2016: Oil Limits and the End of the Debt Supercycle

What is ahead for 2016? Most people don’t realize how tightly the following are linked:

  1. Growth in debt
  2. Growth in the economy
  3. Growth in cheap-to-extract energy supplies
  4. Inflation in the cost of producing commodities
  5. Growth in asset prices, such as the price of shares of stock and of farmland
  6. Growth in wages of non-elite workers
  7. Population growth

It looks to me as though this linkage is about to cause a very substantial disruption to the economy, as oil limits, as well as other energy limits, cause a rapid shift from the benevolent version of the economic supercycle to the portion of the economic supercycle reflecting contraction. Many people have talked about Peak Oil, the Limits to Growth, and the Debt Supercycle without realizing that the underlying problem is really the same–the fact the we are reaching the limits of a finite world.

There are actually a number of different kinds of limits to a finite world, all leading toward the rising cost of commodity production. I will discuss these in more detail later. In the past, the contraction phase of the supercycle seems to have been caused primarily by too high population relative to resources. This time, depleting fossil fuels–particularly oil–plays a major role. Other limits contributing to the end of the current debt supercycle include rising pollution and depletion of resources other than fossil fuels.

The problem of reaching limits in a finite world manifests itself in an unexpected way: slowing wage growth for non-elite workers. Lower wages mean that these workers become less able to afford the output of the system. These problems first lead to commodity oversupply and very low commodity prices. Eventually these problems lead to falling asset prices and widespread debt defaults. These problems are the opposite of what many expect, namely oil shortages and high prices. This strange situation exists because the economy is a networked system. Feedback loops in a networked system don’t necessarily work in the way people expect.

I expect that the particular problem we are likely to reach in 2016 is limits to oil storage. This may happen at different times for crude oil and the various types of refined products. As storage fills, prices can be expected to drop to a very low level–less than $10 per barrel for crude oil, and correspondingly low prices for the various types of oil products, such as gasoline, diesel, and asphalt. We can then expect to face a problem with debt defaults, failing banks, and failing governments (especially of oil exporters). Continue reading

Deflationary Collapse Ahead?

Both the stock market and oil prices have been plunging. Is this “just another cycle,” or is it something much worse? I think it is something much worse.

Back in January, I wrote a post called Oil and the Economy: Where are We Headed in 2015-16? In it, I said that persistent very low prices could be a sign that we are reaching limits of a finite world. In fact, the scenario that is playing out matches up with what I expected to happen in my January post. In that post, I said

Needless to say, stagnating wages together with rapidly rising costs of oil production leads to a mismatch between:

  • The amount consumers can afford for oil
  • The cost of oil, if oil price matches the cost of production

This mismatch between rising costs of oil production and stagnating wages is what has been happening. The unaffordability problem can be hidden by a rising amount of debt for a while (since adding cheap debt helps make unaffordable big items seem affordable), but this scheme cannot go on forever.

Eventually, even at near zero interest rates, the amount of debt becomes too high, relative to income. Governments become afraid of adding more debt. Young people find student loans so burdensome that they put off buying homes and cars. The economic “pump” that used to result from rising wages and rising debt slows, slowing the growth of the world economy. With slow economic growth comes low demand for commodities that are used to make homes, cars, factories, and other goods. This slow economic growth is what brings the persistent trend toward low commodity prices experienced in recent years.

A chart I showed in my January post was this one:

Figure 1. World Oil Supply (production including biofuels, natural gas liquids) and Brent monthly average spot prices, based on EIA data.

Figure 1. World Oil Supply (production including biofuels, natural gas liquids) and Brent monthly average spot prices, based on EIA data.

The price of oil dropped dramatically in the latter half of 2008, partly because of the adverse impact high oil prices had on the economy, and partly because of a contraction in debt amounts at that time. It was only when banks were bailed out and the United States began its first round of Quantitative Easing (QE) to get longer term interest rates down even further that energy prices began to rise. Furthermore, China ramped up its debt in this time period, using its additional debt to build new homes, roads, and factories. This also helped pump energy prices back up again.

