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The peak oil crisis: the last spiral?

Events are moving faster and faster. Equity markets and the dollar are dropping. Oil, gas, diesel and commodities are surging as the investment of last resort.

Margin calls are endangering the financial system. Real estate values and markets are falling. Exotic debt obligations are turning worthless by the billions. Central bankers have started the printing presses and are injecting unprecedented billions of “liquidity” into their banking systems in what so far seems to be a futile effort.

One by one, however, talking heads appear on the business channels to assure us that all will be well by the “third quarter” and that this is a lifetime opportunity to buy equities which will never again be a better bargain. In recent days however, some of the tone of optimistic confidence that has obtained for the last eight months has started to darken a bit and some will even confess it might be a little longer before the good times return.

Missing from all this talk is a realistic appreciation of the role of oil in the world’s economy and the role increasing oil prices will play in the coming economic “recovery.” Although oil prices are discussed dozens of times each day, increases are nearly always attributed to a temporary flight of capital from equities into the safety of commodities. Discussions are formulated around the premise that high oil prices may be unpleasant, but are, as yet, a long way from doing real harm to the country. Eight or nine dollar gasoline in Europe is cited as proof that prices can go much higher without disastrous consequences.

For many months now, the U.S. government and allies in Europe have announced plan after plan to head off further economic declines. Some of these have been quite innovative but few observers have been able to discern any appreciable benefits other than a one or two day jump in the equity markets, a short-lived jump in the dollar and an occasional drop in oil prices. This week’s plan called a "Term Securities Lending Facility" will permit the U.S. Federal Reserve to loan banks and other financial institutions up to $200 billion worth of U.S. Treasury Bills using a range of mortgaged-backed securities, some of dubious value, as collateral.

As several major financial institutions appeared to be on the edge of insolvency earlier this week due to margin calls, the new plan is clearly an act of desperation. The hope is that with the government standing ready to accept securities everyone is pretending still have some value, banks will stop hounding financial institutions with margin calls because there is a rich institution ready to take their dubious paper.

For many months, the Federal Reserve has been relying largely on interest rate cuts to prop up the equities markets. With each cut however, the dollar sank, oil prices rose and the prospects for run-away inflation loomed larger. While this week’s plan sent the Dow Jones soaring up 400 points in the hours after it was announced, nothing has really changed. Oil prices ended the day settled at $108 a barrel, a new all-time high. The government’s new-found willingness to accept over-rated paper that some say may be worth as little as 25 cents on the dollar as collateral changes nothing.

So where does oil fit into all this? The most recent reporting shows that world oil production remains flat and Asian consumption continues to increase. The Chinese just announced that their imports during February were up by 18 percent over February 2007. It is not difficult to fathom why we are seeing record gas and diesel prices in mid-March and why they will be still higher by summer.

Unless the Federal Reserve reverses policy and stops making interest rate cuts in an effort to prop up the equity markets, an event which is widely considered to be highly unlikely, the dollar will continue to fall and oil prices will continue to rise. The downward spiral will continue.

What is largely ignored in all the discussion of economic recovery is that world oil production is likely to start its final decline somewhere in the next 36 to 48 months. Once this becomes evident, prices will start moving much, much higher and shortages will develop. In an environment such as this, recovery from a recession will be far more difficult and is likely to be measured in decades rather than months.

The final spiral will not be difficult to recognize when it comes. Equity markets will drop precipitously. Nearly all economic indicators will turn negative. Oil and other commodities will continue to climb. While this phenomenon will start, or has already started, from the U.S. housing situation, it will spread to other OECD countries, and Asia. For a while, perhaps decades, the oil producing and exporting states will fare much better than those dependent on large imports.

There is much heated debate over whether and how soon there will be a “techno-fix” for the decline of oil – wind, wave, and solar power, electric transport and much lower energy consumption. The factors bearing on how the various techno-fixes will play out are so numerous and interdependent that it is impossible to make much of a judgment about when or whether they will come in sufficient quantities to continue with anything resembling current civilization.

The decline in the availability of affordable oil is likely to come in a relatively quick spiral while widely implemented replacements for oil are likely to be measured in decades.

What do you think? Leave a comment below.

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