Spike in energy prices suggests that sharp changes are ahead

An analysis of what is going terribly wrong in the world economy

The world economy requires stability. People living in the world economy need stability, as well. They need food every day and a place to live. Children need a home situation that they can count on.

Back in the 1950 to 1979 era, when energy supplies of many kinds were growing rapidly, it was possible to build stability into the economic system: Jobs with a company were often long-time careers; pensions after retirement were offered; electricity was sold through regulated “utilities” that charged prices that wrapped in long-term maintenance of the electric grid and the cost of fuel, among other things.

But as high energy prices hit in the 1970s, the system became more and more strained. The mood changed. Margaret Thatcher became the Prime Minister of the UK in 1979, and Ronald Reagan became President of the United States in 1981. Under their leadership, debt was increasingly used to cover longer-term costs, and competition was encouraged. A person might say that a move toward greater complexity, but less stability, of the economic system had begun.

Now, through several iterations, the economy has become increasingly complex, with less and less redundancy to provide stability. The energy price spike that is being experienced today is a warning that something is very, very wrong. As I see the situation, the trend toward complexity has gone too far; the economic system is starting to break down. Sharp changes appear to be ahead. The world economy is shifting into contraction mode, with more and more parts of the system failing.

In this post, I will discuss some of the issues involved. It turns out that energy modelers haven’t understood how detrimental intermittency really is. They modeled intermittent electricity from renewables (wind, water and solar) as far more helpful than it really is. This has been confusing to everyone. The sharp changes that the title of this post refers to represent an early stage of economic collapse.

[1] If energy supplies are inexpensive and widely available, it is easy to build an economy.

I have written in the past about the need for energy supplies to keep the economy functioning properly being analogous to the need for food, to keep humans functioning properly.

The economy doesn’t operate on a single type of energy, any more than a human lives on a single type of food. The economy uses a portfolio of energy types. These include human labor, energy directly from sunlight, and energy from burning various types of fuels, including biomass and fossil fuels.

As long as energy sources are inexpensive and readily available, an economy can grow and provide goods and services for an increasing number of citizens. We can think of this as being analogous to, “As long as buying and preparing food takes little of our wages (or time, if we are growing it ourselves), then there are plenty of wages (or time) left over for other activities.”

But once energy prices start spiking, it looks like there is not enough to go around. In the absence of ways to hide the problem, citizens need to cut back on non-essentials, pushing the economy into recession. Or businesses stop making essential products that require natural gas or coal, such as fertilizer or fuel additives to hold emissions down. The lack of such products can, by itself, be very disruptive to an economy.

[2] Once energy supplies become constrained, energy prices tend to spike. In the early stages of these price spikes, adding complexity allows the economy to better tolerate higher energy costs.

There are many ways to work around the problem of rising energy prices, at least temporarily. For example:

• Build vehicles, such as cars, that are smaller and more fuel efficient.
• Extend fossil fuel supplies by building nuclear power plants, hydroelectric generating plants, wind turbines, solar panels, and geothermal electricity generation.
• Make factories more efficient.
• Add insulation to buildings; eliminate any cracks that might allow outside air into buildings.
• Instead of pre-funding capital costs, use debt to transfer these costs to later purchasers of energy products.
• Encourage competition in providing different parts of electricity production and distribution.
• Develop time-of-day pricing for electricity, so as to keep prices down to the marginal cost of production, even though this does not, in total, repay all costs of production and distribution.
• Cut back on routine maintenance of electricity transmission systems.
• Purchase coal and natural gas imports using spot pricing, rather than long term contracts, as long as these seem to be lower-priced than long-term commitments.
• Throughout the economy, take advantage of economies of scale and mechanization. Build huge companies. Replace human labor wherever possible.
• Stimulate the economy by increasing debt availability and lowering interest rates. This is helpful because a more rapidly growing economy can withstand higher energy prices.
• Use global supply chains to source as large a share of manufacturing inputs as possible from countries with low wages and low energy costs.
• Build very “lean” just-in-time supply chains.
• Create complex financial systems, with debt resold and repackaged in different ways, futures contracts, and exchange traded funds.