The price of oil was trending slightly downward between 2011 and 2014, suggesting that even then, prices were subject to an underlying downward trend. In mid-2014, there was a big downdraft in prices, which coincided with the end of US QE3 and with slower growth in debt in China. Prices rose for a time, but have recently dropped again, related to slowing Chinese, and thus world, economic growth. In part, China’s slowdown is occurring because it has reached limits regarding how many homes, roads and factories it needs.

I gave a list of likely changes to expect in my January post. These haven’t changed. I won’t repeat them all here. Instead, I will give an overview of what is going wrong and offer some thoughts regarding why others are not pointing out this same problem.

Overview of What is Going Wrong

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Rising Energy Costs Lead to Recession; Eventually Collapse

How does the world reach limits? This is a question that few dare to examine. My analysis suggests that these limits will come in a very different way than most have expected–through financial stress that ultimately relates to rising unit energy costs, plus the need to use increasing amounts of energy for additional purposes:

  • To extract oil and other minerals from locations where extraction is very difficult, such as in shale formations, or very deep under the sea;
  • To mitigate water shortages and pollution issues, using processes such as desalination and long distance transport of food; and
  • To attempt to reduce future fossil fuel use, by building devices such as solar panels and electric cars that increase fossil fuel energy use now in the hope of reducing energy use later.

We have long known that the world is likely to eventually reach limits. In 1972, the book The Limits to Growth by Donella Meadows and others modeled the likely impact of growing population, limited resources, and rising pollution in a finite world. They considered a number of scenarios under a range of different assumptions. These models strongly suggested the world economy would begin to hit limits in the first half of the 21st century and would eventually collapse.

The indications of the 1972 analysis were considered nonsense by most. Clearly, the world would work its way around limits of the type suggested. The world would find additional resources in short supply. It would become more efficient at using resources and would tackle the problem of rising pollution. The free market would handle any problems that might arise.

The Limits to Growth analysis modeled the world economy in terms of flows; it did not try to model the financial system. In recent years, I have been looking at the situation and have discovered that as we hit limits in a finite world, the financial system is the most vulnerable part of the system because it ties everything else together. Debt in particular is vulnerable because the time-shifting aspect of debt “works” much better in a rapidly growing economy than in an economy that is barely growing or shrinking.

The problem that now looks like it has the potential to push the world into financial collapse is something no one would have thought of—high oil prices that take a slice out of the economy, without anything to show in return. Consumers find that their own salaries do not rise as oil prices rise. They find that they need to cut back on discretionary spending if they are to have adequate funds to pay for necessities produced using oil. Food is one such necessity; oil is used to run farm equipment, make herbicides and pesticides, and transport finished food products. The result of a cutback in discretionary spending is recession or near recession, and less job availability. Governments find themselves in  financial distress from trying to mitigate the recession-like impacts without adequate tax revenue.

One of our big problems now is a lack of cheap substitutes for oil. Highly touted renewable energy sources such as wind and solar PV are not cheap. They also do not substitute directly for oil, and they increase near-term fossil fuel consumption. Ethanol can act as an “oil extender,” but it is not cheap. Battery powered cars are also not cheap.

The issue of rising oil prices is really a two-sided issue. The least expensive sources of oil tend to be extracted first. Thus, the cost of producing oil tends to rise over time. As a result, oil producers tend to require ever-rising oil prices to cover their costs. It is the interaction of these two forces that leads to the likelihood of financial collapse in the near term:

  1. Need for ever-rising oil prices by oil producers.
  2. The adverse impact of high-energy prices on consumers.

If a cheap substitute for oil had already come along in adequate quantity, there would be no problem. The issue is that no suitable substitute has been found, and financial problems are here already. In fact, collapse may very well come from oil prices not rising high enough to satisfy the needs of those extracting the oil, because of worldwide recession. Continue reading

How Oil Exporters Reach Financial Collapse

Recently, I explained how high oil prices can bring on financial collapse for oil importers. In this post, I’ll discuss the flip side of the situation: how oil exporters reach financial collapse.

