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.
This entry was posted in Financial Implications and tagged , , , . Bookmark the permalink.

1,703 Responses to Why oil prices can’t rise very high, for very long

  1. Harry Gibbs says:

    “American farmers have managed to stay afloat despite years of shrinking crop values, the lowest incomes since the recession and a budding trade war with China. Now, they’re feeling a new squeeze — borrowing money is getting more expensive as interest rates rise. For some, it may be fatal.”

    https://www.bloomberg.com/news/articles/2018-04-24/next-threat-stalking-american-farmers-is-the-end-of-cheap-money

  2. Harry Gibbs says:

    “While everyone on Wall Street is pounding the table over the rising 10-year yield, the 2-year note rose above 2.5 percent Wednesday, a level it last closed at August 2008, just a month before the financial crisis imploded with the collapse of Lehman Brothers.”

    https://www.cnbc.com/2018/04/25/market-is-obsessed-with-10-year-yield-should-be-watching-the-2-year.html

    • Davidin100millionbilliontrillionzillionyears says:

      so let’s put this in proper perspective…

      I’m now looking at a 30 year chart for the 2 year…

      in 2006, the rate was over 5%, and DECLINED to 2.5% in August 2008…

      so the comparison to 2018 is meaningless…

      yeah, I should be pounding my table…

    • Davidin100millionbilliontrillionzillionyears says:

      10 year was 3.03 and now down to 2.97…

      2 year is now 2.48…

      the PPT, Percent Protection Team, is working overtime…

    • dolph says:

      Latin America sends its drugs (and its people) into the United States. In return, the gun manufacturers in the United States send guns into Latin America.

      It’s all quite profitable. Death is profitable as long as humanity reproduces itself. Death will only stop being profitable once so many people die, that population begins to decline.

  3. Harry Gibbs says:

    ““We are pretty confident that oil will be in triple digits by next year,” said Jean-Louis Le Mee from Westbeck Capital.

    “By then the oil market will be feeling the delayed effects of a 40pc slump in investment from late 2014 to early 2017, storing up a structural shortfall of 8m b/d. Westbeck estimates that extra barrels coming on stream from fresh fields will drop from 3m b/d in 2018 to 1.5 b/d in 2019.

    “Nikolaos Panigirtzoglou from JP Morgan says global consumers enjoyed a $1.8 trillion annual windfall – worth 2.2pc of global GDP – when oil prices crashed. This acted as a “tax cut” stimulus for Europe, India, East Asia, and for most US states. The process is now going into reverse. Consumers have seen an $800bn squeeze so far during this rally.

    “On cue, JP Morgan’s instant “Nowcast” tracker of world growth (weighted) has dropped from 4pc to 3.2pc since the start of the year, far below estimates of the International Monetary Fund.

    “It is hard to separate cause and effect. China has been cooling as credit curbs bite. Monetary tightening by the US Federal Reserve is lifting global borrowing costs. The slowdown may prove to be nothing more than a soft patch but late-cycle pathologies abound and there are reasons for caution.

    “The rest of the commodity nexus has yet to show much sign of life. Metals have been lackluster after stripping out price spikes in both aluminium and nickel, caused by US sanctions against Russia. Iron ore is down 16pc this year. Copper is down 6pc.

    “The IHS index of raw materials shows that paper pulp, fibres, lumber, chemicals, and other commodities that are not traded on exchanges have mostly been falling. These items reflect pure supply and demand, mostly free from the distorting influence of financial speculation…”

    And then Ambrose ends with some craziness about higher oil prices spurring a renewables and EV revolution.

    https://www.telegraph.co.uk/business/2018/04/23/geopolitical-storms-threaten-100-oil-us-shale-struggles-plug/

    • We have been depending upon China to pull the world economy along. Also extremely low interest rates. This article gives evidence that China is not growing rapidly. The 21% decline in cell phone sales (in another comment) is another problem. All these things are an increasing worry.

    • Neil says:

      This man’s continued employment is a mystery. It’s some hysterical nonsense every week. He clearly drinks far too much coffee.

  4. zenny says:

    I would of given her a sobriety test. Something not right with her.
    ZH says. and was chairwoman of its ethics committee That makes her a Bolshevik

  5. Baby Doomer says:

    The World Income Database found the U.S. has the highest inequality among all Western countries

    http://wid.world/country/usa/

    Maybe you could use this link for a future article Gail. Its very interactive.

    • daddio7 says:

      At 65 I have never owned a foreign make car. I have drove a few but a car is a car. My 88 year old father always drove Fords and so have I, at least until a few months ago. I bought a Buick Encore for my wife and my very generous son bought me a Nissan Frontier. I wanted a small truck but Ford had stopped making the Ranger.

