Off the keyboard of Gail Tverberg
Published on Our Finite World on April 30, 2013
Discuss this article at the Epicurean Delights Table inside the Diner
I have written in recent posts that oil limits are more complex than what many have imagined. They aren’t just a lack of a liquid fuel; they are inability to compete in a global economy that is based on use of cheaper fuel (coal) and a lower standard of living. Oil prices that are too low for oil exporting nations are a problem, just as oil prices that are too high are a problem for oil importing nations.
Debt limits are also closely tied to oil supply limits. It is actually debt limits, such as those we seem to be reaching right now, that may bring the whole system to a screeching stop. (See my posts How Resource Limits Lead to Financial Collapse, How Oil Exporters Reach Financial Collapse, Peak Oil Demand is Already a Huge Problem, and Low Oil Prices Lead to Economic Peak Oil.)
We have many Main Street Media (MSM) paradigms that mischaracterize our current predicament. But we also have what I would call Green paradigms, that aren’t really right either, because they don’t recognize the true state of our predicament. What we need now is new set of paradigms. Let’s look at a few common beliefs.
Inadequate Oil Supply Paradigm
As I stated above, indications that oil supply is a problem are confusing. MSM seems to believe, “If the US can be oil independent, our oil supply problems are solved.” If a person believes the goofy models our economists have put together, this is perhaps true, but this is not true in the real world.
Without a huge, huge increase in US oil production (far more than is being proposed), being “oil independent” simply means that we are unable to compete in the world market for buying oil exports. US oil consumption ends up dropping, and we end up on the edge of recession, or actually in recession. Oil exports instead go to the countries that have lower manufacturing costs (that is, use oil more sparingly). See Figure 1 below. In fact, even some of the oil products that are created by US refineries end up going to users in other countries, because it is businesses in other countries that are making many of today’s goods, and it is these businesses and the workers they hire who can afford to buy products like gasoline for their cars or diesel for their irrigation pumps.
Figure 1. Oil consumption by part of the world, based on EIA data. 2012 world consumption data estimated based on world “all liquids” production amounts.
The Green version of this paradigm seems to be, “If world oil supply is rising, everything is fine.” This is related to the idea that our problem is “peak oil” production caused by geological depletion, and if we haven’t hit peak oil production, everything is more or less OK. In fact, the limit we are reaching is an economic limit, that comes far before world oil supply begins to decline for geological reasons. See my post, Low Oil Prices Lead to Economic Peak Oil.
The real paradigm is, “Limited oil supply leads to financial collapse.” This is true for both oil exporters and for oil importer. For oil importers, the problem occurs because they cannot import enough oil, and oil is needed for critical parts of the economy. The belief by economists that substitution will take place is not happening in the quantity and at the price level (very low) that it needs to happen at, to keep the economy expanding as it has in the past.
Limited oil supply first leads to high oil prices, as it did in the 2004 to 2008 period; then it leads to government financial distress, as governments try to deal with less employment and lower tax revenue. By the time oil prices start falling because of the poor condition of oil importers, we are well on our way down the slippery slope to financial collapse.
The MSM version of this paradigm is, “Growth can be expected to continue forever.” A corollary to this is, “The economy can be expected to return to robust growth, soon.”
In a finite world, this paradigm is obviously untrue. At some point, we start reaching limits of various kinds, such as fresh water limits and the inability to extract an adequate supply of oil cheaply.
Economists base their models on the assumption that the economy only needs labor and capital; it doesn’t need specific resources such as fresh water and energy of the proper type. Unfortunately, substitutability among resources is not very good, and price is all-important. In the real world, growth slows as resources become more expensive to extract.
The Green version of the growth paradigm seems to be, “We can have a steady state economy forever.” Unfortunately, this is just as untrue as the “Growth can be expected to continue to forever.” Even to maintain a steady state economy requires far more cheap-to-extract oil resources than the earth really has. (US shale oil resources, which are the new hope for oil growth, can only grow if oil prices are sufficiently high.)
We are very dependent on fossil fuels for making our food supply possible and for our ability to make metals in reasonable quantity. Fossil fuels are also necessary for making concrete and glass in reasonable quantities, and for making modern renewable energy, such as hydroelectric dams, wind turbines, and PV panels. We cannot keep 7 billion people alive without fossil fuels. Perhaps the quantity of fossil fuels consumed can be temporarily reduced from current levels, but with continued population growth, any savings will be quickly offset by additional mouths to feed and by the desire of the poorest segment of the population to have the living standards of the richest.
Unfortunately, the correct version of the paradigm seems to be, “Overshoot and collapse is to be expected.” This is what happens in nature, whenever any species discovers a way to way to increase its energy (food) supply. Yeast, when added to grape juice will multiply, until the yeast have consumed the available sugars and turned them to alcohol. They then die.
The same pattern has happened over and over with historical civilizations. They learned to use a new approach that allowed them to increase food supply (such as clearing land of trees and farming the land, or adding irrigation to an area), but eventually population caught up. Research shows that before collapse, they reached financial limits much as we are reaching now. The symptoms, both then and now, were increasingly great wage disparity between the rich and the working class, and governments that needed ever-higher taxes to fund their operations.
Eventually a Crisis period hit these historical civilizations, typically lasting 20 to 50 years. Workers rebelled against the higher taxes, and more government changes took place. Governments fought wars to get more resources, with many killed in battle. Epidemics became more of a problem, because of the weakened condition of workers who could no longer afford an adequate diet. Eventually the population was greatly reduced, sometimes to zero. A new civilization did not rise again for many years.
Figure 2. One possible future path of future real (that is, inflation-adjusted) GDP, under an overshoot and collapse scenario.
It seems to me that unfortunately overshoot and collapse is the model to expect. It is not a model anyone would like to have happen, so there is great opposition when the idea is suggested. Overshoot and collapse is very similar to the model described in the 1972 book Limits to Growth by Donella Meadows and others.
Role of Economics, Science, and Technology Paradigm
The MSM paradigm seems to be, “Economics and the businesses that make up the economy can solve all problems.” Growth will continue. New technology will solve all problems. We don’t need religion any more, because we now understand what makes people happy: More stuff! As long as the economy can give people more stuff, people will be satisfied and happy. Economics even can allow us to find “green” solutions that will solve environmental problems with win-win solutions (assuming you believe MSM).
The Green version of the paradigm seems to be, “Science and technology can solve all problems, and can properly alert us to future problems.” Again, we don’t need religion, because here we can put our faith in science to solve all of our problems.
I am not sure the Green version of the paradigm is any more accurate than the MSM media version. Science is not good at figuring out turning points. It is very easy to miss interactions that are outside the realm of science, and more in the realm of economics–for example, the fact high-priced oil is not an adequate substitute for cheap-to-extract oil, and it is the lack of cheap oil that is causing a major portion of today’s problem.
It is also very easy to put together climate change models that are based on far too high assumptions of the amount of fossil fuels that will be burned in the future, because economic interactions are missed. If debt collapse brings down the economy, it will bring down all fossil fuels at once, meaning that the vast majority of what we think of as reserves today will stay in the ground forever. A debt collapse will also affect renewables, by cutting off production of new renewables, and by making maintenance of existing systems more difficult.
The real paradigm should be, “Neither science and technology, nor economics can solve the problems of humans. We have instincts similar to those of other species to reproduce in far greater numbers than needed for survival, and to utilize all resources available to us. This leads us toward overshoot and collapse scenarios, even though we have great knowledge.“
Because of our propensity toward overshoot and collapse scenarios, humans have a real need for a “moral compass” to tell us what is right and wrong. If there is no longer enough food to go around, how do we decide which family members should get it? Is it OK to start a civil war, if there are not enough resources to go around? There is also a need to deal with our many personal disappointments, such as finding that the advanced degrees we worked so hard on will have little use in the future, and that life expectancies are much lower. Perhaps there is still a need for religion, even though many have abandoned the idea. The “story line” of religions may not sound exactly reasonable, but if a particular religion can provide reasonable guidance on how to handle today’s problems, it may still be helpful.
Climate Change Paradigm
The MSM view of climate change seems to vary with the country. In the US, the view seems to be that it is not too important, and that it can be adapted to. Perhaps the models are not right. In Europe, there is more belief that the models are right, and that local cutbacks in fossil fuel consumption will reduce world CO2 production.
The Green view of climate change seems to be, “Of course climate change models are 100% right. We should rationally be able to solve the problem.” There is only the minor detail that humans (like other species) have a basic instinct to use energy resources at their disposal to allow more of their offspring to live and to allow themselves personally to live longer.
Unfortunately, a more realistic view is that climate change may indeed be happening, and may indeed by caused by human actions, but (1) we are already on the edge of collapse. Moving collapse ahead by a few months will not solve the climate change problem, and (2) collapse itself is an even worse problem than climate change to deal with. By the time rising ocean levels become a problem, population is likely to be low enough that the remaining population can move to higher ground, and agriculture can move to where the climate is more hospitable.
Climate change may indeed cause population to drop even more than it would if our only problem were overshoot and collapse. But because the cause is related to human instincts (having more offspring than needed to replace oneself and the drive to use energy supplies that are available), changing the underlying behavior is extremely difficult.
Over the eons, the earth has been cycling from one climate state to another, with one species after another being the dominant species. Perhaps natural balances are such that the time has now come that humans’ turn as the dominant species is over. The earth is now ready to cycle to a state where some other species is dominant, perhaps a type of plant that can use high carbon dioxide levels. If this is the case, this is another disappointment that we will need to deal with.
Nature of Our Problem Paradigm
The MSM’s paradigm seems to be, “Our problem is getting the economy back to growth.” Or, perhaps, “Our problem is preventing climate change.“
In a way, the MSM paradigm of “Our problem is getting the economy back to growth,” has some truth to it. We are slipping into financial collapse, and in a sense, getting the economy back to growth would be a solution to the problem.
The underlying problem, however, is that oil supply is getting more and more expensive to extract. This means that an increasing share of resources must be devoted to oil extraction, and to other necessary activities (such as desalinating water because we are reaching fresh water limits as well). As a result, the rest of the world’s economy is getting squeezed back. See my post Our Investment Sinkhole Problem. Squeezing the world’s economy creates great problems for all of the debt outstanding. The likely outcome is widespread debt defaults, and collapse of the world economy as we know it.
The Green paradigm seems to be, “We have a liquid fuel supply problem.“ If we can solve this with other liquid fuels, or with electricity, we will be fine. Many Greens also emphasize the climate change problem, so their big issue is finding electric solutions for the liquid fuel supply problems. There is also an emphasis on local food production, especially with respect to perishable foods.
Unfortunately, the real problem seems to be, “We are facing a financial collapse scenario that is likely to wreak havoc on all energy sources at once.” Using less oil products may be helpful for a while, but in the long term, we are dealing with an issue of major system collapses. Using less of a particular product “works” as long as the supply chain for that product is still intact, including the existence of all of the factories needed to make the product, and the existence of trained workers to operate the factories. Banks also need to remain open. World trade needs to continue as well, if we are to keep our supply chains operating. The real danger is that supply chains for many essential services, including fresh water, sewage disposal, medicines, grain production, road repair, and electricity transmission repair will be interrupted. As a result, we will need to find local solutions for all of them.
The situation we are facing is not at all good. While we can do a little, it will be very challenging to build a new system that does not use fossil fuels. In the past, when the world did not use fossil fuels, the population was much lower than today–one billion or less.
Also, in the past, we started simple, and gradually added complexity to solve the problems that arose. This time around, we need to do the reverse. We already have very complex systems, that are too difficult to maintain for the long term. What we need instead is simpler systems that can be maintained with local materials. This is not a direction in which science and technology is used to working.
Creating new systems that require only local resources (and a few other resources, if transport can be arranged) will be a real challenge. Areas of the world that have never adopted modern technology would seem to have the bast chance of making such a change.
Importance of Tomorrow Paradigm
MSM seems to assume that we can save and plan for tomorrow. Greens have a similar view.
Perhaps, given the changes that are happening, we need to change our focus more toward to day, and less toward tomorrow. How can we make today the best day possible? What are the good things we can appreciate about today? Are there simple things we can enjoy today, like sunshine, and fresh air, and our children?
We have come to believe that we can and will fix all of the problems of tomorrow. Perhaps we can; but perhaps we cannot. Maybe we need to simply take each day as it comes, and solve that day’s problems as best as we can. That may be all we can reasonably accomplish.
Off the keyboard of Gail Tverberg
Published on Our Finite World on April 21, 2013
Discuss this article at the Energy Table inside the Diner
We have all heard the story about oil supply supposedly rising and falling for geological reasons. But what if the story is a little different from this–oil production rises and falls for economic reasons? If this is the issue, it doesn’t really matter how much oil is in the ground. What matters is if economic conditions are “right” for continued and rising extraction. I have shown in previous posts that oil prices that are too high are a problem for oil importers while oil prices that are too low are a problem for oil exporters. As a result, oil prices need to be in a Goldilocks zone, or we have serious problems, of one sort or another.
As long as the price of oil keeps rising, there is at least some chance the amount of oil extracted each year will keep rising, because more oil resources will become economic to extract. The real problem arises when oil price falls back from a price level it has held, as it has done recently, and as it did back in July 2008. Then there is a real chance that investment will become non-economic, and because of this, oil production will fall.
Oil prices play multiple roles:
- High oil prices encourage extraction from more difficult locations, because the higher cost covers the additional extraction costs.
- High oil prices allow exporters to have adequate money to pacify their populations, even if their oil exports have been declining, as they have been for many exporters.
- High oil prices allow funds for investment in new oil fields, as old ones deplete.
- High oil prices tend to put oil importing countries into recession, because it raises the costs of goods and services produced, without raising the salaries of the workers. In fact, there is evidence that high oil prices lower wages (both directly and through lower workforce participation).
- High oil prices make countries that use large amounts of oil less competitive with countries that use less fuel in general, and less oil in particular.
When oil prices decline, it is evidence that Items 4 and 5 above are outweighing Items 1, 2, and 3. This tips the scale in the direction of a fall in oil production.
Debt also affects oil prices. As long as investors have faith that businesses can make money, despite high oil prices, they will continue to borrow to expand their businesses. This additional debt helps drive up demand for goods and services of all kinds, including oil, so oil prices rise. Also, if consumers are able to borrow increasing amounts of money, this also drives up demand for goods that use oil, such as cars. But once the debt bubble bursts, it is easy for oil prices fall very far, very fast, as they did in 2008.
If we look at the 2008 situation, oil limits were very much behind the overall problem, even though most people do not recognize this connection. It was the fact that oil limits eventually led to credit limits that caused the system (including oil prices) to crash as it did. High oil prices led to debt defaults and bank write offs, and eventually led to a huge credit contraction in economies of the developed world. This credit contraction affected not just oil demand, but demand for other energy products as well.
The problems of the 2008 period were never really solved: the lack of growth in world oil supply remains, and this lack of growth in world oil supply continues to hold back world economic growth, particularly in developed countries. We recently have not been feeling the effects as much, because with deficit spending, the problems have largely moved from the private sector to the government sector.
The situation remains a tinderbox, however. The financial situation is propped up by ultra-low interest rates, continued government deficit spending, and Quantitative Easing. In a finite world, debt growth cannot continue indefinitely. But if debt growth permanently stops, and switches to contraction, we would end up in an even worse financial mess than in 2008. In fact, such a change would very likely to would lead to a contraction of “Limits to Growth” proportions.
In this post, I will explain some of these issues further.
The Rise and Fall of Oil Prices in 2008
If we look at world oil production and price between January 1998 and July 2008 on an X-Y graph, we see that as long as oil demand stayed below 71 million barrels a day, oil price stayed low (Figure 3, below). But once demand started to push above that level, oil price started to rise rapidly, with little increase in production. It was as if a brick wall on oil supply had been hit. No matter how much the oil price rose, virtually no more production was available.
If we look at an X-Y graph of the non-OPEC portion of oil supply, we see that the situation was even worse for the non-OPEC portion (Figure 4, below). The amount of oil that could be produced at a given price had actually begun to fall back. While in 2003 and 2004, non-OPEC had been able to produce 42 million barrels a day for only $30 barrel, by 2008, non-OPEC could not reach 42 million barrels a day, no matter how high the price. It looked as though non-OPEC had hit “peak oil” production. Geological limits appeared to have the upper hand.
Fortunately, during this period OPEC was able to raise its production somewhat, in response to higher prices, as illustrated in Figure 5, below. Between July 2007 and July 2008, it was able to raise oil production by 2.1 million barrels a day, in response to a $56 dollar a barrel increase in price in a one-year time-period. (The small increase in response to a huge price rise suggests that OPEC’s spare capacity was not nearly as great as claimed, however.)
What brought about the collapse in oil prices in July 2008? I believe it was ultimately a financial limit that was reached that eventually worked its way to the credit markets. Once the credit markets were affected, individuals and businesses were not able to borrow as much, and it was this lack of credit that cut back demand for many types of products, including oil.
The way this cutback in credit came about was as follows: Oil prices had been rising for a very long time–since about 2003, affecting the inflation rate in food and fuel prices. The Federal Reserve Open Market Committee tried (unsuccessfully) to get oil prices down by raising target interest rates. I describe this in an article published in the journal Energy called, “Oil Supply Limits and the Continuing Financial Crisis,” available here or here. The combination of high oil prices and higher interest rates led to falling housing prices starting in 2006 (big oops for the Federal Reserve), and debt defaults, particularly among the most vulnerable (those with sub-price mortgages). As early as 2007, large banks had large debt write-offs, lowering their appetite for more debt of questionable quality. Total US household mortgage debt reached its maximum point on June 30, 2008, and began to fall the following quarter.
By July 2008, the financial problems of consumers in response to high oil prices and falling housing prices had transferred to other credit markets as well. Revolving credit outstanding (mostly credit card debt), hit a maximum in July 2008, and has not recovered (Figure 7 below). (July 2008 is exactly the same month as oil prices began to fall!) Non-revolving credit, such as auto loans, hit a maximum in the same month.
Credit issues kept getting worse. The Federal takeover of Fannie Mae and Freddie Mac took place in September 2008, as did the bankruptcy of Lehman Brothers. By late 2008, cutbacks in credit had spread to businesses including all sectors of the energy industry. I wrote an article on December 1, 2008, documenting that credit issues led to lower prices not only for oil, but for coal, natural gas, nuclear, and renewables as well.
The reason why a cutback in credit availability is a problem is because it is very difficult to buy a new car or home, or to finance a new business operation, if credit isn’t available. In fact, the amount a business or family can spend depends on the sum of their income during a period, plus the amount of additional debt they take on during that period. If the amount of debt outstanding is going down, then, for example, old credit card debt is being paid down faster than new credit card is being added, and the amount currently spent is lower.
The Federal Government tried to fix the situation by running larger deficits (Figure 8), starting the very next quarter after oil prices hit a peak and started declining.
Oil prices rose again starting in 2009 as demand outside the US, Europe, and Japan continued to grow. By 2011, high oil prices were back. The economies of US, Europe and Japan did not bounce back to the kind of economic growth most expected, because at high oil prices, their products were not competitive in a world marketplace that relied on an energy mix that was slanted more toward coal (which is cheaper), and also offered lower wages.
In 2013, world oil supply is still constrained.
It is easy to get the idea from news reports that everything is rosy, but the story presented to us is painted to look much better than it really is. Production from existing sites is constantly depleting. In order to replace declining production, huge investment must be made in new productive capacity. It is as if oil producers must keep running, just to stay in place.
Cash flow has historically financed much investment. Now we read, Energy Industry Struggling to Generate Free Cash Flow.
Many naive people believe Saudi Arabia’s stories about their “productive capacity” of 12.5 million barrels a day, but their maximum crude and condensate production in recent years has been only been 10,040,000, according to the EIA. Their recent production has been only a little over 9 million barrels a day in recent months, according to OPEC Monthly Oil Market Report.
Iraq is supposed to be the great hope for future oil production, yet it increasingly seems to be stumbling toward civil war.
Russia is now the largest oil producer in the world, with a little over 10.0 million barrels a day of crude and condensate production. According to a Russian analyst,”Gas condensate production is the real driver behind the [recent] growth. Crude oil output is falling and organic growth currently is impossible.”
Admittedly, tight oil production has ramped up quickly. But it is an expensive technology, that requires a high oil price, and lots upfront investment. There is evidence that such oil is concentrated in “sweet spots” and these get tapped out quickly. In North Dakota, the earliest area for US tight oil extraction, rig count is down from 203 at the beginning of June, 2012, to 176 at April 19, 2013, according to Baker Hughes. Lynn Helms, Director of the North Dakota Department of Mineral Services gave this explanation, “Rapidly escalating costs have consumed capital spending budgets faster than many companies anticipated and uncertainty surrounding future federal policies on hydraulic fracturing is impacting capital investment decisions.” Meanwhile, North Dakota oil production has recently been flat–perhaps because of weather; perhaps because of other issues as well.
The ramp-up in US crude oil production amounted to 812,000 barrels a day in 2012–very small in comparison to world crude oil needs. World oil production, shown in Figures 1 and 2, is barely affected. In a world with 7 billion people, most of whom would like vehicles, the amount of oil supply being added is tiny.
In 2013, the financial problems of the United States, the Euro-zone, and Japan haven’t gone away.
Current high oil prices make the big oil-importing countries less competitive. It is hard to compete with countries with lower average fuel costs, thanks a mix that it much heavier on coal, and lighter on oil. A graph of oil consumption shows that oil is increasingly going to the Rest of the World, rather than the US, EU, and Japan (Figure 10).
The countries that see little growth in oil consumption are the same ones struggling with low economic growth. Low economic growth makes debt very difficult to repay. Governments are tempted to add more debt, to try to fix their problems.
Tackling government debt problems in 2013 tends to bring recession back.
The big problem when oil prices rise is that workers’ discretionary income is squeezed, because their wages don’t rise at the same time. This problem can somewhat be offset by deficit spending of governments for programs to help the unemployed, and for stimulus.
Once taxes are raised, or benefits are cut, the old problem of lower discretionary income for workers reappears. Thus, the recession that governments so cleverly found a way around previously, re-emerges.
In 2005, there was a very sharp impact to oil prices when high oil prices indirectly affected the credit system. This time, a big issue is rising government taxes and lower benefits. These are staggered in their implementation, so the effect feeds in more slowly. Greece and Spain started their cut-backs early. The US raised Social Security taxes by 2% of wages, as of January 1, 2013. Later it added sequester cuts. All of these effects feed in slowly, and add up.
With respect to debt, in 2013 we are rapidly approaching the time when this time truly is different.
There has been a great deal in the press about a mistake Rienhart and Rogoff recently made in their book, This Time Is Different. I think Rienhart and Rogoff, as well as economists in general, have missed an issue that is much more basic: In a finite world, debt, like anything else, cannot keep growing. The economy (whether economists realize it or not) depends on physical resources, and these are in limited supply. One piece of evidence with respect to the limited supply of oil is the fact that the cost of its extraction keeps rising. This means that fewer resources are available to be used for making other goods and services.
I show in my paper, Oil Supply Limits and the Continuing Financial Crisis, that lower economic growth rates make debt harder to repay. Reinhart and Rogoff seem to confirm this relationship works in practice. In their NBER paper, “This Time is Different: A Panoramic View of Eight Centuries of Financial Crises,” they make the observation, “It is notable that the non-defaulters, by and large, are all hugely successful growth stories.”(They did not seem to understand why, though!)
The 2007-2009 recession partially brought the level of debt down, outside the government sector. Government debt has been ramping up rapidly because tax revenues are down and benefits are up (Figure 8).
Government debt helps take the place of “missing” debt from other sectors (at least in theory). Now government debt is above acceptable levels. US debt is around 100% of GDP, and growing each quarter.
Without rapid economic growth, only a small portion of the debt that remains can be repaid. If increases in taxes/cutback in benefits leave more without work, a new round of debt defaults can be expected. Student loans are particularly at risk. Business loans maybe a problem as well, especially in discretionary industries. Government debt is likely to be a problem, especially for states and municipalities. Banks may again have financial problems, especially if they have exposure to debt from other countries, or student loans.
I am not certain what will happen to the huge amount of US government debt, if Quantitative Easing ever stops. The same might be said of the debt of all of the other countries doing quantitative easing. Who will buy the debt? And at what interest rate? If the interest rate rises, there will be a huge problem, because suddenly loans of all types will have higher interest rates. Governments will need higher taxes yet, to pay their debts. It will be hard to sell cars with higher interest rates on debt. Home prices will likely drop, because fewer people can afford to buy homes with higher interest rates.
I showed in Reaching Debt Limits what a big difference increases in household debt can make to per capita income (Figure 12).
If debt starts long-term contraction, we will truly have a mess on our hands. Businesses will have a hard time investing. Individuals will have a hard time buying big-ticket items, like cars, furniture, and houses. Demand for all types of goods and services will fall. I showed in my post Why Malthus Got His Forecast Wrong that increasing debt was what allowed rapid growth in fossil fuel use. If debt stops growing and starts shrinking, we will get to see the reverse of this phenomenon.
What is Ahead?
Lower oil prices indicate that demand is declining. (The cost of extraction is not lower!) Lower oil demand seems to be related to poorer earnings reports for the first quarter of 2013, which in turn is at least partly related to the increase in US Social Security taxes withheld, starting January 1, 2013. Nothing will necessarily happen quickly, but by next quarter’s earnings reports, some of the “sequester” cuts will be added to the cuts. Businesses with poor earnings are likely to lay off workers, and those workers will file for unemployment benefits. Gradually, we will see increasing evidence of recession.
It is not clear that this time will necessarily lead to the “all time” switch to long-term debt contraction, but it will bring us one step closer, at least in US, and probably in Europe and Japan as well. Oil supply may not drop very much, very quickly. If we are lucky, demand will bounce back and bring prices back up, as in 2009-2010. But with all of the debt problems around the world, it is possible that a contagion will begin, and defaults in one country will spread to other countries. This is what is truly frightening.
Off the keyboard of Gail Tverberg
Published on Our Finite World on April 11, 2013
Discuss this article at the Energy Table inside the Diner
We in the United States, the Euro-zone, and Japan are already past peak oil demand. Oil demand has to do with how much oil we can afford. Many of the developed nations are not able to outbid the developing nations when it comes to the world’s limited oil supply. A chart of oil consumption shows that oil consumption peaked for the combination of the United States, EU-27, and Japan in 2005 (Figure 1).
We can see an even more pronounced version of this pattern if we look at the oil consumption of the five countries known as the PIIGS in Europe: Portugal, Italy, Ireland, Greece, and Spain. All of these countries have had serious declines in oil consumption in recent years, as high oil prices have impeded their economies.
Oil consumption for the PIIGS in total hit its highest level in 2004, before the decline began. Peak oil consumption by country varied a bit: Portugal, 2002; Italy, declining since 1995; Ireland, peak in 2007; Spain, peak in 2007; Greece, peak in 2006.
Peak demand is very much related to jobs. Peak oil demand occurs when a country is not competitive in the world market-place, and because of this, loses industry and jobs. One reason this happens is because the country’s energy cost structure is not competitive in the world market-place. With the run-up in oil prices starting about 2003, oil is by far the most expensive of the traditional energy sources we have available today. Countries that use a large percentage of oil in their energy mix can be expected to have a hard time competing, because of oil’s higher cost.
Anything else that is done which raises costs for businesses will also have an impact. This would include “carbon taxes,” if competitors do not have them, and if there is no tariff on imported goods to reflect carbon inputs.
High-cost renewables can also have an adverse impact, regardless of whether the cost is borne by businesses, consumers or the government.
- If the cost is borne by businesses, those businesses must raise their prices to keep the same profit margins, and because of this become less competitive.
- If the cost is borne by consumers, those consumers will cut back on discretionary expenditures, in order to balance their budgets. This is likely to mean a cutback in demand for discretionary goods by local consumers.
- If the government bears the cost, it still must pass the cost back to businesses or consumers, and thus reduce competitiveness because of higher tax costs.
This importance of competitiveness holds, no matter how worthy a given approach is. If costs were “externalized” before, and are now borne by the local system, it makes the local system less competitive. For example, putting in proper pollution controls will make local industry less competitive, if the competition is Chinese industry, acting without such controls.
One issue in competitiveness is wage levels. Wages in turn are related to standards of living. In a global economy, countries with higher wage levels for workers, and higher benefit levels for workers (such as health insurance and pensions) will be at a competitive disadvantage. Countries that use coal as their prime source of energy will be at an advantage, because workers’ wages will tend to “go farther” in heating their homes and buying electricity.
Countries that are warm in the winter will be at a competitive advantage, because homes don’t have to be built as sturdily, and don’t have to be heated in winter. Workers can commute by bicycle even in the coldest weather.
Energy usage (all types combined, not just oil) is far higher in cold countries than it is in warm wet countries. Countries that extract oil also tend to be high users of energy.
The difference in per capita energy usage among the various countries is truly astounding. For example, Bangladesh’s per capita energy consumption is slightly less than 2% of US energy consumption. This difference in energy consumption means that salaries can be much lower, and thus products made in Bangladesh can be much cheaper, than those made in the United States. This is part of our competitiveness problem, even apart from the energy mix problem mentioned earlier.
In my view, globalization brought on many of our current problems. Perhaps globalization could not be avoided, but we should have foreseen the problems. We could have put tariffs in place to make a more level playing field. See my post, Twelve Reasons Why Globalization is a Huge Problem.
Inadequate world oil supply isn’t exactly the problem. The issue is far more that the price of oil extraction is rising. The price of oil extraction is rising for a variety of reasons, an important one being that we extracted the easy to extract oil first, and what is left is more expensive to extract. Another issue is that oil exporters now have large populations that need to be kept fed and clothed, so they don’t revolt. This is a separate issue, that raises costs, even above the direct cost of extraction. There is no reason to believe that these costs will level off or fall, no matter how much oil the US produces using high-priced methods, such as fracking.
