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

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  2. thanks for this short article, it is also good to have these ideas summarized in few words

    last Art Bertman article about shale rentability (example of Eagle Ford) :
    http://www.artberman.com/wp-content/uploads/ACS-Presentation-21-MAR-2018_REDUCED.pdf

    • Interesting! I would note that even if Art says the breakeven is $53 per barrel, the company really needs more than that, in order to earn a profit for shareholders, pay taxes, and to have funds for reinvestment. So that is still a lowball price. (There may be fixed expenses of other types excluded as well.)

  3. Baby Doomer says:

    Study shows rapid rise in mass school shootings in the US

    More people have died or been injured in mass school shootings in the US in the past 18 years than in the entire 20th century.

    https://www.springer.com/gp/about-springer/media/research-news/all-english-research-news/study-shows-rapid-rise-in-mass-school-shootings-in-the-us/15705646

  4. Baby Doomer says:

    Trump is tweeting about the oil prices now

  5. Dan says:

    How many barrels of oil do we burn in a day? How many characters are you limited to in a “tweet”?

    https://www.msn.com/en-us/money/markets/oil-falls-as-trump-goes-after-opec-in-a-tweet/ar-AAw6LTi?li=BBnbfcN

    • The United States consumes a little under 20 million barrels of day of oil and substitutes (such as ethanol). The amounts the US consumes have been increasing a little each year. The year 2018 looks moderately higher than 2017, so far.

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  7. Excellent discussion from many angles at #1 page, thanks
    https://ourfiniteworld.com/2018/04/19/why-oil-prices-cant-rise-very-high-for-very-long/comment-page-1/#comments

    I’ll piggyback on one particular angle “Daddio07” was trying to hammer out.
    Yep, in practice/history it’s indeed possible to reorganize-mandate-reallocate people only into “useful” jobs, i.e. banning financial speculators, personal bankruptcy courts, real estate agents, also banning most of the non profits and their idle staffers, .. etc.

    However, you soon run into several problems and dead ends as well.
    Since the system most likely can’t be launched universally, sooner or later people will tend to look out over the fence and compare/contrast. So, in the first generation people are happy and supportive to the system which gave them cheap housing, hospitals, schools, unemployment(full employment) “stress free” conditions etc. But from certain point and individual perspective how can possible all these advantages above ever match loud pumped out music, crazy fashion, luring benefits of “open society” albeit with some social/economic “non cohesion” … ? Lolz.

    We have empirical evidence of this phenomenon at play how people discarded socialism ~1970-80s onwards, to large degree on propaganda terms and frivolous consumption items “inferiority”, around the time competing block just unleashed next levels of debt spending – econ support filling into the system. Well, now they are having second thoughts, especially in countries where FDI replaced everything in few decades since 1980s, creating new colonial structures. Only China is still one large exception of dual mode approach, where the state control limits the direct ownership intrusion from abroad and so on.

    • dolph says:

      China is the next hegemon period, even if they get some things wrong.
      They have created a labor and production dependency. Because of this, so much labor and production in America has been made redundant. There is no way to retool again, most of these people have long ago either died or gone into service areas. You cannot “reindustrialize” once you have deindustrialized. It’s a one way street, because the resources aren’t there. We can’t win the trade war, they will simply export to other countries and we’ll be left without parts.

      The energy exporters are agnostic, they are just interested in the best deal. For a long time accepting dollar and U.S. military hegemony was standard practice. But now they can see their problem: the dollar reserves depreciate and their oil exports are dwindling. What to do?

      China may go in and say: ok, export what remains to us. You’ll get gold backed yuan and we’ll help you build a solar infrastructure and on top of that provide you with weapons as well. Any smart exporter has to at least look at that deal.

    • daddio7 says:

      I wasn’t arguing a low energy lifestyle for a few while the world in general speeds on. I was postulating how all countries can maintain much of the comforts we enjoy now, minus the political a religious wars but that is an argument for another day.

      Human nature will not allow what could be done to actually occur. It will be every man, corporation, and government for themselves. It is just entertaining to imagine a better world.

  8. adonis says:

    the scientists are bringing in a new financial system based on sustainability they will be officially pulling the plug on the first of june 2018 remember one thing the financial system ended in 2008 and has been on life support ever since that has given them 10 years to prepare for this global currency reset that will bring in a new financial system which will kick the can down the road for at least another 20 years. IN 41 days time I should know if I am a ‘delusistani’ worthy of the tinfoil brigade or if i have correctly deduced the clues leading to the solving of this great conspiracy.We are living in exciting times i hope you are having as much fun as i am.

    • Greg Machala says:

      Feed 7 billion people for 20 more years? With what? People are already starving. Diseases are gaining momentum. Trade is breaking down.

      • Davidin100millionbilliontrillionzillionyears says:

        not 7 billion…

        The Core might perhaps maybe be able to “kick the can” for another 20 years if they keep cutting off energy resources to the periphery…

        that might perhaps maybe be quasi-BAU, but it will undoubtedly be chaotic…

        • Yep, at least attempted quasi BAU for the core (possible + semi core) in the near/mid term horizon is obviously one of the highest probability scenarios, in my book ~ +25% chance of “guaranteed” outcome – conservatively estimating – for next decade or so..

          Well, but the devil is hidden in the details so it is going to be pretty horrible anyway be it more leaning towards direct oppression or not given the multitude of other intervening dependencies-options..

      • adonis says:

        part of the plan involves de-population i read the words in a paper put out by the sustainability scientists of ‘ rapid de-population’ they did not elaborate any further on the subject,

        • Artleads says:

          Restoring abortion availability where it’s been lost over the past 30 years could be consistent with that.

    • Davidin100millionbilliontrillionzillionyears says:

      “We are living in exciting times i hope you are having as much fun as i am.”

      adonis, it’s great to hear that you are so upbeat about the near future…

      it IS exciting!

      often fun!

      by the way…

      I can make you a tinfoil hat…

      or I can give you the instructions to make one yourself…

      you will need it on June 2nd!

      wheeeeeee!

      this is fun and exciting!

      • adonis says:

        on june the 2nd if nothing occurs i will don my tinfoil hat now to find out how to construct a tinfoil hat just in case….

    • Davidin100millionbilliontrillionzillionyears says:

      “Doomer: A hardcore prepper who is sure that disaster is imminent.”

      based on many posts I’ve seen here on OFW, a Doomer certainly doesn’t have to be a prepper…

      actually, really solidly entrenched Doomers often seem to think that prepping is not worth the effort…

    • Davidin100millionbilliontrillionzillionyears says:

      though “more” people are prepping…

      it’s human nature that we tend to discount the future…

      which is why most of us will not be “preparing for the worst”…

      anyway…

      “preparing for the worst” is almost by definition an exercise in futility…

      • xabier says:

        One can sensibly prepare for a rather bumpy, twisty, road; but not for crashing into a ravine at 120mph.

        • Baby Doomer says:

          Yup…I argue that its a math issue. If you prepare you going be totally outnumbered by the unprepared by a thousand to one…And without the rule of law and a prosperous society in place you are dead…For example try go living as a homesteader in place like Syria, and see how long you last..Once the goons see smoke coming from your prepper chimney they are going to know you have food, water, and most likely woman…nuff said..

    • For three days, I see.

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