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The Peak Oil Crisis: Oil in the Great Recession

Earlier this week the Associated Press grappled with the issue of whether or not the current economic downturn has reached the point that it can be called a depression. After consulting many learned scholars the answer seems to be that it is too early to make such a pronouncement.

According to some, it is going to take three growth-less years during which unemployment will have to climb above 10 percent and the GDP will have to decline by at least 10 percent before the term should come into common use. (During the 1930's unemployment climbed above 25 percent and the economy shrank about 27 percent.) While we have not fulfilled these requirements, some are already suggesting it can be called a "Great Recession."

Last weekend, as a member of a panel on the outlook for energy at a student conference called Power Shift 09 in Washington, I was asked about what happens to peak oil in a depression. The implication was that if the global economy gets really, really bad in the next few years and the demand for oil drops so far, so fast, that nobody would notice that much of the investment in new oil production had stopped. If demand falls fast enough, declining world oil production resulting from depletion overtaking new production simply won't be noticed.

As the bad economic news continues to pour in, and the equity markets keep falling through support level after support level, the chances that we are heading into a very serious recession seem to be improving. In recent days, guests on the financial news networks have turned somber. Instead to talking about buying opportunities before the great cyclical rebound, more are speaking of uncharted waters and that we could see the Dow at 4,000 or even 3,000 in the next couple of years.

Across the ocean, OPEC currently seems much less certain that it can control oil markets through production cuts and seems less enthusiastic to implement further cuts. In recent weeks oil prices have stabilized around $40 a barrel and thus far a 3 million barrels a day (b/d) production cut has had little noticeable effect on raising prices in the midst of the economic storm.

The high oil prices last summer and the economic slump this winter have combined to cut U.S. oil consumption by about 1.2 million b/d or 6 percent during 2008. Oil consumption in Japan and Korea has dropped along with their exports, but Beijing continues to talk bravely about 8 percent economic growth in 2009. If this forecast holds true, it implies that China could increase its oil consumption this year, but certainly not as fast as in recent years.

The great unknown is how much effect a major economic contraction will have on oil consumption. Industrial consumption of oil will drop as economies contract as will discretionary consumption by those who have lost a portion of their former incomes. For other uses such as agriculture, home heating, public safety and utilities, it will be very difficult to make major reductions in consumption in the short run. However, for a world in which oil consumption is deeply engrained in nearly all facets of life, much will be given up before large drops in oil consumption take place.

In addition to the state of the economy, the price of oil obviously will play a major role in determining the level of consumption. Currently prices are relatively cheap, but should OPEC production cuts succeed in pushing prices back towards $100 a barrel, economically weakened consumers will have little choice but to take abnormal measures to reduce their consumption.

Currently world oil consumption is only down by a few million b/d from the all-time high levels of 2007-8. If this level of consumption holds, then the current OPEC production cuts of 3-4 million b/d seem to be on track to reduce stockpiles and force prices higher. The other side of the coin, however, is that the global economic situation is deteriorating far faster than most expected. It is possible that world oil consumption could quickly fall from a high of 86 million b/d in 2007 to 80 or even 70 million b/d simply because consumers can no longer afford and industries no longer need oil products in such volume.

In this situation, a new set of forces would come into play. While OPEC seems to be able to cut oil production by 3 or 4 million b/d, deliberately cutting production by 10 or 15 million b/d seems out of the question. The economies of the exporting nations that are already in financial trouble would simply collapse if oil exports were reduced by 50 percent. The consequences would be political turmoil and likely changes of government. The over-supply of oil would force prices lower. Analysts are already predicting that if oil goes to $20 a barrel there will be widespread reductions in oil production around the world as many fields can no longer produce oil this cheaply.

In a deep depression, supply constraints would no longer be a problem. If annual world oil production were reduced from the current 30 billion barrels per year to 25 or less, geological, and "above ground" constraints on production would likely be delayed for many years. Those individuals and institutions who could still afford oil would likely have available all they can use and probably at moderate prices.

What the global economy would look like under this scenario is another thing altogether. It would obviously be bad, very bad, but the details of the suffering are simply unknowable - there are too many variables.
It appears there are least two possible scenarios that could play out in the months ahead. Either demand holds up to a level at which OPEC can control the situation and we have higher prices, or the Great Recession causes demand for oil to simply melt due to lack of economic activity and declining incomes.

What do you think? Leave a comment below.

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