      So far I am not impressed with how the Nissan drives. The gas pedal binds so you go from idle to one quarter power when it does move. The steering seems to have no caster, the truck veers from side to side with the slightest movement of the steering wheel and even with power steering it feels heavy.

      I guess I am just not sophisticated enough to appreciated the finer things of life. Maybe that’s why I voted for Trump.

      • Fast Eddy says:

        The last car I would ever buy would be one that is made by an American company…. utter rubbish (I’ve been stuck with one of these a few times when I rented….)

        • Christiana says:

          VW has got best first quarter ever: http://www.faz.net/aktuell/wirtschaft/unternehmen/volkswagen-hat-noch-nie-so-viele-autos-verkauft-15562934.html

          But still, near where I live, they are “closing” a factory. Meaning, VW promised to change for this specific factory to EV. We will see, in Dresden they make 70 E-Golf a day, than they want to make a 100.000 EV a year. Modell was not presented yet.

        • daddio7 says:

          Wow, you are compering low end fleet rental beaters to eighty thousand dollar premium makes. And what makes a car rubbish? To me a car just has to be reliable, comfortable, and easy to drive. I lived on a farm, we kept every car, truck, and tractor we bought so I know about long term reliability. At 16 my dad let me drive 1956 Ford coupe that was 12 years old. That one we didn’t keep, he broke my heart and gave it to a needy person. I felt better when he bought me a 68 Chevrolet Impala. It was the base model but is was black and shiny.

          My son is a lawyer so he thought he should drive a BMW. His 535i spent about as much time at the dealership than in his garage. One day when the little icon of a car up on jacks lit up on the dash he nursed it into a Ford dealership and drove away in a Ford Focus. He couldn’t be happier.

          My wife made me stop keeping old vehicles so I gave the 2000 Grand Marquis she was driving before we got the Buick to a Vietnam vet I met at my doctor’s office. I sold the 1998 4×4 Chevrolet truck I was driving to my farmer neighbor. He was going to use it as a work truck for his crew but looks like his 14 year old daughter has claimed it. She has been riding a four wheeler around the 50 acre field alongside my home since she was 6 or 7. Today I saw her zoom by in my old truck.

          Now, as a farmer, I see tractors like you see cars. I have drove Japanese tractors, Russian tractors, Ford and most other North American makes. Nothing come close to a John Deere. Even though we no long have the farm I kept the 81 John Deere 510 backhoe and my brother has the 1971 John Deere 3020 tractor. Few of the millionaire farmers in my area drive their own tractors but all you see the Mexicans driving are John Deere’s.

          It would seem that Ford was making cars for people like me but now most people are not like me. Doesn’t matter, as little as I drive that Nissan will still be running fine when they put me in the ground. The Buick should last my wife ten years. Who knows what will have transpired by then.

          • JesseJames says:

            I have a John Deere….good tractor. I also have an old Ford 61 Powermaster. 4cylinders of extreme low end torque. Wow! That thing has low end power.

          • Fast Eddy says:

            The problem with American cars … is that they have a reputation for disposability/unreliability….

            Then the Japanese came along…..

            And the made in America brand was damaged — permanently.

            I have a Japanese vehicle — it has never been in the shop – except for servicing.

            I have a German vehicle — it has never been in the shop – except for servicing.

            Never.

            Then there is that iconic American brand – Tesla —- always in the shop — and it can take months to get parts….

            Thank you kindly but why anyone would buy an American car is beyond me.

          • Fast Eddy says:

            The latest CR car reliability data show that performance from the domestic brands is all over the map, spanning from the highest-ranked Buick to the lowest-ranked Cadillac.

            We scrutinized data from about 400,000 subscribers who reported on 640,000 vehicles in our latest survey to answer the age-old debate of how American-brand cars compare against those from Asia and Europe.

            The short answer, illustrated in the chart below, is that the Asian brands dominated with the highest average predicted reliability score, followed by Europe, and ultimately trailed by America.

            REGION AVERAGE PREDICTED RELIABILITY SCORE
            Asia 64
            Europe 50
            U.S. 38

            https://www.consumerreports.org/car-reliability-owner-satisfaction/car-reliability-us-automakers-vs-the-world/

            As I was saying… why anyone would be an American vehicle…. is beyond me….

            Fast Eddy – World Champion … adds another scalp to his collection.

  6. Baby Doomer says:

    Putin’s nuclear ‘doomsday machine’ could trigger 300 ft tsunamis, but the worst effects might come from the fallout

    https://www.businessinsider.co.za/russia-doomsday-weapon-submarine-nuke-2018-4

Comments are closed.