When oil prices rise, wages don’t rise at the same time. In fact, in the US there is evidence that wages stagnate when oil prices are high, partly because fewer are employed, and partly because the wages of those employed flatten.
The countries that are most affected by rising oil prices are the countries that use oil to the greatest extent in their mix of energy products. In Figure 3, that would be the PIIGS. The rest of the US, EU-27, and Japan would be next in line.
When oil prices rise, consumers need to balance their budgets. The price of oil products and food rises, so they cut back on discretionary items. Their smaller purchases of discretionary goods and services means that workers in discretionary sectors get laid off.
Businesses find that the price of oil used in manufacturing and shipping their products has risen. If they raise the sales price of the goods to reflect their higher costs, it means that fewer people can afford their products. This too, leads to cutbacks in sales, and layoffs of workers. Sometimes businesses decide to outsource production to a cheaper country, or use more automation, as a way of mitigating the cost increases that higher oil prices add, but automation or outsourcing also tends to reduce US wages.
The net effect of all of these changes is that there are fewer workers with jobs in the countries with high oil usage. This reduces the demand for oil in the high oil usage countries, both from business owners making goods and from the consumers who might use gasoline to drive their cars. This price mechanism is part of what leads to the oil consumption shift we see in Figure 1.
We are dealing with is close to a zero-sum game, when it comes to oil supply. The amount of oil that is extracted from the ground is almost constant (very slightly increasing for the world in total). If prices stayed at the low level they were in the past (say $20 barrel), there would not be enough to go around. Instead, higher prices redistribute oil to countries that can use it manufacture goods at low overall cost. Workers in factories making these goods are then able to afford to buy goods that use oil, such as a motor scooter.
Citigroup recently released a report titled, “Global Oil Demand Growth, – the End is Nigh.” Its subtitle says,
The substitution of natural gas for oil combined with increasing fuel economy means oil demand is approaching a tipping point.
This is out-and-out baloney, for a number of reasons:
1. There are way too many of “them” compared to the number of “us,” for energy efficiency to make even a dent in our problem.
2. When we look at past oil consumption, changes in vehicle energy efficiency did not make a big difference.
3. Substituting natural gas for oil still leaves cost levels for the US, Europe, and Japan very high, compared to those for the rest of the world, where little energy is used.
4. There are really separate markets in many parts of the globe. Our market is collapsing because of high price. Perhaps increased efficiency and natural gas substitution will help low-cost producers until they reach a different limit of some sort.
Let’s look at these issues separately.
There are way too many of “them” relative to us, for energy efficiency to even make a dent in our problem.
If we look at world population, this is what we see:
Using a ruler, we could probably make fairly reasonable projections of future population for each of these groups.
If we look at per capita oil consumption for the two groups separately, there is a huge disparity:
Per capita oil consumption for the EU, US, and Japan group peaked in 1973–a very long time ago. In recent years, it has been drifting down fairly rapidly, just to keep up with a slight per capita rise in oil consumption of the Rest of the World. Even with recent changes, per capita oil consumption of the EU, US and Japan group is more than 4.5 times that of the rest of the world.
If cars were made more efficient, more people could afford them. The market for cars is unbelievably huge, compared to today’s market, if costs could be brought down. Furthermore, gasoline accounts for less than half of US oil consumption. Even if efficiency were improved to allow cars to use half as much fuel, it would save a little less than one-fourth of current oil consumption. How far would this oil go in satisfying the needs of 6 billion other people–and growing every year?
When we look at past oil consumption, changes in vehicle energy efficiency did not make a big difference.
If we look at per capita oil consumption in the US, split between gasoline and other oil products, we see that the big drop in oil consumption came from the drop in other oil products–that is the commercial and industrial part of US oil consumption.
The amount of fuel used for gasoline has stayed in the 10 to 12 barrels a year per capita band, since 1970, in spite of huge improvements in vehicle efficiency.
I recently wrote a post called Why is US Oil Consumption Lower? Better Gasoline Mileage? In it, I looked at the decrease in US oil consumption between 2005 and 2012. I concluded that the majority of the decrease in consumption was due to a drop in commercial use. Only 7% was due to an improvement in miles per gallon for gasoline powered vehicles.
Substituting natural gas for oil still leaves the US (as well as Europe and Japan) very high priced, compared to the rest of the world, that doesn’t use much energy.
Living in the US, Europe or Japan, it is hard to get an idea of the cost structure of the rest of the world. We are so far above the cost structure of the rest of the world that substituting natural gas for oil would do little to fix the situation.
We can also debate how much substitution of natural gas will actually do, and in what timeframe. In the US, natural gas is temporarily very cheap. But it costs more to extract shale gas than the market currently pays, in many areas. Also, a recently University of Texas study showed that Barnett Shale was past peak production, if prices do not rise.
There are really separate markets in many parts of the globe. Our market is collapsing because of high price. Perhaps increased efficiency and natural gas substitution will help low-cost producers, until they reach a different limit of some sort.
When a country is not competitive, it is not just oil consumption that drops, but consumption of other energy products as well. If we look at the per capita energy consumption of the US, EU-27, and Japan combined, we see that non-oil energy consumption per capita reached its peak in 2004, and is now declining (Figure 10, below). If consumers are too poor to buy oil products, they are also too poor to buy products made with other types of energy.
The Rest of the World followed a very different pattern of energy consumption. Non-oil consumption soared, on a per capita basis. Oil consumption also increased on a per capita basis.
More detailed data shows that the big increase in non-oil consumption was a huge rise in coal consumption, after China was admitted to the World Trade Organization in December 2001.
How does peak oil demand work out in the end?
I would argue that lack of competitiveness in world markets is a limit that the US, EU-27 and Japan are hitting right now, but at slightly different rates. EU-27 now seems to be ahead in the race to the bottom, partly because its combined currency. I wrote a post in March 2012 called Why High Oil Prices Are Now Affecting Europe More Than the US, explaining the situation.
It seems to me, though, that a big piece of the problem with lack of competitiveness gets transferred to the governments of the affected countries. This happens because collection of tax revenue lags, because not enough people are working, and those who are working are earning lower wages. At the same time increased payouts are needed to stimulate the economy, and to provide benefits to the many without jobs.
Governments increase their debt to meet the revenue shortfall. They reduce interest rates to record-low levels, to stimulate the economy. They also use Quantitative Easing, or “printing money” to try to lower long-term interest rates, and to try to make their exports more competitive. Unfortunately, these actions do not solve the basic structural problem of high and rising world oil prices, and the fact that these rising prices make their economies increasingly less competitive in the world marketplace.
One possible way I see of the current situation working out is that the total energy consumption (including all types of energy products, not just oil) of the EU, US and Japan will continue to fall, as high-priced oil continues to erode our competitive position in the world marketplace.
The slope of the decline is based on the type of decline experienced by the Former Soviet Union, in the years immediately following its collapse. This pattern might reflect a combination of different patterns for different countries. Greece and Spain, for example might continue to fall quite quickly. The US might lag the EU in the speed at which problems take place. The likely path seems downward, because any action taken to fix the government gap between income and expense can be expected to have a recessionary impact, and thus have an adverse impact on energy consumption.
The Rest of the World is now growing rapidly, but at some point they will start reaching limits. One of these limits will be lack of an export market. Another will be lack of spare parts, because businesses in the US, Europe and Japan are failing for financial reasons. Some of these limits will relate to pollution and lack of fresh water. The effect of these limits will also be to raise costs. For example, a shortage of water can be worked around through desalination, but this raises costs. Lack of spare parts can be worked around by building a new plant to make the spare part. Pollution problems can be mitigated by pollution controls, but these add costs. These higher costs, when passed on to consumers will also lead to a cutback in demand for discretionary goods, and the same kinds of problems experienced in oil exporting nations. Thus, these countries will also have “Peak Demand” problems, because of rising prices, related to limits they are reaching.
I don’t know exactly how soon the Rest of the World will hit limits, but given the interconnectedness of the world system, it would seem to be within the next few years. Figure 13 shows one estimate of how this may occur.
Here again, individual countries may do better than others. Countries with little connectedness to the world system (for example, countries in central Africa) may have fewer problems than others. Of course, their energy consumption (of the type measured by the EIA or BP) is very low now. They may use cow dung and fallen branches for fuel, but these are not counted in international data.
Figure 14, below, shows the sum of the amounts from Figures 12 and 13. Thus, it gives one estimate of future world energy consumption based on Peak Demand considerations.
If there is a silver lining to all of this, it is that world CO2 emissions are likely to start falling quite rapidly, because of Peak Oil Demand. World CO2 emissions could quite possibly drop below 20% of current levels before 2050. In the scenario I show, energy consumption drops faster than forecasts such as those put out by the Energy Watch Group. Such forecasts do not take into account financial considerations, so are likely overstated.
The downside of Peak Oil Demand is that the world we live in will be very much changed. Population levels will likely drop, indirectly because of serious recession, job loss, and cutbacks in government benefits. The financial system will need to be completely revised, because debt financing will make sense much less often than today. In fact, in a shrinking world economy, money can no longer act as a store of value. There no doubt will be some people who survive and prosper, but their lives will likely be very different from what they are today.
Off the keyboard of Gail Tverberg
Published on Our Finite World on March 29, 2013
Discuss this article at the Epicurean Delights Smorgasbord inside the Diner
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.
The Way Resource Extraction Reaches Financial Limits
When a company decides to extract a resource such as oil, gold, or fresh water, it looks for the least expensive source available. After many years of extraction, the least expensive sources become depleted, and the company must move on to more expensive resources. It always looks like there are plenty of resources left; they are just increasingly expensive to extract. Eventually an extraction limit is reached; this limit is a price limit.
As easy to extract resources become more depleted, it becomes necessary to invest more resources of every type in extraction (for example, manpower, oil, natural gas, fresh water), in order to extract a similar amount of the resource. I have called this the Investment Sinkhole problem.
The need to use greater resources in the process of resource extraction leaves fewer resources available for other purposes. Prices adjust to reflect this out of balance. If there is no substitute available for the resource that is reaching limits, the economy adjusts by contracting to match the amount of resource that is available at an affordable price. Some economists might call the situation “reduced demand at high price”. What the situation looks like, in terms most of us are used to using, is recession or depression.
Part of the confusion is that many people completely miss the fact that there is a close connection between cheap energy supply of the exact type needed (for example, gasoline for cars, diesel for trucks, electricity for many factory applications) and the ability of the world economy to make goods and services.
If the price of energy of the type a particular manufacturer or service provider uses increases (say gasoline or diesel or natural gas or electricity), that manufacturer or service provider in the short term has no choice but to pay the increased price, because there is no substitute for energy of the right type. If the manufacturer or service provider tries to pass these higher costs on to its customers, there is likely to be a cutback in demand, leading to a need for layoffs. Alternatively, with longer lead time, the company may be able to find a way around the problem of increased costs, by using more automation, or by outsourcing production to a country where costs are cheaper. Any of these responses leads to reduced US employment and recessionary impacts.
What History Says about Prior Collapses
Until fossil fuels came into widespread use, civilizations regularly grew until they reached limits of some sort, and then collapsed. There are many books looking at this issue. David Montgomery, in Dirt: The Erosion of Civilizations talks about the role soil erosion and soil degradation play in bringing civilizations down. Sing Chew, in The Recurring Dark Ages, talks about how ecological stress, deforestation, and climate change have led to long periods of collapse and low economic activity. Joseph Tainter, in The Collapse of Complex Societies, talks about how increasingly complex solutions to the problems of the day lead to ever-higher administrative costs that eventually become too expensive to afford.
Peter Turchin and Surgey Nefedov in the book Secular Cycles take more of an analytical approach. They look at how cycles actually played out, based on financial and other detailed records of the day. Their analysis considered eight economies, the earliest of which began in 350 B. C. E.. The pattern they found looks disturbingly like the pattern that the world has been going through since the widespread use of fossil fuels began about 1800: A civilization starts its existence when a new resource becomes available, for example by deforesting land to be used for agriculture (or in our case, finding ways fossil fuels could be used). A civilization experiences Growth for 100+ years as the population is able to grow with the new resource available to it.
Eventually the civilization reaches a Stagflation period. This happens when the civilization starts reaching limits. Population is much higher, the size of the governing class is much larger, and feedbacks like erosion and soil depletion start to play a role. In my view, Stagflation period began for the United States around 1970, when US oil production began to fall.
Turchin and Nefedov found that during the Stagflation period, population growth slows and wages stop rising. Wage disparity increases, and debt grows. The cost of food and other resources becomes more variable, and begins to spike. The level of required taxes grows, as the number of government administrators grows and as armies increase in size. (Joseph Tainter refers to this growth in government services as a product of increased complexity.)
Eventually, after 50 or 60 years, a Crisis Phase begins, when it is no longer possible to raise taxes enough to cover all of the governmental costs. In this period, wages of commoners drop to such a low level that nutrition declines, leading to epidemics and a higher death rate. Commoners often revolt, leading to government collapses. Wars for resources are sometimes fought. The Crisis Phase lasts a variable length of time, typically 20 to 50 years, with the length of time seeming to be shorter in the more recent cycles analyzed. There is considerable die-off from illness and warfare in the Crisis Phase.
It seems to me that the United States, most of Europe, and Japan are now very close to the point where they will enter the Crisis Phase of a similar cycle.
The Nature of the Financial Predicament We Are Reaching
At the beginning of this post, I mentioned that rising investment costs lead to what I call an investment sinkhole problem, as we extract fuels and ores that require increasingly expensive inputs near the bottom of Figure 1. An examples might be tight oil, that is extracted using “fracking”. While we hear much about the hoped-for higher supply, we don’t hear that the newer types of oil are available only because oil prices are high. They can’t be expected to bring oil prices down. An investment sinkhole means that our dollar of investment doesn’t go as far; it is precisely the opposite of increased productivity.
When we were still far from reaching resource limits, efficiency improvements could more than make up for the loss of efficiency that comes from the Investment Sinkhole effect. But as we get closer to limits, the situation is reversed. Efficiency improvements are outweighed by the ratcheting up of extraction costs, because of the Investment Sinkhole effect. This means that instead of increased wealth being added to the system by efficiency improvements over time, we find the Sinkhole effect predominates. The common worker needs to spend an increasing proportion of his paycheck on necessities, leaving less for discretionary items. The result is recession, or very slow economic growth.
When the Investment Sinkhole problem starts to predominate, financial models suddenly don’t work very. Central banks react by cutting interest rates, in an attempt to stimulate economic growth. They also try to stimulate the economy by Quantitative Easing. This adds more money to the economy, and attempts to reduce longer-term interest rates. Of course, if the problem is really structural, there is no bounce-back to economic growth. The temporary fix becomes a bridge to nowhere.
A Long-Term View of our Financial Problems
In the previous section, we talked about our immediate problems. But what about our longer-term problems?
Today’s financial system is based on the assumption that individuals and businesses can make and keep financial promises. This system worked well, when resource prices were flat or declining, as was the case prior to 2000. It was possible for businesses and governments to take out loans under the expectation of continued prosperity, and for individuals to buy houses and cars under the expectation that they would continue to have jobs, so that they could continue to make auto loan or mortgage payments.
The situation changes dramatically, if the long-term expectation is for oil prices and other commodity prices to keep ratcheting upward. We don’t really have substitutes for oil and other commodities, so if we want to keep obtaining them, we need to pay the ever-higher cost. Even devices such as more efficient cars are affected by higher prices, because they too, use fossil fuels in their construction, and depend on ever more expensive technology.
In a period when commodity prices are ratcheting upward, businesses find it increasingly difficult to forecast whether new facilities will continue to be economic 10, 20 or 40 years. Businesses find that customers gradually have less discretionary income, instead of more, so it becomes increasingly difficult for these customers to afford the products which are being sold. This makes business planning much more difficult.
If a bank makes a long-term loan, it needs to include a much larger provision for the expected cost of loan write-offs. These higher loan write-off provisions causes interest rates to rise, making long-term loans unaffordable for many (or most) people and businesses. Governments are hugely affected as well.
Without access to cheap loans, and with resource prices (especially oil, but sometimes desalinated water instead of well water, and natural gas) ratcheting upward, business failures rise. This leads to more layoffs, and more defaults on mortgages and auto loans. Interest rates on these can be expected to rise as well.
All of these effects mean that debt-financing becomes much less attractive. Debt defaults, such we have just seen in Cyprus and Greece, become more common. This is not a temporary passing phase; it is a permanent long-term situation, caused by the ratcheting up of oil and other commodity prices, as resource extraction becomes more expensive.
In such an environment, the amount of goods and services available tends to decline over time. Continued economic growth changes to continued economic contraction. If governments issue fiat money, it declines in value over time as well. (Money is sometimes defined as a “store of value,” but this becomes less possible.) One way this decline could occur is if those holding money have an expectation for continued inflation. Alternatively, money can be subject to an automatic downward adjustment that reduces its value on a monthly or annual basis.
With such a system, individuals discover that if they have money, the best strategy is to spend it immediately, rather than to try to save for retirement or some distant goal. Investments in stock markets, or in stocks of new companies, are likely to decline.
Without the availability of debt at a reasonable cost, businesses find it much more difficult to expand or to begin from scratch. New businesses tend to be small ones, that can finance their own operations by bootstrapping–that is, self-financing by using the profits on early sales to pay for materials needed for later sales, and hopefully for a little expansion as well.
All of these issues mean that if there is a financial collapse, picking ourselves up afterward will be quite difficult. Our current financial system would need substantial modification to work in such a system. The size of the current financial sector would likely shrink dramatically.
If the various countries of the world set up different financial systems to deal with the new realities, connecting them into a world system is likely to be difficult. Political stability is likely to be lower in a system such as this. How does one arrange long-term contracts, when there is a very real possibility that the government of the country that is party to an agreement may have collapsed, prior to the end of the contract?
What Brings the Whole System Down?
It is easy to think of a long list of things that might bring the system down. In fact, there are so many contenders that if any one of them starts the collapse, it seems likely others will push it on its way.
Clearly one of the issues is the wide gap between US Federal Government revenue and government expenditures.
If the US government (or the government of any of the many countries who are having difficulty balancing their budgets) tries to raise taxes or cut benefits, to get revenue and expense back in line, the outcome is likely to be more recession and more layoffs. Debt defaults are likely to rise, putting banks into financial difficulty. There will then be a need for more bank bailouts, and a rerun of the problems we saw in 2008, but with governments in poorer financial condition to solve these problems.
Another possible way the system could be brought down is by rising interest rates for governments, perhaps because of all of the failures elsewhere around the globe. Rising interest rates will mean that a government’s budget is even more unbalanced than it was before, because the higher interest rates translate to higher government expenses.
These higher government interest rates would quickly be reflected in other interest rates, such as mortgage interest rates and interest on corporate loans. Sale of homes would drop dramatically, as interest rates rise. Prices of homes would likely drop as well. Business investment would drop dramatically. Much of the “stimulus” that the government has put in place would disappear. We likely would be headed back into major recession.
A third possibility relates to the Quantitative Easing that has been done recently, and the artificially low interest rates that have resulted, even for longer-term loans. Investors who have to contend with these low interest rates will try to find ways around them, and in the process, create bubbles in asset prices. These bubbles invariably burst, with bad outcomes. For example, the WSJ recently published an article titled, “Investors pile into housing, this time as landlords.” Of course, when something goes wrong (like mis-estimating returns, or oil prices rising higher, leading to more pressure on renters’ ability to pay), the same investors are likely to pile right back out, puncturing the new bubble. Commercial investors rushing out will pull down property values, leading to yet more mortgage defaults as homeowners again find their loans “underwater”.
A fourth possibility is that oil prices will ratchet upward again. Alternatively, natural gas may rise from its current artificially low price level in the US, to more like European or Japanese levels. Either of these would lead to more financial pressures on citizens, and more debt defaults. Banks would likely again be in difficulty, needing bail outs.
A fifth possibility is that the Euro ceases to be a currency. Alternatively, some of the debtor nations could drop out of the Euro, allowing the Euro to rise for remaining nations, thus putting the remaining nations in a worse position for selling their exports. In either of these scenarios, the European crisis could be exported to the US, partly as reduced demand for our goods, and partly through exposure of banks to European defaults.
A sixth possibility is the effects of ObamaCare will destabilize an already weak economy, as businesses attempt to circumvent its effects by substituting more part-time workers for full-time workers.
A seventh possibility is that pensions start running into real financial difficulty, because of artificially low interest rates. The US government may be called in to bail out pension funds, or the Pension Benefit Guaranty Corporation, at high cost.
An eighth possibility is that states start leaving the United States, because they feel that they would be better off on their own, as taxes and mandatory programs (such as ObamaCare) become increasingly difficult to deal with.
What does the shape of the decline look like?
Many people who base their views on geological depletion of oil expect that the decline will be somewhat slow, matching geological decline. I don’t think geological decline rates will have much to do with the shape of the decline, except for perhaps setting an upper bound as to how well things might, in theory, work out.
The big question in my mind is how well the international financial system will hold together. There is a close corollary question: How successful will be at replacing it on a timely basis if it does fall apart? My concern is that if banks are suddenly closed, businesses of all types will fail. This could include companies extracting oil as well as companies selling electric power and companies providing fresh water.
If there are long-term problems with the financial system, international trade is likely to be greatly reduced. Businesses making trades are likely to want greater assurances that they will actually be paid than is the case today. This could take the form of bilateral trade with trusted partners, or “I’ll ship you Product A if you will ship me Product B,” as a form of barter.
A slowdown in world trade could have dramatic repercussions quickly with respect to our ability to keep basic services in good repair, because we are now dependent on international trade for replacement parts of products we use every day (such as cars and trucks). Nearly everything that is manufactured today incorporates raw materials from around the world, and uses machines that depend on parts from around the world.
Another question is whether there will be huge political disruptions. If banks are closed, someone usually is blamed. We have seen many ways these political disruptions can take place. Some examples might include Syria, Egypt, the Former Soviet Union, and Greece.
One scenario I can imagine is that some parts of a country are subject to more disruption than others. In one part of the country, banks may be closed, while in another part, states may be able to reopen closed banks. Or electricity outages may occur following a storm, and never be repaired, while other locations nearby are doing fairly well. There may be political riots, but these are often located in areas where politicians are located, not in other areas.
Perhaps it is just as well that we don’t know exactly what the decline will look like. Not knowing gives us some chance for optimism.
Off the keyboard of Gail Tverberg
Published on Our Finite World on March11,2013
Discuss this article at the Epicurean Delights Table inside the Diner
A friend asked me to put together a presentation on our energy predicament. I am not certain all of the charts in this post will go into it, but I thought others might be interested in a not-so-difficult version of the story of the energy predicament we are reaching.
My friend also asked what characteristics a new fuel would need to have to solve our energy predicament. Because of this, I have included a section at the end on this subject, rather than the traditional, “How do we respond?” section. Given the timing involved, and the combination of limits we are reaching, it is not clear that a fuel suitable for mitigation is really feasible, however.
Energy makes the world go around
Energy literally makes the world turn on its axis and rotate around the sun.
Energy is what allows us to transform a set of raw materials into a finished product.
Energy is also what allows an us to transport goods (or ourselves) from one location to another. Services of any type require energy–for example, energy to light an office building, energy to create a computer, and human energy to make the computer operate. Without energy of many types, we wouldn’t have an economy.
Increased energy use is associated with increasing prosperity.
Energy use and oil use have risen more or less in tandem with GDP increases. Oil is expensive and in short supply, so its increases have tended to be somewhat smaller than total energy increases. This happens because businesses are constantly seeking ways to substitute away from oil use.
China is an example of a country with very high growth in energy use. China’s energy use started growing rapidly immediately after it joined the World Trade Organization in December 2001. China’s energy use is mostly coal.
European countries with bank bailouts show declining oil consumption.
Increased fuel use is also associated with rising population growth.
On Figure 6 above, the fuel use and population growth rise very rapidly, after fossil fuels were added about 1800. In fact, the lines overlay each other, so it is not possible to see both. Adding fossil fuels allowed much better food supply, sanitation, and medical care, all leading to huge population growth.
World population is still growing rapidly, especially outside of the developed countries. The countries with the most population growth (blue) are only now beginning to obtain goods and services that the developed world takes for granted, like better medical services, cars, and electricity for every home. Their fuel use is growing rapidly.
There are huge differences in kinds of energy.
This chart illustrates a few of the kinds of energy available. Each has its particular uses. Businesses will substitute a cheaper source of energy whenever they can. Businesses especially seek ways to substitute away from human energy, since it is the most expensive type. One approach is automation. This substitutes machines (running on electricity or oil) for human labor. Another approach is outsourcing the manufacturing of goods to countries that have lower-cost labor.
One factor that limits fuel switching from oil to electricity is the amount of machinery currently using oil. Robert Hirsch says
Worldwide machinery operating on oil is valued at $50 to $100 trillion (Automobiles, airplanes, tractors, trucks, ships, buses, etc.)
There is also a huge investment in roads, bridges, refineries, and pipelines. Past transitions have taken more than 30 years, because it usually makes economic sense to wait for current machinery to reach the end of its economic life before replacing it.
LIMITS WE ARE REACHING
Unfortunately, we live in a finite world. At some point we start reaching limits.
One limit we are reaching is how many people the world will support, without unduly affecting other species. There are now over 7 billion humans on earth, compared to fewer than 200,000 gorillas and chimpanzees, which are also primates.
The natural order is set up so that each species–including humans–reproduces in far greater numbers than is needed to replace itself. Natural selection chooses which of the many organisms will survive. With the benefit of fossil fuel energy, humans (as well as their cows, pigs, goats, chickens, dogs and cats) have been able to survive in far greater numbers than other species. In fact, paleobiologists tell us that the Sixth Mass Extinction has begun, thanks to humans. At some point, interdependencies are disturbed, and we can expect more population collapses.
Another limit is pollution of many types. This image is of air pollution, but there is also water pollution and CO2 pollution. Even what we think of as renewable energy often poses pollution challenges. For example, battery recycling/disposal can pose pollution challenges. Mining of rare earth minerals, used in electric cars, wind turbines, and many high tech devices is often cited as being very polluting in China.
Another limit is declining soil quality. In the natural order, soil is not disturbed by plowing, and the nutrients animals use are recycled back into the soil, after they use them.
As we disturb this natural order, we find erosion reduces top-soil depth. The amount of organic matter in the soil is reduced, making crops less drought-resistant. Nutrients such as phosphorous and potassium are often depleted, and need to be added as soil amendments, requiring fossil fuel transport. Soils often suffer from salinity related to irrigation. Nitrogen levels also become depleted.
It is possible to mitigate these problems using fossil fuels. However, we discover that our ability to feed 7 billion people becomes increasingly dependent on continued fossil fuel use. If we increase biofuel production, this tends to make the situation worse. Techniques such as regrading of hills to improve rainwater absorption can help the situation, but this too requires energy.
Another limit is imposed by the Second Law of Thermodynamics. Entropy happens. Things fall apart. All of the “stuff” humans have produced (including roads, bridges, pipelines, electricity transmission equipment, cars, and computers) keeps degrading, and eventually needs to be replaced. If we intend to continue to have roads, we need to keep repairing them and building new ones. Using current technology, this requires an increasing amount of fossil fuel energy.
Another limit arises because we extract the cheapest, easiest to extract resources first. (Figure 11) As a result, at some point, the cost of extraction rises, because the cheap resources have already been depleted. Outside observers don’t necessarily notice a difference as the quality of resources drops over time; it always looks as if there is an increasing quantity of reserves available as we move down the resource triangle.
Unfortunately, the apparently increased resources are not really comparable to what was already extracted. The resources lower down in the resource triangle, such as oil and gas that requires “fracking” to extract, require the use of increased energy resources. The speed of extraction is often remarkably slower–light oil flows like milk, while heavy oil can be the consistency of peanut butter. Extracting oil using fracking has been compared to getting oil from the pores of a concrete driveway.
Another example is fresh water. Initially we take it from a local stream, or from a shallow well, where little energy (and cost) is required to obtain it. As this resource depletes, we seek other sources–deeper wells, or water piped from afar, or desalination. All of these approaches use much more energy. If the world’s total energy supply is not growing rapidly, using more energy for water supply is likely to mean less energy is available for other uses. I discuss this issue in Our Investment Sinkhole Problem.
An example of how resource depletion can work is illustrated with US oil supply. US oil production (blue) suddenly began to decline in 1970, despite the oil industry’s best efforts to extract more. By scrambling around quickly, it was possible to add more oil production from Alaska (red), but this soon declined as well.
It wasn’t until oil prices rose in the late 2000s that it made economic sense to use technology which had been developed much earlier to extract tight oil. Tight oil is expensive oil to extract. How much production will rise from current levels depends to a significant extent on how much oil prices are able to increase in the future. The higher that oil prices rise, the greater the recessionary impact that can be expected, but the more oil that can be produced.
World oil supply is now about level, except for the small increase added by US and Canadian oil supply. (Figure 13) One concern with world oil supply as flat as it is, is that at some point, world oil supply will suddenly take a nosedive, just as US oil production did.
Another concern is that the developing world will get the majority of the world oil supply, leaving little for historically large users (Figure 13). US, Europe, and Japan experienced severe recession in the 2007-2009 period, and still are seeing economic headwinds, at the same time that countries that were able to obtain the oil continued to experience economic growth.
I think of our current situation as being like that of a host who gives a party for 10 people. There is enough food to go around, but just barely. The host decides to invite another 50 people to the party. Surprise! Suddenly there is a shortfall. Globalization has its downside!
