Low Oil Prices: An Indication of Major Problems Ahead?

Many people, including most Peak Oilers, expect that oil prices will rise endlessly. They expect rising oil prices because, over time, companies find it necessary to access more difficult-to-extract oil. Accessing such oil tends to be increasingly expensive because it tends to require the use of greater quantities of resources and more advanced technology. This issue is sometimes referred to as diminishing returns. Figure 1 shows how oil prices might be expected to rise, if the higher costs encountered as a result of diminishing returns can be fully recovered from the ultimate customers of this oil.

Figure 1. Chart showing expected long-term rise in oil prices as the full cost of oil production becomes increasingly expensive due to diminishing returns.

In my view, this analysis suggesting ever-rising prices is incomplete. After a point, prices can’t really keep up with rising costs because the wages of many workers lag behind the growing cost of extraction.

The economy is a networked system facing many pressures, including a growing level of debt and the rising use of technology. When these pressures are considered, my analysis indicates that oil prices may fall too low for producers, rather than rise too high for consumers. Oil companies may close down if prices remain too low. Because of this, low oil prices should be of just as much concern as high oil prices.

In recent years, we have heard a great deal about the possibility of Peak Oil, including high oil prices. If the issue we are facing is really prices that are too low for producers, then there seems to be the possibility of a different limits issue, called Collapse. Many early economies seem to have collapsed as they reached resource limits. Collapse seems to be characterized by growing wealth disparity, inadequate wages for non-elite workers, failing governments, debt defaults, resource wars, and epidemics. Eventually, population associated with collapsed economies may fall very low or completely disappear. As Collapse approaches, commodity prices seem to be low, rather than high.

The low oil prices we have been seeing recently fit in disturbingly well with the hypothesis that the world economy is reaching affordability limits for a wide range of commodities, nearly all of which are subject to diminishing returns. This is a different problem than most researchers have been concerned about. In this article, I explain this situation further.

One thing that is a little confusing is the relative roles of diminishing returns and efficiency. I see diminishing returns as being more or less the opposite of growing efficiency.

Figure 2.

The fact that inflation-adjusted oil prices are now much higher than they were in the 1940s to 1960s is a sign that for oil, the contest between diminishing returns and efficiency has basically been won by diminishing returns for over 40 years.

Figure 3.

Oil Prices Cannot Rise Endlessly

It makes no sense for oil prices to rise endlessly, for what is inherently growing inefficiency. Endlessly rising prices for oil would be similar to paying a human laborer more and more for building widgets, during a time that that laborer becomes increasingly disabled. If the number of widgets that the worker can produce in one hour decreases by 50%, logically that worker’s wages should fall by 50%, not rise to make up for his/her growing inefficiency.

The problem with paying higher prices for what is equivalent to growing inefficiency can be hidden for a while, if the economy is growing rapidly enough. The way that the growing inefficiency is hidden is by adding Debt and Complexity (Figure 4).

Figure 4.

Growing complexity is very closely related to “Technology will save us.” Growing complexity involves the use of more advanced machinery and ever-more specialized workers. Businesses become larger and more hierarchical. International trade becomes increasingly important. Financial products such as derivatives become common.

Growing debt goes hand in hand with growing complexity. Businesses need growing debt to support capital expenditures for their new technology. Consumers find growing debt helpful in affording major purchases, such as homes and vehicles. Governments make debt-like promises of pensions to citizen. Thanks to these promised pensions, families can have fewer children and devote fewer years to child care at home.

The problem with adding complexity and adding debt is that they, too, reach diminishing returns. The easiest (and cheapest) fixes tend to be added first. For example, irrigating a field in a dry area may be an easy and cheap way to fix a problem with inadequate food supply. There may be other approaches that could be used as well, such as breeding crops that do well with little rainfall, but the payback on this investment may be smaller and later.

A major drawback of adding complexity is that doing so tends to increase wage and wealth disparity. When an employer pays high wages to supervisory workers and highly skilled workers, this leaves fewer funds with which to pay less skilled workers. Furthermore, the huge amount of capital goods required in this more complex economy tends to disproportionately benefit workers who are already highly paid. This happens because the owners of shares of stock in companies tend to overlap with employees who are already highly paid. Low paid employees can’t afford such purchases.

