Our Oil Problems are Not Over!

If a person reads US newspapers, it is easy to get the impression that all of the world’s oil problems are over. But this is not really the case.

An Overlooked Part of the Problem: High Oil Prices

A major piece of the world’s oil problem is high price. Prices continue to be far above historic levels, now in 2013.

Figure 1. World oil price (Brent equivalent) in 2011$,  based on BP 2013 Statistical Review of World Energy data.

Figure 1. World oil price (Brent equivalent) in 2011$, based on BP 2013 Statistical Review of World Energy data.

High oil prices disrupt economies around the world because when oil prices rise, the wages of the vast majority of workers do not rise to compensate. Workers find that they need to adjust their spending patterns because the higher price of oil leads to higher prices for many things, including the cost of commuting, the cost of food, and the cost of buying goods that have been shipped long distance.

When workers adjust their spending patterns, discretionary spending is cut. This leads to patterns we associate with recession, or perhaps just slow growth. Unemployment rises, and there is less demand for new homes and cars.

Governments are also affected, because many of their costs, such as building roads, are higher. They also have to pay benefits to workers who can’t find jobs, or who can only find only low-paying jobs. Governments find it increasingly difficult to collect enough taxes because of the low wages of workers. Problems with rising deficits and the debt ceiling become the order of the day. Does any of this sound familiar?

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High Oil Prices are Starting to Affect China and India

Update: Not long after I wrote this post, the EIA revised the oil consumption amounts by country that they had published a few days earlier. The numbers changed substantially for quite a few of the countries outside the US and Europe. While the trend is still to lower growth in oil usage in 2011 and 2012 in China and India than in 2010, the trend is less pronounced.

Furthermore, we now have another set of numbers to check against EIA’s oil consumption amounts. BP released Statistical Review of World Energy 2013 yesterday, June 12. A comparison of annual increases in oil consumption (on a barrels of oil per day basis, not adjusted for population growth) from the three sources is as follows:

Comparison of growth in oil consumption, based on EIA original 2012 numbers, EIA revised 2012 numbers, and BP new Statistical Review of World Energy data. (All amounts based on "barrels per day" consumption.)

Comparison of growth in oil consumption, based on EIA original 2012 numbers, EIA revised 2012 numbers, and BP new Statistical Review of World Energy data. (All amounts based on “barrels per day” consumption.)

There seems to be fairly consistent reporting of oil consumption for major OECD countries, but this is  less the case for non-OECD countries. The lack of stability in reported oil consumption, both between reporting organizations and between reports, suggests that oil consumption numbers have “large error bands” around them. Below is a revised version of my original post.

Revised post. Based on revised EIA data, it appears that at current high oil prices, oil  demand the United States and Europe is being reduced. There are some indications that oil demand in China and India are flattening, but these are preliminary. For those who are wondering how high oil prices need to be, to be “too high,” the answer is, “We are already there, for the United States and Europe. We are getting there for China and India. In fact, continued high oil prices are a big reason behind the recessionary forces we are now seeing around the world.”

China and India, like the United States and most of Europe, are oil importers. Over time, we should expect high oil prices to have an impact on all importers. While the original EIA data suggested that China and India were affected in  2011 and 2012, the impact is much more muted using revised data.

In this post, I also explain why a person might expect a difference in the impact of high oil prices on oil importing countries compared to oil exporting countries.
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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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The Connection of Depressed Wages to High Oil Prices and Limits to Growth

In my view, wages are the backbone an economy. If workers have difficulty finding a job, or have difficulty earning sufficient wages, the lack of wages will be a problem, not just for the workers, but for governments and businesses. Governments will have a hard time collecting enough taxes, and businesses will have a hard time finding enough customers. There can be business-to-business transactions, but ultimately somewhere “downstream,” businesses need wage-earning customers who can afford to pay for goods and services. Even if a business produces a resource that is in very high demand, such as oil, it still needs wage-earning customers either to buy the resource directly (for example, as gasoline), or to buy the resource indirectly (for example, as food which uses oil in production and transport).

It is not just any wages that are important. It is the wages paid by private companies (rather than governments) that are important, as the backbone to the economy. Governments tend to get their revenues from private citizens and from businesses, both of which are dependent on wages of private citizens. There are a few pieces outside of this loop, such as taxes on imports from foreign countries. With the advent of free international trade, this source is disappearing. Another piece outside the US wage-loop is taxes on resource extraction, if these resources are exported.

Instead of using the analogy of a backbone, perhaps I should say that wages are the base that ultimately determines the quantity of goods and services an economy can afford.