A third concern is that oil prices will disrupt economies of oil importing nations. Oil prices rose sharply after US oil production dropped in the 1970s. They began rising rapidly again about 2003, as the world became more globalized. In addition, oil resources became increasingly expensive to extract. There is little possibility now that oil prices can decline for long without a drop in oil production.
Oil price spikes lead to recession. Economist James Hamilton has shown that ten out of the most recent 11 US recession were associated with oil price spikes. When oil prices rise, food prices tend to rise at the same time. Consumers cut back on discretionary spending, because fuel for commuting and the price of food are necessities. This cutback in spending leads to layoffs in the discretionary sector and recession.
High oil prices also seem to lead to depressed wages. (Figure 15. Here, I am dividing total wages for all non-government employees or by the total US population, and then taking this average wage, and adjusting if for inflation.) This is the effect we would expect, if the major substitution caused by high oil prices is a loss of human employment. This shift tends to occur because human energy is very expensive, and because wages tend to be a big share of a company’s costs.
Figure 16 shows an illustration of the effect that happens. If oil prices rise, the cost of making goods and transporting them to their destination rises. If the sales prices of goods doesn’t rise, a business’ profits will shrink. (Before and after the oil price rise shown in black box). The company will consider low profits unacceptable.
The company has several ways of fixing its lower profit. Wages tend to be one of the company’s largest costs, so these are a likely target. One approach is automation. This may slightly raise electricity costs, but it will lower wage costs, and raise profits. Another approach is outsourcing production to a low-cost country like China. This will lower wage costs and probably other costs, leading to higher profit for the company.
A third approach is what I call “making a smaller batch.” It involves closing unprofitable offices, or flying fewer jets, so that the quantity produced matches the new lower demand for the product, given the higher required sales’ price, now that the oil price is higher. Any of these approaches reduces the amount of wages paid to US employees.
HOW DOES THIS CONCLUDE?
A person could argue that any of the limits could eventually bring the system down. The pressure on wages is particularly a problem, since a further rise in oil prices would seem likely to lead to more job loss, and further pressure on wages of those who keep their jobs. The large amount of debt outstanding is another issue of concern.
My personal view is that the most likely scenario is that the various limits will work together to produce secondary effects, and it is the secondary effects that are likely to bring society down. These secondary effects are Financial (wealth disparity, debt defaults, inability to collect enough taxes), Political (not enough taxes, uprising by the lower classes, government collapse) and Disease Susceptibility (inadequate food, medicine, and sanitation due to inadequate wages and government cutbacks).
These effects are similar to ones experienced in the past when economies started reaching resource limits, based on the research of Peter Turchin and Sergey Nefedov reported in the book Secular Cycles. In the past, societies seemed to go through about 300 year cycles. The first was Growth, lasting over 100 years. The second was Stagflation, lasting perhaps 50 or 60 years. This third was Crisis, with population decline, lasting up to 50 years (but perhaps a much shorter time). The fourth was Depression/ Intercycle.
If we estimate that today’s complete cycle started in 1800 with the use of coal, and the Stagflation period started about 1970 with the decline in US oil production, then we now seem to be nearing the Crisis stage. Of course, each situation is different. This is the first time we are reaching resource limits on a world-wide basis.
There is considerable evidence that we are already reaching the situation where governments are encountering financial distress of the type shown in Figure 17. With wages being depressing in recent years (Figure 15), it is difficult to collect as much taxes as required. At the same time, expenses are elevated to handle the many issues that arise (such as payments to the unemployed, subsidies for alternative energy, and the higher costs of road repairs due to higher asphalt costs). The big gap between revenue and expense makes it hard to fix our current financial predicament, and increases the likelihood of political problems.
REQUIREMENTS FOR A FUEL TO FIX OUR CURRENT PREDICAMENT
Is it possible to fix our current situation? To really fix the situation, we would need to reproduce the situation we had in the post-World War II period–when energy was cheap, and growing very rapidly. Economists have observed that historically, the cost of energy was very low. Given the importance of energy, its low price was an important feature, not a bug. It is what allowed society to have plenty of energy for growth, at minimal cost.
In order for a new alternative fuel to truly fix our current predicament, it would need the following characteristics:
- Abundant – Available in huge quantities, to meet society’s ever-growing needs.
- Direct match for current oil or electricity – Needed to avoid the huge cost of building new infrastructure. Electricity needs to be non-intermittent, to avoid the cost of mitigating intermittency. We also need an oil substitute. This oil substitute theoretically might be generated using electricity to combine carbon dioxide and water to create a liquid fuel. Such substitution would require time and investment, however.
- Non-polluting – No carbon dioxide or air and water pollution.
- Inexpensive – Ideally no more than $20 or $30 barrel for oil equivalent; 4 cents/kWh electricity. Figure 15 shows wage growth has historically occurred primarily below when oil was below $30 barrel.
- Big energy gain in the process, since it is additional energy that society really needs – This generally goes with low price.
- Uses resources very sparingly, since these are depleting.
- Available now or very soon
- Self-financing – Ideally through boot-strapping–that is, generating its own cash flow for future investment because of very favorable economics.
It is interesting that when M. King Hubbert originally made his forecast of the decline of fossil fuels, he made his forecast as if an alternative fuel would become available in huge quantity, by the time of the decline. His original idea (in 1956) was that the new fuel would be nuclear. By 1976, his view was that the new fuel needed to be some version of solar energy.
What kind of solar energy might this be? Solar panels PV located on the ground are heavy users of resources, because they have a low capacity factor (percentage of the time they are actually collecting sunlight), and because they need to be fairly sturdy, to withstand wind, rain, and hail. Space solar theoretically would be much better, because it is much more sparing in its use of resources–it would have over a 99% capacity factor, and the PV film could be much thinner. Timing for space solar would be a big issue, however, assuming financial issues can be worked out.
Also, even if space solar or some other fuel should provide the fuel characteristics we need, we still need to address the population issue. As long as world population keeps rising, humans are an increasing strain on earth’s resources.
Off the keyboard of Gail Tverberg
Published on Our Finite World on March 1, 2013
Discuss this article at the Epicurean Delights Smorgasbord inside the Diner
If an economy is growing, it is easy to add debt. The additional growth in future years provides money both to pay back the debt and to cover the additional interest. Promotions are common and layoffs are few, so a debt such as a mortgage can easily be repaid.
The situation is fairly different if the economy is contracting. It is hard to find sufficient money for repaying the debt itself, not to mention the additional interest. Layoffs and business closings make repaying loans much more difficult.
If an economy is in a steady state, with no growth, debt still causes a problem. While there is theoretically enough money to repay the debt, interest costs are a drag on the economy. Interest payments tend to move money from debtors (who tend to be less wealthy) to creditors (who tend to be more wealthy). If the economy is growing, growth provides at least some additional funds offset to this loss of funds to debtors. Without growth, interest payments (or fees instead of interest) are a drain on debtors. Changing from interest payments to fees does not materially affect the outcome.
Recently, the growth of most types of US debt has stalled (Figure 3, below). The major exception is governmental debt, which is still growing rapidly. The purpose of sequestration is to slightly slow this growth in US debt.
The growth in government debt occurs because of a mismatch between income and expenditures. There is a cutback in government revenue because high oil prices make some goods using oil unaffordable, causing a cutback in production, and hence employment. The government is affected because unemployed workers don’t pay much in taxes. Government expenditures are still high because many unemployed workers are still collecting benefits.
What can we expect going forward? Will the debt situation get even worse?
I think we can expect that from here, the debt situation will deteriorate. One issue is rising oil prices. While there seems to be a large supply of oil available, it is at ever-higher cost of extraction, because of diminishing returns. (This is even true of tight oil, such as from the Bakken.) Furthermore, I recently showed that not only do high oil prices adversely affect government finances, they also adversely affect wages.1
Figure 4. US per capita non-governmental wages, in 2012 dollars. Non-governmental wages and population from Bureau of Economic Analysis; Adjusted to 2012 cost level using CPI-Urban from Bureau of Labor Statistics
If wages are low, the temptation is for governments to try to create more “spendable income” by increasing debt. This can’t really fix the situation, however. The real issue is increasingly high oil prices, which adversely affect both government finances and wages. Adding debt adds yet more interest payments, adding a further burden to wage earners, and creating a need for payback in the future, when wages are even lower.
Ultimately (which may not be very long from now), the debt system appears likely to collapse. The Quantitative Easing (QE) which a number of governments are now using to hold down interest rates and make more funds available to lend cannot continue forever. While there are claims that QE is a bridge to “when growth returns,” it is seriously doubtful that economic growth will ever return. Inexpensive oil is simply too essential to today’s economy. As oil prices rise, wages fall, and demand for oil is further constrained. Falling wages also reduce demand for debt, as payback becomes more difficult.
How Household Debt Adds to Spendable Income
One thing readers may have not thought about is that it is the increase in debt that adds to a person’s (or company’s) spendable income. For example, taking out a car loan allows a person to buy a car. Paying back the loan over a period of years tends to reduce spendable income. If, in the aggregate, the amount of debt outstanding starts decreasing each year, spendable income is actually reduced below the level of wages, because in total, the balance is being reduced.
If we add the increase in household debt (mortgages, credit cards, student loans, car loans, etc.) to wages, this is the pattern we see historically. (The increase has been adjusted for inflation using CPI-Urban):
Figure 5. Per capita wages (excluding government wages) similar to Figure 5. Also, the sum of per capita wages and the increase in household debt, also on a per-capita basis, and also increased to 2012$ level using the CPI-Urban. Amounts from US BEA Table 2.1 and Federal Reserve Z1 Report. *2012 estimated based on partial year data.
The pattern is very much what we would expect, given what we know about recent debt patterns. The amount of debt rose rapidly in the early 2000s, when interest rates were lowered and lending standards relaxed. Some people bought new homes. Home prices escalated, with the higher demand. Many homeowners were able to refinance at lower interest rates. In the process, homeowners were able to “pull out” funds that they could use for any purpose they liked–fixing up the house, buying a new car, or going on a vacation.
By 2008, the party was over. In fact, the amount that was added through debt started decreasing in 2006 and 2007, after the Fed Reserve raised interest rates, in an attempt to choke back inflation caused by high oil prices. I talk about this in Oil Supply Limits and the Continuing Financial Crisis, available here or here.
Increased Government Debt Can Also Add to Spendable Income
In Figure 5, we added the increase in household debt to wages, to get an estimate of spendable income, adjusted for debt. Theoretically, at least part of the increase in government debt might also be added to spendable income, since it is often used (in leu of increased taxes) for programs that benefit citizens. (Some of the increased debt is used for things like bailing out banks, which is of questionable value in raising the spendable income of individuals, so perhaps not all of the increase in government debt should be added in estimating spendable income. Also, increased interest costs related to higher debt amounts would tend to have a dampening effect on spending, if interest rates are not continually dropping, as they have been under QE.)
If we add the increase in government debt (all kinds, including state and local) to the amounts shown in Figure 5, this is what we get:
Figure 6. Amounts shown in Figure 5, plus change in government debt added to the sum of (wages plus increase in household debt). Non-Government debt from Federal Reserve Z1 report, with changes adjusted to 2012 cost levels using CPI Urban. *2012 amounts estimated based on partial year values.
How much did citizens really spend? The Bureau of Economic Analysis tells us that as well, as an item called Personal Consumption Expenditures. We sometimes hear that in the United States, personal consumption of goods and services makes up more than 70% of GDP. In fact, this percentage has been growing since about 1950.
Figure 7. Wages (excluding government wages) as a percentage of GDP and personal consumption as a percentage of GDP, both based on data of the US Bureau of Economic Analysis. *2012 estimated based on partial year data.
Strangely enough, wages excluding governmental wages have been falling as a percentage of GDP during the same period. How can wages be falling at the same time personal consumption is rising? I think that a large part of the answer may very well be “increasing debt.”
If we compare wages to personal consumption expenditures, we find that wages were about 2/3 of personal consumption expenditures at the beginning of the period graphed, but gradually fell to a lower and lower share of Personal Consumption Expenditures.3 If we add a line to Figure 6 showing 2/3 of personal consumption expenditures, the line comes out very close to where we might guess it would, if all of household debt increases, and part of government debt increases were acting to increase personal spending (Figure 8).
Figure 8. Same data shown on Figure 6, plus a line equal to 2/3 of Personal Consumption as shown on BEA Report 2.4.5. also adjusted to a per capita and 2012 cost basis using CPI-Urban.
While there are too many variables to make this comparison exact, it does indicate that the increases in debt levels are of the right order of magnitude to explain what would otherwise be a very strange anomaly.
I might mention, too, that part of the reason that Personal Consumption Expenditures can be rising as a percentage of GDP is the fact that investment has been falling, as businesses move their manufacturing offshore, and as other changes take place. According to the American Society of Civil Engineers, we are allowing bridges, roads, and dams to deteriorate, and not adequately maintaining electrical transmission infrastructure. We are reaching limits on how far we can allow investment to drop, however. In fact, the time is coming when we will need to increase investment, or face loss of some of the infrastructure we take for granted.
Figure 9. United States domestic investment compared to consumption of assets, as percentage of National Income. Based on US Bureau of Economic Analysis Table 5.1.
Where Do Debt Limits Put Us
Even if all debt limits were to do is erase the beneficial impact of debt increases, based on Figure 8, it appears that spendable income (or Personal Consumption Expenditures) would decrease by about 23%, to bring it back to might be expected based on wages.
In fact, reaching debt limits is likely be a messy affair, with some type of change (such as increasing rising interest rates as QE fails, or the US dollar losing its reserve currency status, or huge changes in the Eurozone) leading to changes that affect governments and currencies around the world. It seems likely that trade might be disrupted. Some governments might be replaced, and the debt of prior governments repudiated by the new governments. It is not clear what would happen to personal and corporate debt. In many countries, reform governments have redistributed land and other property. In such a circumstance, neither prior land ownership nor prior debt would have much meaning.
In our current circumstances, we are reaching debt limits because of a specific resource limit — lack of inexpensive oil. Oil is used almost exclusively as a transportation fuel and in many other applications as well (such as construction, farming, pharmaceutical manufacturing, and synthetic fabrics). Expensive oil is not really a substitute, and neither is intermittent electricity. We are reaching other limits as well. Perhaps the most pressing of these is availability of fresh water. Fresh water can be obtained by desalination, but expensive water is not really a substitute for cheap water, for the same reason that expensive oil is not really a substitute for cheap oil. See my post, Our Investment Sinkhole Problem.
The situation of reaching debt limits because of resource limits is a worrisome one, because it is hard to see a way to fix the situation. People often say that our debt problem arises because we have a financial system in which money is loaned into existence, and as a result, requires growth to pay back debt with interest. I am not sure that this is really the problem.
We have been used to a financial system that “works” in a growing economy. In such a system, it makes sense to take out loans on new business ventures. In such a system, money is also a store of value. In a shrinking economy, relationships change. Some loans will still “make sense,” but such loans will be a shrinking proportion of current loans, with long-term loans being especially vulnerable. Money will either need to “expire,” or a high rate of inflation will need to be expected, making interest rates on loans very high. In a shrinking economy, businesses will fail much more often, and workers will more often lose their (fossil fuel supported) jobs.
Some have suggested that new local currencies will fix our problems. I am doubtful this will be the case. The problem may well be that all currencies start being more local in nature. What we may lose is interchangeability based on trust.
 As background for those who have not read my post The Connection of Depressed Wages to High Oil Prices and Limits to Growth, wages recently have been depressed, in part because fewer people are working. Figure 4 above, showing “Per Capita Non-Government Wages,” provides a measure of how wages have changed. This is calculated by taking wages for all US residents, subtracting wages of government workers, and dividing by the total US population (not just the number working). The average wage calculated in this manner is than adjusted to the 2012 price level based on the CPI-Urban price index. Government workers have been omitted because I am trying to get at the base from which other funding comes. Government wages are ultimately paid by taxes on workers in private companies.
The thing that is striking about Figure 4 is that a similar pattern occurs in the 1973 to 1983 period as the 2002 to 2012 period. Oil prices were high in both periods. (Figure 10, below). In fact, the vast majority of wage growth has occurred when oil prices were $30 or less in 2012$.
Figure 10. Per capita non-government wages, calculated by dividing non-government wages from the Bureau of Economic Analysis by the US population, and then bringing to 2012$ using CPI-Urban price index, together with historical oil prices in 2012$, based on BP 2012 Statistical Review of World Energy data, updated with 2012 EIA Brent oil price data.
There are several reasons why rising oil prices can be expected to reduce the number of people working, or the hours they work:
(a) Discretionary sector layoffs. Consumers find that the price of food (which uses oil in its production and transport) and of commuting is rising. Prices of other goods are also rising. This forces consumers to cut back on discretionary spending. Employees in discretionary sectors get laid off, because of these impacts.
(b) General layoffs. Even outside discretionary sectors, employees may be laid off, if the cost of goods rises indirectly because of a rise in oil price. Often this will be because of higher transport cost, but it could because of another use of oil, such as by construction equipment, or as a raw material. With higher costs of delivered products, companies find that demand falls, if they raise prices sufficiently to maintain profit margins. (This falling demand occurs because some consumers can no longer afford their products.) Businesses find it necessary to scale back the size of their operations–lay off workers and close stores or other facilities. Alternatively, businesses can move operations to China or another low cost site of operation, to reduce costs, but this also leads to layoffs of US employees.
(c) Government layoffs. Eventually the government tax base is reduced, because of a smaller proportion of the population paying taxes. Governments also find a need to pay our more in direct costs–such as more for unemployment insurance, and more for asphalt (an oil product) for paving roads. Governments also find themselves laying off workers.
The effects outlined above can be mitigated to some extent by changes such as moving closer to work and more fuel efficient cars. But experience seems to suggest that even more what happens is that the effects shift from sector to sector over time, as businesses “fix” their problems, leaving them to with wage-earners and governments.
The high price oil situation was mostly resolved in the early 1980s, because other relatively inexpensive oil was available to drill, bringing the price down again. (The new price, at $30 barrel, was still 50% higher than the $20 barrel price prior to the crisis, though.) The availability of new low-priced supplies seems much less likely now, because we extracted the inexpensive-to-extract oil first. We are now reaching diminishing returns. While there seems to be plenty of oil available, it is high-priced oil. This is even true of the new “tight oil” supplies in the Bakken and several other areas.
 Government debt in this post refers to all types of government debt combined, including state and local debt. Within this debt, only debt classified as “Marketable” is included. As such, it does not include debt owed to the Social Security system (because contributions that were collected by the Social Security system were spent on something else, and are not available to pay Social Security recipients) or to other pre-funded government agencies. Such debt is a future liability, not affecting today’s spending, so I didn’t add it in. (The Federal Reserve Z1 report also does not include it.) There are, in fact, a huge number of government obligations that are not reflected, such as promises to bail out pension programs and FDIC coverage of bank accounts, because they are contingent in nature. Such programs can be expected to add to the problems we would have, if our debt system should fail.
 We would not expect non-government wages to equal Personal Consumption Expenditures, since for one thing, wages of non-government employees leave out expenditures by government employees. They also leave out various derivative amounts, such as expenditures by entrepreneurs, and expenditures of amounts that would be classified as rents and dividends. Changes in savings rates would also play a role.
Off the keyboard of Gail Tverberg
Published on Our Finite World on February 22, 2013
Discuss this article at the Epicurean Delights Smorgasbord inside the Diner
Globalization seems to be looked on as an unmitigated “good” by economists. Unfortunately, economists seem to be guided by their badly flawed models; they miss real-world problems. In particular, they miss the point that the world is finite. We don’t have infinite resources, or unlimited ability to handle excess pollution. So we are setting up a “solution” that is at best temporary.
Economists also tend to look at results too narrowly–from the point of view of a business that can expand, or a worker who has plenty of money, even though these users are not typical. In real life, the business are facing increased competition, and the worker may be laid off because of greater competition.
The following is a list of reasons why globalization is not living up to what was promised, and is, in fact, a very major problem.
1. Globalization uses up finite resources more quickly. As an example, China joined the world trade organization in December 2001. In 2002, its coal use began rising rapidly (Figure 1, below).
In fact, there is also a huge increase in world coal consumption (Figure 2, below). India’s consumption is increasing as well, but from a smaller base.
2. Globalization increases world carbon dioxide emissions. If the world burns its coal more quickly, and does not cut back on other fossil fuel use, carbon dioxide emissions increase. Figure 3 shows how carbon dioxide emissions have increased, relative to what might have been expected, based on the trend line for the years prior to when the Kyoto protocol was adopted in 1997.
3. Globalization makes it virtually impossible for regulators in one country to foresee the worldwide implications of their actions. Actions which would seem to reduce emissions for an individual country may indirectly encourage world trade, ramp up manufacturing in coal-producing areas, and increase emissions over all. See my post Climate Change: Why Standard Fixes Don’t Work.
4. Globalization acts to increase world oil prices.
The world has undergone two sets of oil price spikes. The first one, in the 1973 to 1983 period, occurred after US oil supply began to decline in 1970 (Figure 4, above and Figure 5 below).
After 1983, it was possible to bring oil prices back to the $30 to $40 barrel range (in 2012$), compared to the $20 barrel price (in 2012$) available prior to 1970. This was partly done partly by ramping up oil production in the North Sea, Alaska and Mexico (sources which were already known), and partly by reducing consumption. The reduction in consumption was accomplished by cutting back oil use for electricity, and by encouraging the use of more fuel-efficient cars.
Now, since 2005, we have high oil prices back, but we have a much worse problem. The reason the problem is worse now is partly because oil supply is not growing very much, due to limits we are reaching, and partly because demand is exploding due to globalization.
If we look at world oil supply, it is virtually flat. The United States and Canada together provide the slight increase in world oil supply that has occurred since 2005. Otherwise, supply has been flat since 2005 (Figure 6, below). What looks like a huge increase in US oil production in 2012 in Figure 5 looks much less impressive, when viewed in the context of world oil production in Figure 6.
Part of our problem now is that with globalization, world oil demand is rising very rapidly. Chinese buyers purchased more cars in 2012 than did European buyers. Rapidly rising world demand, together with oil supply which is barely rising, pushes world prices upward. This time, there also is no possibility of a dip in world oil demand of the type that occurred in the early 1980s. Even if the West drops its oil consumption greatly, the East has sufficient pent-up demand that it will make use of any oil that is made available to the market.
Adding to our problem is the fact that we have already extracted most of the inexpensive to extract oil because the “easy” (and cheap) to extract oil was extracted first. Because of this, oil prices cannot decrease very much, without world supply dropping off. Instead, because of diminishing returns, needed price keeps ratcheting upward. The new “tight” oil that is acting to increase US supply is an example of expensive to produce oil–it can’t bring needed price relief.
5. Globalization transfers consumption of limited oil supply from developed countries to developing countries. If world oil supply isn’t growing by very much, and demand is growing rapidly in developing countries, oil to meet this rising demand must come from somewhere. The way this transfer takes place is through the mechanism of high oil prices. High oil prices are particularly a problem for major oil importing countries, such as the United States, many European countries, and Japan. Because oil is used in growing food and for commuting, a rise in oil price tends to lead to a cutback in discretionary spending, recession, and lower oil use in these countries. See my academic article, “Oil Supply Limits and the Continuing Financial Crisis,” available here or here.
Developing countries are better able to use higher-priced oil than developed countries. In some cases (particularly in oil-producing countries) subsidies play a role. In addition, the shift of manufacturing to less developed countries increases the number of workers who can afford a motorcycle or car. Job loss plays a role in the loss of oil consumption from developed countries–see my post, Why is US Oil Consumption Lower? Better Gasoline Mileage? The real issue isn’t better mileage; one major issue is loss of jobs.
6. Globalization transfers jobs from developed countries to less developed countries. Globalization levels the playing field, in a way that makes it hard for developed countries to compete. A country with a lower cost structure (lower wages and benefits for workers, more inexpensive coal in its energy mix, and more lenient rules on pollution) is able to out-compete a typical OECD country. In the United States, the percentage of US citizen with jobs started dropping about the time China joined the World Trade Organization in 2001.
7. Globalization transfers investment spending from developed countries to less developed countries. If an investor has a chance to choose between a country with a competitive advantage and a country with a competitive disadvantage, which will the investor choose? A shift in investment shouldn’t be too surprising.
In the US, domestic investment was fairly steady as a percentage of National Income until the mid-1980s (Figure 9). In recent years, it has dropped off and is now close to consumption of assets (similar to depreciation, but includes other removal from service). The assets in question include all types of capital assets, including government-owned assets (schools, roads), business owned assets (factories, stores), and individual homes. A similar pattern applies to business investment viewed separately.
Part of the shift in the balance between investment and consumption of assets is rising consumption of assets. This would include early retirement of factories, among other things.
Even very low interest rates in recent years have not brought US investment back to earlier levels.
8. With the dollar as the world’s reserve currency, globalization leads to huge US balance of trade deficits and other imbalances.
With increased globalization and the rising price of oil since 2002, the US trade deficit has soared (Figure 10). Adding together amounts from Figure 10, the cumulative US deficit for the period 1980 through 2011 is $8.6 trillion. By the end of 2012, the cumulative deficit since 1980 is probably a little over 9 trillion.
A major reason for the large US trade deficit is the fact that the US dollar is the world’s “reserve currency.” While the mechanism is too complicated to explain here, the result is that the US can run deficits year after year, and the rest of the world will take their surpluses, and use it to buy US debt. With this arrangement, the rest of the world funds the United States’ continued overspending. It is fairly clear the system was not put together with the thought that it would work in a fully globalized world–it simply leads to too great an advantage for the United States relative to other countries. Erik Townsend recently wrote an article called Why Peak Oil Threatens the International Monetary System, in which he talks about the possibility of high oil prices bringing an end to the current arrangement.
At this point, high oil prices together with globalization have led to huge US deficit spending since 2008. This has occurred partly because a smaller portion of the population is working (and thus paying taxes), and partly because US spending for unemployment benefits and stimulus has risen. The result is a mismatch between government income and spending (Figure 11, below).
Thanks to the mismatch described in the last paragraph, the federal deficit in recent years has been far greater than the balance of payment deficit. As a result, some other source of funding for the additional US debt has been needed, in addition to what is provided by the reserve currency arrangement. The Federal Reserve has been using Quantitative Easing to buy up federal debt since late 2008. This has provided a buyer for additional debt and also keeps US interest rates low (hoping to attract some investment back to the US, and keeping US debt payments affordable). The current situation is unsustainable, however. Continued overspending and printing money to pay debt is not a long-term solution to huge imbalances among countries and lack of cheap oil–situations that do not “go away” by themselves.
9. Globalization tends to move taxation away from corporations, and onto individual citizens. Corporations have the ability to move to locations where the tax rate is lowest. Individual citizens have much less ability to make such a change. Also, with today’s lack of jobs, each community competes with other communities with respect to how many tax breaks it can give to prospective employers. When we look at the breakdown of US tax receipts (federal, state, and local combined) this is what we find:
The only portion that is entirely from corporations is corporate income taxes, shown in red. This has clearly shrunk by more than half. Part of the green layer (excise, sales, and property tax) is also from corporations, since truckers also pay excise tax on fuel they purchase, and businesses usually pay property taxes. It is clear, though, that the portion of revenue coming from personal income taxes and Social Security and Medicare funding (blue) has been rising.
I showed that high oil prices seem to lead to depressed US wages in my post, The Connection of Depressed Wages to High Oil Prices and Limits to Growth. If wages are low at the same time that wage-earners are being asked to shoulder an increasing share of rising government costs, this creates a mismatch that wage-earners are not really able to handle.
10. Globalization sets up a currency “race to the bottom,” with each country trying to get an export advantage by dropping the value of its currency.
Because of the competitive nature of the world economy, each country needs to sell its goods and services at as low a price as possible. This can be done in various ways–pay its workers lower wages; allow more pollution; use cheaper more polluting fuels; or debase the currency by Quantitative Easing (also known as “printing money,”) in the hope that this will produce inflation and lower the value of the currency relative to other currencies.
There is no way this race to the bottom can end well. Prices of imports become very high in a debased currency–this becomes a problem. In addition, the supply of money is increasingly out of balance with real goods and services. This produces asset bubbles, such as artificially high stock market prices, and artificially high bond prices (because the interest rates on bonds are so low). These assets bubbles lead to investment crashes. Also, if the printing ever stops (and perhaps even if it doesn’t), interest rates will rise, greatly raising cost to governments, corporations, and individual citizens.
11. Globalization encourages dependence on other countries for essential goods and services. With globalization, goods can often be obtained cheaply from elsewhere. A country may come to believe that there is no point in producing its own food or clothing. It becomes easy to depend on imports and specialize in something like financial services or high-priced medical care–services that are not as oil-dependent.
As long as the system stays together, this arrangement works, more or less. However, if the built-in instabilities in the system become too great, and the system stops working, there is suddenly a very large problem. Even if the dependence is not on food, but is instead on computers and replacement parts for machinery, there can still be a big problem if imports are interrupted.
12. Globalization ties countries together, so that if one country collapses, the collapse is likely to ripple through the system, pulling many other countries with it.
History includes many examples of civilizations that started from a small base, gradually grew to over-utilize their resource base, and then collapsed. We are now dealing with a world situation which is not too different. The big difference this time is that a large number of countries is involved, and these countries are increasingly interdependent. In my post 2013: Beginning of Long-Term Recession, I showed that there are significant parallels between financial dislocations now happening in the United States and the types of changes which happened in other societies, prior to collapse. My analysis was based on the model of collapse developed in the book Secular Cycles by Peter Turchin and Sergey Nefedov.
