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Age of petroleum ends in systemic imbroglio

If you are puzzled by the debate over the future of oil and, like most of us, have no access to primary data to form an independent opinion based on physical facts, there is still help available to see through the fog of information and disinformation. Consider the following:

Conservative estimates published by U.S. Government sources indicate that the world is fast approaching the point where half of its oil endowment will be gone; consumption outpaces new discoveries of conventionally accessible reserves by a wide margin; loud and clear market signals for increased supplies during the past decade remained unanswered; and the current flow of capital into expanding production to levels commensurate with the planet’s economic ambitions is wholly inadequate.

These four seemingly unrelated observations in toto lead to the conclusion that the maximum rate of global oil output cannot be far. If we could complete the graph of historical production with 20 more annual entries, and calculated a 10-year moving average for the century of 1930-2030, a smooth, Hubbert-like curve rising, peaking, and descending without recourse would appear on the screen.

Contrast the apparent, cost-dictated difficulties a sustained increase of oil production faces with forecasts of further growth in the world’s already precarious dependence on this paleo-biological substance, and the picture becomes even clearer: The peak is not a knife edge-like turning point. It is a time zone, a temporal force field. Its effects are felt long before and after it shows up as a statistic. We are already living cheek by jowl with its consequences, but the perplexingly contradictory expert opinion on reserves, tainted with brazen claims of superabundance, and resistance against parting with routine economic and political motivations prevent their recognition.

While it is generally acknowledged that the world economy needs to reconfigure its energy base so as to rely primarily on renewable sources, it is rarely admitted that the requisite process of transition cannot be smooth. Putting it as succinctly as possible, here is the reason why.

There is conflict between economic growth objectives and the structural transformation of the energy base.

Our techno-economic civilization’s dependence on fossil sources is so overwhelming that the expansion of the renewable energy sector is inconceivable without heavy reliance on them. An economist might say that the coefficient of renewable-energy supply elasticity for fossil-fuel demand is a positive number (hopefully less than 1.0).

Even if a solar panel and cell manufacturing plant is able to produce the energy it needs, its total material (metals and minerals), off-plant energy demands involved in warehousing, marketing, transportation (personnel and goods), and administration are built into the economy’s input-output grid. Renewable energy generation is entangled in the flow of inputs into the sectors and the transaction of outputs among them. A drastic change in the scheme implies an epochal development in technology as well as in the ways value added is generated and distributed; that is, income and employment, living standards and socioeconomic institutions are maintained.

John Donne’s “No man is an island . . .” applies to every heroic effort aimed at carving out a local sanctuary of “green energy.”

Fumbling on the margin of transition is possible without transforming the economic structure; which, given the past threescore years’ advances in trade liberalization, has acquired a distinctly transnational character. However, prohibitive obstacles would emerge before the scale and tempo of the process could reach its tipping point.

Transition’s unsolved problems

A "tradeoff" exists between using resources (including energy and material inputs of fossil origin) to feed the growth of material production (industry and agriculture) and to support the economy’s structural transformation.

Hearing this, conventional economics comes out swinging with the old one-two: Economic growth is not confined to such a zero-sum game (resources constantly expand); and the desired transformation has always been envisaged as gradual. Then the knock-out blow: Knowledge, efficiency, and organization have reduced the human economy’s dependence on natural resources.

To show how ineffectual and off target this entire argumentation is, let us begin with the intended “knock-out.” It is true that material resources and energy carriers together account for less than ten percent of the GDP in developed economies, but so does the weight of blood supply in the average human body. Restricting that small percentage in either case spells calamity. Vulgar (un-ecological) economics has turned the economy-natural resource relationship on its head and tries to keep it that way.

The “old one-two” also misses the target for reasons that are at once physical and systemic.

The scale of a primarily renewable-energy-based world economy may be smaller than the one already in existence; a circumstance that long-term official growth targets, certainly justified by the abject poverty of at least one billion people and the legitimate aspiration of billions of others to raise their levels of living to developed country standards, completely ignore.

As the substitution of renewable for nonrenewable (primarily fossil) energy continues, nature exerts resistance at some point; the scale limit begins to bind. Either economic growth or transition must halt. Both alternatives lead to severe disequilibrium. The first because increased pauperization and the apparent irreducibility of income differentials would endanger social peace. Also, since an economic order built on competition among private firms cannot exist without expansion, the free enterprise system would flounder.

The second alternative is equally untenable because the depletion of nonrenewable resources, proceeding along a rising marginal cost curve or, equivalently, along a descending Energy Return on Energy Invested (EROI) schedule, increases production costs across the entire spectrum of activities. Supply curves shift upwards.

The problem that substitution tries avoid -- running out of affordable nonrenewable resources -- becomes more acute as time passes.

The prevalent incentive system, which is naturally aligned with traditional consumer capitalism, rejects a large-scale substitution of nonrenewable resources. It does not jibe with its endless long-term growth perspective and it reflexively repels the requisite transformation in the short run.

This is the mechanism through which the system’s complex defense network unconsciously immunizes “poisonous greening:” When energy prices are low, energy carriers flow into expanding the production of consumer goods. But when as a result of the system’s inability to maintain the abundance of cheap energy, the exchange value of carriers begins to increase faster than the general price level, aggregate demand receives a shock. The resultant threat of recession closes the door on private incentives. The economy’s currently unchangeable dependence on oil seals it.