Unfortunately, we have many examples of countries that were oil exporters, but are dealing with collapse situations. Egypt, Syria, and Yemen all have had political disruptions since 2011. These may not be called financial collapse, but they all took place as the country’s oil exports decreased and as the price of imported food rose. Another example is the Former Soviet Union (FSU). It collapsed in 1991, after a period of low oil prices, in what looks very much like a financial collapse.

There are several dynamics at work in the financial collapse of oil exporters:

  1. Oil exporters are often dependent on oil export revenue to fund government programs.
  2. The need for government programs grows as population grows and as the price of food  rises.
  3. The amount of oil that can be extracted in a given year often declines over time, as initial stores are depleted.
  4. Exports often decline even more rapidly than oil supply, because of rising oil consumption as population grows.

In general, high oil prices are good for oil exporters (except the effect on food prices). At the same time, oil importers strongly prefer low oil prices.  As a result, we end up with a price tug of war between oil importers and oil exporters.

One additional issue is declining Energy Return on Energy Invested. Countries often have the option of reducing their rate of decline by adding production in areas which are more expensive to drill (say deeper, smaller locations offshore Norway) or by using enhanced oil recovery methods. Such approaches add costs (and energy use), and further add to the price that oil exporters need for their product.

Egypt, Syria, and Yemen

Egypt, Syria, and Yemen are three countries that the press would say are suffering from the continuing impact of the Arab Spring revolutions, which began in 2011, or of civil war. The similarity of the oil production and consumption charts for the three countries (shown below) suggests that declining oil exports likely played a major role as well.  Continue reading

How Resource Limits Lead to Financial Collapse

Resource limits are invisible, so most people don’t realize that we could possibility be approaching them. In fact, my analysis indicates resource limits are really financial limits, and in fact, we seem to be approaching those limits right now.

Many analysts discussing resource limits are talking about a very different concern than I am talking about. Many from the “peak oil” community say that what we should worry about is a decline in world oil supply. In my view, the danger is quite different: The real danger is financial collapse, coming much earlier than a decline in oil supply. This collapse is related to high oil price, and also to higher costs for other resources as we approach limits (for example, desalination of water where water supply is a problem, and higher natural gas prices in much of the world).

The financial collapse is related to Energy Return on Energy Invested (EROEI) that is already too low. I don’t see any particular EROEI target as being a threshold–the calculations for individual energy sources are not on a system-wide basis, so are not always helpful. The issue is not precisely low EROEI. Instead, the issue is the loss of  cheap fossil fuel energy to subsidize the rest of society.

If an energy source, such as oil back when the cost was $20 or $30 barrel, can produce a large amount of energy in the form it is needed with low inputs, it is likely to be a very profitable endeavor. Governments can tax it heavily (with severance taxes, royalties, rental for drilling rights, and other fees that are not necessarily called taxes). In many oil exporting countries, these oil-based revenues provide a large share of government revenues. The availability of cheap energy also allows inexpensive roads, bridges, pipelines, and schools to be built.

As we move to energy that requires more expensive inputs for extraction (such as the current $90+ barrel oil), these benefits are lost. The cost of roads, bridges, and pipelines escalates. It is this loss of a subsidy from cheap fossil fuels that is significant part of what moves us toward financial collapse.

Renewable energy generally does not solve this problem. In fact, it can exacerbate the problem, because the cost of its inputs tend to be high and very “front-ended,” leading to a need for subsidies. What is really needed is a way to replace lost tax revenue, and a way to bring down the high cost of new bridges and roads–that is a way to get back to the cost structure we had when oil (and other fossil fuels) could be extracted cheaply.

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