It is not just the United States that is in perilous financial condition. Many European countries and Japan are in similarly poor condition. The failure of one country has the potential to pull many others down, and with it much of the system. The only countries that remain safe are the ones that have not grown to depend on globalization–which is probably not many today–perhaps landlocked countries of Africa.
In the past, when one area collapsed, there was less interdependence. When one area collapsed, it was possible to let cropland “rest” and deforested areas regrow. With regeneration, and perhaps new technology, it was possible for a new civilization to grow in the same area later. If we are dealing with a world-wide collapse, it will be much more difficult to follow this model.
Off the keyboard of Gail Tverberg
Published on Our Finite World on February 8, 2013
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We are used to expecting that more investment will yield more output, but in the real world, things don’t always work out that way.
In Figure 1, we see that for several groupings, the increase (or decrease) in oil consumption tends to correlate with the increase (or decrease) in GDP. The usual pattern is that GDP growth is a little greater than oil consumption growth. This happens because of changes of various sorts: (a) Increasing substitution of other energy sources for oil, (b) Increased efficiency in using oil, and (c) A changing GDP mix away from producing goods, and toward producing services, leading to a proportionately lower need for oil and other energy products.
The situation is strikingly different for Saudi Arabia, however. A huge increase in oil consumption (Figure 1), and in fact in total energy consumption (Figure 2, below), does not seem to result in a corresponding rise in GDP.
At least part of problem is that Saudi Arabia is reaching limits of various types. One of them is inadequate water for a rising population. Adding desalination plants adds huge costs and huge energy usage, but does not increase the standards of living of citizens. Instead, adding desalination plants simply allows the country to pump less water from its depleting aquifers.
To some extent, the same situation occurs in oil and gas fields. Expensive investment is required, but it is doubtful that there is an increase in capacity that is proportional to its cost. To a significant extent, new investment simply offsets a decline in production elsewhere, so maintains the status quo. It is expensive, but adds little to what gets measured as GDP.
The world outside of Saudi Arabia is now running into an investment sinkhole issue as well. This takes several forms: water limits that require deeper wells or desalination plants; oil and gas limits that require more expensive forms of extraction; and pollution limits requiring expensive adjustments to automobiles or to power plants.
These higher investment costs lead to higher end product costs of goods using these resources. These higher costs eventually transfer to other products that most of us consider essential: food because it uses much oil in growing and transport; electricity because it is associated with pollution controls; and metals for basic manufacturing, because they also use oil in extraction and transport.
Ultimately, these investment sinkholes seem likely to cause huge problems. In some sense, they mean the economy is becoming less efficient, rather than more efficient. From an investment point of view, they can expect to crowd out other types of investment. From a consumer’s point of view, they lead to a rising cost of essential products that can be expected to squeeze out other purchases.
Why Investment Sinkholes Go Unrecognized
From the point of view of an individual investor, all that matters is whether he will get an adequate return on the investment he makes. If a city government decides to install a desalination plant, the investor’s primary concern is that someone (the government or those buying water) will pay enough money that he can make an adequate return on his investment over time. Citizens clearly need water. The only question is whether citizens can afford the desalinated water from their discretionary income. Obviously, if citizens spend more on desalinated water, the amount of discretionary income available for other goods will be reduced.
The same issue arises with pollution control equipment installed by a utility, or by an auto maker. The need for pollution control equipment arises because of limits we are reaching–too many people in too small a space, and too many waste products for the environment to handle. The utility or auto makers adds what is mandated, since clearly, buyers of electricity or of an automobile will recognize the need for clean air, and will be willing to use some of their discretionary income for pollution control equipment. Mandated renewable energy requirements are another way that governments attempt to compensate for limits we are reaching. These, too, tend to impose higher costs, and indirectly reduce consumers’ discretionary income.
All types of mineral extraction, but particularly oil, eventually reach the situation where it takes an increasing amount of investment (money, energy products, and often water) to extract a given amount of resource. This situation arises because companies extract the cheapest to extract resources first, and move on to the more expensive to extract resources later. As consumers, we recognize the situation through rising commodity prices. There is generally a real issue behind the rising prices–not enough resource available in readily accessible locations, so we need to dig deeper, or apply more “high tech” solutions. These high tech solutions indirectly require more investment and more energy, as well.
While we don’t stop to think about what is happening, the reality is that increasingly less oil (or other product such as natural gas, coal, gold, or copper) is being produced, for the same investment dollar. As long as the price of the product keeps rising sufficiently to cover the higher cost of extraction, the investor is happy, even if the cost of the resource is becoming unbearably high for consumers.
The catch with energy products is that consumers really need the products extracted–the oil to grow the food they eat and for commuting, for example. We also know that in general, energy of some sort is required to manufacture every kind of product that is made, and is needed to enable nearly every kind of service. Oil is the most portable of the world’s energy sources, and because of this, is used in powering most types of vehicles and much portable equipment. It is also used as a raw material in many products. As a result, limits on oil supply are likely to have an adverse impact on the economy as a whole, and on economic growth.
The Oil and Gas Part of the Problem
A major issue today is that oil supply is already constrained–it is not rising very quickly on a world basis, no matter how much investment is made (Figure 3).
As noted above, the easy-to-extract oil and gas was extracted first. New development is increasingly occurring in expensive-to-extract locations, such as deep water, Canadian oil sands, arctic oil, and “tight oil” that requires fracking to extract. This oil requires more energy to produce, and more inputs of other sorts, such as water for fracking. Because of rising costs, the price of oil has tripled in the last 10 years.
Investment costs also continue to soar because of rising costs associated with exploration and production. Worldwide, oil and gas exploration and production spending increased by 19% in 2011 and 11% in 2012, according to Barclays Capital. Such spending produced only a modest increase in output–about 0.1% increase in crude oil production in 2011, and 2.2% increase in the first 10 months of 2012, based on EIA data. Natural gas production increased by 3.1% in 2011, according to BP. Estimates for 2012 are not yet available.
If we want to “grow” oil and gas production at all, businesses will need to keep investing increasing amounts of money (and energy) into oil and gas extraction. For this to happen, prices paid by consumers for oil and gas will need to continue to rise. In the US, there is a particular problem, because the selling price of natural gas is now far below what it costs shale gas producers to produce it–a price estimated to be $8 by Steve Kopits of Douglas Westwood. The Henry Hub spot natural gas price is now only $3.38.
The question now is whether oil and gas investment will keep rising fast enough to keep production rising. Barclays is forecasting only a 7% increase in worldwide oil and gas investment in 2013. According to the forecast, virtually none of the investment growth will come from North America, apparently because oil and gas prices are not currently high enough to justify the high-priced projects needed. The flat investment forecast by Barclays suggests a major disconnect between what the IEA is saying–that North America is on its way to becoming an energy exporter–and the actual actions of oil and gas companies based on current price levels. Of course, if oil and gas prices would go higher, more investment might be made–a point I made when writing about the IEA analysis.
What will the ultimate impact be on the economy?
I would argue that for most of the developed (OECD) countries, the ultimate impact will be a long-term contraction of the economy, similar to that illustrated in Scenario 2 of Figure 4.
What happens is that as we increasingly reach limits, more and more investment capital (and physical use of oil) is allocated toward the investment sinkholes. This has a double effect:
(1) The prices paid for resources that are subject in investment sinkholes need to continue to rise, in order to continue to attract enough investment capital. This is true both for goods that directly come from investment sinkholes (oil, gas and water) and from products that have a less direct connection, but depend on rising-cost inputs (such as food and electricity).
(2) Products outside of essential goods and services will increasingly be starved of investment capital and physical resources. This happens partly because of the greater investment needs in the sinkhole areas. Also, as consumers pay increasing amounts for essential goods and service because of (1), they cut back on the purchase of discretionary items, reducing demand for non-essentials.
In some real sense, because of the sinkhole investment phenomenon, we are getting less and less back for every dollar invested (and every barrel of oil invested). This phenomenon as applied to energy resources is sometimes referred to as declining Energy Return on Energy Invested.
As discussed above, world oil supply in recent years is quite close to flat (Figure 3). The flat supply of oil is further reduced by the additional oil investment required by sinkhole projects, such as the ones Saudi Arabia is undertaking. Also, there is a tendency for the developing world to attract a disproportionate share of the oil supply that is available, because they can leverage its use to a greater extent. Both of these phenomena lead to a shrinking oil supply for OECD countries.
The combination of shrinking OECD oil supply, together with the need for oil for many functions necessary for economic growth, leads to a tendency for the economies of OECD nations to shrink. It is hard to see an end to this shrinkage, because there really is no end to the limits we are reaching. No one has invented a substitute for water, or for unpolluted air. People talk about inventing a substitute for oil, but biofuels and intermittent electricity are very poor substitutes. Often substitutes have even higher costs, adding to the investment sinkhole problem, rather than solving it.
Where we are now
When resource prices rise, the impact is felt almost immediately. Salaries don’t rise at the same time oil prices rise, so consumers have to cut back on some purchases of discretionary goods and services. The initial impact is layoffs in discretionary sectors of the economy. Within a few years, however, the layoff problems are transformed into central government debt problems. This happens because governments need to pay benefits to laid-off workers at the same time they are collecting less in taxes.
The most recent time we experienced the full impact of rising commodity prices was in 2008-2009, but we are not yet over these problems. The US government now has a severe debt problem. As the government attempts to extricate itself from the high level of debt it has gotten itself into, citizens are again likely to see their budgets squeezed because of higher taxes, lay-offs of government workers, and reduced government benefits. As a result, consumers will have less to spend on discretionary goods and service. Layoffs will occur in discretionary sectors of the economy, eventually leading to more recession.
Over time, we can expect the investment sinkhole problem to get worse. In time, the impact is likely to look like long-term contraction, as illustrated in Scenario 2 of Figure 4.
Is there an End to the Contraction?
It is hard to see a favorable outcome to the continued contraction. Our current financial system depends on long-term growth. The impact on it is likely to be huge stress on the financial system and a large number of debt defaults. It is even possible we will see a collapse of the financial system, or of some governments.
In a way, what we are talking about is the Limits to Growth problem modeled in the 1972 book by that name. It is the fact that we are reaching limits in many ways simultaneously that is causing our problem. There are theoretical ways around individual limits, but putting them together makes the cost impossibly high for the consumer, and places huge financial stress on governments.
Off the keyboard of Gail Tverberg
Published on Our Finite World on January 24, 2013
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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:
- 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.
- How can high oil prices continue to act as a “drag” on the economy, long after the initial spike is past?
- 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).
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.
Other Changes an Airline Can Make to Fix Profitability
Apart from cutting back on the number of flights and retiring inefficient jets in the process, there are other things an airline can do to offset the higher “wages” demanded by the jet fuel employees union. One is to reduce the wages of human workers. For example, wages and pension plans of pilots can be cut back, or hours lengthened. Wages of other workers can be frozen or cut back.
Another approach is a merger with another airline, so that “redundant” employees can be eliminated, and flights can perhaps be cut back further. Of course, these layoffs and cutbacks in wages will add to recessionary impacts, because these workers will have less discretionary income.
A third approach to restoring profitability is to automate some of the functions previously handled by human employees. In this case, electricity is used to substitute for human workers. We can think of this automation as substituting new “electrical employees” (analogous to the “jet fuel employees”) for human employees. Relative to the amount of physical work (pushing buttons, moving luggage, etc.) humans can do, humans are far higher paid than either “oil employees” or “electricity employees”. If we assume that the energy of humans is similar to that used by a 100 watt light bulb, at $20,000 a year, humans are paid roughly 1,500 times as much as “oil employees” and 3,500 times as much as “electricity” employees, to do equivalent physical work. So if automation is an option, it almost always saves money.
A fourth way an airline can reduce costs is by purchasing lighter, more fuel-efficient jets. Making a transition of this type takes a long time. Boeing’s Dreamliner 787 is an attempt in this direction, with a 20% fuel savings anticipated. Boeing has over 800 jets of this type on order, but the 50 already in use have been grounded until battery problems are resolved. Quite a few changes have been made in the new jet, so there is a possibility of additional problems also needing to be ironed out, before production ramps up as planned.
Another Example: Asphalt
Asphalt is another product whose consumption has dropped in recent years.
The amount of asphalt produced in 2012 was only about 70% as much as was produced in 1994. The reason for the shortfall in asphalt is partly because at current high oil prices, refineries can make more profit by selling high-valued products like gasoline, diesel, and jet fuel than they can make by selling asphalt. A recent EIA article titled, Hydrocracking is an important source of diesel and jet fuel, makes the statement, “A refinery’s ability to upgrade low-value products into high-value products and convert high-sulfur material to low-sulfur material with a secondary unit like a hydrocracker plays a key role in determining its economic fate.”
State budgets are tight for a variety of reasons, including inadequate gasoline taxes to cover the cost of maintaining roads. While part of the need for asphalt can be obtained from recycling, many governments are finding that today’s asphalt costs are so high that concrete roads would be cheaper in the long run. Many states have found it necessary to go back to gravel on some of the smaller roads, because of the high cost of paving today. State and local budgets are likely to be stretched even farther if the US government solves its budget woes by sending programs back to the states, and lets the states work out the funding.
What happens when a state decides move some roads from asphalt back to gravel? For one thing, jobs lost in the road paving business. Also, the new gravel roads have an uneven surface, providing more rolling resistance, so automobile and truck mileage is poorer. In addition, roads tend to degrade more quickly, keeping long-term maintenance costs high. If budgets are tight and roads are not maintained, there is a chance gravel roads will become unusable.
If local governments continue to use asphalt for paving (or switch to concrete, which has even higher initial costs, but lasts longer), they find a need to cut back on other types of services they provide, if they are to avoid a tax increase. This leads to services such as library hours being cut. Cutting back on services reduces both wages and energy costs (lighting and heating/cooling costs). The effect is not all that different from what happens in the airline industry: cuts are made that affect both wages and energy usage of many types. Employee wages seem to be especially affected because changes in employee hours can be made more easily than, say, closing a building or running fewer school buses.
The More General Problem
It is not just airlines and users of asphalt that cut back because of high oil prices. The story plays out in different ways in many industries. Clearly any restaurant is at risk if high oil prices cause consumers to cut back on discretionary purchases, because reducing the frequency of eating out is an easy way of reducing discretionary expenditures. If restaurants have fewer customers, some restaurants will close and are not replaced. This is the restaurant industry’s way of “making a smaller batch”. The result is fewer jobs, less oil use, and less use of resources in general.
Another type of discretionary purchase that gets cut when oil prices are high is the purchase of a new car. A recent article by the New York Times says that the recovery of auto sales since the recent recession has been very slow, with charts for several countries. Reduced car sales is yet another example of making a “smaller batch.” The result is fewer jobs, less use of oil, and less use of many other types of resources.
A similar story can be told about new home sales. These dropped in the recent recession, and have been slow to recover. The drop-off is frequently attributed to the housing bubble bursting, but rising oil prices played an important role as well. When oil prices increased in the 2004-2005 period, the Federal Reserve raised interest rates, trying to cut oil prices. Instead, the higher interest rates together with lower discretionary income from high oil prices led to lower housing prices, starting in 2006. (See my article from the journal Energy, here or here.)
The Economic Implications of High Oil Prices
Our economy is all about “adding value”. But where does this value added come from? To a significant extent, this value comes from adding external energy of some sort. It is really the “energy employees” I mentioned earlier that add this value. Human workers are needed as well, but with automation, the number of human workers required tends to decline.
The ability of external energy to add value is what causes the link between GDP, energy consumption, and oil consumption. Oil plays a special role, because it is easily transported, and can be used in many situation where electricity or some other form of energy (such as human energy, wind energy, or natural gas) would not work.
If we look at a graph of changes GDP compared to changes in world oil and energy usage, (Figure 3, below), we see that all three tend to rise and fall together. In fact, changes in oil and energy usage appear to slightly precede GDP changes. This is the pattern we would expect, if economics are causing a “smaller batch” to be made when oil prices are high.
Part of this change may simply reflect a transfer of energy use from less efficient industries (ones using more high-priced oil in their fuel mix) to more efficient industries (ones using less high-priced oil in their fuel mix). If could also reflect a shift in oil and energy distribution to more less efficient countries (ones using more high-priced oil in their fuel mix) to more efficient countries (ones using less high-priced oil in their fuel mix). For example, Greece (which specializes in vacation tourism, and which uses much oil in its energy mix) would be expected to be an oil/energy loser (Figure 4, below).
China (which uses much coal in its energy mix and thus keeps costs low, and specializes in inexpensive manufacturing) would be expected to be an oil/energy gainer (Figure 5, below). See my posts, Energy Leveraging: An Explanation for China’s Success and the World’s Unemployment and Why Coal Consumption Keeps Rising, for discussion of this issue.
High prices work together with a number of other factors (including increased automation and increased competition from countries with lower wages) to force wages of humans down, and to reduce the number with jobs. The proportion of US citizens with jobs started declining about the year 2000 and accelerated with the recent recession:
If we look at the ratio of wages (broadly defined, including proprietors’ income and taxes paid on behalf of employees by employers, but not including transfer payments, such as Social Security payments and Unemployment Insurance) to GDP in Figure 7, below, we see that the ratio of wages to GDP has been dropping since 2000–another indication that human wages are not keeping up with the rest of the economy.
If “Energy Employees” Are Really Doing Most of the Work
If it is really the “energy employees” doing most of the work, then the models used by many economists today are not really correct, and some of the standard beliefs based on these model aren’t right either. For example:
1. The idea that the value of oil or other energy to the economy is proportional to its price doesn’t hold. This can be seen from the examples provided. In fact, if oil or another needed energy product is removed, very close to no work gets done. Humans can provide a little energy, but compared to the energy of oil or electricity, our efforts are puny, and very high-priced. Without external energy, humans’ efforts are limited to tasks like digging with a stick in the ground, or making baskets with reeds that they have gathered.
2. One type of energy doesn’t necessarily substitute easily for another type of energy. Just as one type of employee (mechanic, airline pilot, or flight attendant) can’t necessarily be substituted for another, one type of energy cannot necessarily be substituted for another. Dreamliner’s battery problems illustrate that even trying to substitute a little more electrical energy for oil energy can provide a technological challenge.
3. Somewhat surprisingly, high oil prices remain a drag on the economy permanently, because the high wages of the “oil employees” remain. Output isn’t any higher with these higher wages, so there is not a proportional benefit to society from these higher oil wages. More human workers may be hired in the oil extraction process (often in another country). But even if more workers are hired in the same country, their output does not replace the entirely different kind of output that is provided by the (now-unaffordable to many) high-priced oil.
Another factor in the slow uptake of high oil prices is the fact that governments can temporarily hide some of the effects of high-priced oil through unemployment benefits and stimulus programs. This temporary cover-up cannot continue for long, though, because governments (such as the US and other oil importers) soon run into problems with high deficits (as is happening now). When governments raise taxes or reduce benefits to solve their financial problems, the deferred high-priced oil problems return, showing that the problem never really left.
4. An economy which is mostly services, is not insulated from the problem of high oil prices. Both the airline and asphalt examples illustrate how high oil costs can circulate through the economy and disrupt discretionary spending, even in the US. (Also see Ten Reasons Why High Oil Prices are a Problem.)
Services tend to be the “fluff” of society because for the most part, because we could live without them, at least temporarily. For now, we have a temporary respite from oil-price impacts because of high deficit spending by governments. If governments are forced to balance their budgets, cutbacks seem likely in many areas of services, including medicine for the elderly, higher education, and government-sponsored research programs. If cutbacks occur in areas such as these, we can expect that GDP will shrink faster than savings in oil and energy use–a reversal of what has happened in the past, and a reversal of what many economists have come to expect in the future.
Also, contrary to popular belief, we cannot increase the economy very much by simply selling services that do not require energy to one another. It really takes “energy employees” to play their role as well. Without external energy, we can dig in each others’ back yards with sticks, but this activity doesn’t add much to the economy. We need “energy employees” playing their role as well, if we are to have computers, and metal scissors, and the many other tools we expect, even in a service economy.
Off the keyboard of Gail Tverberg
Published on Our Finite World on January 17, 2013
Discuss this article at the Epicurean Delights Smorgasbord inside the Diner
A person might think from looking at news reports that our oil problems are gone, but oil prices are still high.
In fact, the new “tight oil” sources of oil which are supposed to grow in supply are still expensive to extract. If we expect to have more tight oil and more oil from other unconventional sources, we need to expect to continue to have high oil prices. The new oil may help supply somewhat, but the high cost of extraction is not likely to go away.
Why are high oil prices a problem?
1. It is not just oil prices that rise. The cost of food rises as well, partly because oil is used in many ways in growing and transporting food and partly because of the competition from biofuels for land, sending land prices up. The cost of shipping goods of all types rises, since oil is used in nearly all methods of transports. The cost of materials that are made from oil, such as asphalt and chemical products, also rises.
If the cost of oil rises, it tends to raise the cost of other fossil fuels. The cost of natural gas extraction tends to rises, since oil is used in natural gas drilling and in transporting water for fracking. Because of an over-supply of natural gas in the US, its sales price is temporarily less than the cost of production. This is not a sustainable situation. Higher oil costs also tend to raise the cost of transporting coal to the destination where it is used.
Figure 2 shows total energy costs as a percentage of two different bases: GDP and Wages.1 These costs are still near their high point in 2008, relative to these bases. Because oil is the largest source of energy, and the highest priced, it represents the majority of energy costs. GDP is the usual base of comparison, but I have chosen to show a comparison to wages as well. I do this because even if an increase in costs takes place in the government or business sector of the economy, most of the higher costs will eventually have to be paid for by individuals, through higher taxes or higher prices on goods or services.
2. High oil prices don’t go away, except in recession.
We extracted the easiest (and cheapest) to extract oil first. Even oil company executives say, “The easy oil is gone.” The oil that is available now tends to be expensive to extract because it is deep under the sea, or near the North Pole, or needs to be “fracked,” or is thick like paste, and needs to be melted. We haven’t discovered cheaper substitutes, either, even though we have been looking for years.
In fact, there is good reason to believe that the cost of oil extraction will continue to rise faster than the rate of inflation, because we are hitting a situation of “diminishing returns”. There is evidence that world oil production costs are increasing at about 9% per year (7% after backing about the effect of inflation). Oil prices paid by consumers will need to keep pace, if we expect increased extraction to take place. There is even evidence that sweet sports are extracted first in Bakken tight oil, causing the cost of this extraction to rise as well.
3. Salaries don’t increase to offset rising oil prices.
Most of us know from personal experience that salaries don’t rise with rising oil prices.
In fact, as oil prices have risen since 2000, wage growth has increasingly lagged GDP growth. Figure 3 shows the ratio of wages (using the same definition as in Figure 2) to GDP.
If salaries don’t rise, and prices of many types of goods and services do, something has to “give”. This disparity seems to be the reason for the continuing economic discomfort experienced in the past several years. For many consumers, the only solution is a long-term cut back in discretionary spending.
4. Spikes in oil prices tend to be associated with recessions.
Economist James Hamilton has shown that 10 out of the last 11 US recessions were associated with oil price spikes.
When oil prices rise, consumers tend to cut back on discretionary spending, so as to have enough money for basics, such as food and gasoline for commuting. These cut-backs in spending lead to lay-offs in discretionary sectors of the economy, such as vacation travel and visits to restaurants. The lay-offs in these sectors lead to more cutbacks in spending, and to more debt defaults.
5. High oil prices don’t “recycle” well through the economy.
Theoretically, high oil prices might lead to more employment in the oil sector, and more purchases by these employees. In practice, this provides only a very partial offset to higher price. The oil sector is not a big employer, although with rising oil extraction costs and more US drilling, it is getting to be a larger employer. Oil importing countries find that much of their expenditures must go abroad. Even if these expenditures are recycled back as more US debt, this is not the same as more US salaries. Also, the United States government is reaching debt limits.
Even within oil exporting countries, high oil prices don’t necessarily recycle to other citizens well. A recent study shows that 2011 food price spikes helped trigger the Arab Spring. Since higher food prices are closely related to higher oil prices (and occurred at the same time), this is an example of poor recycling. As populations rise, the need to keep big populations properly fed and otherwise cared for gets to be more of an issue. Countries with high populations relative to exports, such as Iran, Nigeria, Russia, Sudan, and Venezuela would seem to have the most difficulty in providing needed goods to citizens.
6. Housing prices are adversely affected by high oil prices.
If a person is required to pay more for oil, food, and delivered goods of all sorts, less will be left over for discretionary spending. Buying a new home is one such type of discretionary expenditure.
US housing prices started to drop in mid 2006, according to data of the S&P Case Shiller home price index. This timing fits in well with when oil prices began to rise, based on Figure 1.
7. Business profitability is adversely affected by high oil prices.
Some businesses in discretionary sectors may close their doors completely. Others may lay off workers to get supply and demand back into balance.
8. The impact of high oil prices doesn’t “go away”.
Citizens’ discretionary income is permanently lower. Businesses that close when oil prices rise generally don’t re-open. In some cases, businesses that close may be replaced by companies in China or India, with lower operating costs. These lower operating costs indirectly reflect the fact that the companies use less oil, and the fact that their workers can be paid less, because the workers use less oil. This is a part of the reason why US employment levels remain low, and why we don’t see a big bounce-back in growth after the Great Recession. Figure 4 below shows the big shifts in oil consumption that have taken place.
A major part of the “fix” for high oil prices that does takes place is provided by the government. This takes the place in the form of unemployment benefits, stimulus programs, and artificially low interest rates.
Efficiency changes may provide some mitigation, as older less fuel-efficient cars are replaced with more fuel-efficient cars. Of course, if the more fuel-efficient cars are more expensive, part of the savings to consumers will be lost because of higher monthly payments for the replacement vehicles.
9. Government finances are especially affected by high oil prices.
With higher unemployment rates, governments are faced with paying more unemployment benefits and making more stimulus payments. If there have been many debt defaults (because of more unemployment or because of falling home prices), the government may also need to bail out banks. At the same time, taxes collected from citizens are lower, because of lower employment. A major reason (but not the only reason) for today’s debt problems of the governments of large oil importers, such as US, Japan, and much of Europe, is high oil prices.
Governments are also affected by the high cost of replacing infrastructure that was built when oil prices were much lower. For example, the cost of replacing asphalt roads is much higher. So is the cost of replacing bridges and buried underground pipelines. The only way these costs can be reduced is by doing less–going back to gravel roads, for example.
10. Higher oil prices reflect a need to focus a disproportionate share of investment and resource use inside the oil sector. This makes it increasingly difficult maintain growth within the oil sector, and acts to reduce growth rates outside the oil sector.
There is a close tie between energy consumption and economic activity because nearly all economic activity requires the use of some type of energy besides human labor. Oil is the single largest source of energy, and the most expensive. When we look at GDP growth for the world, it is closely aligned with growth in oil consumption and growth in energy consumption in general. In fact, changes in oil and energy growth seem to precede GDP growth, as might be expected if oil and energy use are a cause of world economic growth.
The current situation of needing increasing amounts of resources to extract oil is sometimes referred to one of declining Energy Return on Energy Invested (EROEI). Multiple problems are associated with declining EROEI, when cost levels are already high:
(a) It becomes increasingly difficult to keep scaling up oil industry investment because of limits on debt availability, when heavy investment is made up front, and returns are many years away. As an example, Petrobas in Brazil is running into this limit. Some US oil and gas producers are reaching debt limits as well.
(b) Greater use of oil within the industry leaves less for other sectors of the economy. Oil production has not been rising very quickly in recent years (Figure 6 below), so even a small increase by the industry can reduce net availability of oil to society. Some of this additional oil use is difficult to avoid. For example, if oil is located in a remote area, employees frequently need to live at great distance from the site and commute using oil-based means of transport.
(c) Declining EROEI puts pressure on other limited resources as well. For example, there can be water limits, when fracking is used, leading to conflicts with other use, such as agricultural use of water. Pollution can become an increasingly large problem as well.
(d) High oil investment cost can be expected to slow down new investment, and keep oil supply from rising as fast world demand rises. To the extent that oil is necessary for economic growth, this slowdown will tend to constrain growth in other economic sectors.
Airline Industry as an Example of Impacts on Discretionary Industries
High oil prices can be expected to cause discretionary sectors to shrink back in size. In many respects, the airline industry is the “canary in the coal mine,” showing how discretionary sectors can be forced to shrink.
In the case of commercial air lines, when oil prices are high, consumers have less money to spend on vacation travel, so demand for airline tickets falls. At the same time, the price of fuel to operate airplanes rises, making the cost of operating airplanes higher. Business travel is less affected, but still is affected to some extent, because some long-distance business travel is discretionary.
Airlines respond by consolidating and cutting back in whatever ways they can. Salaries of pilots and stewardesses are reduced. Pension plans are scaled back. New more fuel-efficient aircraft are purchased, and less fuel-efficient aircraft are phased out. Less profitable routes are closed. The industry still experiences bankruptcy after bankruptcy, and merger after merger. If oil prices stabilize for a while, this process stabilizes a bit, but doesn’t really stop. Eventually, the commercial airline industry may shrink to such an extent that necessary business flights become difficult.
There are many discretionary sectors besides the airline industry waiting in the wings to shrink. While oil prices have been high for several years, their effects have not yet been fully incorporated into discretionary sectors. This is the case because governments have been able to use deficit spending and artificially low interest rates to shield consumers from the “real” impacts of high-priced oil.
Governments are now finding that debt cannot be ramped up indefinitely. As taxes need to be raised and benefits decreased, and as interest rates are forced higher, consumers will again see discretionary income squeezed. New cutbacks are likely to hit additional discretionary sectors, such as restaurants, the “arts,” higher education, and medicine for the elderly.