Together, these approaches comprise “complexity.” They tend to make the economic system less resilient. At least temporarily, they pass fewer of the higher costs of energy products through to current citizens. As a result, the economy can temporarily withstand a higher price of energy. But the system tends to become brittle and prone to failure.

[3] There are limits to added complexity. In fact, complexity limits are what are likely to make the economic system fail.

Joseph Tainter, in The Collapse of Complex Societies, makes the point that there are diminishing returns to added complexity. For example, the changes that result in the biggest gains in fuel savings for vehicles are the ones added first.

Another drawback of added complexity is the extreme wage disparity that tends to result. Instead of everyone earning close to the same amount, those at the top of the hierarchy get a disproportionate share of the wages. This is what leads to many of the problems we are seeing today. Would-be workers don’t want to apply for jobs, even when they seem to be available. Citizens become unhappy and rebellious. Lower-paid workers may not eat well, so that pandemics spread more easily.

The underlying problem is that population tends to rise, but it becomes harder and harder to produce food and other necessities with the arable land and energy resources available. Ugo Bardi uses Figure 1 to show the shape of the expected decline in goods and services produced in such a situation:

According to Bardi, Seneca in the title refers to a statement written by Lucius Annaeus Seneca in 91 CE, “It would be of some consolation for the feebleness of ourselves and our works if all things should perish as slowly as they come into being. As it is, increases are of sluggish growth, but the way to ruin is rapid.” In fact, this shape seems to approximate the type of cycle Turchin and Nefedov observed when analyzing several agricultural civilizations that collapsed in their book Secular Cycles.

[4] An increasing amount of complexity has been added since 1981 to help compensate for rising oil and other energy prices.

The prices of commodities, including oil, tend to be extremely variable because storage is very limited, relative to the large quantities used every day. There needs to be a very close match between supply and demand, or prices will rise very high or fall very low.

Oil is exceptionally important because it is the single largest source of energy for the world economy. It is heavily used in food production and in the extraction of minerals of all types. If the price of oil increases, the price of food tends to rise, as does the price of metals of many types. Oil is also important as a transportation fuel.

In the early days, before depletion led to higher extraction costs, oil prices remained stable and low (Figure 2), as a result of utility-type pricing by the Texas Railroad Commission. Oil prices started to spike, once depletion became more of a problem.

Economists tell us that oil and other commodity prices depend on “supply and demand.” When we look at turning points for oil prices, it becomes clear that financial manipulations play a significant role in determining oil demand. Such manipulations lead to prices that have practically nothing to do with the underlying cost of producing commodities. The huge changes in prices seem to reflect actions by central bankers to encourage or discourage lending (QE on Figure 3).

Quantitative easing (QE) makes it cheaper to borrow money. Adding QE tends to raise oil prices; deleting QE seems to reduce oil prices. These prices have little direct connection with the cost of extracting oil from the ground. Instead, prices are closely related to the amount of complexity being added to the system and whether it is having its intended impact on energy prices.

At the time of the 1973-1974 oil crisis, many people thought that the world was truly running out of oil. The petroleum industry did, indeed, succeed in extracting more. The 2005 to 2008 period was another period of concern that the world might be running out of oil. Then, in 2014, when oil prices suddenly fell, the dominant story suddenly became, “There is plenty of oil. The world’s biggest problem is climate change.”

In fact, there was no real reason to believe that the shortage situation had changed. US oil from shale had a brief run-up in production in the 2007 to 2019 period, but this production was unprofitable for producers, especially after oil prices dropped in 2014 (Figures 2 and 3). Producers of oil from shale are no longer investing very much in new production. With the sweet spots of fields depleted and this low level of investment, it will not be surprising if oil production from shale continues to fall.

The real story is that the supply of oil, coal and natural gas is limited by the extent to which additional complexity can be added to the economy, to keep selling prices so that they are both:

• High enough for producers of these products, so that they can both pay adequate taxes and make adequate reinvestment.
• Low enough for consumers, especially for the many consumers around the world with very low wages.

Many people have missed the point that, at least since 2014, financial manipulations have not kept prices for fossil fuels high enough for producers. Low prices are driving them out of business. This is the case for oil, coal and natural gas. In fact, low prices caused by giving wind and solar priority on the electric grid are driving producers of nuclear electricity out of business, as well.