The net result of greater wage and wealth disparity is that it becomes increasingly difficult to keep prices high enough for oil producers. The many workers with low wages find it difficult to afford homes and families of their own. Their low purchasing power tends to hold down prices of commodities of all kinds. The higher wages of the highly trained and supervisory staff don’t make up for the shortfall in commodity demand because these highly paid workers spend their wages differently. They tend to spend proportionately more on services rather than on commodity-intensive goods. For example, they may send their children to elite colleges and pay for tax avoidance services. These services use relatively little in the way of commodities.

Once the Economy Slows Too Much, the Whole System Tends to Implode

A growing economy can hide a multitude of problems. Paying back debt with interest is easy, if a worker finds his wages growing. In fact, it doesn’t matter if the growth that supports his growing wages comes from inflationary growth or “real” growth, since debt repayment is typically not adjusted for inflation.

Figure 5. Repaying loans is easy in a growing economy, but much more difficult in a shrinking economy.

Both real growth and inflationary growth help workers have enough funds left at the end of the period for other goods they need, despite repaying debt with interest.

Once the economy stops growing, the whole system tends to implode. Wage disparity becomes a huge problem. It becomes impossible to repay debt with interest. Young people find that their standards of living are lower than those of their parents. Investments do not appear to be worthwhile without government subsidies. Businesses find that economies of scale no longer work to their advantage. Pension promises become overwhelming, compared to the wages of young people.

The Real Situation with Oil Prices

The real situation with oil prices–and in fact with respect to commodity prices in general–is approximately like that shown in Figure 6.

Figure 6.

What tends to happen is that oil prices tend to fall farther and farther behind what producers require, if they are truly to make adequate reinvestment in new fields and also pay high taxes to their governments. This should not be too surprising because oil prices represent a compromise between what citizens can afford and what producers require.

Figure 7. Illustration indicating that the world has already reached a point where no oil price works for both oil suppliers and oil consumers.

In the years before diminishing returns became too much of a problem (back before 2005, for example), it was possible to find prices that were within an acceptable range for both sellers and buyers. As diminishing returns has become an increasing problem, the price that consumers can afford has tended to fall increasingly far below the price that producers require. This is why oil prices at first fall a little too low for producers, and eventually seem likely to fall far below what producers need to stay in business. The problem is that no price works for both producers and consumers.

Affordability Issues Affect All Commodity Prices, Not Just Oil

We are dealing with a situation in which a growing share of workers (and would be workers) find it difficult to afford a home and family, because of wage disparity issues. Some workers have been displaced from their jobs by robots or by globalization. Some spend many years in advanced schooling and are left with large amounts of debt, making it difficult to afford a home, a family, and other things that many in the older generation were able to take for granted. Many of today’s workers are in low-wage countries; they cannot afford very much of the output of the world economy.

At the same time, diminishing returns affect nearly all commodities, just as they affect oil. Mineral ores are affected by diminishing returns because the highest grade ores tend to be extracted first. Food production is also subject to diminishing returns because population keeps rising, but arable land does not. As a result, each year it is necessary to grow more food per arable acre, leading to a need for more complexity (more irrigation or more fertilizer, or better hybrid seed), often at higher cost.

When the problem of growing wage disparity is matched up with the problem of diminishing returns for the many different types of commodity production, the same problem occurs that occurs with oil. Prices of a wide range of commodities tend to fall below the cost of production–first by a little and, if the debt bubble pops, by a whole lot.

We hear people say, “Of course oil prices will rise. Oil is a necessity.” The thing that they don’t realize is that the problem affects a much bigger “package” of commodities than just oil prices. In fact, finished goods and services of all kinds made with these commodities are also affected, including new homes and vehicles. Thus, the pattern we see of low oil prices, relative to what is required for true profitability, is really an extremely widespread problem.

Interest Rate Policies Affect Affordability

Commodity prices bear surprisingly little relationship to the cost of production. Instead, they seem to depend more on interest rate policies of government agencies. If interest rates rise or fall, this tends to have a big impact on household budgets, because monthly auto payments and home payments depend on interest rates. For example, US interest rates spiked in 1981.

