, additional excess supply and further reduction in air price.

[4] Reduced price means less revenue to air producers.

[5] Owners of idled air rigs still have debts to pay (money borrowed to build air rig in the first place). They are willing to undercut the market price of air just to get revenue to pay their debts, even if they aren’t making a profit otherwise. This drives the price even lower.

So air prices fall, even though the cost of air production continues to rise.

This begins to look like an economic crisis. A natural response of governments is to print money so that consumers have more money available to purchase air, without deferring other purchases.

This can work for a while, but ultimately fails when there is no overall growth in economic activity to match the increased money supply. The debt comes due (usually in the form of higher taxes). There isn’t enough productive activity in the economy to easily pay back the debt. As a result, consumers must defer even more of their consumption to repay debt, ultimately resulting in even lower air prices.

Eventually either the debt market or air market runs the risk of failing entirely.

[1] When economic activity falters, people can no longer repay their debts (or earn enough income to pay taxes toward government debt). Either of these outcomes is bad both for borrowers and lenders.

[2] If economic activity falters, market forces push air producers to a zero-profit price point. At this point, producers have enough money to keep the rigs running and cover debt payments, but no more. Ultimately this cannibalizes the ability of air producers to maintain existing air supplies. They are unable to purchase replacement machines, if any one breaks. They cannot make new investments.

Clearly, this situation cannot continue. High prices cannot be passed on to consumers, or they will be unable to buy other necessities of life. At the same time, if the producers do not get high enough prices, they cannot continue to provide the air or any other commodity that is needed.

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 financial problems for oil producers and for oil exporting countries. We are really dealing with a physics problem that affects many parts of the economy at once, including wages and the financial system. I try to look at the overall problem.
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1,703 Responses to Why oil prices can’t rise very high, for very long

    • zenny says:

      They are toast …from your link
      Martin Harangozo said he was fired by GE with no severance after raising questions about “bad” accounting.

      “GE transitioned from an honest company to a dishonest company,” Harangozo said.

      Underscoring the challenges facing GE, Moody’s lowered its credit outlook on the conglomerate to negative on Wednesday because of the expected costs of a Justice Department investigation into its subprime-mortgages business.

      Moody’s warned it could downgrade GE’s credit rating if the company fails to improve cash flow significantly or if revenue keeps shrinking at the beleaguered power division. GE shares dropped nearly 5% on Wednesday, leaving them down 53% over the past year.

      One retiree pleaded with Flannery to turn around the company — fast.

      “My whole life has been GE,” he said. “Give it all you’ve got. We’re with you.”
      They also have other lawsuits coming from Japan and china Not sure if they are valid but my gut tells me yes…One would be well advised NEVER COUNT ON A COMPANY PENSION

    • Christiana says:

      2017 was best year for German carmakers! They sold incredibly much and payed some minor fines in the US.

      • Fast Eddy says:

        ‘The Society of Motor Manufacturing and Traders (SMMT) said poor weather had affected production.’

        You gotta like how they post that at the top of the article – no explanation whatsoever… just accept that weather .. um… weather… weather inside the factory…. caused the assembly lines to slow down?????

        How about I fix that… People are flat broke and unable to take on more debt so they are not buying new vehicles.

    • Baby Doomer says:

      Globalism means people are expected to understand when their lives are pulled out from under them for the continued gain of the stock market. Keep those shares climbing by screwing over the workforce. Walmart is painted as the bad guy while people just love their Amazon slaves because they don’t have to look at them. Shareholder’s fight wage improvements because their stocks will go down as expenses increase. Because everyone’s retirement is based on stock values, we all become partners in the oppression of others. It’s an evil system and will be the death of America and the West.

      • Or think about the problem as being issues of a dissipative structure. There is nothing we can really do about the problem.

        There are some competing systems such as communism that seem to be in theory ‘fairer.” But in the end, they get beaten out by approaches that dissipate energy more quickly.