Oil producers require a price of $120 a barrel or more to cover all of their costs. Without a much higher price than available today (even with oil prices over $80 per barrel), shale oil production can be expected to fall. In fact, OPEC and its affiliates won’t ramp up production by very large amounts either because they, too, need much higher prices to cover all their costs.

[5] Economists and analysts of many types put together models that give misleading results because they missed several important points.

After oil prices fell in late 2014, it became fashionable to believe that vast amounts of fossil fuels are available for extraction, and that our biggest problem in the future would be climate change. Besides low prices, one reason for this concern was the high level of fossil fuel proven reserves reported by many countries around the world.

Even fossil fuel companies started to invest in renewables because of the poor returns experienced from fossil fuel investments. It looked to them as if investment in renewables would be more profitable than continued investment in fossil fuel production. Of course, the profits of renewables were largely the result of government subsidies, particularly the subsidy of “going first.” Giving wind and solar first access when they happen to be available tends to lead to very low, and even negative, wholesale prices for other electricity producers. This drives these other producers of electricity out of business, even though they are really needed to correct for the intermittency of renewables.

There were many things that hardly anyone understood:

• Energy prices in today’s financially manipulated economy bear little relationship to the true cost of production.
• Fossil fuel producers need to be guaranteed long-term high prices, if there is to be any chance of ramping up production.
• Intermittent renewables (including wind, solar, and hydroelectric) have little value in a modern economy unless they are backed up with a great deal of fossil fuels and nuclear electricity.
• Our real problem with fossil fuels is a shortage problem. Price signals are very misleading.
• The models of economists are mostly wrong. The use of carbon pricing and intermittent renewables will simply disadvantage the countries adopting them.

The reason why geologists and fossil fuel producers give misleading information about the amount of oil, coal and natural gas available to be extracted is because it is not something they can be expected to know. In a sense, the question is, “How much complexity can the economy withstand before it becomes too brittle to handle a temporary shock, such as a pandemic shutdown?” It isn’t the amount of fossil fuels in the ground that matters; it is the follow-on effects of the high level of complexity on the rest of the economy that matters.

[6] At this point, ramping up fossil fuel production would be very difficult because of the long-term low prices for fossil fuels. Unfortunately, the economy cannot get along with only today’s small quantity of renewables.

Most people don’t realize just how slowly renewables have been ramping up as a share of world energy supplies. For 2020, wind and solar together amounted to only 5% of world energy supplies and hydroelectric amounted to 7% of world energy supplies. The world economy cannot function on 12% (or perhaps 20%, if more items are included) of its current energy supply any more than a person’s body can function on 12% or 20% of its current calorie intake.

Also, the world’s reaction to the pandemic acted, in many ways, like oil rationing. Figure 6 shows that consumption was reduced for oil, coal and natural gas. An even bigger impact was on the prices of these fuels. Prices fell, even though the cost of production was not falling. (See, for example, Figure 2 for the fall in oil prices.)

These lower prices left fossil fuel providers even worse off financially than they were previously. Some providers went out of business. They certainly do not have reserve funds set aside to develop the new fields that they would need to develop, if they were to ramp up production for oil, coal and natural gas now. Because of this, it is virtually impossible to ramp up fossil fuel production now. A lead time of at least several years is needed, besides a clear way of funding the higher production.

[7] Every plant and animal and, in fact, every growing thing, needs to win the battle against intermittency.

As mentioned in the introduction, humans need to eat on a regular basis. Hunter-gatherers solved the problem of intermittency of harvests by moving from area to area, so that their own location would match the location of food availability. Early agriculture and cities became possible when the growing of grain was perfected. Grain was both storable and portable, so it could be used year around. It could also be brought to cities, allowing people to live in a different location from where the crops were stored.

We can think of any number of adaptations in the plant and animal kingdom to intermittency. Some birds migrate. Bears hibernate. Deciduous trees lose their leaves each fall and grow them back again each spring.

Our supply of any of our energy products is in some sense intermittent. Oil wells deplete, so new ones need to be drilled. Biomass burned for fuel grows for a while, before it is cut down (or falls down) and is burned for fuel. Solar energy is available only until a cloud comes in front of the sun. In winter, solar energy is mostly absent.

[8] Any modeling of the cost of energy needs to take into account the full system needed to “bridge the intermittency gap.”

