Why stimulus can’t fix our energy problems

Economists tell us that within the economy there is a lot of substitutability, and they are correct. However, there are a couple of not-so-minor details that they overlook:

  • There is no substitute for energy. It is possible to harness energy from another source, or to make a particular object run more efficiently, but the laws of physics prevent us from substituting something else for energy. Energy is required whenever physical changes are made, such as when an object is moved, or a material is heated, or electricity is produced.
  • Supplemental energy leverages human energy. The reason why the human population is as high as it is today is because pre-humans long ago started learning how to leverage their human energy (available from digesting food) with energy from other sources. Energy from burning biomass was first used over one million years ago. Other types of energy, such as harnessing the energy of animals and capturing wind energy with sails of boats, began to be used later. If we cut back on our total energy consumption in any material way, humans will lose their advantage over other species. Population will likely plummet because of epidemics and fighting over scarce resources.

Many people appear to believe that stimulus programs by governments and central banks can substitute for growth in energy consumption. Others are convinced that efficiency gains can substitute for growing energy consumption. My analysis indicates that workarounds, in the aggregate, don’t keep energy prices high enough for energy producers. Oil prices are at risk, but so are coal and natural gas prices. We end up with a different energy problem than most have expected: energy prices that remain too low for producers. Such a problem can have severe consequences.

Let’s look at a few of the issues involved: Continue reading

Our Latest Oil Predicament

It is impossible to tell the whole oil story, but perhaps I can offer a few insights regarding where we are today.

[1] We already seem to be back to the falling oil prices and refilling storage tanks scenario.

US crude oil stocks hit their low point on January 19, 2018 and have started to rise again. The amount of crude oil fill has averaged about 365,000 barrels per day since then. At the same time, prices of both Brent and WTI oil have fallen from their high points.

Figure 1. Average weekly spot Brent oil prices from EIA website, with circle pointing to recent downtick in prices.

Many people believe that the oil problem, when it hits, will be running out of oil. People with such a belief interpret a glut of oil to mean that we are still very far from any limit.

[2] An alternative story to running out of oil is that the economy is a self-organized system, operating under the laws of physics. With this story, too little demand for oil is as likely an outcome as a shortage of oil.

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$50 Oil Doesn’t Work

$50 per barrel oil is clearly less impossible to live with than $30 per barrel oil, because most businesses cannot make a profit with $30 per barrel oil. But is $50 per barrel oil helpful?

I would argue that it really is not.

When oil was over $100 per barrel, human beings in many countries were getting the benefit of most of that high oil price:

  • Some of the $100 per barrel goes as wages to the employees of the oil company who extracted the oil.
  • Often, the oil company contracts with another company to do part of the oil extraction. Part of the $100 per barrel is paid as wages to employees of the subcontracting companies.
  • An oil company buys many goods, such as steel pipe, which are made by others. Part of the $100 per barrel goes to employees of the companies making the goods that the oil company buys.
  • An oil company pays taxes. These taxes are used to fund many programs, including new roads, schools, and transfer payments to the elderly and unemployed. Again, these funds go to actual people, as wages, or as transfer payments to people who cannot work.
  • An oil company pays dividends to stockholders. Some of the stockholders are individuals; others are pension funds, insurance companies, and other companies. Pension funds use the dividends to make pension payments to individuals. Insurance companies use the dividends to make insurance premiums affordable. One way or another, these dividends act to create benefits for individuals.
  • Interest payments on debt go to bondholders or to the bank making the loan. Pension plans and insurance companies often own the bonds. These interest payments go to pay pension payments of individuals or to help make insurance premiums more affordable.
  • A company may have accumulated profits that are not paid out in dividends and taxes. Typically, they are reinvested in the company, allowing more people to have jobs. In some cases, the value of the stock may rise as well.

When the price falls from $100 per barrel to $50 per barrel, the incomes of many people are adversely affected. This is a huge negative with respect to world economic growth.

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The real oil limits story; what other researchers missed

For a long time, a common assumption has been that the world will eventually “run out” of oil and other non-renewable resources. Instead, we seem to be running into surpluses and low prices. What is going on that was missed by M. King Hubbert, Harold Hotelling, and by the popular understanding of supply and demand?

The underlying assumption in these models is that scarcity would appear before the final cutoff of consumption. Hubbert looked at the situation from a geologist’s point of view in the 1950s to 1980s, without an understanding of the extent to which geological availability could change with higher price and improved technology. Harold Hotelling’s work came out of the conservationist movement of 1890 to 1920, which was concerned about running out of non-renewable resources. Those using supply and demand models have equivalent concerns–too little fossil fuel supply relative to demand, especially when environmental considerations are included.

Virtually no one realizes that the economy is a self-organized networked system. There are many interconnections within the system. The real situation is that as prices rise, supply tends to rise as well, because new sources of production become available at the higher price. At the same time, demand tends to fall for a variety of reasons:

  • Lower affordability
  • Lower productivity growth
  • Falling relative wages of non-elite workers

The potential mismatch between amount of supply and demand is exacerbated by the oversized role that debt plays in determining the level of commodity prices. Because the oil problem is one of diminishing returns, adding debt becomes less and less profitable over time. There is a potential for a sharp decrease in debt from a combination of defaults and planned debt reductions, leading to very much lower oil prices, and severe problems for oil producers. Financial institutions tend to be badly affected as well. If a person looks at only past history, the situation looks secure, but it really is not.

Figure 1. By Merzperson at English Wikipedia - Transferred from en.wikipedia to Commons, Public Domain, https://commons.wikimedia.org/w/index.php?curid=2570936

Figure 1. By Merzperson at English Wikipedia – Transferred from en.wikipedia to Commons, Public Domain, https://commons.wikimedia.org/w/index.php?curid=2570936

Substitutes aren’t really helpful; they tend to be high-priced and dependent on the use of fossil fuels, including oil. They cannot possibly operate on their own. They add to the “oversupply at high prices” problem, but don’t really fix the need for low-priced supply.

Why supply tends to rise as prices rise

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Why oil under $30 per barrel is a major problem

A person often reads that low oil prices–for example, $30 per barrel oil prices–will stimulate the economy, and the economy will soon bounce back. What is wrong with this story? A lot of things, as I see it:

1. Oil producers can’t really produce oil for $30 per barrel.

A few countries can get oil out of the ground for $30 per barrel. Figure 1 gives an approximation to technical extraction costs for various countries. Even on this basis, there aren’t many countries extracting oil for under $30 per barrel–only Saudi Arabia, Iran, and Iraq. We wouldn’t have much crude oil if only these countries produced oil.

Figure 1. Global Breakeven prices (considering only technical extraction costs) versus production. Source:Alliance Bernstein, October 2014

Figure 1. Global breakeven prices (considering only technical extraction costs) versus production. Source: Alliance Bernstein, October 2014

2. Oil producers really need prices that are higher than the technical extraction costs shown in Figure 1, making the situation even worse.

Oil can only be extracted within a broader system. Companies need to pay taxes. These can be very high. Including these costs has historically brought total costs for many OPEC countries to over $100 per barrel.

Independent oil companies in non-OPEC countries also have costs other than technical extraction costs, including taxes and dividends to stockholders. Also, if companies are to avoid borrowing a huge amount of money, they need to have higher prices than simply the technical extraction costs. If they need to borrow, interest costs need to be considered as well.

3. When oil prices drop very low, producers generally don’t stop producing.

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