        • xabier says:

          What also undermined the Soviet system – ‘state capitalist’ supposedly transitioning to ‘Full Communism’ = Utopia, in which no one would lack anything, ever be hungry or homeless, etc – was that it was founded on murder and compulsion, created an elite directing these activities and itself consuming more energy than the lower layers of society, and continued on the basis of lies, propaganda, all-pervasive cynical corruption, and the denial of individual spiritual dignity.

          A human being only had value in so far as it conformed to the system: Soviet Man or Woman,

          That is not a full human existence.

          Fairness and equality are not the highest values: we must be free to err, to fail, to die, even to exploit or be exploited by others.

          Where there is no physical or spiritual struggle, no danger, then there is only death of the soul.

          And that is just what happened in the Soviet bloc (and in another way is happening here, with the ever-increasing manipulation and surveillance of people via puerile slogans and technology – foreshadowed in Nazi Germany).

          • I expect that there is a little of this in Japan and China’s systems as well. To have so many people in such small spaces, they really need nations valuing conformity. We in the US have been way out in front in allowing lack of conformity. But this can only happen in a high energy per capita world.

          • SomeoneInAsia says:

            QUOTE:***Fairness and equality are not the highest values: we must be free to err, to fail, to die, even to exploit or be exploited by others. Where there is no physical or spiritual struggle, no danger, then there is only death of the soul. And that is just what happened in the Soviet bloc (and in another way is happening here, with the ever-increasing manipulation and surveillance of people via puerile slogans and technology – foreshadowed in Nazi Germany).***

            Aren’t the manipulation and surveillance of people you speak of a form of exploitation, which you extol? In which case what reason do you have to complain?

          • Fast Eddy says:

            I am unaware of any species of animal that practices communism.

            It is an unnatural state. It defies the laws of nature.

        • Pogo says:

          Communism philosophy totally missed the boat too with its focus on “means of production”. Means of production is largely irrelevant if resources are consumed and depleted.

          While advocates of quasi communism pretend to support both environmental justice and social justice ( social justice being more stuff to consume) environmental justice is always ignored if social justice is threatened. Real issues ignored as always.

          Gail may be the only human I have ever encountered who hasn’t missed the boat.

    • xabier says:

      People only rage because it is no longer delivering the goods for them.

      If they were in a better position, they wouldn’t give a damn about the iniquities of the system as such.

      Pure hypocrisy for the most part, not a question of principles.

  1. adonis says:

    to the finite worlders that are listening here’s what’s gonna happen the system will die on the 01.06.18 three monthsl later the new system will take over on 01,09,18 and the world will be a much happier place.Think of Adonis when this all goes down exactly on time.

  2. Harry Gibbs says:

    “Britons were only beginning to use steam engines, canals and factories the last time the U.K. experienced such a poor decade of productivity.

    “Total factor productivity since 2007 was the worst since the late eighteenth century, around the time of the industrial revolution, according to a Bank of England blog post Wednesday…”

    “Average productivity growth was negative for the first time in almost a century, BOE researcher John Lewis said.

    ““Whatever the cause, productivity growth over the past decade has been remarkably poor by most historical standards,” he said…”

    https://www.bloomberg.com/news/articles/2018-04-25/u-k-productivity-worst-since-industrial-revolution-boe-says

  3. Harry Gibbs says:

    “Former Chair of the Federal Reserve Janet Yellen said that she hoped the reversal of QE would be as “dull as watching paint dry”. However, given the scale of central bank assets set to be shed, this is unlikely to be the case. When the banking sector began to cave in September 2008, the Fed’s balance sheet stood at just $905bn – six percent of GDP. It is now being wound down from a peak of $4.5trn, which represents around a quarter of US GDP (see Fig 1). Together, the ECB, Bank of England, Bank of Japan and the Fed have amassed balance sheets of over $14trn.

    “In the face of an impeding global bout of ‘QE in reverse’, economists are stressing the fact that this is by and large new territory. In the words of Christopher Martin of the Institute for Policy Research, there are very real “dark areas” in our knowledge of the process in reverse…”

    https://www.worldfinance.com/banking/the-qe-reversal

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