It would be very helpful if new unconventional oil developments would fix the problem of high-cost oil, but it is difficult to see how they will. They are high-cost to develop and slow to ramp up. Governments are in such poor financial condition that they need taxes from wherever they can get them–revenue of oil and gas operators is a likely target. To the extent that unconventional oil and gas production does ramp up, my expectation is that it will be too little, too late, and too high-priced.
 Wages include private and government wages, proprietors’ income, and taxes paid by employers on behalf of employees. They do not include transfer payments, such as Social Security.
Off the keyboard of Gail Tverberg
Published on Our Finite World on August 15, 2011
Discuss this article at the Epicurean Delights Smorgasbord inside the Diner
The issues we are confronted with today seem to be a subset of the issues foretold in the book Limits to Growth back in 1972. At some point, the economy cannot continue to grow as rapidly as it did in the past. It appears to me that the most immediate limit we are hitting today is inadequate low-priced oil, but there are other limits lurking not far away–inadequate fresh water and excessive pollution, for example. When the economy cannot grow as fast, or actually starts declining, recession sets in. Governments start having debt problems. Financial markets start behaving strangely.
This issue is a difficult one to talk about, because there really is no good solution. I have talked to a couple of groups recently (one a church group; one a peak oil group), about this issue. This is a copy of the presentation I used (Bumping up against the Growth Ceiling (PDF) or Bumping up against the Growth Ceiling (PowerPoint)). In this post, I will discuss my presentation.
The world is finite. We know that, logically, the amount of any resource extracted from the world’s crust cannot continue to increase year-after-year, forever. But most of us have never thought about the idea that economic growth might eventually stop because of limits we hit.
It seems to me that the financial problems we are reaching today reflect a fundamental mismatch. We have a financial system that requires growth. At the same time, world oil supply has stopped rising enough to keep oil prices down. This mismatch threatens to put a cap on economic growth, especially for large users of oil such as the United States and many European countries.
Let me start by describing why our economy needs economic growth.
Europe has used coal for about 450 years, according to Tony Wrigley. The use of coal helped reduce the amount of firewood needed (cream-colored area), and thus helped prevent deforestation. The use of coal also led to economic growth, because its energy could be put to many uses. According to Wrigley’s analysis, wind and water never produced a large share of the total energy supply.
In recent years, oil and natural gas have been added to the energy mix. All of these fossil fuels have helped increase the amount of food produced and the quantity of manufacturing done, and thus, economic growth.
The fact that we have had fossil fuel driven economic growth for such a long time–at least 450 years–has helped create the belief that economic growth is the natural state of affairs. It is easy to believe that it will always continue.
Our financial system today depends on the use of debt, and the repayment of that debt with interest. We don’t usually think of it, but in a growing economy, it is much easier to repay debt with interest than in a declining economy, because, on average, things are getting better over time. This is easiest to see for an organization like the government that funds its borrowing with taxes. These taxes tend to rise when the economy is growing, making it easier to repay debt and the interest on that debt.
The same principle works for other individuals and businesses. If an economy is growing, a person is more likely to be able to keep his job, to get a new job if he is laid off, and to get promotions, so it is easier to repay loans and the interest on those loans.
Of course, the reverse is true in a shrinking economy, or even a level economy. The loan plus interest leaves the borrower with less money left over for other things, so is more difficult to repay.
Reinhart and Rogoff wrote a well-known academic paper, and made the observation quoted in Slide 8, apparently not understanding why this relationship existed. It seems to illustrate the relationship that a person would expect, based on Slides 6 and 7.
Economic growth provides many types of benefits. If the economy is growing, people have jobs, and many are getting raises. People can afford to buy bigger homes, so home prices tend to rise. The stock market tends to rise, because companies are making increasingly large amounts of money, and people believe that they will continue to make more money in the future. The number of people employed tends to rise, because of rising demand for goods and services.
Governments find that taxes rise, even without raising tax rates, because citizens are prospering. Charitable organizations, like churches, see rising contributions.
With the use of fossil fuels, it was possible to greatly increase food production. Population grew in the same time period that fuel use grew. World population is now about 7 billion, compared to about 450 million in 1500 . Thus, population is now more than 10 times as high as it was in 1500.
In this slide, I show a few of uses of oil. Oil is especially important for growing and transporting food. Thus, its use helps explain the recent population rise.
Thee unfavorable outcomes shown on slide 12 are just the reverse of the favorable outcomes mentioned earlier, when there was adequate economic growth. We recognize them as problems we have seen during recent recession.
Next I would like to talk about how limited oil supply is constricting economic growth.
On this slide, I divide world oil production into two parts–oil produced by the Organization of Petroleum Exporting Countries (OPEC) and oil produced by Non-OPEC countries. OPEC countries claim to have plenty of spare capacity, but it is hard to see that such capacity actually exists from their actions. Neither OPEC or Non-OPEC production has increased very much since 2005, even when prices spiked very high in 2008. OPEC cut back production somewhat when oil prices dropped, but that is more or less expected, because at a low price, some extraction may no longer be profitable.
Readers should be aware that statements made by OPEC countries are not audited. When US oil companies were involved in the Middle East prior to 1980, oil reserves were much lower than today. After state-owned oil companies took over, there was competition to raise reported reserves. Some of these increases may be simple exaggerations; others may be correct, if a person includes oil that can be produced at a dribble a year, over many, many years. But we are likely kidding ourselves if we think the high reserves indicate spare capacity, or likely higher production in the future.
Also, statements about OPEC raising oil production aren’t necessarily very truthful. If they do raise production, it may only be to cover rising internal consumption, with virtually no impact on exports.
We often read that there is a huge amount of oil available, in the oil sands in Canada or in the oil shale in Colorado, for example. The problem is that not all oil is equivalent. Some oil is a liquid, and is easy to extract. Other oil is not a liquid, or is in very inconvenient locations. Our problem is that a lot of the easy-to-extract, cheap-to-extract oil from the top of the triangle was extracted first, and is now gone. What is left is mostly oil that is much harder to extract. As an example, some oil is very “heavy” and oil companies may need to use steam to heat the oil, and then collect the dribbles of melted oil.
To elaborate a bit further on why we can’t get the oil out, one problem is that quite a bit of the cheap oil has been extracted, and expensive oil (which we have plenty of) seems to cause recession. Economist James Hamilton has shown that 10 out of 11 of the most recent recessions occurred in conjunction with oil price spikes. (We will talk a more later about why high oil prices tend to cause recession.)
In order to justify extracting the very expensive-to-extract oil, companies need very high prices for a long time, so that they have reasonable confidence that prices will be sufficiently high when the oil is extracted and ready to sell. But oil prices don’t seem to stay high long enough–high oil prices seem to lead to recession, and recession brings them back down again.
I might mention, too, that there is a theoretical upper bound for prices. Just as you wouldn’t use more than one barrel of oil to extract a barrel of oil, at some point, the resources that go into extracting the oil become too high, relative to the benefit to be obtained from using that oil. If this happens, there is no point in extracting the oil–it makes more sense to leave it in the ground. For some of the oil resources, we may be approaching the too-expensive-to-extract limit.
The fact that world oil production is more or less on a plateau is not entirely unexpected. In many countries, oil production has risen, reached a peak or plateau, and then begun declining. If the world is the sum of production of individual countries, the world might also eventually get to a peak or plateau.
For the United States – 48 states (blue on Slide 17), oil production suddenly started declining in 1971, after hitting a peak in 1970. When we realized that there was a problem, we quickly got to work on extracting oil from other areas. We ramped up production in Alaska in the late 1970s (red “layer” on the map), and added a pipeline so that the oil could be transported better. The amount of oil obtained from Alaska has now dropped to less than half of its peak amount.
Eventually, we started drilling in the area designated as “Federal offshore,” mostly in the Gulf of Mexico (light green layer on graph). The oil from the Federal Offshore area is still increasing, but no one expects that it will bring us back up to the 1970 level of peak production. Last year’s oil spill occurred in the Federal offshore area.
The decline in US oil production had been predicted in advance, although oil companies did not believe the forecasts. M. King Hubbert had predicted in 1956 that oil production in the United States would peak between 1965 and 1970. In the same paper, he also predicted that world oil production would reach a peak around the year 2000.
Hyman Rickover, a four star admiral in the US Navy, gave a speech in 1957 in which he explained the importance of oil, and talked about the fact that oil supplies were expected to run short around 2000, and natural gas and coal not too much later. Because of the likely shortfall, he said the nation should conserve its resources and should tell its children about the upcoming problem, so that planning could be made for the difficult transition away from fossil fuels. Needless to say, schools have not taught much about this problem.
On Slide 18, I show oil production of two areas that were brought on-line after it became clear that US oil production was falling shortly after 1970. The top graph shows European crude oil, which is mostly oil from the North Sea. Its production was on a plateau from 1996 to 2001, but is now declining.
The bottom graph shows Mexican crude oil production. It was ramped up quickly after it became clear that US crude oil production was declining. The graph indicates that since 2004, Mexican oil production has been declining as well.
With all of these areas experiencing declining production, it is not surprising that world oil production has been close to flat. There theoretically is non-liquid oil that could be steamed out, and very deep oil that could be extracted at great cost, but all of this would require huge expense, long lead-times, and assurance that oil prices would be high at the time the oil was finally extracted.
Having flat (or close to flat) world oil production wouldn’t be a major problem, if world demand for oil weren’t rising. But what is happening is that countries like China and India are using a greater percentage of the available oil. Oil exporters are also using more, because their populations are growing rapidly. When these countries use more, this leaves less oil for the United States and other “developed” nations to consume.
I’d like to talk a little now about what happens when an economy doesn’t have enough inexpensive oil.
One thing that tends to happen when oil prices rise is that food prices tend to rise as well. This occurs mostly because oil is used in food production and transport. The fact that food and fuel prices rise at the same time causes a double problem for consumers, since food and fuel for commuting are both necessities. As a result, consumers tend to cut back on discretionary expenditures when oil prices rise.
Higher food prices can have other impacts as well. If people’s incomes haven’t risen and the increase in food price is severe, or if many are unemployed, there may be riots, and governments may be overthrown. We have already seen this in the Middle East and North Africa. If governments cut back on programs for the poor, as in London, this may further raise the potential for riots.
The graph shows that there tends to be a tie between world economic growth and growth in oil use. The tie may be less close after 2005, because of greater coal use in recent years.
Slide 23 shows the steps I see that lead from rising oil prices to recession. I might add that when discretionary spending drops–such as fewer trips to restaurants–employers tend to lay off workers. The fact that these workers have been laid off further adds to the cutback in the purchase of discretionary goods and further adds to debt defaults.
If many people are laid off from work, governments start finding themselves with increasing financial problems for several reasons:
- Lower taxes collected, because fewer people are working
- Higher expenditures, because there are more unemployed people
- Need for stimulus funds, to try to increase employment
- Need for funds to bail out banks and insurance companies
What seems to happen when there is a shortage of cheap oil is that the whole economy tends to shrink. The way I think of it is similar to making a batch of cookies. If a baker finds that he has a recipe that calls for four cups of flour, but he only has three, he needs to make a smaller batch. When he does this, he uses less of his other ingredients as well – sugar, eggs, shortening, and chocolate chips. If he had planned to use a whole bag of chocolate chips, he may only need to use part of a bag.
The economy seems to work in a similar fashion. If oil is too high-priced, the economy shifts to a mode of operation that uses less oil, but also employs fewer workers, uses less steel and copper, and uses less electricity. We call it recession.
Now I’d like to talk a little about what happens after an economy starts hitting the ceiling with respect to economic growth.
One thing that seems to happen is that oil prices seem to keep spiking.
The last recession ran from December 2007 to June 2009. This period started while oil prices were rising, before they hit a peak in July 2008, and ended after prices had collapsed and were again on the upswing.
We are now in the midst of another oil price (and food price) spike. We don’t know for certain that we are headed into a recession, but evidence is starting to point in that direction. Reported economic growth has been less than 1% in the first half of 2011. Given the past history of recessions being associated with oil price spikes, we shouldn’t be surprised if this spike leads to recession in the not too distant future.
Another thing that seems to happen as we start hitting limits is that private debt (blue on Slide 27) starts to decline. This is related to what I said on Slides 6 and 7 about the need for economic growth in order for debt to work out well. If oil prices are high, and recessionary forces are starting to hit, people don’t want to take out loans to expand their businesses, because it doesn’t look like there will be enough sales to support the expansion. Workers don’t want to move up to new bigger homes, partly because they haven’t gotten raises recently, and partly because future prospects don’t look all that good. Some credit card consumers find their cards cut off, because they have failed to make required payments.
Government debt (in red) tends to increase rapidly, but not rapidly enough to keep total debt rising the way it was prior to hitting growth limits. (Government debt in red is added to the private debt in blue, to produce the total debt.)
Government debt grows for a couple of reasons. First, tax revenues tend not to rise as rapidly, or to actually fall, because of higher unemployment rates. Second, government expenditures are higher, both for programs to help the unemployed, and for stimulus programs. This combination leads to the type of debt limit crisis that we recently experienced. Many European governments are experiencing similar difficulties.
We can’t know precisely how things will turn out, or exactly what the time frame will be. But at least some estimates are that things will turn out very badly. The shape of the graph shown in Slide 28 is sometimes called “Overshoot and Collapse.”
The problem we have is that the world’s population has grown to 7 billion people. If we substantially cut back on oil (or on fossil fuels in general), there is a question as to whether we will have enough food and water to support the 7 billion people alive today. If we had very many fewer people, we would have much less of a problem.
Some of the particular problems we are running into now relate to government debt, and inability to fund government programs for the unemployed at reasonable tax rates. It is not clear how these can be resolved. It is virtually impossible to raise tax rates enough to cover the cost of currently promised benefits, especially if unemployment rates rise even higher in the future. At the same time, cutting benefits can lead to riots–or even the overthrow of governments.
At this point, alternatives look like they will be too little, too late.
The closest substitute for oil is biofuels, but the ethanol we use today tends to use a huge amount of our corn crop, with very little ethanol yield. In 2011, ethanol is expected to use a little more than half of America’s corn crop. The energy content of a tank of ethanol is equivalent to the amount of food needed to feed a small person for a year. And of course, using a large amount of corn for ethanol tends to keep food prices up.
Most of the mitigations we hear about are electric–wind, and solar photovoltaic, and geothermal, and biogas. One problem with electric mitigations is that they don’t directly fix our oil shortage problem. The cars you and I drive today don’t run on electricity; they run on gasoline or diesel fuel.
Another problem with electricity mitigations is that they tend to produce only a small quantity of electricity. The layer I show as renewables includes all of the “new renewables” I listed above, plus wood scraps and sawdust, which are sometimes burned for electricity. The renewables line is getting thicker, but its growth is almost matched by the shrinkage in hydroelectric over the years. So in total, we aren’t getting very far, very quickly.
Also, I should point out that even if an alternate source of energy is called “renewable,” it doesn’t really mean that it could be maintained for very long, without the use of fossil fuels. Our electricity transmission wires are maintained using trucks and helicopters that use oil-based fuels. Wind turbines (and replacement parts for repairing wind turbines) are shipped using oil-based fuels. It requires fossil fuels to make solar panels.
Another issue is that alternative fuels are often expensive. If high-priced oil is leading to recession, it is difficult to see how even higher-priced alternatives will fix the situation.
Let me conclude by talking a little about where we go from here.
It seems to me that we have to take one day at a time. Worrying about tomorrow doesn’t do a lot of good.
I think we can probably expect another recession and more layoffs. The recession will probably be severe, because governments are in worse financial condition than they were last time around, and will tend to contribute to the recessionary problems, rather than offset them with stimulus funds.
It seems as if there is the possibility of a cutback of government programs. If this happens, there may be people who are hungry, and in need of assistance. There may even be riots.
If a bad recession occurs, almost every business, charity, and church congregation will be in similar circumstances. If sales or donations decrease, they will need to choose between laying off staff or defaulting on debt. Banks and insurance companies are likely to be faced with a large number of debt defaults. It is not clear that these debt defaults will necessarily result in evictions–it wouldn’t work for banks to own a large number of houses, and have people out on the streets.
It seems to me that we should do what we can do today, and not wait until sometime in the future, when the world situation may not be as good. My husband and I took a trip to China in May, figuring that our opportunity might not be as good in a few years.
We should also count our blessings. We live today with luxuries that even kings did not have a few hundred years ago. Life expectancies a few hundred years ago were only 30 to 40 years. Many readers have already lived longer than could be expected, not too long ago.
There is no real solution to our predicament. Even if a cheap liquid fuel could be found in abundance tomorrow, at most what it would do would be move the problem down the road a little way. Population would continue to grow. Pollution would become a greater and greater issue. We would have more problems with fresh water. We would likely come to another limit, in not too many years.
What should we do individually? One possible remedy is to keep some water and food on hand, in case of temporary unavailability. This can work for a short time, but it is really not feasible to store, say, 20 years worth of food and water.
I think that we should plan as if electricity may someday may not be available, or may be available only intermittently, because all of the various systems (financial, oil, electricity) are closely connected, so a disruption in one system may affect other systems. It is good to plan for windows that open, and non-electrical approaches for key business functions.
Gardening sounds like a good idea, and it is. But I don’t think we can count on a garden to save us, if there are starving people near by. In some sense, we really need a solution for everyone, but with 7 billion people in the world, this is difficult to do.
I would not count on paper investments, because of the potential for a large number of debt defaults. If governments are in poor condition, their guarantee of bank accounts and pension plans means less than it did in the past.
High population is clearly an issue. It would be great to be able to fix this problem through smaller family sizes, but doing so is not as easy as it sounds. If there is economic decline in the future, birth control may become less available and governments may not be able to continue to fund their retirement programs. These changes may lead to families having more children, rather than fewer.
I don’t know that any of us have the right answer as to what to do. The best we can do is pool our thoughts. Those who believe in a higher power may want to seek guidance from above, as well. But there are clearly no easy answers.
Off the keyboard of Gail Tverberg
Published on Our Finite World on January 6, 2013
Discuss this article at the Epicurean Delights Smorgasboard inside the Diner
We have been hearing a lot about escaping the fiscal cliff, but our problem isn’t solved. The fixes to date have been partial and temporary. There are many painful decisions ahead. Based on what I can see, the most likely outcome is that the US economy will enter a severe recession by the end of 2013.
My expectation is that credit markets are likely see increased defaults, as workers find their wages squeezed by higher Social Security taxes, and as government programs are cut back. Credit is likely to decrease in availability and become higher-priced. It is quite possible that credit problems will adversely affect the international trade system. Stock markets will tend to perform poorly. The Federal Reserve will try to intervene in credit markets, but if the US government is one of the defaulters (at least temporarily), it may not be able to completely fix the situation.
Less credit will tend to hold down prices of goods and services. Fewer people will be working, though, so even at reduced prices, many people will find discretionary items such as larger homes, new cars, and restaurant meals to be unaffordable. Thus, once the recession is in force, car sales are likely to drop, and prices of resale homes will again decline.
Oil prices may temporarily drop. This price decrease, together with a drop in credit availability, is likely to lead to a reduction in drilling in high-priced locations, such as US oil shale (tight oil) plays.
Other energy sources are also likely to be affected. Demand for electricity is likely to drop. Renewable energy investment is likely to decline because of less electricity demand and less credit availability. By 2014 and 2015, less government funding may also play a role.
This recession is likely be very long term. In fact, based on my view of the reasons for the recession, it may never be possible to exit from it completely.
I base the foregoing views on several observations:
1. High oil prices are a major cause of the United States Federal Government’s current financial problems. The financial difficulties occur because high oil prices tend to lead to unemployment, and high unemployment tends to lead to higher government expenditures and lower government revenue. This is especially true for oil importers.
2. The United States and world’s oil problems have not been solved. While there are new sources of oil, they tend to be sources of expensive oil, so they don’t solve the problem of high-priced oil. Furthermore, if our real economic problem is high-priced oil, and we have no way of permanently reducing oil prices, high oil prices can be expected to cause a long-term drag on economic growth.
3. A cutback in discretionary spending is likely. US workers are already struggling with wages that are not rising as fast as GDP (Figure 2). Starting in January, 2013, US workers have the additional problem of rising Social Security taxes, and later this year, a likely cutback in government expenditures. The combination is likely to lead to a cutback in discretionary spending.
4. The size of our current financial problems, both in terms of US government income/outgo imbalance and debt level, is extremely large. If high oil prices present a permanent drag on the economy, we cannot expect economic growth to resume in a way that would fix these problems.
5. The financial symptoms that the US and many other oil importers are experiencing bear striking similarities to the problems that many civilizations experienced prior to collapse, based on my reading of Peter Turchin and Sergey Nefedov’s book Secular Cycles. According to this analysis of eight collapses over the last 2000 years, the collapses did not take place overnight. Instead, economies moved from an Expansion Phase, to a Stagflation Phase, to a Crisis Phase, to a Depression/Intercycle Phase. Timing varies, but typically totals around 300 years for the four phases combined.
It appears to me that the corresponding secular cycle for the US began in roughly 1800, with the ramp up of coal use. Later other modern fuels, including oil, were added. Since the 1970s, the US has mostly been experiencing the Stagflation Phase. The Crisis Phase appears to be not far away.
The Turkin analysis started with a model. This model was verified based on the experiences of eight agricultural civilizations (beginning dates between 350 BCE and 1620 CE). While the situation is different today, there may be lessons that can be learned.
Below the fold, I discuss these observations further.
Issue 1. High oil prices tend to lead to government financial problems.
Food prices tend to rise at the same time as oil prices, partly because oil is used in the production of food (for example, plowing, irrigation, herbicides and insecticides, harvesting, transport to market). Also, because oil is in short supply, corn is now being grown for use as ethanol to be used as a gasoline-extender. Growing additional corn puts pressure on food prices, because it drives up the price of land and encourages farmers to put more land into corn production, and less into other crops.
The reason governments are affected by high oil and food prices is as follows. When oil and food prices rise, buyers cut back in discretionary spending, so as to have enough for “basics,” including food and commuting expenses. Workers are laid off in discretionary industries, such as vacation travel and restaurants. These laid off-workers pay less taxes, and sometimes default on loans. Governments are quickly drawn into these problems, for two reasons:
- Their tax revenue is lower, because of layoffs in discretionary sectors.
- Their expenditures are higher, because of the need to pay more unemployment benefits, provide economic stimulus, and bail out banks.
Oil importers are especially affected, because they are also paying out funds to oil exporters. The countries with well-publicized financial problems (including several European countries, the United States, and Japan) tend to be major oil importers.
Oil exporters are not adversely affected to the same extent, because they have additional revenue from higher prices on oil they are exporting. They may still be somewhat affected because of rising food prices, and the fact that higher oil revenues do not necessarily go to those buying food. A recent study shows that food shortages helped trigger the Arab Spring protests.
Part of the reason that the impact of high oil prices is as severe as it is, is because there are many follow-on effects. For example, if oil prices rise, the price of shipping goods of all types rises. If businesses are able to pass through these higher costs, discretionary income of buyers for other goods falls. If not, businesses find that their higher costs lead to lower profits. To bring profit margins back up to an acceptable level, businesses may lay off workers.
As another example, prices of homes are likely to be adversely affected by high oil prices, because a family with inadequate discretionary income will forgo moving to a larger home, and may even default on a mortgage.
It should be noted that the impact of high oil prices doesn’t completely go away unless oil prices go down and stay down. Businesses can partly mitigate the impact of high oil prices by laying off workers in discretionary segments. Some businesses will fail completely, however. Replacement may be by an overseas company, with a lower cost structure that uses less oil. See my post on energy leveraging.
Workers generally must permanently adjust their budgets to higher food and oil prices. This is often difficult to do. The lack of jobs is a particular problem–something that workers cannot fix by themselves. Government programs can mitigate the job shortfall, by paying benefits to unemployed workers and by reducing interest rates, so that businesses can more easily make investments that will lead to more employment. These programs are costly, though, and are a major cause of the current mismatch between government income and expense.
Issue 2. World oil problems have not been solved.
There have been a number of reports this years, such as one by the International Energy Agency, seeming to suggest that the world oil problem has been solved. These analyses are incomplete. They do not recognize that our real problem is a financial problem. Our economy (everything from interstate highways to electric transmission to Social Security programs) was put in place using cheap ($10 or $20 barrel) oil. Shifting to today’s high cost of oil (up near $100 barrel) causes severe economic dislocations. There is no more cheap oil to be found, however, because oil companies extracted the cheapest to extract oil first and now the “easy oil” is gone.
The impression one gets from reading the papers is that US oil production is having a huge impact on world oil production. If a person looks at the numbers, world oil production is close to flat. Rising US production makes up for falling European production, but doesn’t do a whole lot more.
The rise in United States oil production is indeed somewhat helpful, but we are still many years away from being “energy independent” and even farther from becoming “oil independent.” The real issue is high oil prices, and these are not being fixed.
Our financial problems are here and now, in 2013. Promises of hoped-for higher oil production in several years at a still very high price don’t fix today’s financial problems. In fact, they will likely continue to contribute to financial problems in the future.
Issue 3. Declining wages and increased taxes can be expected to lead to a decline in discretionary spending.
As indicated at the beginning of the post, wages (including earnings of businesses owners considered as “proprietors,” but not including “transfer payments” such as Social Security and unemployment insurance) have not been growing as fast as GDP since 2000. Below is a repeat of Figure 2 shown at top of post.
There seem to be several reasons behind this decline. One reason, already mentioned, is high oil prices leading to US layoffs, because of decreased discretionary expenditures.
Another reason for the decline is increased automation. Electricity can often be substituted for human labor, reducing costs, but also reducing jobs. Economists seem to term this change higher labor productivity. They also seem to believe that new jobs will appear from somewhere, but in practice, this is not happening. Instead, lack of jobs is part of what is leading to recessionary influences.
Another reason for the decline is increased competition from countries with lower labor costs and lower fuel costs. China joined the World Trade Organization in December 2001, and its manufacturing (and thus use of fuels) increased dramatically shortly thereafter.
Another reason is demographic. Baby boomers are reaching retirement age. This has already begun affecting the number of individuals who retire each year. In the future, the number of retirees can be expected to increase further.
In total, we see a very large drop in the percentage of US citizens with jobs, starting about 2000 (Figure 6). This is very close to the time that China ramped up its growth (Figure 5).
In calendar years 2011 and 2012, workers’ contributions for Social Security funding were temporarily reduced by 2% of wages, as a way of stimulating the economy. As of January 1, 2013, this temporary reduction was removed. For a couple with combined wages of $100,000, take-home pay is thus being decreased by $2,000 per year. With less disposable income, workers can be expected to cut back somewhere–buying a larger home, buying a new car, or going out to eat.
So far, only a small amount of other tax increases have been put in place, and only a few cuts have been made. More tax increases or benefit cuts will be needed later this year to bring revenue and expense into better alignment. Any such change will tend to have a recessionary impact, because citizens’ discretionary incomes will be affected.
Issue 4. The spending gap and the amount of debt look too big to be fixable without excellent economic growth.
As noted above, wages have not been keeping up with GDP. The majority of federal taxes are based on wages, so in my comparisons, I use wages, rather than GDP, as a base.
If we use the wage base from Figure 2, the amount of government outgo vs income (all levels, not just federal) is as follows:
Based on Figure 7, the issue in recent years has been primarily rising expenditures. These higher expenditures would seem to be partly because of high-priced oil, but also because of other influences noted above that are leading to declining employment. The amount of the gap is close to 15% of wages–something that is very hard to fix. Even the current increase in Social Security taxes (“only” 2% of wages) will exert downward pressure on discretionary spending.
A related issue is that compared to wages (using the same wage base as in Figure 2), debt of all kinds is extremely high.
Government debt is in now more than household debt of all kinds, including mortgage, credit card, auto, and student loans. It is close to two times the wage base used in this analysis.
One issue with paying down debt is that during the pay-down period, the government (or individual) reducing the debt “feels poorer,” because funds available for spending on goods and services needed today is lower. This happens because some current tax revenue, or some current wages, must be used to pay down debt, and thus is not available for today’s spending. This is a turn-around from the increasing debt situation experienced many times in the past. For example, part of the reason times seemed good in the 2002-2006 period was because people were able to refinance their homes and use the funds to buy a new car or add on a family room. If we are forced to pay down debt, we have the reverse effect.
Issue 5. Similarity to “Secular Cycles” of Peter Turchin and Sergey Nefedov.
Throughout the ages, many economies that have experienced long-term expansion. Eventually, they reached limits of some sort and collapsed. The book Secular Cycles by Peter Turchin and Sergey Nefedov takes an analytical approach to looking such past cycle. They developed a fairly complex model of what they would expect over time, in terms of trends in wages, prices, population, income inequality, and other variables. They then examine historical records (relating to eight civilizations in four countries, with “start dates” between 350 BCE and 1620 CE) to see whether this predicted pattern was born out in practice. In general, the authors found good agreement with the predicted model.
Typically, civilizations analyzed were reaching upper limits in population growth because of limits on food availability, but sometimes limits on water or fuel also were important. The model predicted four phases (expansion, stagflation, crisis, and depression/ intercycle). The typical length of the entire cycle was 300 years. The length of the various segments was fairly variable. The stagflation stage often lasted 50 or 60 years. The crisis stage tended to be shorter, more often in the 20 to 50 year range. There often was overlap between phases, with a civilization seeming to cycle back and forth between, say, expansion and stagflation.
In the model, there are various feedback loops. For example, as the number of workers rises relative to the amount of land, the price of land and food tends to rise. Jobs outside of agriculture do not rise proportionately, so wages of common workers tend to fall in inflation adjusted terms. With lower wages for common workers, nutrition declines. Eventually, the population becomes weakened, and population declines. There are also other players–the elite and the state itself.