As far as I can see, the only pricing system that generates enough funds is one that takes into account the full system needs, including the need to overcome intermittency and the need for transportation of the energy to the user. In fact, I would argue that even more than this needs to be included. Good roads are generally required if the system is to be kept in good repair. Good schools are needed for would-be workers in the energy system. Any costs associated with pollution should be wrapped into the required price. Thus, the true cost of energy generation really should include a fairly substantial load for taxes for all of the governmental services that the system requires. And, of course, all parts of the system should pay their workers a living wage.

This high level of pricing can only be provided by utility type pricing of fossil fuels and electricity. The use of long-term contracts to purchase fossil fuels, uranium or electricity can also build in most of these costs. The alternative approach, buying fuels using spot contracts or pricing based on time of day electricity supply, looks appealing when costs are low. But such systems don’t build in sufficient funding for replacement of depleted fields or the full cost of a 24/7/365 electrical system.

Modelers didn’t understand that the “low prices now, higher prices later” approaches that were being advocated don’t really work for the long term. As limits are approached, prices tend to spike badly. Modelers had assumed that the economic system could handle such spikes in prices, and that the spikes in prices would quickly lead to new supply or adaptation. In fact, huge spikes in prices are very disruptive to the system. New supply is what is really needed, but providers tend to be too damaged by previous long periods of artificially low prices to provide this supply. The approach looks great in academic papers, but it leads to rolling blackouts and unfilled natural gas reservoirs for winter.

[9] Major changes for the worse seem to be ahead for the world economy.

At this point, it seems as if complexity has gone too far. The pandemic moved the world economy in the direction of contraction but prices of fossil fuels tend to spike as the economy opens up.

The recent spikes in prices are highly unlikely to produce the natural gas, coal and oil that is required. They are more likely to cause recession. Fossil fuel suppliers need high prices guaranteed for the long term. Even if such guarantees could be provided, it would still take several years to ramp up production to the level needed.

The general trend of the economy is likely to be in the direction of the Seneca Cliff (Figure 1). Everything won’t collapse all at once, but big “chunks” may start breaking away.

The debt system is a very vulnerable part. Debt is, in effect, a promise of goods or services made with energy in the future. If the energy isn’t there, the promised goods and services won’t be available. Governments may try to hide this problem with new debt, but governments can’t solve the underlying problem of missing goods and services.

Pension systems of all kinds are also vulnerable. If fewer goods and services are being made in total, they will need to be divided up differently. Pensioners are likely to get a reduced share, or nothing at all.

Importers of fossil fuels seem likely to be especially affected by price spikes because exporters have the ability to cut back in the quantity available for export, if total supply is inadequate. Europe is one part of the world that is especially dependent on oil, natural gas and coal imports.

The combined production of hydroelectric, wind and solar and biofuels (in Figure 9) amounts to only 19% of Europe’s total energy consumption (shown in Figure 8). There is no possible way that Europe can get along only with renewable energy, at any foreseeable time in the future.

European economists should have told European citizens, “There is no way you can get along using renewables alone for many, many years. Treat the countries that are exporting fossil fuels to you very well. Sign long term contracts with them. If they want to use a new pipeline, raise no objection. Your bargaining power is very low.” Instead, European economists talked about saving the planet from carbon dioxide. It is an interesting idea, but the sad truth is that if Europe takes itself out of the contest for energy imports, it mostly leaves more fossil fuels for exporters to sell to others.

China stands out as well, as the world’s largest consumer of energy, and as the world’s largest importer of oil, coal and natural gas. It is already encountering electricity shortages that are leading to rolling blackouts. In fact, rolling blackouts in China started almost a year ago in late 2020. China is, of course, a major exporter of goods to the rest of the world. If China has major energy problems, the rest of the world will no longer be able to count on China’s exports. Lack of China’s exports, by itself, could be a huge problem for the rest of the world.

I could continue speculating on the changes ahead. The basic problem, as I see it, is that we have reached limits on oil, coal and natural gas extraction, pretty much simultaneously. The limits are really complexity limits. The renewables that we have today aren’t able to save us, regardless of what the models of Mark Jacobson and others might say.

In the next few years, I am afraid that we will find out how collapse actually proceeds in a very interconnected world economy.