Figure 8. US short and long term interest rates. Graph by FRED.

This spike in interest rates led to a major cutback in energy consumption and in GDP growth.

Figure 9. World GDP Growth versus Energy Consumption Growth, based on data of 2018 BP Statistical Review of World Energy and GDP data in 2010$ amounts, from the World Bank.

Oil prices began to slide, with the higher interest rates.

Figure 10.

Figure 11 indicates that the popping of a debt bubble (mostly relating to US sub-prime housing) sent oil prices down in 2008. Once interest rates were lowered through the US adoption of Quantitative Easing (QE), oil prices rose again. They fell again, when the US discontinued QE.

Figure 11. Figure showing collapsing debt bubble at the time US oil prices peaked, and the use of Quantitative Easing (QE) to stimulate the economy, and thus bring prices back up again.

While these charts show oil prices, there is a tendency for a broad range of commodity prices to move more or less together. This happens because the commodity price issue seems to be driven to a significant extent by the affordability of finished goods and services, including homes, automobiles, and restaurant food.

If the collapse of a major debt bubble occurs again, the world seems likely to experience impacts somewhat similar to those in 2008, depending, of course, on the location(s) and size(s) of the debt bubble(s). A wide variety of commodity prices are likely to fall very low; asset prices may also be affected. This time, however, government organizations seem to have fewer tools for pulling the world economy out of a prolonged slump because interest rates are already very low. Thus, the issues are likely to look more like a widespread economic problem (including far too low commodity prices) than an oil problem.

Lack of Growth in Energy Consumption Per Capita Seems to Lead to Collapse Scenarios

When we look back, the good times from an economic viewpoint occurred when energy consumption per capita (top red parts on Figure 12) were rising rapidly.

Figure 12.

The bad times for the economy were the valleys in Figure 12. Separate labels for these valleys have been added in Figure 13. If energy consumption is not growing relative to the rising world population, collapse in at least a part of the world economy tends to occur.

Figure 13.

The laws of physics tell us that energy consumption is required for movement and for heat. These are the basic processes involved in GDP generation, and in electricity transmission. Thus, it is logical to believe that energy consumption is required for GDP growth. We can see in Figure 9 that growth in energy consumption tends to come before GDP growth, strongly suggesting that it is the cause of GDP growth. This further confirms what the laws of physics tell us.

The fact that partial collapses tend to occur when the growth in energy consumption per capita falls too low is further confirmation of the way the economics system really operates. The Panic of 1857 occurred when the asset price bubble enabled by the California Gold Rush collapsed. Home, farm, and commodity prices fell very low. The problems ultimately were finally resolved in the US Civil War (1861 to 1865).

Similarly, the Depression of the 1930s was preceded by a stock market crash in 1929. During the Great Depression, wage disparity was a major problem. Commodity prices fell very low, as did farm prices. The issues of the Depression were not fully resolved until World War II.

At this point, world growth in energy consumption per capita seems to be falling again. We are also starting to see evidence of some of the same problems associated with earlier collapses: growing wage disparity, growing debt bubbles, and increasingly war-like behavior by world leaders. We should be aware that today’s low oil prices, together with these other symptoms of economic distress, may be pointing to yet another collapse scenario on the horizon.

Oil’s Role in the Economy Is Different From What Many Have Assumed

We have heard for a long time that the world is running out of oil, and we need to find substitutes. The story should have been, “Affordability of all commodities is falling too low, because of diminishing returns and growing wage disparity. We need to find rapidly rising quantities of very, very cheap energy products. We need a cheap substitute for oil. We cannot afford to substitute high-cost energy products for low-cost energy products. High-cost energy products affect the economy too adversely.”

In fact, the whole “Peak Oil” story is not really right. Neither is the “Renewables will save us” story, especially if the renewables require subsidies and are not very scalable. Energy prices can never be expected to rise high enough for renewables to become economic.