Figure 1. Author's view of structure of the economy. Non-governmental wages form the base of the entire economy.

Figure 1. Author’s view of structure of the economy. Non-governmental wages form the base of the entire economy.

Obviously there are other kinds of income, such as “rents,” but these, too, ultimately come from wage earners. Furthermore, businesses cannot earn money to pay dividends unless some consumer, somewhere, can afford to buy the goods and services their business is selling.

I have written recently about how the proportion of Americans with jobs rose to a peak, and since has been declining.

Figure 2. US Number Employed / Population, where US Number Employed is Total Non_Farm Workers from Current Employment Statistics of the Bureau of Labor Statistics and Population is US Resident Population from the US Census.  2012 is partial year estimate.

Figure 2. US Number Employed / Population, where US Number Employed is Total Non_Farm Workers from Current Employment Statistics of the Bureau of Labor Statistics and Population is US Resident Population from the US Census. 2012 is partial year estimate.

I decided in this post to look at the dollars these workers are earning. In particular, I decided to look at wages, other than government wages, adjusted to today’s cost level using the “CPI- Urban,” cost index of the Bureau of Labor Statistics.  I discovered that these wages are doing very poorly. I also discovered a disturbing connection between high oil prices and flattening or declining wages. Putting all of these pieces together suggests a connection to “Limits to Growth.”

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How High Oil Prices Lead to Recession

There is ample evidence that spikes in oil prices leads to recession, at least in the US, which is an oil-importing nation. James Hamilton has shown that 10 out of the last 11 US recessions were associated with oil price spikes. How does this happen? An analogy can perhaps help explain the situation. This analogy also sheds light on a number of related economic mysteries:

  1. How can oil have a far greater impact on the world economy than its share of the world GDP would suggest? After all,  BP’s World Energy Outlook to 2030 shows the world cost of oil is only a little over 4% of world GDP.
  2. How can high oil prices continue to act as a “drag” on the economy, long after the initial spike is past?
  3. Why isn’t a service economy insulated from the problems of high oil prices? After all, its energy use is relatively low.

The Oil Analogy

An oil product, such as jet fuel, is in some ways analogous to a specialized employee, with skills different from what human employees have. Let’s think of an airline. It has human employees–pilots, copilots, flight attendants, baggage workers, mechanics, and airport check-in personnel. None of these human employees can actually provide the energy to make the jet fly, however. It takes jet fuel to do that.

What happens if the price of jet fuel triples? Jet fuel is now more that than triple the price (near $3.00 gallon) it was in the late 1990s (under $1.00 gallon, at today’s prices).

Figure 1. Jet fuel price in December 2012 $. Jet fuel price per gallon is Spot Gulf Coast price from EIA; price adjustment based on CPI-Urban, from US Bureau of Labor Statistics.

Figure 1. Jet fuel price in December 2012 $. Jet fuel price per gallon is Spot Gulf Coast price from EIA; price adjustment based on CPI-Urban, from US Bureau of Labor Statistics.

The high cost of jet fuel is analogous to the jet fuel employees’ union demanding triple the wages they were paid previously. So what is the airline to do? With very high aviation fuel prices, many tourists who might buy airline tickets will be “priced out” of the market for long distance travel. The airline can sell some airline tickets at higher prices, but not as many.

One thing airlines can do is to cut the number of flights, taking the least fuel-efficient planes out of service and reducing flights on routes with the most unfilled seats. According to a recent Wall Street Journal article, airlines spend 34% of revenue on fuel. With such a high fuel cost, even with these changes, airline ticket prices will remain high. But perhaps with fewer flights, the airline can make a profit.

If an airline cuts its number of flight, this leads to an “across the board” cut in the goods and services the airline buys. The airline will use less jet fuel (and thus use fewer “jet fuel employees”). If it is able to retire quite a few fuel-inefficient jets, “jet fuel employees” will be cut to a greater extent than human employees. It will use fewer human workers, at all levels: pilots, copilots, flight attendants, and ground workers of all types. The airline will reduce its electricity usage because it needs fewer gates in airports for its operations. The airline will also need less gasoline because it will operate fewer baggage-transport vehicles and other ground vehicles.

In many ways, the airline is simply shrinking in size to reflect reduced demand for its high-priced services. When this happens in multiple industries, the result looks very much like recession. I described this situation earlier in a post called How is an oil shortage like a missing cup of flour?. In that post, I said that if oil supplies are short, the situation is not too different from a baker who does not have enough flour to make a full batch of cookies. If he still wants to make cookies, he needs to make a smaller batch, and so needs to cut back on all of the other ingredients as well.

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