Oil Limits Reduce GDP Growth; Unwinding QE a Problem

We know the world economic pattern we have been used to in years past–world population grows, resource usage grows (including energy resources), and debt increases. The economy grows fast enough that paying an interest rate a little higher than the inflation rate “works”  for both lenders and borrowers. Borrowers are able to handle the required interest rate, because their wages are rising fast enough to buy homes and cars at prevailing interest rates. Unemployment is not too much of a problem because jobs grow with population and resource usage. Governments do fairly well, too, because they can tax the growing wages of the population sufficiently to get enough taxes to pay the benefits they have promised to constituents.

This model “works” fairly well, as long as the economy is growing fast enough–population continues to grow and resource extraction continues to grow as planned. In a finite world, we know that this model cannot work forever. At some point, we can expect to start reaching limits.

What do these limits look like?  I would argue that in the case of resource extraction, these limits look like increasingly high cost of extraction. We need to extract resources from increasingly deep locations, in increasingly out-of-the way places, using increasingly more energy intensive techniques. For a while, improved technology is sufficient to keep costs down, but eventually the cost of extraction begins to rise. Some of the rising cost may even be taxes, because the country where the extraction is located needs higher taxes to keep a growing population properly fed and housed, so they do not rebel and disrupt production.

When the cost of extraction begins to rise, it is as if we are pouring more manpower and more resources of many types (steel, fracking fluid, jet fuel, electricity, diesel fuel) into a deep pit, never to be used again. When we put more resources in, we get the same amount of resource out, or even less than in the past. If we want to continue to increase the amount we extract, we have to further increase the quantity of resources used in extraction. I have referred to this issue as the Investment Sinkhole problem. Obviously, if we put more manpower and other resources into this pit, we have less for other purposes.

A recent example of resources hitting limits is oil. World oil prices started increasing about 2004 (Figure 1). Analysts say that these rising prices are related to rapidly increasing production costs. Oil company presidents say that we extracted the cheap to extract oil first, and most of it is now gone. Recent reports of major oil companies say profits are dropping, despite high oil prices.

Figure 1. World crude oil production and Brent spot oil price, both based on EIA data.

Figure 1. World crude oil production and Brent spot oil price, both based on EIA data.

Oil is an important commodity because it represents about 33% of the world’s energy supply. It is the world’s primary transportation fuel. It is a very important fuel in agriculture, operating farm equipment, transporting fertilizer, running diesel irrigation pumps, making herbicides and pesticides, and transporting goods to market. Therefore, if oil prices rise, food prices are likely to rise well. In fact, since nearly all goods are transported, an oil price rise affects nearly all goods and quite a few services.

There are really two issues when the cost of oil extraction rises:

1. If the sales price of oil rises, to what extent will this increase adversely affect the economic growth oil importing economies? Rising oil prices mean that the salaries of workers do not go as far, so they must cut back on discretionary goods. Profits of companies will also fall, because it is hard to raise prices of goods, without reducing the quantity sold. In my view, the run-up in oil prices since 2004 explains pretty much all of the “Great Recession’s” impact on oil importing economies. See my article Oil Supply Limits and the Continuing Financial Crisis. In the next section, I show evidence that oil price increases have had a very adverse impact on GDP growth of oil importers.

2.  While the cost of oil extraction is expected to continue to rise, can the sales price of oil really increase to match this higher extraction cost? If oil price can’t rise because of affordability issues (low salary growth, low growth in debt, or cutbacks in government transfer payments), then there is likely to be a crisis of a different kind. Oil exporters will find that oil prices are not high enough to cover their costs, and will cut back drilling to what is profitable. In fact, countries that are producing oil mostly for themselves, such as the US, are also likely to see their oil production drop, because prices will not be high enough to justify new investment. In such a situation, both oil importers and oil exporters are much worse off, because most of our systems are dependent on oil, and less oil will be available.

The Federal Reserve now is discussing the possibility of stopping quantitative easing. If this is done, I expect it will have a very adverse economic effect: long-term interest rates will rise and asset prices are likely to fall. If commodity prices fall as well, then we could find ourselves in the scenario outlined in the preceding paragraph, in which oil prices drop lower than the cost of production for many producers.

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Inflation, Deflation, or Discontinuity?

A question that seems to come up quite often is, “Are we going to have inflation or deflation?” People want to figure out how to invest. Because of this, they want to know whether to expect a rise in prices, or a fall in prices, either in general, or in commodities, in the future.

The traditional “peak oil” response to this question has been that oil prices will tend to rise over time. There will not be enough oil available, so demand will outstrip supply. As a result, prices will rise both for oil and for food which depends on oil.

I see things differently. I think the issue ahead is deflation for commodities as well as for other types of assets. At some point, deflation may “morph” into discontinuity. It is the fact that price falls too low that will ultimately cut off oil production, not the lack of oil in the ground.

Even with little oil, there will still be some goods and services produced. These goods and services will not necessarily be available to holders of assets of the kind we have today. Instead, they will tend to go to those who produced them, and to those who win them by fighting over them.

Up and Down Escalator Economies

It seems to me that economies operate on two kinds of escalators–an up escalator, and a down escalator. The up escalator is driven by a favorable feedback cycle; the down escalator is driven by an unfavorable feedback cycle.

For a long time, the US economy has been on an up escalator, fueled by growth in the use of cheap energy. This growth in cheap energy led to rising wages, as humans learned to use external energy to leverage their own meager ability to “perform work”–dig ditches, transport goods, perform computations, and do many other tasks that machines (powered by electricity or oil) could do much better, and more cheaply, than humans.

Debt helped lever this growth up even faster than it would otherwise ramp up. Continued growth in debt made sense, because growth seemed likely for as far in the future as anyone could see. We could borrow from the future, and have more now.

Unfortunately, there is also a down escalator for economies, and we seem to be headed in that direction now. Such down escalators have hit local economies before, but never a networked global economy. From this point of view, we are in uncharted territory.
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Understanding our Economic Trajectory – 1952 to Today

This is a guest post by “Shunyata.” Shunyata has training in financial engineering, actuarial science, statistics, and mechanical engineering. While he does not work directly with structural economic theory, his background in financial engineering gives him insights. The observations below represent Shunyata’s personal opinions based on his study of economics and monetary policy to protect his personal interests. This post is not intended to represent investment advice.

Since 1952, US Nominal GDP has grown by about 6% per year. Why did this growth occur?

A. Did the economy discover new efficiencies and/or develop new natural resources?

B. Did Government monetary policy artificially inflate GDP?

C. Did Society borrow against tomorrow to purchase luxuries today? (…meaning that Society borrowed against tomorrow’s GDP to inflate today’s growth.)

Certainly reality is a mixture of all three mechanisms, but is one dominant? We would hope for (A). We can live with (B). But (C) would be troubling.

We can evaluate the impact of monetary policy by examining Real GDP trends. Figure 1 shows Gross GDP divided by CPI to bring everything to 2011 levels.

Figure 1

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