Some characteristics of the four phases are as follows:
- Expansion phase (growth) – Increasing population, relatively low taxes, political stability, low grain prices, and high real (inflation-adjusted) wages.
- Stagflation phase (compression) – Slowing population growth, much heavier taxes needed to support a growing elite class, low but increasing political instability, rising grain prices, declining real wages for most workers, increasing indebtedness, and increasing urbanization.
- Crisis phase (state breakdown) – Population declining from the peak (typically by disease or by deaths from warfare), high income inequality, political instability increasing to a peak, high but very variable grain prices, high urbanization, tax system in a state of crisis, peasant uprisings.
- Depression/intercycle – Low population, attempts to restore state, declining economic inequality, grain prices decreasing but variable.
It seems to me that the United States and much of the world are going through a cycle much as described by Turchin. The Growth Phase of our current cycle seems to have begun around 1800, with the rise of coal use. Stagflation in the United States seems to have started with the drop in US oil production in 1970. All of the government budget and debt problems now seem to suggest that we are reaching the Crisis Phase.
Obviously, there are differences from the civilizations modeled, because we now live in a much more integrated world. Furthermore, earlier societies did not depend on oil and other modern fuels the way we do today. We do not know how the current situation will play out, but the comparison is concerning.
Off the Keyboard of Gail Tverberg
Published on December 12, 2012 on Our Finite World
Discuss this article at the Environment Table inside the Diner
Most of us have heard that Thomas Malthus made a forecast in 1798 that the world would run short of food, and that great famine would result. But most of us don’t understand why he was wrong. This issue is relevant today, as we grapple with the issues of world hunger and of oil consumption that is not growing as rapidly as consumers would like–certainly it is not keeping oil prices down to historic levels.
What Malthus Didn’t Anticipate
Malthus was writing immediately before fossil fuel use started to ramp up.
The availability of coal allowed more and better metal products (such as metal plows, barbed wire fences, and trains for long distance transport). These and other inventions allowed the number of farmers to decrease at the same time the amount of food produced (per farmer and in total) rose. On a per capita basis, energy consumption rose (Figure 2) allowing farmers and others more efficient ways of growing crops and manufacturing goods.
If it hadn’t been for the fossil fuel ramp up, starting first with coal, Malthus might in fact have been right. As it was, population was able to ramp up quickly after the addition of fossil fuels.
A person can see that there was a particularly steep rise in population, right after World War II, in the 1950s and 1960s (Figure 3). This is when oil consumption mushroomed (Figure 2, above), and when oil enabled better transport of crops to market, use of tractors and other farm equipment, and medical advances such as antibiotics.
It is likely that increased consumer and business debt following World War II (Figure 4) also played a role in the post-World War II ramp up.
The reason I say that debt likely played a role in this ramp is because at the end of World War II, people were, on average, pretty poor. The United States had recently been through the Depression. Many were soldiers coming back from war, without jobs. Without a ramp up in factory work and related employment, many would be unemployed. A ramp up in debt fixed several problems at once:
- Allowed low-paid workers funds to buy new products, such as cars, that used oil
- Allowed entrepreneurs funds to set up factories
- Allowed pipelines to be built, and other support for ramped up oil extraction
- Provided jobs for many coming home from the war effort
The debt ramp up, and the resulting increase in oil production, raised living standards. Figure 2 shows that the increase in per capita energy consumption was far greater in the 1950 to 1970 period when oil production was ramped up than in the coal ramp-up between 1840 and 1920. The long coal ramp-up period does not appear to have been accompanied by such a big ramp-up in debt.
A tentative conclusion might be that as long as we can keep ramping up availability of energy products and debt, Malthus’s views are not very relevant.
Of course, things aren’t looking as benign today. World oil production has been close to flat since about 2005 (Figure 5).
The world has been able to increase production of other fuels to compensate so far. Unfortunately, the big increase is in coal (Figures 1 and 2). This mostly relates to growth in the economies of Asian countries, which are large users of coal.
The cost of oil has more than tripled in the last ten years. The higher cost of oil is a problem, because it leads to recession, unemployment, and governmental debt problems in oil-importing countries. See my posts High-Priced Fuel Syndrome, Understanding Our Oil-Related Fiscal Cliff, and The Close Tie Between Energy Consumption, Employment, and Recession.
Continued increase in debt now seems to be running into limits. Federal government debt is in the news every day, and non-government debt seems to be contracting relative to GDP, based on Figure 4.
I am not sure that we can conclude that we are headed for catastrophe the day after tomorrow, but the graphs give a person reason to pause to think about the situation.
The reason I write posts is to try to pull together the big picture. If we only look at the latest new item forecasting huge increases in tight oil production or talking about 200 years of natural gas, it is easy to reach the conclusion that all of our problems are past. If we look at the big picture, they clearly are not.
Debt problems are closely related to high oil prices in recent years. Debt problems are today’s issue, and they are not being considered in the huge oil and gas forecasts we see everywhere. The new tight oil and the new shale gas resources likely will need to be financed by increasing amounts of debt, so there is a direct connection with debt. There is also an indirect connection, through governmental debt problems, higher taxes, and the likely resulting recession (leading to lower oil prices, perhaps too low to sustain the high cost of extraction).
Also, it is interesting that the supposedly huge increases in US oil supply don’t really translate to any discernible bump in world oil supply in Figure 5.
We know that the world is finite, and that in some way, at some point in the future, easily extractable supplies of many types of resources will run short. We also know that pollution (at least the way humans define pollution) can be expected to become an increasing problem, as an increasing number of humans inhabit the earth, and as we pull increasingly “dilute” resources from the ground.
Based on earth’s long-term history, and on the experience of other finite systems, it is clear that at some point, perhaps hundreds or thousands of years from now, the earth will cycle to a new state–a new climate with different dominant species. It may turn out that these new species are plants, rather than animals. The new dominant species will likely ones that can benefit from our waste. Humans would of course like to push this possibility back as long as we can.
At this point, my goal is to pull together a view of the big picture, in a way that other analysts usually miss. The picture may not be pretty, but we at least need to understand what the issues are. Is the shift in the cycle very close at hand? If so, what should our response be?
Off the keyboard of Gail Tverberg
Published on Our Finite World on November 13, 2012
Discuss this article at the Epicurean Delights Smorgasboard inside the Diner
The International Energy Agency (IEA) provides unrealistically high oil forecasts in its new 2012 World Energy Outlook (WEO). It claims, among other things, that the United States will become the world’s largest oil producer by 2020, and will become a net oil exporter by 2030.
Figure 1. Author’s interpretation of IEA Forecast of Future US Oil Production under “New Policies” Scenario, based on information provided in IEA’s 2012 World Energy Outlook.
Figure 1 shows that this increase comes solely from the expected rise in tight oil production and natural gas liquids. The idea that we will become an exporter in later years occurs despite falling production, because “demand” will drop so much.
The oil price forecasts underlying these and other forecasts in the report are approximately as follows:
Figure 2. Author’s interpretation of future average world oil prices, as provided by IEA in their 2012 WEO report. (Forecast provided by IEA is more “concave downward”.) Historical amounts are based on BP 2012 Statistical Review of World Energy amounts.
One reason the WEO 2012 estimates are unreasonable is because the oil prices shown are unrealistically low relative to the production amounts forecast in the report. This seems to occur because the IEA misses the problem of diminishing returns. As the easy-to-produce oil becomes more depleted, and we need to move to more difficult reservoirs, the cost of extraction increases.
In fact, there is evidence that the “tight” oil referenced in Exhibit 1 is already starting to reach production limits, at current prices. The only way these production limits might be reasonably overcome is with higher oil prices–much higher than the IEA is assuming in any of its forecasts.
Higher oil prices cause a huge problem because of their impact on the world economy. The IEA in fact mentions that current high oil prices are already acting as a brake on the global economy in its first slide for the press. Higher oil prices also mean that investment costs required to reach target production levels will be even higher than forecast by the IEA, adding another impediment to reaching its forecast production levels.
If higher prices put the economies of oil importing nations into recession, then oil prices will drop lower, reducing the incentive to invest in new oil production infrastructure. In fact, we could find ourselves reaching “peak oil” because of an economic dilemma: while there seems to be plenty of oil available, the cost of extracting it may be reaching a point where it is more expensive than consumers can afford. As a result, some oil that we know about, and have been counting as reserves, will have to be left in the ground.
The IMF has recently done modeling that is relevant to this issue in a working paper called “Oil and the World Economy: Some Possible Futures.” This analysis may provide some insight as to what the real situation will be.
The Problem of Diminishing Returns
One issue that the IEA has not properly modeled is the issue of declining resource quality, leading to diminishing returns and a rising “real” (inflation adjusted) cost of production. This situation is often described as reflecting declining Energy Return on Energy Invested (EROEI).
The reason diminishing returns are a problem is because when a producer decides to extract oil, or gas or coal, the producer looks for the cheapest, easiest to extract, resource first. It is only when this resource is mostly depleted that the producer will seek locations where more expensive, harder to extract resource is available. Thus, over time, the inflation adjusted cost of extracting a resource tends to increase.
In terms of the triangle shown, producers tend to start at the top, with the “best” of the resource, and work their way toward the bottom. One result of this approach is that the cost per unit of production tends to rise, even as there are technology advances and efficiency gains, because the quality of the resource is declining.
Reserves tend to increase over time with this approach, because as producers work their way down the triangle in the diagram, they always see an increasing quantity of lower quality resources. The new reserves are increasingly expensive to extract, in inflation adjusted terms. There is no flashing light that says, “Above this price, customers won’t be able to afford to purchase this resource any more,” though. As a result, the increasingly low quality reserves get added to reported amounts, even though in some cases, the cost of products made with these reserves (say gasoline or diesel) will send economies into recession.
It should be noted that the issue of diminishing returns exists for almost any kind of resource. It exists for uranium extraction, since there is always more available, just harder to reach, or in lower concentration. Diminishing returns exists for gold, copper, and for nearly any other kind of metal. This means we often need more oil for metal extraction and processing, as we dig deeper or find ore that is mixed with a higher proportion of waste product.
The problem of diminishing returns also seems to hold for renewables. The first biofuel developed was ethanol from corn, since the process of making alcohol from corn has been known for ages. Newer approaches, such as ethanol from biomass and biofuel from algae, tend to be much more expensive. As a result, when we add new biofuel production, it is likely to be more expensive, and thus harder for the customer to afford. If we want it, we will need increasingly high subsidies.
Wind energy is also subject to diminishing returns. Onshore wind was developed first, and it is far less expensive than offshore wind, which was developed later. Early units of wind added to an electric grid do not disturb the electric grid to too great an extent. Later units of wind energy add increasingly large costs: long distance transmission lines, electrical storage, and other balancing–something that is generally overlooked in making early cost analyses.
Diminishing returns seem even to happen for energy efficiency. We have been working on energy efficiency a very long time. We have a tendency to pick the low-hanging fruit first. Later expenditure for efficiency may be less cost-effective.
Why Light Tight Oil Won’t Increase as in Figure 1
Tight oil, also referred to as “shale oil,” is supposed to be the United States’ oil savior, if we believe the IEA. The Bakken and Eagle Ford plays are the best known examples.
Rune Likvern of The Oil Drum has shown that drilling wells in the Bakken already seems to be reaching diminishing returns. The choicest locations appear to have been drilled first, and the locations being drilled now give poorer yields. He has also shown that the average well in the Bakken now requires a price of $80 to $90 barrel, which is close to the recent selling price. If increased production is desired, the price of oil will need to start increasing (and keep increasing) to provide the incentive needed to drill wells in less-choice location.
There are other issues as well. If there is a need to drill an increasing number of wells just to stay even, or an even larger number, to increase the amount of oil produced, we start to reach limits on many kinds: number of rigs available, number of workers available, miles driven for water to be used for fracking. Perhaps the issue that will limit production first, though, is limits on debt available to producers. Rune Likvern has also shown that cash flows from tight oil extraction tend to run “in the red,” so an increasing amount of debt financing is needed as operations ramp up. At some point, companies hit their credit limit and have to stop adding new wells until cash flow catches up.
Evidence Regarding Rate of Growth of Oil Extraction Costs
Bernstein Research recently published information showing that the marginal cost of oil production was $92 barrel in 2011 for non-OPEC, non Former Soviet Union oil producers at the 90th percentile of production. This cost is increasing at 14% per year (or about 12% a year in inflation adjusted terms). Even at the median marginal cost level, costs appear to be increasing at a compound annual growth rate of 9% (or about 7% in inflation adjusted terms). See also this FTAlphaville post.
If we take the $92 barrel cost in 2011 at the 90th percentile of production and increase it by 7% a year (arguably we should be using 12% per year), the real cost will be $169 barrel in 2020, and $467 a barrel in 2035. These are far in excess of the IEA oil price estimates shown on Figure 2. There is no reason to believe that Bakken and other tight oil production costs would be substantially cheaper.
Other Issues That Appear Not to be Handled Well by IEA WEO 2012
There are three other issues that the IEA has not handled well, in my opinion.
1. Rising Real Need for Fuels of Some Sort
WEO 2012 shows falling “demand” for fuel. Demand, as economists define demand, has to do with how much customers can afford. It is quite possible that demand will fall because people can’t afford the fuel.
It seems to me would be better to start by analyzing how the real need for fuels is changing. Once this is determined, adjustments can be made to reflect other ways the same benefits can be provided, assuming this is possible.
Regarding the real need for fuel, if we look at species that are in some ways similar to humans, such as chimpanzees and gorillas, we find that these animals have no need for fuels, because they live in the way that they are biologically adapted: There are only a relatively small number of them (less than 1,000,000 per species) living in territory which is restricted to their biological adaptation. They do not need their food cooked, or spears or other tools to keep away predators, or shelter from the elements.
Humans don’t live in the way that we are biologically adapted. Because there are so many of us, we need to grow our own food, and gather water from natural sources. Because we do not have big heavy jaws because there is little easy-to-chew food available, we need to cook much of our food. Because we live in diverse areas of the world, we need shelter and adaptive clothing. As humans move to cities, we have even greater needs. We need antibiotics and immunizations to prevent epidemics. We need fuel for commuting, unless we sleep on the floor of the factory where we work. We need fossil fuel for cooking, because traditional fuels such as dung or twigs are not available in sufficient quantities in urban areas.
Another need for fuel, besides directly responding to human needs, is to offset the continued degradation (entropy) of built infrastructure. As the number of humans expands, so do the miles of roads, the number of bridges, the miles of pipelines, the number of homes and schools, and many other kinds infrastructure. All of this infrastructure wears out. Roads need to be repaired almost every year, especially in cold climates. Electrical transmission lines need to be put back in place after every major storm.
Population is also, of course, rising. When we put these issues together (rising fuel need with urbanization, rising population, and increasing entropy), it is clear that the services humans need from fuels will continue to rise, whether or not “demand” as economists measure it appears to rise.
Most of these fuel services will need to come from fossil fuels, rather than renewables, for two reasons: (1) This is the way our infrastructure now is built, and it is expensive and time-consuming to change it. (2) Biological sources are quite limited compared to the needs of 7 billion humans. According to Chew in The Recurring Dark Ages, deforestation started to occur in multiple locations 6,000 years ago, when the world population was about 20 million people.
2. Substitution for Oil
The IEA seems to err in the direction of assuming that substitution can be made more quickly than it really can be. In general, whenever substitution is done, new devices need to be created that use the new fuel, or new plants need to be developed that transform one type of fuel to another type of fuel. Doing either of these things will temporarily add to demand for fossil fuels. There is also a cost involved.
Only the heavier portion of natural gas liquids can be added directly to gasoline supply. Most natural gas liquids are used for other purposes, such as making plastics, or propane for home heating, or making liquid petroleum gas (LPG). LPG is used for cooking in some parts of the world and for operating vehicles that have been designed to use it.
The IEA seems to assume that efficiency gain can have a big impact on the need for oil. The issue it seems to lose sight of is that efficiency gains are a two-edged sword. When a device is made more efficient, the usual effect is that it can be operated more cheaply. This means that more people can afford it, and demand may increase. In the early days, electricity was very expensive. As its cost came down with efficiency gains, its use went up dramatically.
Putting All of These Issues Together
It is very clear to me that the IEA oil estimates way too high, unless prices are much higher. Of course, prices can’t really be much higher, or the economy will go into recession. As a result, production both for the US and the rest of the world is likely to be much lower than forecast by the IEA.
It would be useful to have a better estimate of exactly where the world is headed. One way this might be done is by adapting the indications of a new IMF working paper called Oil and the World Economy: Some Possible Futures. The working paper considers some unknown time, between now and 2020, when the rate of increase in oil supply is assumed to decrease by 1%. While it is not stated in the report, it appears to me that this is similar to what actually happened about 2005, when the rate of oil production increase dropped from 1.3%” annual increase to 0.1%, a 1.2% decrease. (Figure 4, below).
I have a few observations regarding such an adaption:
(a) The model could be adjusted to consider the fact that a drop in the trend rate of about 1.2% actually took place in 2005, rather than simply assuming that a 1% decrease will happen at some unspecified point in the future. It appears to me that shift in the oil extraction trend line underlies many of the world’s problems in the last several years.
(b) The treatment in the model of diminishing returns should be adjusted. It is my understanding that this is currently handled assuming a 2% annual increase in real costs of production. The model could be adjusted to reflect a more realistic (higher) annual cost in oil production, and indirectly, required selling price.
(c) The authors of the IMF report suggest building a more resource-based model, and I would agree that this would be helpful. There are many interlinkages that the current model cannot adequately capture. A more resource-driven model, especially one that considers balance sheets of world governments, would appear to be better.
My View of What is Happening Now
As noted above, world crude oil production seems to have hit a plateau, starting about 2005. This is working its way through the economy with varying effects over time. The major effect at this point of time seems to be on the finances of governments that import oil, although it started earlier, with different aspects more apparent.
In general, what happens as we reach a situation of diminishing returns, and thus rising real oil prices, seems to be as follows:
As the price of oil rises, the price of food and commuting tend to rise. Both of these are considered essential by most consumers, so consumers cut back in discretionary spending, to have sufficient funds for the essentials. This leads to layoffs in discretionary industries, such as vacation travel and restaurant eating. The rise in laid off workers leads to an increase in debt defaults, and problems for banks. Housing and commercial real estate prices tend to fall, because of reduced demand, further adding to debt default problems.
Governments of oil importers get drawn into this in many ways: (1) Their revenues are reduced, because they receive less tax revenue from people who are laid off from work and from businesses with fewer sales. (2) They are asked to prop up failing banks, and to stimulate the economy. (3) They are also asked to pay workers who have been laid off from work. The net of all of this is that the governments of many oil importers find themselves with huge budget deficits, and declining ability to fix these deficits. This pattern is precisely what we are seeing today in many of Eurozone countries, the United States, Japan.
The statements about rising oil production in the US are just a distraction. Diminishing returns mean that US oil production will never increase very much. Oil costs will remain high, and this will be the real issue disturbing economies around the world.
Off the keyboard of Gail Tverberg
Published on Our Finite World on November 6, 2012
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Last week, I gave a talk called Financial Issues Affecting Energy Security at the Advances in Energy Studies conference in Mumbai, India. The general topic of the conference was, “Energy Security and Development-The Changing Global Context.”
As I look at the situation, it seems to me that many of the crises around the world are connected to oil supply and the cost of this oil supply. If oil supply gets tighter, there is potential for these crises to get worse. In this talk, I will also show the connection of oil supply limits to some of the financial crises we see today, and to energy security. I will also show some slides on the Indian oil and coal situation, and explain some connections to world limits.
World GDP, oil consumption, and energy consumption tend to move in tandem (Slide 2). While the figures shown above are for the world, the same situation tends to exist for smaller groupings as well. Countries with rapid economic growth tend to use a growing amount of energy, especially oil. This is logical, because making goods and services tends to use energy. For example, growing food and transporting it using modern methods uses oil.
Another reason energy consumption and growth in GDP tend to go together is because workers who earn a salary by making goods or services can afford to buy goods and services using oil and other energy products. For example, they may be able to afford to buy a car or to go on a vacation. People who have lost their jobs have much less to spend on goods and services. This is another reason energy (and oil) consumption tends to be higher when more people have jobs–that is during periods of economic growth.
Countries with little economic growth tend to be ones with little growth in oil consumption, and in energy consumption in general.
If we look at world oil supply and price (Slide 3), we see that there have been two big price spikes. The first one came in the 1970s and early 1980s, after the oil production of the United States began to fall in 1971. The United States found itself increasingly dependent on imports, leaving the door open for the Arab Oil Embargo. By the mid-1980s, the world got its oil supply problem under control, partly by drilling for oil in new places (North Sea, Alaska, and Mexico) and partly by finding ways to reduce oil consumption (smaller cars; shifting electricity production to coal or nuclear instead of oil).
In recent years, we are facing a second sharp rise in oil prices. This sharp rise really reflects both a “demand” and a “supply” problem:
(1) Demand. World demand for oil started rising sharply after China joined the World Trade Organization in 2001. China, India, and other Asian countries began rapid economic growth, leading to a greater need for oil and other energy products. Slide 3 shows world supply did not show any unusual “spurt” to meet this demand. Instead prices began to rise.
(2) Supply. To a significant extent, “The easy oil is gone“. What is left in the ground is oil that is both expensive and slow to extract. Two examples of such oil are “shale oil” and bitumen from the Canadian oil sands. Because of high extraction costs, these types of oil need a high sales price to justify their extraction. In fact, a recent report indicates that costs in the Canadian oil sands are soaring. If growth in oil sands production is to continue at forecast levels, oil prices will need to be higher than has recently been the case.
If we look at a graph of growth in oil supply with fitted trend lines, we can see that the rate of growth has in fact been declining over time. This is precisely the opposite of what is needed to accommodate the energy needs of rapidly growing countries such as India and China, and is part of the reason for current high prices.
If we look at world oil consumption divided among three different parts of the world (Slide 5), we see three very different patterns:
(1) European Union, United States and Japan combined. Consumption has fallen since 2005. These are precisely the countries with serious recessions in the 2007-2009 period, when oil consumption was dropping rapidly.
(2) Former Soviet Union (FSU) – Consumption fell when the Soviet Union collapsed in 1991, and has never recovered.
(3) Remainder (many countries, including China, India, and oil exporters) – Consumption grows rapidly, year after year, even though world supply is not growing by much.
If world oil supply remains relatively flat (as is recently the case on Slide 4), and the growth pattern shown on Slide 5 continues, it is clear that there will soon be a conflict. Either the EU, US, Japan grouping will need to drop their consumption by more, or the “Remainder” group will need to slow down on their consumption, or both. This pattern could mean slower growth for the “Remainder” grouping, or outright recession for the European Union, US and Japan.
(1) Because oil prices are not subsidized, higher oil prices are passed through to consumers. These higher prices lead consumers to cut back on discretionary expenses because oil is used for some of the necessities of life, including food production and commuting to jobs. As a result, people in discretionary industries, such as vacation travel, and restaurants, tend to be laid off. There may also be debt defaults, if laid-off workers cannot afford to repay loans. The combination of these factors leads to recession.
(2) Governments are affected, too, because laid-off workers pay less in taxes. Furthermore, laid-off workers often need unemployment benefits and other benefits to mitigate their circumstances. The government may also choose to “stimulate” the economy, or to bail out banks with bad loans. With all of the additional spending and less revenue, recessionary forces get transferred to the governmental sector. This is why so many governments are now troubled with high debt.
(3) In the Euro zone, counties in poor financial condition find it necessary to pay higher interest rates. adding to the country’s financial difficulties. The US has been spared this problem so far, partly because it is viewed as a “safe haven” from Euro problems, and partly because it has the ability to manipulate the level of its currency.
Countries vary in their exposure to high oil prices. Oil importers who get a large share of their total energy from oil (as opposed to other types of fuel) seem to be most at risk. The PIIGS (Portugal, Italy, Ireland, Greece and Spain) tend to be countries using large share of oil in their energy mix. A country which can’t regulate its own currency, such as Greece and other Euro countries is at particularly high risk, because of the problem with higher interest rates mentioned earlier (because these countries cannot drop the value of their currency, to make their exports more competitive).
Eventually, it seems likely that high oil prices will affect all economies, even those of oil exporters. Extra funds from oil exports do not “make their way” to all consumers. So while some parts of an economy may be booming, others will collapse from lack of funds.
Greece provides an example of the dip in oil consumption that occurs when a country enters a recession. Greece’s largest industry is tourism. High oil prices affect consumers’ ability to purchase vacations in Greece. Large multinational companies (such as Coca Cola Hellenic) decide to move out, for more stability, further adding to the country’s problems. With less investment, the country has an even greater tendency to spiral downward.
Other European countries requiring bailouts tend to follow a similar pattern to Greece (Slide 9).
One such country is Egypt (Slide 10). For quite some time, it was an oil exporter. It historically has subsidized both food and oil prices. It has run into problems recently because oil consumption has been rising at the same time that oil production has been falling. Without oil exports to sell, it is very hard to have enough money to fund subsidies of food and oil. Cutbacks in subsidies lead to civil unrest, and the situation starts going downhill quickly. I wrote a post about the Egypt situation earlier, What Lies Behind Egypt’s Problems?
India is not an oil exporter, but it has been subsidizing diesel prices. The graph shown on Slide 11 shows that oil consumption has been rising rapidly, while India’s own oil production has been almost flat. This combination is problematic, because it becomes very expensive to subsidize increasing imports. The growing gap puts pressure on the rupee. It also leads to deficit spending, which in turn leads to a lower sovereign debt rating.
India is now using more coal for generation than it is exporting. Furthermore, the rate of increase in supply and consumption seem to be diverging, with coal production recently becoming much flatter than consumption.
Coal imports cannot be expected to rise indefinitely. China and Europe are both interested in purchasing coal imports, so there is competition for available supply. Also, coal imports tend to be expensive, because of the cost of transport. Coal import costs put pressure on India’s financial condition, just as oil imports do.
Shortages of oil, coal and gas are already taking a toll on India’s economic growth, according to the Wall Street Journal: Grinding Energy Shortage Takes Toll on India’s Growth.
It seems to me that government officials are making plans for the future without really understanding what a limited supply of cheap oil means. What it means, in practical terms, is that governments and citizens will be poorer, rather than richer, in the future. There will be fewer people employed in jobs that require external energy (practically all jobs in Western countries today). Because of energy constraints, wages of most workers will tend to fall in inflation adjusted terms.
Governments will be particularly be affected, because there will be a drop in their tax revenue at the same time that there is more need for governmental services. It will be difficult to keep up pension programs and fuel subsidy programs. The higher cost of fuel (including cooking fuel, where there are subsidies) will mean that consumers will find fuel less affordable. Governments of countries that are particularly affected are likely to be subject to major changes, as citizens become increasingly unhappy with the status quo.
We can look at countries such as Greece to get an idea of the more direct financial security impacts that we can expect. In Greece, we find that high solar feed in tariffs are increasingly a problem, and have recently been reduced. Two electricity companies that rely heavily on natural gas have gone bankrupt. The possibility of rotating blackouts has been mentioned, if the country cannot afford to import high-priced natural gas and oil for electricity. As the highest cost-electricity becomes less affordable, an increasing proportion of electricity seems likely to come from the lowest cost fuel, locally produced lignite.
Also in Greece, non-payment of bills, theft of electricity, and theft of copper wire are already being reported as problems.
In Portugal, China recently bought an interest in the company operating Portugal’s electric grid. The sale was necessitated by the poor financial condition of the company.
Civil unrest is increasingly becoming a problem in countries with shortfalls in affordable energy. Greece. Spain, and Egypt all report civil unrest. If nothing else, such unrest could lead to damage to energy structures, such as electric power plants, including nuclear plants.
As there is more competition for limited resources, the world as we have known it is likely to change. Willingness to accept foreigners into one’s country will decline, if there are not enough good-paying jobs to go around. There will be direct conflict over resources, such as China and Japan’s recent oil dispute.
The Euro zone brought together unequal countries, nearly all of which were short on energy supplies. Now, we are hearing increasing reports about the possibility of the Euro zone’s financial disintegration.
Even within countries, there is the possibility of rich areas wanting to be free from areas which are less well off. We see this dynamic playing out as there are growing calls in Catalonia for independence from Spain.
As countries face the need to cutback, rather than grow, world trade can be expected to decline. In fact, the Wall Street Journal recently reported, “World Trade Volumes Decline for Third Month.” While it is not certain the current dip will continue, this is a pattern we can expect to see again. Conflict between countries, such as we are seeing between Japan and China, can be expected to lead to a drop in trade. The need for austerity measures in countries with financial problems is also likely to lead to a drop in trade.
While it would be nice to assume “Business as Usual” will continue, and “a rising tide will lift all boats,” these situations look increasingly less likely. What we are instead seeing is that a lowering tide can adversely affect the energy security of many countries at the same time. This is not an easy thought to consider, especially for a country such as India, whose per-capita energy use lags far behind the world average.
Off the keyboard of Gail Tverberg
Published on Our Finite World on October 25, 2012
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We seem to hear two versions of the story of limited oil supply:
1. The economists’ view, saying that the issue is a simple problem of supply and demand. Substitution, higher prices, demand destruction, greater efficiency, and increased production of oil at higher prices will save the day.
2. A version of Hubbert’s peak oil theory, saying that world oil production will rise and at some point reach a plateau and begin to decline, because of geological depletion. The common belief is that the rate of decline will be determined by geological considerations, and will roughly match the rate at which production increased.
In my view, neither of these views is correct. My view is a third view:
3. An adequate supply of cheap ($20 or $30 barrel) oil is no longer available, because most of the “easy to extract” oil is gone. The cost of extracting oil keeps rising, but the ability of oil-importing economies to pay for this oil does not. There are no good low-cost substitutes for oil, so substitution is very limited and will continue to be very limited. The big oil-importing economies are already finding themselves in poor financial condition, as higher oil prices lead to cutbacks in discretionary spending and layoffs in discretionary industries.