The issues we should truly be concerned about are Collapse, as encountered by many economies previously. If Collapse occurs, it seems likely to cut off production of many commodities, including oil and much of the food supply, indirectly because of low prices.

Low oil prices and low prices of other commodities are signs that we truly should be concerned about. Too many people have missed this point. They have been taken in by the false models of economists and by the confusion of Peak Oilers. At this point, we should start considering the very real possibility that our next world problem is likely to be Collapse of at least a portion of the world economy.

Interesting times seem to be ahead.

 

 

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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1,594 Responses to Low Oil Prices: An Indication of Major Problems Ahead?

  1. Baby Doomer says:

    Electricity was first installed in the White House in 1891. It was such a new concept that President Benjamin Harrison and his wife both refused to touch light switches due to their fear of electrocution so the White House staff had to follow them around and turn the lights off and on for them

    https://www.energy.gov/articles/history-electricity-white-house

    • Chrome Mags says:

      Helped do some remodeling work on an old house once and the electrical in the wall was held in place with porcelain every foot or so. The wire itself was covered in what felt like some kind of fabric. Just 2 wires, no neutral (which is used to even out electrical load). The ground is used in case there is lightening. When I was a kid, people would sometimes replace screw in fuses with a penny. Trouble is the penny would allow any amount of E to pass through so it could be the source of a fire.

  2. Uncle Bill says:

    Yes Sir Hurray! BAU full throttle….

    The escalation seems to show that The US and its allies are openly against the progress of the climate negotiations. US President, Donald Trump had already announced the withdrawal of his country from the climate Treaty, he must, however, respect the period of notice of three years.

    Saudi Arabia and Kuwait hope as the oil States has always been a lax policy on CO2. Also Russia was always skeptical of the climate Treaty. Observers of the negotiations fear that the dispute over the word “welcome” was just the prelude to a larger crisis of the world-climate-Treaty.
    Re: Is EROEI Important Pt. 3
    Postby shortonoil » Sun 09 Dec 2018, 11:20:59

    If the world’s major oil producers are ready to do battle over “one word” in a climate report (Cop24), it is hard to imagine what they will do over the word “Peak”. The Saudis will cut your tongue out for uttering the word. But if there is no economy, there will be no CO2 production; unless it’s people burning their houses down piece by piece to stay warm in the winter

    • Chrome Mags says:

      It’s a conundrum all right.

      • Uncle Bill says:

        We’re doomed,” says Mayer HillmanHillman, an 86-year-old social scientist and senior fellow emeritus of the Policy Studies Institute, with such a beaming smile that it takes a moment for the words to sink in. “The outcome is death, and it’s the end of most life on the planet because we’re so dependent on the burning of fossil fuels.
        Even if the world went zero-carbon today that would not save us because we’ve gone past the point of no return.”

        Although Hillman has not flown for more than 20 years as part of a personal commitment to reducing carbon emissions, he is now scornful of individual action which he describes as “as good as futile. he says. “We’ve got to stop burning fossil fuels. So many aspects of life depend on fossil fuels, except for music and love and education and happiness. These things, which hardly use fossil fuels, are what we must focus on.

        Can it be done without a collapse of civilisation? “I don’t think so,” says Hillman. “Can you see everyone in a democracy volunteering to give up flying? Can you see the majority of the population becoming vegan? Can you see the majority agreeing to restrict the size of their families.
        Standing in the way is capitalism. Can you imagine the global airline industry being dismantled when hundreds of new runways are being built right now all over the world? It’s almost as if we’re deliberately attempting to defy nature. We’re doing the reverse of what we should be doing, with everybody’s silent acquiescence, and nobody’s batting an eyelid.

        • Can you imagine all debt becoming un-payable? Can you imagine asset prices (homes, farms, shares of stock) dropping dramatically in price. There is a lot more than capitalism standing in the way, I fear.