The government is caught up in this, as layoffs lead to more need for stimulus funds and for payments to unemployed workers, at the same time that tax revenue is reduced. There can be a temporary drop in oil prices (as there was in late 2008), as recession worsens, but eventually demand rises again, oil prices rise again, and the pattern of layoffs and increased governments financial problems occurs again.
Without substitutes at a price that the economy can afford, economies will adapt to lower amounts of oil they can afford by worsening recession, debt defaults, and reduced international trade. There may be tendency for international alliances (such as the Euro) to fall apart, and for countries to break into smaller units (Catalonia secede from Spain, or countries break up the way the Soviet Union and Yugoslavia did).
At some point, probably not too many years in the future, the amount of oil extracted from the ground will drop, reflecting a combination of geological and economic factors. The fall may very well be quite steep. While we can’t expect to extract more than geology will allow, there is nothing to say that political and economic factors will allow extraction of this amount. If civil war breaks out in an oil producer, production may drop quickly. Or if oil prices drop because of severe recession, drilling of new fields and wells may drop off quickly, leading to lower production as existing wells deplete, and not enough new supply as added. There may also be disruption in international sales of oil.
What the Economists’ View Misses
The economists’ view misses the fact that it is external energy that makes the economy operate the way it does. (See my earlier posts, here, here and here.) If energy products are higher priced, energy importers can afford less of them, and there is a tendency of their economies to shrink back to what their economies can afford—fewer employed workers and fewer government programs. I talk about the connection between employed workers and energy consumption in The Close Tie Between Energy Consumption, Employment and Recession.
As the growth rate in energy supplies decreases (oil by itself, or in total), the economy tends to shrink back. Initially (in the 1970s and 1980s), the economy shrinking back looked like it was slowing down – no longer undertaking big new initiatives like interstate highway systems and major electrical grid expansions, and adding new initiatives for taking care of the poor. Then the economy shrinking back morphed into a bigger emphasis on debt financing; less concern about keeping up infrastructure the way it had in the past; and switching from manufacturing of goods to production of services, to keep energy needs lower.
Another way of keeping down energy use was by keeping wages down. Since wages translate to purchase of things that energy can make, lower wages allow an economy to “get by” with less energy consumption. In the US, the quest for lower wages has manifested itself in many ways—the failure of men’s median wages to rise after the mid 1970s, the increasing use of women (at lower average wages) in the workforce, and later outsourcing of jobs to countries overseas with lower wages (and thus less energy consumption by workers).
Eventually, the economy shrinking back has become more disruptive. It looks more like recession, with job layoffs, debt defaults, and serious government funding problems. Governments find themselves going deeper and deeper into debt, as tax revenue lags, and there is more need for stimulus funding and benefits for unemployed workers. In such an atmosphere, government stability is at risk. This seems to be where quite a few of the European countries are right now. The United States is not far away either, with many of its problems hidden by deficit spending, “quantitative easing,” ultra low interest rates, and the fiscal cliff.
The Myth of Substitution
A big part of the economists’ problem in figuring out the problem with limited cheap oil supply is their assumption that energy is not very important. It doesn’t cost very much, so why worry about it? Certainly, there should be substitutes. For example, if we can’t afford to make goods, we should be able to switch to the production of services, since these don’t require as much energy to produce. This might be a method of substitution.
But think about this. In our own life, our own energy comes from food. If someone told you that we were having a problem with food supply, but the economists said not to worry, we would find a substitute, how convinced would you be that economists really knew what they were talking about? Do you feel less hungry after a haircut, or a trip to get a loan at a bank (two standard types of services)? Perhaps they were underestimating the importance of food.
Something like that happens with other forms of energy as well. It is virtually impossible to substitute away. There is a little substitution over time of one form of energy for another, just as there is substitution of wheat for corn. But in general, each type of energy has its own uses, and it is hard to substitute one type for another. A car runs on gasoline. It is possible to substitute up to 10% or 15% corn ethanol in the gasoline, but unless significant changes are made, it is not possible to run the car on natural gas or on coal.
A big part of economists’ problem with overestimating the role of substitution is their missing the adverse impact of high oil prices (or other high energy prices) on the economy. As I have explained previously, when oil prices rise, both the cost of food and cost of commuting tend to rise. Workers cut back on discretionary spending, so as to have enough money for commuting and food expenses, leading to layoffs in discretionary industries. Housing prices stagnate or drop, as people cut back their expectations of moving to a higher priced home. Governments find themselves in increasingly poor financial condition, trying to fix these problems, with lagging tax revenue. All of this creates substantial economic problems, which cannot be overlooked.
The comment a person often hears is, “As soon as the price of oil rises high enough, _______ will substitute for it.” This doesn’t work for a couple of reasons: (1) By the time the price rises that high, the economy will be “in the tank” anyhow; a high-priced substitute doesn’t fix the problem. (See my post High-Priced Fuel Syndrome) (2) Substitutes generally use oil in their production, either directly or indirectly, so when the price of oil rises, the price of the substitutes tends to rise as well, although probably not as much as the oil price rise.
Substitution to date is not taking place very quickly. On a worldwide basis, 87% of current energy use comes from fossil fuels, based on BP’s 2012 Statistical Review of World Energy Data. The remainder is divided as follows, in the year 2011:
▪ Nuclear amounted to 5% of the total;
▪ Hydroelectric amounted to 6% of the total, and
▪ Renewables (including wind, solar, biofuels, wood, waste, geothermal, and others) come to a total of 2% of world energy supply.
There has been some substitution away from oil for a long time, because oil is high priced. Often, this occurs through electrification of various processes. The electricity used in this process is today mostly from natural gas and coal, with lesser amounts from nuclear, hydroelectric, and other renewables.
The speed with which substitution of electricity for oil is taking place varies, with stationary applications working best, and transportation being slow to change. According to the US Energy Information Administration, in 2011, only 0.3% of US transportation fuel was electricity. The rest of transportation was divided as follows: Oil, 92.7%; Biofuels, 4.3%; Natural Gas, 2.7%.
Another application which is a significant user of oil, but for which little substitution toward electricity is readily available, is in food production. Oil is used in operating farm machinery, in making herbicides and insecticides, and in transporting food to market. This is a reason why many people are interested in local food production, using techniques that use less oil.
What the Peak Oilers Missed
If a person goes back and looks at M. King Hubbert’s 1956 paper, Nuclear Energy and the Fossil Fuels, they will discover that Hubbert talks about a very optimistic scenario: the use of nuclear energy rising, before the use of oil and other fossil fuels begins to decline. See my post, Will the decline in world oil supply be fast or slow?
Elaborating further on this idea, Hubbert, in his 1962 paper, Energy Resources – A Report to the Committee on Natural Resources, writes about the possibility of having so much cheap energy that it would be possible to essentially reverse combustion–combine lots of energy, plus carbon dioxide and water, to produce new types of fuel plus water. If we could do this, we could solve many of the world’s problems–fix our high CO2 levels, produce lots of fuel for our current vehicles, and even desalinate water, without fossil fuels.
The problem that arises if we don’t have such a substitute for fossil fuels is a severe one. How do we keep our current economy operating, if oil prices, or fossil fuels in general, become high priced, and start interfering with the economy? At some point, the interference will become so great that recession will set in, in many major oil importing nations. Oil prices will drop, and oil producers will not be able to extract oil at those prices. There may be major financial impacts as well—governments dropping out of the Euro, the US government facing a financial cliff, and other countries (Japan, Britain, and China, for example) facing difficulties as well.
In my view, the shape of down slope in oil production is likely to be steeper than the pattern by which oil supply increases. Geology determines the maximum amount of extraction, but it doesn’t determine how much will actually be extracted. Economic conditions need to be right for the extractions to take place. Low oil prices by themselves could cause political upheaval in some oil exporting nations. If there are huge international trade problems, this could reduce demand as well.
Why International Trade Can Be Expected to Contract
Huge economic growth since World War II has been enabled by increased international cooperation and increased globalization. It is now possible to make many high-tech goods using trained specialists who travel around the world and raw materials imported from countries that will put up with high levels of pollution. These high-tech goods can be very cheap, if they are assembled in a country such as China with cheap labor.
Once countries start operating in a mode of “not enough energy to go around,” the model of global cooperation starts disintegrating. If unemployment becomes an increasing problem, then countries are no longer be willing to let in cheap labor from lesser-developed countries. We can see this happening in the United States, with respect to workers from Mexico.
If oil is becoming a problem, we will see more spats, of the type recently occurring between Japan and China, leading to lower trade. There may even be more resource wars. Large countries encountering financial problems will see individual units wanting to go their own way, with the parts that are doing better economically wanting to disassociate themselves from the have-nots.
High oil prices are likely to lead to more defaults on loans. In fact, Figure 4 shows that the countries most at risk of defaulting tend to be the ones that imported the largest percent of their energy from oil in 2006, before the recent crisis begin. As the world encounters more and more loan defaults, this too can be expected to erode interest in foreign trade. Such trade will likely not disappear, but may be carried on to a greater degree between trusted partners, or on more of a barter basis. For example, a certain quantity of oil may be traded for goods that the oil-producing country can use.
Businesses, Governments and Consumers form a Networked System
The way the world operates today, each business is added to the existing web of governments, businesses and consumers that exists today. Some businesses succeed, while others fail. Success or failure depends the laws that are in effect, the resources that are available, what competition there is, and the purchasing power of customers.
If energy is in short supply, more and more governments and businesses will fail, and increasing numbers of consumers will find themselves without jobs in the traditional economy. Banks may be overwhelmed by debt defaults. At some point, supply chains will become so disrupted that it will be hard for anything other than small local businesses to succeed.
This will correspond to what Joseph Tainter talks about as moving to a state of lower complexity. We don’t know exactly when or how this will happen, but it appears that we are already moving in this direction. The next years seem likely to be challenging ones!
Off the keyboard of Gail Tverberg
Published on Our Finite World on October 17, 2012
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We keep hearing about the many benefits of natural gas–how burning it releases less CO2 than oil or coal, and how it burns with few impurities, so does not have the pollution problems of coal. We also hear about the possibilities of releasing huge amounts of new natural gas supplies, through the fracking of shale gas. Reported reserves for natural gas also seem to be quite high, especially in the Middle East and the Former Soviet Union.
But I think that people who are counting on natural gas to solve the world’s energy problems are “counting their chickens before they are hatched”. Natural gas is a fuel that requires a lot of infrastructure in order for anything to “happen”. As a result, it needs a lot of up-front investment, and several years time delay. It also needs changes on the consumption side (requiring further investment) that will allow this natural gas to be used. If the cost is higher than competing fuels, this becomes a problem as well.
In many ways, natural gas consumption is captive to other things that are happening in the economy: an economy that is industrializing rapidly will easily be able to consume more natural gas, but an economy in decline will find it hard to scrape together funds for new ways of doing what was done previously, now with natural gas. Increased use of renewables seems to call for additional use of natural gas for balancing, but even this is not certain, because in many parts of the world, natural gas is a high-priced imported fuel. Political instability, often linked to high oil and food prices, creates a poor atmosphere for new Liquefied Natural Gas (LNG) facilities, no matter how attractive the pricing may seem to be.
In the US, we have already “hit the wall” on how much natural gas can be absorbed into the system or used to offset imports. US natural gas production has been flat since November 2011, based on EIA data (Figure 1, below).
Even with this level of production, and a large shift in electricity production from coal to natural gas, natural gas is still on the edge of “maxing out” its storage system before winter hits (Figure 2, below).
Figure 2. US natural gas in storage, compared to five-year average. Figure prepared by US Energy Information Administration, Weekly Natural Gas Storage Report as of October 5, 2012.
World Natural Gas Production
The past isn’t the future, but it does give a little bit of understanding regarding what the underlying trends are.
World natural gas production/consumption (Figure 3) has been increasing, recently averaging about 2.7% a year. If we compare natural gas to other energy sources, it has been second to coal in terms of the amount by which it has contributed to the total increase in world energy supplies in the last five years (Figure 4). This comparison is made by converting all amounts to “barrels of oil equivalent”, and computing the increase between 2006 and 2011.
Figure 4. Increase in energy supplied for the year 2011, compared to the year 2006, for various fuels, based on BP’s 2012 Statistical Review of World Energy data.
In order for natural gas to be an energy savior for the world, natural gas consumption would need to increase far more than 2.7% per year, and outdistance the increase in coal consumption each year. While a modest increase from past patterns is quite possible, I don’t expect a miracle from natural gas.
Natural Gas: What Has Changed?
The basic thing that has changed is that fracking now permits extraction of shale gas (in addition to other types of gas), if other conditions are met as well:
- Selling price is high enough (probably higher than for other types of natural gas produced)
- Water is available for fracking
- Governments permit fracking
- Infrastructure is available to handle the fracked gas
Even before the discovery of shale gas, reported world natural gas reserves were quite high relative to natural gas production (63.6 times 2011 production, according to BP). Reserves might theoretically be even higher, with additional shale gas discoveries.
In addition, the use of Liquified Natural Gas (LNG) for export is also increasing, making it possible to ship previously “stranded” natural gas, such as that in Alaska. This further increases the amount of natural gas available to world markets.
What Stands in the Way of Greater Natural Gas Usage?
1. Price competition from coal. One major use for natural gas is making electricity. If locally produced coal is available, it likely will produce electricity more cheaply than natural gas. The reason shale gas recently could be sold for electricity production in the United States is because the selling price for natural gas dropped below the equivalent price for coal. The “catch” was that shale gas producers were losing money at this price (and have since dropped back their production). If the natural gas price increases enough for shale gas to be profitable, electricity production will again move back toward coal.
Many other parts of the world also have coal available, acting as a cap on the amount of fracked natural gas likely to be produced. A carbon tax might change this within an individual country, but those without such a tax will continue to prefer the lower-price product.
2. Growing internal natural gas use cuts into exports. This is basically the Exportland model issue, raised by Jeffrey Brown with respect to oil, but for natural gas. If we look at Africa’s natural gas production, consumption, and exports, this is what we see:
Figure 5. Africa natural gas production, consumption, and exports, based on BP’s 2012 Statistical Review of World Energy.
In Africa, (mostly northern Africa, which exports to Europe and Israel), consumption has been rising fast enough that exports have leveled off and show signs of declining.
3. Political instability. Often, countries with large natural gas resources are ones with large oil resources as well. If oil production starts to drop off, and as a result oil export revenue drops off, a country is likely to experience political instability. A good example of this is Egypt.
Figure 6. Egypt’s oil production and consumption, based on BP’s 2012 Statistical Review of World Energy.
No matter how much natural gas Egypt may have, it would not make sense for a company to put in an LNG train or more pipeline export capability, because the political situation is not stable enough. Egypt needs oil exports to fund its social programs. The smaller funding amount available from natural gas exports is not enough to make up that gap, so it is hard to see natural gas making up the gap, even if it were available in significant quantity.
Iran is a country with large natural gas reserves. It is reportedly looking into extracting natural gas for export. Again, we have a political stability issue. Here we have an international sanctions issue as well.
4. “Need the natural gas for myself later” view. A country (such as Egypt or the United States or Britain) that has been “burned” by declining oil production may think twice about exporting natural gas. Even if the country doesn’t need it now, there is a possibility that vehicles using natural gas could be implemented later, in their own country, thus helping to alleviate the oil shortage. Also, there are risks and costs involved with fracking, that they may not choose to incur, if the benefit is to go to exporters.
5. Cost of investment for additional natural gas consumption. In order to use more natural gas, considerable investment is needed. New pipelines likely need to be added. Homeowners and businesses may need to purchase gas-fired furnaces to raise demand. If it is decided to use natural gas vehicles, there is a need for the new vehicles themselves, plus service stations and people trained to fix the new vehicles. Additional natural gas storage may be needed as well. Additional industrial production is difficult to add, unless wages are low enough that the product being sold will be competitive on the world market.
Existing “pushes” toward better insulation have the effect of reducing the amount of natural gas used for heating homes and businesses, so work in the opposite direction. So do new techniques for making nitrogen-based fertilizer using coal, rather than using natural gas.
6. Touchy balance between supply and consumption. If additional production is added, but additional uses are not, we have already seen what happens in the United States. Storage facilities get overly full, the price of natural gas drops to unacceptably low levels, and operators scramble to cut back production.
The required balance between production and consumption is very “touchy”. It can be thrown off by only a few percent change in production or consumption. Thus an unusually warm winter, as the United States experienced last year, played a role in the overly full storage problem. A ramp up of production of only a few percent can also cause an out of balance situation. Unless a developer has multiple buyers for its gas, or a “take or pay” long-term contract, it risks the possibility that the gas that is has developed will not be wanted at an adequate price.
7. Huge upfront investment requirements. There are multiple requirements for investing in new shale gas developments. Each individual well costs literally millions of dollars to drill and frack. The cost will not be paid back for several years (or perhaps ever, if the selling price is not high enough), so debt financing is generally needed. If fracking is done, a good supply of water is needed. This is likely to be a problem in dry countries such as China. There is a need for trained personnel, drilling rigs of the right type, and adequate pipelines to put the new gas into. While these things are available in the United States, it likely will take years to develop adequate supplies of them elsewhere. All of the legislation that regulates drilling and enables pipeline building, needs to be in place as well. Laws need to be friendly to fracking, as well.
Growth in Exports to Date
Exports grew as a percentage of natural gas use through about 2007 or 2008.
Figure 7. World natural gas exports as percentage of total natural gas produced, by year, based on EIA data (older years) and BP’s 2102 Statistical Review of World Energy for 2010 and 2011.
In recent years, natural gas exports have fallen slightly as a percentage of total gas extracted. Thus, if world natural gas supplies have risen by an average of 2.7% per year for the past five years, exports available for import have risen a little less rapidly than the 2.7% per year increase. A major ramp-up in export capability would be needed to change this trend.
While we hear a lot about the rise in exports using LNG, its use does not seem to be adding to the overall percentage of natural gas exported. Instead, there has been a shift in the type of export capacity being added. There are still a few pipelines being added (such as the Nord Stream pipline, from Russia to Germany), but these are increasingly the exception.
The Shale Gas Pricing Debate
Exactly what price is needed for shale gas to be profitable is subject to debate. Shale gas requires the payment of huge up-front costs. Once they are drilled and “fracked,” they will produce for a long period. Company models assume that they will last as long as 40 years, but geologist Arthur Berman of The Oil Drum claims substantial numbers are closed down in as few as six years, because they are not producing enough natural gas to justify their ongoing costs. There is also a question as to whether the best locations are drilled first.
Logically a person would expect shale-gas to be quite a bit more expensive to produce than other natural gas because it is trapped in much smaller pores, and much more force is required to extracted it. In terms of the resource triangle that I sometimes show (Figure 8, below), it epitomizes the low quality, hard to extract resource near the bottom of the triangle that is available in abundance. We usually start at the top of the resource triangle, and extract the easiest and cheapest to extract first.
Berman claims that prices $8.68 or higher per million Btu are needed for profitability of Haynesville Shale, and nearly as high prices are needed to justify drilling other US shale plays. The current US price is about $3.50 per million Btu, so to be profitable, the price would need to be more than double the current US price. Prices for natural gas in Europe are much higher, averaging $11.08 per million Btu in September 2012, but shale gas extraction costs may be higher there as well.
The US Energy Information Administration admits it doesn’t know how the economics will work out, and gives a range of projected prices. It is clear from the actions of the natural gas industry that current prices are a problem. According to Baker Hughes, the number of drilling rigs engaged in natural gas drilling has dropped from 936 one year ago to 422, for the week ended October 12, 2012.
Backup for Renewables
One area where natural gas excels is as a back up for intermittent renewable energy, since it can ramp up and down quickly. So this is one area where a person might expect growth. Such a possibility is not certain, though:
1. How much will intermittent renewables continue to ramp up? Governments are getting poorer, and have less funds available to subsidize them. They do not compete well on when they go head to head with fossil fuels, nuclear, and hydroelectric.
2. When intermittent renewables are subsidized with feed in tariffs, and requirements that wind power be given priority over fossil fuels, it can provide such an unlevel playing field that it is difficult for natural gas to be profitable. This is especially the case in locations where natural gas is already higher-priced than coal.
The Societal “Recipe” Problem
Our economy is built of many interdependent parts. Each business is added, taking into account what businesses already are in place, and what laws are in effect. Because of the way the economy currently operates, it uses a certain proportion of oil, a certain proportion of natural gas, and more or less fixed proportions of other types of energy. The number of people employed tends to vary, too, with the size of the economy, with a larger economy demanding more employees.
Proportions of businesses and energy use can of course change over time. In fact, there is some flexibility built in. In particular, in the US, we have a surplus of natural gas electricity generating units, installed in the hope that they would be used more than they really are, and the energy traded long distance. But there is less flexibility elsewhere. The cars most people drive use gasoline, and the only way to cut back is to drive less. Our furnaces use a particular fuel, and apart from adjusting the temperature setting, or adding insulation, it is hard to make a change in this. We only make major changes when it comes time to sell a car, replace a furnace, or add a new factory.
In my view, the major issue the world has been dealing with in recent years is an inadequate supply of cheap oil. High priced oil tends to constrict the economy, because it causes consumers to cut back on discretionary spending. People in discretionary industries are laid off, and they tend to also spend less, and sometimes default on their loans. Governments find themselves in financial difficulty when they collect fewer taxes and need to pay out more in benefits. While this issue is still a problem in the US, the government has been able to cover up this effect up in several ways (ultra low interest rates, a huge amount of deficit spending, and “quantitive easing”). The effect is still there, and pushing us toward the “fiscal cliff.”
The one sure way to ramp up natural gas usage is for the economy as a whole to grow. If this happens, natural gas usage will grow for two reasons: (1) The larger economy will use more gas, and (2) the growth in the economy will add more opportunities for new businesses, and these new businesses will have the opportunity to utilize more natural gas, if the price is competitive.
I have compared the situation with respect to limited oil supply as being similar to that of a baker, who is trying to bake a batch of cookies that calls for two cups of flour, but who has only one cup of flour. The baker is able to make only half a batch. Half of the other ingredients will go unused as well, because the batch is small.
To me, discovering that we have more natural gas than we had before, is analogous to the baker discovering that instead of having a dozen eggs in his refrigerator, there are actually two dozen in his refrigerator. In fact, he finds he can even go and buy more eggs, if he is willing to pay double the price he is accustomed to paying. But the eggs really do not fix the missing cup of flour problem, unless someone can find a way to change eggs into flour very cheaply.
Basic Energy Types
To me, the most basic forms of energy resources are (1) coal and (2) oil. Both can be transported easily, if it is possible to extract them. Natural gas is very much harder to transport and store, so it is in many ways less useful. It can be made work in combination with oil and coal, because the use of coal and oil make it possible to build pipelines and make devices to provide compression to the gas. With coal and oil, it is also possible to make and maintain electric transmission lines to transport electricity made with natural gas.
I sometimes talk about renewable energy being a “fossil fuel extender,” because they hopefully make fossil fuels “go farther”. In some ways, I think natural gas is an extender for oil and coal. It is hard to imagine a society powered only by natural gas, because of the difficulties in using it, and the major changes required to use it exclusively.
In the earliest days, natural gas was simply a “waste product” of oil extraction. It was “flared” to get rid of it. In many parts of the world, natural gas is still flared, because the effort it takes to collect it, transport it, and make it into a useful product is still too high.
The hope that natural gas will be the world’s energy savior depends on our ability to make this former waste product into a product that will replace oil and coal. But unless we can put together an economy that needs and uses it, most of it probably will be left in the ground. The supposedly very high reserves will do us no good.
Off the keyboard of Gail Tverberg
Published on Our Finite World on September 26, 2012
Discuss this article at the Epicurean Delights Smorgasboard inside the Diner
Governments and economists around the world have not figured out that what the world economy is suffering from, to varying degrees, is “high-priced fuel syndrome“.
High-priced fuel syndrome has a number of symptoms:
- Slow economic growth, or contraction
- People in discretionary industries laid off from work
- High unemployment rates
- Debt defaults (or huge government intervention to prevent debt defaults)
- Governments in increasingly poor financial condition
- Declining home and business property values
- Rising food prices
- Lower tolerance for immigrants
- Huge difficulty in funding retirement programs, programs for disabled, and regular pension plans
- Rising international tensions related to energy supply
The countries with the most problem with high-priced fuel syndrome are the industrialized countries that are big importers of oil. This is the case because oil has been a particularly high-priced fuel in the past few years. Importing high-priced oil adds challenges of its own, since funds used for imported oil flow out of the country.
While oil is the biggest culprit in high-priced fuel syndrome, high-priced fuels of other sorts can play a role as well. Natural gas is recently high-priced in Europe and Japan, but not the USA. The higher natural gas price contributes to a higher average energy cost level for these countries. High-priced renewables, such as off-shore wind and solar photovoltaic, can be expected to act in a similar fashion, because they add to the price challenge customers face.
At this point, Europe is hardest-hit by high-priced fuel syndrome. In part this is because Europe is a big importer of both oil and gas, and both are high-priced. European countries have also encouraged the use of high-priced renewables, adding to their difficulties.
While many people have laughed at the issue of the world “running out of oil” (or natural gas, or some other substitute fuel), it seems to me that they have basically missed the point. There is always lots of fuel in the ground, or available through devices we create that produce “renewable” fuel. The major issue is that the fuel becomes too expensive for the economy to afford.
The United States, Europe, and Japan were industrialized back when fuels were cheap, in the pre-1972 era (Figure 1, above). The cost structure of government welfare programs (such as Social Security, Medicare, unemployment) also assume that the economy will continue as it did with low-priced fuels. Substituting ever more-expensive fuels can be expected to push a country toward economic contraction, reduction in programs that the economy can no longer afford, and the symptoms listed above.
Why We are Encountering Rising Fuel Prices
When companies begin extracting oil (or natural gas, or coal), they start with the easiest, cheapest-to-extract first. In Figure 2, oil (or natural gas or coal) extraction starts at the top of the triangle, and gradually works down the triangle.
As we require more and more fuel, we gradually seek out less-desirable sources of fuels. These fuels tend to be slower to extract, and are more expensive for what we get. They are often more polluting as well.
Oil is the fuel that we recently have had a problem with easy-to-extract supply running low. We had a somewhat similar problem in the mid 1970s and early 1980s. At that point there was still plenty of cheap oil left in areas where we had not yet drilled (Alaska, North Sea and Mexico, for example), so the problem was temporary, lasting only until we could drill more oil.
This time, the problem seems to be permanent. The chief executives of oil companies Total and Shell have been quoted as saying, “The days of so-called ‘easy oil’ are over, making it harder to meet demand without complicated and expensive projects.”(Voss, 2007). Examples of such expensive-to-extract oil include deep-water oil and tight oil that must be “fracked”. The fact that the cheap oil is mostly gone is the major reason why oil prices are higher than they were five or ten years ago. If oil prices had not risen, it is likely that the amount of oil extracted each year would be declining.
There are alternative fuels such as ethanol and biodiesel, but they also tend to be expensive.
Natural gas and coal aren’t immediate substitutes for oil. For example, they won’t act as fuels in most of today’s cars, trucks and airplanes. While there are long-term possibilities for substitution, the high-priced fuel syndrome is today’s problem, not a future problem.
Rising Fuel Costs Cause the Economy to Contract
There are a number of ways rising fuel costs can cause the economy to contract. The problem is that consumers’ incomes don’t rise, just because oil prices rise. If consumers are required to pay more for a necessity, they will cut back on discretionary goods and services. A few examples:
Food prices. If oil prices rise, the price of food tends to rise as well, because oil is used in many ways in producing food: cultivation of fields, planting fields, chemical sprays (herbicides, pesticides), transporting soil amendments, harvesting fields, and transporting food to market.
Oil prices are monthly average Brent Oil spot prices, as published by the US Energy Information Administration. http://www.eia.gov/dnav/pet/hist/LeafHandler.ashx?n=pet&s=rbrte&f=m
Low-income customers tend to be disproportionately affected by rising food prices. They especially tend to cut back on discretionary spending, such as buying a car or going out to a restaurant, in order to be able to afford enough food. As a result, workers in discretionary industries are laid off.
Commuting cost. If oil cost rises, the price of auto travel rises. Some auto travel, particularly commuting, is a necessity. Consumers, particularly lower-income consumers, tend to cut back on discretionary spending, such as vacation trips, to afford essential trips.
Businesses. Businesses are affected in multiple ways by rising oil prices. First, businesses in discretionary industries find that their “unit-sales” are down, because customers are spending more on food and commuting, as a result, need to cut back elsewhere. Lower unit-sales are likely to lead to lay-offs.
In many instances, businesses also use oil directly in the products they sell. For example, airlines use jet fuel. If oil prices rise, they have they either face lower profits, or need to raise prices to recoup their higher costs. This type of price increase further stresses customers’ budgets.
Electricity. While the current US problem is oil prices, rising electricity prices would be expected to have a similar effect. Every business today uses electricity in various ways–electric lights, running computers, running elevators, operating tools of various sorts. If electricity costs rise because of higher natural gas prices or because of greater renewable surcharges, it will raise the cost of the product produced.
Businesses again have the choice of raising the price to consumers, or facing declining profits. If they raise prices, they will be less competitive with suppliers from other countries, who may not be facing rising electricity costs, if their source of electricity (perhaps coal or nuclear) is not rising in price as fast.
If electricity prices rise, consumers’ budgets will be stressed in a similar way to the way that they are stressed by rising oil prices. This, too, can be expected to lead to a cutback in discretionary expenditures.