          • Uncle Bill says:

            Way back in the day I enrolled in a upper level “Public Economics” course at a local University. Remember one exchange with the Professor, a Lady of sharp intellect from a foreign land…Turkey perhaps. Well, in that era (1980s) Economic models stressed maximization for opitimal inputs/outputs. Catch phrases of the vocabulary to legitimize the field in Business. Unfortunately, I being a closet OFWorlder challenged that premise, stating rather with need to focus on minimizing and strive for internal optimal enrichment rather than external. Focusing on the arts, poetry, philosophy and inner harmony.
            One only has to realize the chaos is not out there, as within ourselves.
            Needless to say, it did not go over too well with her being from a rather poor country.
            She was sympathetic, but stood steadfast to her discipline and we moved on.
            On a bright note my term paper titled, ” Uncle Sam’s Baby…Nuclear Power Industry”, was well received and she agreed the external costs were being subsidized by the public at large and its development was really a propaganda program to establish a means to establish a nuclear weapons apparatus in the military.
            Entrenched thinking is hard to move, until it is shoved.

        • xabier says:

          Hmm. I think love also depends on fossil fuels – just try turning down the central heating with a woman in the house: poor heating = expensive divorce!

          • Uncle Bill says:

            Ain’t that the TRUTH…as a buddy claimed…”they expect it, feeling entitled!”
            Yes, collapse will be very unpleasant for hitched men…

  3. Harry McGibbs says:

    “…the pound is suddenly sliding amid reports that the government will cancel tomorrow’s parliamentary vote on the Brexit withdrawal deal.

    “Theresa May is holding a conference call with ministers right now; some have apparently revealed that the vote, due on Tuesday night, has been ditched.”

    https://www.theguardian.com/business/live/2018/dec/10/stock-markets-trade-war-growth-fears-uk-gdp-business-live?page=with:block-5c0e544ce4b0b950d12f9f1f#block-5c0e544ce4b0b950d12f9f1f

    • Harry McGibbs says:

      “European banks face a crucial two-week period before finding out if they will receive formal notice to begin closing £45tn of derivatives positions UK clearing houses, further raising their anxiety about access to London’s capital markets post-Brexit…

      “The EU has to formally recognise UK clearers as being properly regulated and supervised. Without approval, EU banks and brokers cannot use UK venues to trade derivatives and face a hefty rise in trading costs — or an inability to hedge their market exposures.”

      https://www.ft.com/content/f6407f50-fb9f-11e8-aebf-99e208d3e521

    • xabier says:

      Here’s the real UK headline:

      ‘Cost of Imported Chorizo Soars! Bearded men in Basque berets seen running to the shops as if a bull were after them, trampling down anyone who stands in their way.’

      • Harry McGibbs says:

        Time to stash one of these in the crawl-space, I think, Xabier.

        • Chrome Mags says:

          Post collapse when hoards of city folk are in starvation mode, you drive down Main Street, slow to a stop, open the back of a truck, put down a ramp and slide that giant salami out on to the street, quickly get back in and drive off, watching the masses gnaw through it while battling one another to get a chunk of it. An hour later you drive by and it’s all gone.

          Then you go to that same location at the same time the following day, but this time on foot and thousands of people will be waiting hoping it wasn’t a fluke.

        • xabier says:

          I’ll take the rack of hams in the back, too. The aroma must be over-powering, which is why the room is empty……

  4. Harry McGibbs says:

    “The “yellow vest” protests have been “a catastrophe” for the French economy, the finance minister says.

    “On Friday, the French retail federation told Reuters news agency that retailers had lost about €1bn since the protests first began on 17 November. Mr Le Maire said last week, before the most recent protests, that the restaurant trade had declined by between 20% and 50%. And Francois Asselin, head of the confederation of small and medium-sized businesses, told the Journal du Dimanche newspaper (in French) that overall the protests could cost his members €10bn. There are concerns that the protests could lead to a drop in tourism.”

    https://www.bbc.co.uk/news/world-europe-46499996

    • Harry McGibbs says:

      “The president of euro zone finance ministers group said in an interview published on Monday that he hoped the Italian government would be able to submit a revised draft budget to the European Union. “The rules of the Stability and Growth Pact apply to all. I hope that the Italian government will be able to revise its budget draft,” Mario Centeno, Portugal’s Finance Minister and head of the Eurogroup, was quoted as saying by German newspaper Sueddeutsche Zeitung.”

      https://www.reuters.com/article/us-italy-budget-centeno/italy-must-be-treated-like-every-other-country-eurogroup-head-idUSKBN1O90DK

    • zenny says:

      Yes riots are bad for business.

      • Dan says:

        I bet the company that makes yellow vests is loving those riots.
        Here in E Texas some guy down the road got into the flag business after 911 and you see his big cigar boat with a US Flag painted on it from time to time.
        Bet window fixers and graffetti removal companies are doing well.
        You know what else isn’t good for business – $6.50 gallon gas.

  5. Harry McGibbs says:

    “Data this morning showed Japan’s economy shrunk in the September quarter at more than double the rate previously thought. It follows a preliminary reading for Japan’s Q3 economic growth about a month ago, which wasn’t pretty. The figures indicated Japan’s economy shrunk at an annualized rate of 1.2%, partially dragged down by natural disasters which slowed production. But given the export-intensive nature of Japan’s economy, it also raised doubts around the outlook for global trade and economic activity.”

    https://www.businessinsider.com/japan-gdp-growth-global-economic-risks-2018-12?r=UK&IR=T

  6. Harry McGibbs says:

    “Australia’s regulators have been warned to prepare “contingency plans for a severe collapse in the housing market” that could lead to a “crisis situation” in one or more financial institutions… CoreLogic data shows house prices in Sydney fell another 0.5 per cent in the first week of December, bringing the total decline to 10 per cent from the peak in July last year. That surpasses the previous record set during the last recession between 1989 and 1991 when prices fell 9.6 per cent, making it the worst decline since the firm began collecting data in 1980.”

    https://www.news.com.au/finance/economy/australian-economy/oecd-warns-australia-to-prepare-contingency-plans-for-a-severe-collapse-in-the-housing-market/news-story/19d35f6461b01ae456162a3208277c50

  7. Harry McGibbs says:

    “Small-time investors who flooded into [US] real estate in the past decade to take advantage of low borrowing costs and rising home values are starting to cut back. The moves indicate that the market’s short-term risk-takers see limited upside—and possible turbulence—ahead.”

    https://www.wsj.com/articles/housing-slowdown-unnerves-the-fix-and-flip-crowd-1544371200

  8. O Baruah says:

    TODAY, Indian Central Bank( Reserve Bank of India), governor resigned. There’s deep trouble in India. Right wing government is eroding autonomy of institutions like RBI. High unemployment, overpopulation, agrarian crisis, crowded cities, banking problems ( bad loans)… All killing India.
    But government is shouting that India is the fastest growing major economy in the world.

    But we(Indians) all know how long this growth will last.

    https://economictimes.indiatimes.com/industry/banking/finance/banking/urjit-patel-resigns-as-the-rbi-governor/articleshow/67026103.cms

    • jupiviv says:

      I believe we have another Indian commenter here. I’ve long held that India or China will be the canaries in the BAU mine, out of the large economies that is. Now it looks like Brazil might beat you to it.

    • If the price is lower than we thought, the quantity is irrelevant.

      The Permian is part of an overall world networked economy. If it fails, the Permian fails.

    • Baby Doomer says:

      The recent USGS Delaware assessment is politically motivated; there is no doubt in my mind. Much the same as the EIA constantly over exaggerates oil production…the “agenda” is to keep oil prices low, OPEC scared (its not), Wall Street engaged and the shale oil industry going wide open with people that don’t know squat about the oil business cheerleading for it. The Director of the USGS is an appointee; read his nomination comments about science and politics, then read his comments about the Delaware study giving America a bigger chance at “energy dominance.” The American shale oil industry has not even been able to pay for what its already produced; who in the world are we trying to “dominate?” The combined national debts of Russia and the KSA are a little over what total public and private shale oil debt is in the US. Google it.

      The USGS itself says it will require over 318,000 wells (laterals) to recover this imaginary oil and I place those actual costs well over $3 trillion, with a ‘t.’ Moreover given the bench EUR estimates most of that imaginary oil will require $150 to remotely be economic. One can “science” technically recoverable, as yet undiscovered resources all they want, it is essentially still guesses and meaningless ones at that.

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