Follow-on effects. Laid-off workers may move in with relatives and cut back on driving to save on costs. This helps reduce demand for both homes and automobiles. With less demand for homes, housing prices may decline, especially in parts of the country with significant layoffs and plentiful housing supply.
Laid-off workers may default on loans, creating financial distress for banks. Even people who still have jobs may find the hours they work reduced, so that their take-home pay is lower. They too may cut back on discretionary expenditures.
Impact on Governments
Governments suffering from high-priced energy syndrome can expect a number of negative impacts:
- Laid-off workers expect to collect unemployment benefits. If there are other kinds of benefits that they might collect under some other program (disability, retirement, low-income assistance), they will want them as well.
- If citizens are working fewer hours or laid off, the amount of taxes they pay is lower.
- Banks and other industries are likely to need bailing out, as borrowers default on loans.
- The government will be faced with direct increases in costs, because the government uses oil to fuel its autos and jets.
- The government will face increasing costs on products it buys that use oil, such as asphalt for highway projects.
- Local governments may face reduced tax revenue because of declining home and business property values.
Figure 4 below shows US Federal Government Income and Outlays, in recent years:
It is clear from Figure 4 that income had dropped at the same time outlay has risen. Even though the crisis is supposedly past, there is still a huge gap between income and outlays. Outlays in recent years are higher than would be expected based on pre 2005 trends, while revenues are lower than would be expected. Revenue would need to be more than 50% higher, to match outgo, for 2009 through 2012 fiscal years.
The amounts shown in Figure 4 are consolidated, so include programs such as Social Security and Medicare, besides “on budget” spending. How many readers could afford to contribute 50% more than they currently pay for the sum of (Federal Income Taxes + Social Security + Medicare funding)? If the government were to actually raise taxes this much, there would be a huge new round of lay-offs, because consumers would find their after-tax income much reduced, leading to even more cuts in discretionary spending.
Needless to say, the US government will do everything in its power to cover up its problems. In a later section, we will discuss how this huge deficit is being hidden.
Note that the only years during which US Federal Government income exceeded outgo in Figure 4 are 1998 through 2001. These years approximately coincide with the time period when historical oil prices were at the lowest level in recent years (Figure 5, below).
Impacts of the Oil Price Increase in 2006 – 2008 Period
While most people now don’t think of oil prices in 2006 as being high, according to Figure 5, oil prices already had more than doubled from 2002 levels by 2006. If we look back at the financial situation in 2006-2007, we see impacts very similar to what we would expect from rising oil prices.
Sub-prime borrowers began to default as early as 2006 (Bernanke, 2007). As mentioned earlier, it was people who were on the “edge” financially who were most at risk of defaults on home loans. Sub-prime borrowers would seem to be on the “edge” financially and thus were particularly as risk, because they lacked the financial qualifications to obtain “prime” interest rates.
Home prices started to drop in 2006 as well (Figure 6, above), and they haven’t been able to recover yet. We don’t think of homes as being discretionary spending items, but people can’t move into more expensive homes unless their incomes are rising. First-time buyers will also tend to put off purchases, if their financial situation is tight. The construction industry was one of the industries to face large lay-offs.
Defaults on loans caused considerable problems in the financial industry. “Short sales” (in which the sales price of a home is insufficient to pay off the remaining mortgage because the price of a home has fallen) also caused losses to the financial industry. The financial system was not set up with the idea that there may be a systemic problem of this sort. As a result, many banks found themselves in financial difficulty and needed governmental bailouts.
Other industries, such as auto manufacturing and insurance, also required bailouts. These patterns are precisely what one might expect from rising oil prices.
I make arguments similar to these in Oil Supply Limits and the Continuing Financial Crisis. James Hamilton (2009) has shown that the rise in oil prices alone were sufficient to bring on recession in the 2007-2008 recession.
One other important factor also affecting the 2006 to 2008 period was target interest rates. The Federal Reserve Open Market Committee (FOMC) raised interest rates during the 2004 to 2006 period (Figure 7, below).
The basic idea in manipulating interest rates is that low interest rates are supposed to increase economic activity, because low interest rates make it less expensive to buy a car, using a loan, or to take out a home improvement loan. They also make it less expensive for businesses to finance expansion with a loan. Higher interest rates are supposed to decrease economic activity, because of the opposite impact.
Ludlum (2009) reviewed the minutes of the Federal Reserve Open Market Committee (FOMC). The FOMC noticed rising energy and food prices as early as December 9, 2003. It wasn’t until June 2004, though, that the FOMC first raised interest rates, in an attempt to “damp down” demand for oil. The committee’s view (not stated in the minutes, but implied by rising interest rates) was that the rapid expansion of the US economy was leading to rising oil and food prices. The expectation was that raising interest rates would damp down US demand for oil, and bring inflationary pressures affecting oil prices under control. The FOMC continued to raise interest rates by 0.25% at each of its meetings (the minutes repeatedly comment about rising energy and food prices), until the target interest rate reached 5.25% in June 2006). The FOMC did not start bringing interest rates down again until September 2007.
If the problem were really rising US demand for oil, this approach might have worked. In fact, the real issue was rising oil demand elsewhere, especially China, India and other Asian countries. China had joined the World Trade Organization in December 2001, and was ramping up its exports starting in 2002 and 2003. It also didn’t help that world oil supply was not rising very quickly, so rising demand led to rising oil prices.
The combination of higher interest rates and rising oil prices provided a “double whammy” to the US economy, helping push the US economy into recession. Europe and Japan also experienced major recession. The parts of the world with rapidly growing oil consumption generally did not experience recession.
The Growing Economy Problem
At least part of the reason for the High-Priced Fuel Syndrome is the fact that with all of the world’s debt, there is a need for growth to continue indefinitely. In a growing economy, it is as if we can always “borrow from the future,” because the future is always bigger and better than the past. We start running into huge problems if this is not true.
- Figure 9. Repaying loans is easy in a growing economy, but much more difficult in a shrinking economy.
Part of the problem is that repaying loans is difficult in a shrinking economy (Figure 9), because less funds are “left over” after loan repayment. If we think of the situation as a government whose revenues start declining, we can understand what the problem is with repaying debt, plus interest on that debt. (Arguably inflation could play a role for a while, but lenders soon would catch on, and require higher interest to compensate for inflation.)
As long as the economy grows each year (and government revenue is higher), it makes sense for the government (and many others) to keep borrowing. But if the economy starts shrinking, we have a serious issue, because the government not only needs to stop borrowing more, but it also has to face the prospect of repaying what it already owes.
The situation is not too different for individual borrowers and for businesses. For individual borrowers, the risk is of being laid off from work, and not being able to find new job. For businesses, it is the risk of fewer buyers for their products, and because of this, less revenue in the future. With less revenue, fixed costs become a larger and larger share of total revenue, making it harder to repay debt.
Thus, in a shrinking (or even a flat) economy, debt defaults become more and more of a problem. Banks find themselves in more and more financial difficulty. This is basically the issue referred to earlier, with respect to high oil prices causing loan defaults.
Paying for Social Security and Medicare benefits is another area where growth makes a big difference. If an economy is growing, there is always a growing population of young workers to pay for benefits to the elderly. If the number of workers shrinks relative to the retired population because of high unemployment or few children, funding becomes a problem. This is yet another area where we have been counting on growth to continue indefinitely, to keep the model functioning as planned.
Recent Government Cover Up of High-Priced Fuel Syndrome
We noted above that the Federal Reserve raised interest rates in the 2004 to 2006 period, in an apparent attempt to damp down oil demand. Starting in September 2007, the FOMC took the opposite tack. Instead of raising interest rates, they brought them down, bringing them as close to zero as they could by late 2008. See Figure 7, above. The intent of this move was to stimulate the economy, by making borrowing less expensive.
Then the Federal Reserve decided to go further, and take up what it called Quantitative Easing, which is what other people call “printing money”—buying the government’s own debt, and some related debt. Target interest rates affected only short-term debt. Through the use of Quantitative Easing, it hoped to lower longer-term interest rates, as well, and thus provide even more of the low-interest rate benefit to potential borrowers. The United Kingdom and the Eurozone are taking a somewhat similar approach.
A major reason for Quantitative Easing (besides the stated business reasons for decreasing interest rates) seems to be lowering the amount of interest payments that the government itself would need to pay. This would help reduce the big gap between governmental outgo and income (Figure 4, above).
A second reason for Quantitative Easing is that it was a way of enabling the huge amount of deficit spending taking place. Without Quantitative Easing, the government would have had to go, “hat in hand”, to the world market, asking for additional loans. There might be a possibility of not all of the loans being sold, or of higher interest rates being required. By buying back a large share of the US’s own debt, it was able to make certain that interest rates would stay low, and that there would be an adequate market for the debt.
Impacts of Government Cover-up
One problem with artificially low interest rates is that the interest rates, in effect, steal from one segment of society, and use it to subsidize a different segment of the economy. The segment of the economy that is “stolen from” consists of pension plans, and people who would otherwise be saving their money, perhaps for retirement, and would benefit from interest income. Part of the reason that pension plans are having so much difficulty with funding now is because of artificially low interest rates. Pensions plans will need to be bailed out, or contributions will need to be much higher, if the system continues with artificially low interest rates.
Another even more major problem is that without a return to growth, there is no nice way to end the low interest rate/Quantitative Easing policy. One possibility is that at some point, the dollar will drop relative to other currencies, and the price of imported oil will become even higher. This will make the situation worse.
Somehow the situation must be resolved. One possibility is that the government will greatly reduce benefits and raise taxes, so as to balance its budget. Alternatively, there could be a major governmental change, perhaps leading to a totally new governmental structure and different currencies. It is possible that there will be hyperinflation, or some type of break in international trade. Countries may trade more with trusted partners, or may require collateral for trade.
Impact of High-Priced Fuel Syndrome on Exporters
This post has mostly been about the impact of High-Price Fuel Syndrome on energy importers, such as the United States, Europe, and Japan. The situation isn’t quite as bad for energy exporters, but they are not completely spared.
Energy exporters are usually in a better position financially than importers, because they collect funds from the oil or other type of high priced energy they sell. These funds can be used to fund government programs. If the energy exporter is fortunate to still have some “cheap to extract” oil left, the energy exporter can perhaps subsidize oil prices for its own people. This approach works much better when population is relatively small, such as Saudi Arabia, than when population is large, such as Russia, because with subsidy, internal use tends to rise, and exports decline.
Even when a country is an energy exporter, high oil prices or other high energy prices can be a problem. One issue is that those who benefit from high oil prices (oil companies, oil workers, local economies, governments that tax oil production) are not the same as the economy in general. For example, if oil prices are high, the major producing areas, such as Alberta, Canada can benefit, even as the rest of Canada behaves much like an oil importer, with job losses.
Another issue is the one illustrated in Figure 3, that of food prices tending to rise as oil prices rise. The Middle East is an oil exporter, but a food importer. If food prices rise at the same time as oil prices, the government finds it necessary to cushion this cost increase for the poor. To do this, they must raise food subsidies, or increase the level of payments to those who are unemployed. Making these changes quickly is not necessarily easy. There is considerable evidence that the 2011 “Arab Spring” uprisings were related to high food prices (Lagi, 2011).
So even for oil exporters, high oil prices may lead to problems.
In summary, we are running short of cheap energy, especially cheap oil. High priced oil (or high priced energy of any type) tends to slow down the economy, leading to economic contraction. Our financial system is not made for contraction. Ben Bernanke and others have used artificially low interest rates and Quantitative Easing to try to cover up our current problems, but this is not a long-term solution. At some point, the underlying problems will become evident, and some type of discontinuity will take place. The economic situation will change from one of growth to decline.
Our system of benefits and taxes to pay for those benefits is based on the cost structure that was possible with cheap energy, and the growth that was possible with cheap energy. Very major changes will be needed, if government outgo is to made to match income. Basic programs such as unemployment, Medicare, and Social Security will either have to be reduced, or taxes raised substantially. Maintenance of huge amounts of infrastructure (such as roads, water and sewer pipelines, electricity transmission lines, and schools) can be expected to be increasingly expensive as well.
It is not clear exactly how the current situation will play out, but a return to cheap energy and robust economic growth seems very unlikely. A more likely outcome is a serious discontinuity, with affected countries much poorer afterward.
Bernanke, B. S., The Subprime Mortgage Market, Speech at the Federal Reserve Bank of Chicago’s 43rd Annual Conference on Bank Structure and Competition, May 17, 2007. Available at http://www.federalreserve.gov/newsevents/speech/bernanke20070517a.htm
Hamilton JH. Causes and consequences of the oil shock of 2007-08. Brook-
ings Papers on Economic Activity:215e61. Accessible at http://www.brookings.edu/~/media/Files/Programs/ES/BPEA/2009_spring_bpea_papers/2009a_bpea_hamilton.pdf; Spring 2009.
Lagi M., Bertrand, K., and Bar-Yam, Y. The Food Crises and Political Instability in North Africa and the Middle East, Complex Systems Institute, 2012 Available at http://arxiv.org/pdf/1108.2455v1.pdf
Ludlum, S. Further Evidence of the Influence of Energy on the US Economy – Part 2, The Oil Drum, April 23, 2009. Available at http://www.theoildrum.com/node/5326
Tverberg, G. Oil Supply Limits and the Continuing Financial Crisis, Energy, 2012, 37 (27-34).
Voss S. and Patel, T. Total, Shell Executives Say ‘Easy Oil’ Is Gone (Update 1), Bloomberg, April 5, 2007 Available at http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aH57.uZe.sAI
Off the keyboard of Gail Tverberg
Published on Our Finite World on September 17th, 2011
Discuss this article at the Epicurean Delights Smorgasbord inside the Diner
The number of jobs available to job-seekers has been a problem for quite a long tine now—since 2000 in the United States, and longer than that in Europe. If we look at the percentage of the US population who are employed, it is now back to 1984 or 1985 levels.
I have run into a number of clues about what is happening. In this post, I’d like to discuss what I am seeing. Part of the problem is that high oil costs squeeze the economy, reducing employment. Part of the problem is growing trade with Asia. It is even possible that the Kyoto protocol (which the US did not sign) has something to do with what we are seeing. Let me start by explaining a fairly strange relationship.
A Strange Relationship – A Close Tie Between the Amount of Energy Consumed and the Number of People Employed
Since 1982, the number of people employed in the United States has tended to move in a similar pattern to the amount of energy consumed. When one increases (or decreases), the other tends to increase (or decrease). In numerical terms, R2 = .98.
I have written recently about the close long-term relationship between energy consumption and economic growth. We know that economic growth is tied to job creation, so it stands to reason that energy consumption would be tied to job growth1. But I will have to admit that I was surprised by the closeness of the relationship for the period shown.
This close relationship is concerning, because if it holds in the future, it suggests that it will be very difficult to reduce energy consumption without a lot of unemployment. It also would seem to suggest that a shortage of energy supplies (as reflected by high prices) can lead to unemployment.
Why Rising Energy Cost (Particularly Oil) Leads to Lower Employment and Less Energy Consumption
Suppose oil prices rise2. The critical issue is that consumers’ incomes do not rise at the same time. Consumers’ budgets get squeezed, and they cut back on discretionary spending. For example, they may go out to restaurants less, make fewer long-distance vacation trips, put off buying a new car, or contribute less to their favorite charities. Workers in discretionary sectors of the economy tend to get laid off, as a result. We have come to know this as part of recession.
(The impact of an oil price rise will be worse if other fuel prices, such as natural gas, rise as well. It will be mitigated, if natural gas prices are low, as they are in 2012 in the United States. Europe has much higher natural gas prices than the United States. This is big part of the reason why recessionary impacts are now worse in Europe than the United States.)
In the case of high oil prices and lay-offs, less energy of all types–not just oil–is used. Laid-off workers may move in with relatives, and thus reduce their living expenses. Each laid-off worker would have used oil to get to their job, and this will no longer be required. The jobs experiencing layoffs themselves may have required fuel use of various types, such as heat for buildings, fuel for airplanes, or electricity used in making new cars, and this is reduced as well.
There is also likely to be a link to housing prices. Moving up to a more expensive home is a discretionary expenditure. If people’s incomes are squeezed by high oil prices, and some are being laid off, there will be less demand for homes as well. This lower demand can be expected to reduce housing prices, especially in areas where commuting distances are longest (and thus, oil use for commuting greatest). There are also likely to be layoffs in the construction industry, as there is less demand for new homes and new buildings of all sorts.
As I have mentioned previously, James Hamilton (2011) has shown that 10 out of 11 recessions in the United States since World War II were associated with oil price spikes.
High Energy Costs in One Area Tend to Lead to Substitution to Places Where Energy Costs Are Lower
If there is a possibility of international trade, manufacturing and some types of services will tend to move to areas where costs are lowest. Part of these costs are energy costs. A manufacturer with cheap electricity costs will have an advantage over one with higher electricity costs. As energy costs rise (as they have in recent years), they get to be more important in determining where manufacturing will be done.
Besides direct energy costs, wages are another part of the difference in costs from one part of the world to another. Wages tend to be lower in the warmer areas of the world. In part, this is because energy from the sun provides much of the needed energy for heating homes, so there is less need for supplemental energy. This means that wages do not need to be as high for a comparable standard of living.
If we look at recent world energy consumption, we see rapid growth in energy consumption. This pattern is quite different from the US pattern we saw in Figure 2, which was much flatter.
Figure 4 below shows that there has been a striking difference in how energy consumption has grown in various parts of the world.
Energy consumption has been quite flat in the grouping of industrialized countries I show first (European Union-27, USA, and Japan). The Former Soviet Union (FSU) collapsed in 1991, and the consumption for those countries has never recovered. Energy consumption for the “Rest of the World” has been increasing amazingly rapidly since 2002. The rest of the world includes China, India, Bangladesh, and many small countries, plus oil exporters, such as Saudi Arabia and Mexico. Although I don’t break it out separately on Figure 4, the increase in energy consumption since 2002 has been especially marked in Asia.
The “bend” in the line for “Rest of the World” energy consumption took place immediately after China joined the World Trade Organization in December 2001. If we look at China’s fuel consumption by itself, we see that its huge rise in energy consumption (Figure 5, below) came mostly from increased coal consumption starting at that time. Oil consumption also increased. Nuclear and renewables are too small to be visible on the chart.
Other countries, especially Asian countries like India, also ramped up their energy consumption at a similar time. India also uses coal as its primary fuel, with 53% of its energy consumption in 2011 coming from coal (based on BP 2012 data).
While I don’t have employment data for Figure 4 groupings, I do have economic growth data (Real GDP is Gross Domestic Product, adjusted to remove effects of inflation), shown in Figure 6, below.
Figure 6 indicates that the economy of the “Rest of World” has been growing much faster than the EU, USA, and Japan grouping since 2001. In fact the Rest of the World’s growth has been much faster for nearly the entire period shown on the graph. Based on the steeper rise in energy consumption of the “Rest of World,” in Figure 4 compared to the old industrialized countries grouping, this might be the predicted result.
One point that many people miss is that the Great Recession of 2007-2009 was to a significant extent a phenomenon of the older industrialized countries. EU, USA, and Japan all were hit very hard, while the “Rest of the World” almost sailed along. This can be seen in the energy consumption data on Figure 4, and the economic growth data on Figure 6. The Rest of the World slowed down a bit, but even during that period, its growth rate exceeded the best growth rate of the EU, USA, and Japan grouping during the 1984-2011 period (based on Figure 6).
Is it Possible to Change the Relationship between Energy Consumption and Number Employed?
The answer is pretty clearly, yes, but lower wages may be part of the mix.
Let’s look at how the United States changed its energy consumption, per number of people employed, over time. If we go back to the 1949 to 1972 time period, we also see a close relationship ( R2 = 99%) between US energy consumption and employment, but it is a different close relationship than since 1982, (shown in Figure 2, near the top of this post).
During the 1949 to 1972 period, energy consumption was consistently rising faster than the number of people employed. Oil was cheap, as were other energy sources, so not too much thought was given to how efficiently it was used. Also, as we will see in Figure 9, wages for workers were rising much more quickly (in inflation-adjusted terms) than they have been in more recent times.
About 1972, we discovered we had a big problem:
Oil had been our largest source of energy, and our own domestic production was dropping quite rapidly. By 1973, the Arabs had discovered our vulnerability, and the 1973 Oil Embargo began, leading to a sharp rise in gasoline prices. The US Federal Government regulated oil prices from 1973 to 1981. At the same time, a major effort was made to switch oil use to another fuel whenever possible. Electricity generation was switched to include more coal and nuclear (based on EIA data), and to remove production using oil. There was great demand for more fuel-efficient cars, leading to the import of cars from Japan (a country that had been making smaller cars for years), and the down-sizing of US cars.
As a result, the period 1972-1982 was a time when energy consumption was relatively flat, but employment rose. A big part of this rise reflected the addition of women who had not previously worked outside of the home to the work force. With the higher price of oil, salaries did not go as far, so having another family member working was helpful. According to Toosi, the percentage of women who were part of the workforce rose from 43.3% in 1970 to 51.1% 1980. Wages of women were lower than those of men (Figure 10, below), helping to hold down the average wage.
Also, the wages of lower-paid men stopped rising in real (inflation-adjusted) terms. (The wages shown are Figure 5 are median wages–50% of wage-earners earn more than that amount and 50% year earn less.) Wages of high-paid workers, such as business executives and physicians (not shown on the chart), were still rising.
It is hard to tell what the relative impacts were of the many changes that took place in the 1972 to 1982 time period. Clearly, lower average wages (with more women in the work force) and flatter wages were a big part of the change. But there were other changes as well, including more imported manufactured goods, changes to fuels other than oil, and more efficient use of oil, all contributing to the differences we see between Figure 2 and Figure 7. The US became a net importer during this period as well, and thus began running up external debt (based on US Bureau of Economic Analysis data).
Comparing energy-employment patterns in Figure 2 and Figure 7 may be confusing for some. I show the change in the relationship in another way in Figure 11. Here I show (energy consumption/number of people employed). It shows that energy consumption per employed person was rising prior to 1972, came down for a variety of reasons in the 1972-1982 period, and is now pretty close to flat (decreasing slightly).
On a positive note, one factor that has helped keep quality of life up is increased efficiency in using energy. Homes are better insulated now. Home heating and cooling units are more efficient. Businesses have worked hard to keep energy use down, because energy is a major factor in their cost structure. For example, we read about airlines retiring their less fuel-efficient jets. Thus, even though energy consumption divided by number of workers is flat or trending slightly downward, our standard of living has risen considerably since 1970 or 1980.
Another thing that has helped improve living standards is the amount of manufactured goods we are now importing from China and other countries around the world, especially Asian countries. The amount of debt we need to keep amassing to buy all of the goods we buy abroad is a problem, however, because we are not earning enough to pay the full amount of these goods. If we could count on economic growth forever, perhaps we could simply “grow” out of this debt, but this seems increasingly unlikely, for reasons I will discuss in later posts.
The United States Hit Peak Percentage Employed in 2000
If we look at the percentage of the US population who have jobs outside the home (or self-employed farm workers), the trend is quite alarming (Figure 12):
While the percentage of people with jobs was rising between 1960 and 2000, in recent years it has dropped. The recent drop seems to be at least in part related to the shift in energy consumption growth (and jobs) to the “Rest of the World,” which includes China, India, and many other developing countries and oil exporting countries. Jobs that the United States would have had, seem to have been shifted elsewhere.
The percentage of US population employed outside the home or farm has grown for a very long time. The increase started in the 1800s, as the use of coal allowed a reduction to the number of workers needed in farming, because it allowed more use of metals, enabled the use of electricity, and helped make farmers more efficient. See my post The Long-Term Tie Between Energy Supply, Population, and the Economy. See also Smil, (1994) and Lebergott (1966). Later, women increasingly joined the work force, especially after World War II.
The combination of rising energy costs (especially oil) and increased international trade gave China and other Far Eastern countries an opportunity to ramp up their manufacturing and service industries (call centers in India, for example). Jobs migrated to China and to other countries with low energy costs (thanks to lots of coal in the mix) and low costs of living, thanks in part to better solar heating.
There had always been some foreign trade, but the amount of trade increased in the late 1970s, when we started importing smaller cars from Japan, as well as more oil. It increased again later, especially after China entered the World Trade Organization in late 2001. US imports of goods and services increased from $54 billion in 1970, to $291 billion in 1980, to $616 billion in 1990, to $1.4 trillion in 2000, and to $2.7 trillion in 2011 (US Bureau of Economic Analysis).
Role of World Trade. Figure 4 suggests that world trade makes a huge difference in the amount of energy consumed. If we truly wanted to reduce our energy consumption (which I doubt world leaders are really interested in), we could reduce world trade through taxes on imports, or some other mechanism. The number of people employed would likely drop as well, although perhaps part of the difference could be made up by greater efficiency and by lower wages for individual workers.
The important role of world trade also brings up another issue. If world trade were, for some reason, interrupted or seriously scaled back, this would likely significantly reduce energy consumption (and employment) around the world.
Energy Consumption vs Number of Jobs Patterns by Country will Vary. I have shown US data. Patterns in other countries are likely to vary, in part because of the different specializations (amount of services compared to manufacturing, for example) of different countries, and different wage levels in different countries.
Good Intentions Aren’t Always Helpful. The Kyoto Protocol with respect to Climate Change was adopted in 1997. Figure 4 and Figure 5 suggest that adding China to the World Trade Organization had far more impact, and in the opposite direction. In fact, additional carbon taxes on goods that require high energy input may have encouraged competition in countries without such controls. Furthermore, reduced oil consumption through, say, higher taxes on gasoline, left more oil on the world market, to be used by developing countries. (This is related to “inelastic supply” of oil. Reducing demand in one area leaves more supply for other areas.)
Figure 13 shows that while Kyoto Protocol may have helped reduce emissions in some countries, world carbon dioxide emissions have grown more than what would have been expected, based on the 1987-1997 trend in emissions. If the Kyoto Protocol influenced China’s and the rest of Asia’s decision to ramp up exports, this decision would have indirectly affected job availability in the United States, even if the US was not a signer of the Protocol.
The “Smaller Batch” Issue. If there is not enough energy to go around at prices people can afford to pay, recession seems to be nature’s way of fixing the situation. I compare the situation to a chemical formula, or to a cake recipe. If one necessary ingredient is in short supply, the economy behaves as if it is making a “smaller batch”. It contracts in a way that leaves out those who were most marginal to begin with–such as employees of discretionary industries, and borrowers who could only barely make payments on loans (subprime borrowers), and countries with the highest energy costs. Employment is reduced, and unemployed people tend to move in with friends or their family, to cut expenses. This reduces energy consumption.
Increased Wage Dispersion May Reflect Another of Nature’s Coping Mechanisms. In the animal kingdom, any “K-selected species,” such as a dog or cats or primates, (probably including humans), has an inborn instinct toward hierarchical behavior. The manifestation of this instinct tends to be greater as there is greater crowding, and greater competition for resources (Dilworth, 2009). The intent in the animal kingdom is survival of the fittest, with those at the bottom of the hierarchy being starved out, if there is not enough to go around.
It is striking to me that since the mid-1970s, we have seen what could perhaps be interpreted as increased hierarchical behavior in humans and corporations. Wage dispersion has tended to become greater since the mid-1970s, when we started encountering energy supply problems. We have also seen the growth of international businesses. These large businesses have been increasingly favorably taxed, because they can choose tax havens around the world to incorporate. All of these changes tend to concentrate wealth at the top, in large companies and in the wealth of high paid workers. Perhaps all of this is a coincidence, but the timing is striking.
Increased use of part-time and contract jobs might be considered a trend in this direction as well. Job sharing has been proposed as a way of dealing with having an inadequate number of jobs in the older industrialized countries, but this tends to act in the same way (pushes the wages of lower-paid workers down, while leaving the top wages untouched).
Economic Models. Economic models seem not to take into account the very substantial shift in percentage of the population employed. Part of economic growth on the “way up” was growth in the percentage of people employed. If economists miss this change, as well as the fact that the percentage now seems to be headed down, their models will be wrong. Expected economic growth may disappear.
The World War II baby boom generation is now reaching retirement age. This change will tend to push the percentage of population employed down further, all other things being equal.
Impact on Governments. If fewer people are employed, this is a problem for governments around the world. Governments in Europe are particularly affected now, partly because of the generous benefits they offer. The US budget deficit is very much related to this issue as well. I will write more about debt and government funding in another post.
 The idea of looking at employment in relationship to the economy after reading Mario Giampietro and Kozo Mayumi’s book, The Biofuel Delusion: The Fallacy of Large-Scale Agro-Biofuel Production, Earthscan, 2009.
 While total energy costs are important, individual energy costs, such as gasoline cost, are important as well, because there is little short-term substitutability across sectors. For example, coal is not an option for running today’s gasoline-powered cars, and public transport is not an option in most of the US. If there is a long enough lead-time and citizens can afford the transition, substitutions might be made, but it is not something we can count very much in the short term.
Hamilton, J. D. Historical oil shocks. NBER working paper No. 16790. Feb 2011. Available from http://www.nber.org/papers/w16790.pdf
Toosi, M. A Century of Change; the US Labor Force 1950 to 2050, in Monthly Labor Review, Bureau of Labor Statistics, May 2002. Available from http://www.bls.gov/opub/mlr/2002/05/art2full.pdf
Smil, Vaclav, Energy in World History, Westview Press, 1994.
Lebergott, S. Labor Force and Employment 1800 to 1960, in Brady, D. S., Editor, Output, Employment and Productivity in the United States after 1800, National Bureau of Economic Research. (1966) Available at http://www.nber.org/chapters/c1567.pdf
Dilworth, C. Too Smart for Our Own Good, Cambridge University Press, 2009.