The obvious requirement for substituting away from oil is that its price should exceed the price of the substitute by a significant margin. However, given the importance of oil in every single cell of the body economic, the price of solar and wind energy, for example, would tend to rise with the barrel.

The incentive that worked (and still works) in substituting consumer and manmade capital goods for one another will not lead to a sustainable energy base.

The currently experienced will-o’-the-wisp reprieve from the oil constraint only reinforces this ever more obvious conclusion. Goldilockean, “not too low and not too high” oil prices neither spur the private sector to green the world’s energy base nor is it more than a strictly temporary phenomenon. It is tied to persistent unemployment in the United States, the world’s largest consumer and importer of crude. Once demand begins to press against supply as a result of “India and China,” the price of oil will go up to disruptive levels once again with or without resumption of U.S. growth.

The micro-foundations of the mixed economy are such that the elasticity of substitution between nonrenewable and renewable energy sources is too low in the desired direction. Even when the price of oil rises above its renewable-source substitutes -- sluggishly for the reasons cited; the global input ratio, “quantity of nonexhaustible substitutes for oil consumed per a given period divided by the quantity of oil consumed during the same period” will not increase to an extent that would be needed to accomplish transition to a significantly more sustainable world economy.

To summarize, the physical constraint facing the global economy invalidates the “expansion of resources” argument, and the one that claims that transition will be accomplished with gradual smoothness falters on the system’s micro-level resistance. There is trouble also with the macro-foundations.

Public authority in the mixed economy is insufficient to clear the logjam.

A petit tour of recent macrohistory in support of this proposition follows.

The Great Depression turned the United States of the 1930s into an experimental laboratory in which democratic institutions and traditions allowed society to seek a new equilibrium between labor and capital and develop modalities appropriate for guiding the growth of mass production and consumption. The resultant “mixed economy” (solidified legally, ideologically, and psychologically by the Employment Act of 1946) was cloned with incredible speed and matter-of-fact naturalness by the rest of the industrialized world immediately after the war.

Based on the principle of multilateralism, the United Nations, with its panoply of chartered organizations, provided the framework of international cooperation. Since supranational institutions remained subordinate to nation states; i.e., they cannot be regarded as a “World Government,” the current global system may best be described as mixed economy/weak multilateralism. (Until the end of the Cold War, it seemed that there were two competing global systems vying for domination. In retrospect, this view is incorrect. During its peak years, the Soviet Bloc represented less than five percent of world trade and, to avoid ruinous isolation á la Kim Jong-il’s North Korea, countries under communist control had to conduct their international relations within the industrial-democracy-dominated UN framework.)

Multilateral institutions -- especially the WTO/GATT, the IMF, and The World Bank -- are the guardians of the world order’s “mixed economy” character.

Only pariah regimes remain outside these agencies, but once inside, they are contractually obligated to abide by the fundamental principle of the mixed economy: Laissez fair, with government’s role restricted to using mainly indirect tools of governance; i.e., fiscal and monetary measures.

The system tolerates state-led industrial policies within limits, particularly when it comes to developing countries. But the pressure against the idea and practice of government support extended to specific economic sectors or industries is relentless. Using its virtually apostolic authority, neoclassical academe has come close to turning the claim that government interference does more harm than good into an edict. It has injected into public policy analysis mathematical models that treat tax and tariff reductions as automatically growth-spurring, job-creating achievements of enlightened societies.

The substantial public role in Asia’s economic progress over the past decades has been smeared and rubbed to innocuousness through definitions and by imparting more clout to econometric work in support than in opposition to the principle that “privatization and liberalization” is the quickest, surest, and least-expensive way to high living standards.

Time relentlessly tests the appropriateness of economic organization for its ability to fulfill social objectives.

No matter how successful the system of mixed economy/weak multilateralism has been in increasing and spreading prosperity over half a century, it is no exception. If it becomes widely recognized that it cannot harmonize the planet’s activities with its physical limitations, it will have to go too. This may indeed be the case.

The curve depicting the marginal social cost of oil production faces an abrupt acclivity, the introduction of substitutes is mired in demanding oil as a complement, and the entire process seems helpless without enlarging the role of the state beyond the mixed economy’s legal-institutional parameters.

This new reality, which differs so profoundly from what postwar generations came to regard as permanent, does not announce itself clearly. But nor is it hidden beyond any hope of grasping it. A little unorthodox eyeballing suffices to show that, given the role that oil now plays in global welfare, the system is out of whack; the stasis built around it has been punctuated. Specifically, one of the mixed economy’s canonical principles, the independence of the market rate of interest from any given industry, no longer applies.

Checking out from “Hotelling”

The “Hotelling Rule,” dating to 1931, retains a considerable influence on the way economists think about nonrenewable resources. It has been stated in many different ways, but the bottom line is simple enough: The market rate of interest (i), characterizing general economic conditions, plays a key role in deciding how fast to draw down reserves.

If owners of a scarce resource expect return on investments they could make in the rest of the economy to exceed the appreciation of their reserves, increasing extraction makes good sense. The appreciation of reserves is measured by dividing next year’s expected “rent” (profits to be obtained exclusively as a result of possessing the scarce resource) -- denoted as λ (t + 1) -- by this year’s “rent,” λ (t ). When λ (t + 1) / λ (t) is smaller than overall return in the economy -- (i +1) -- there will be more of the scarce resource on the market since (1 + i) > λ (t + 1) / λ (t) makes it rational for the owners to step up the liquidation of reserves and invest the proceeds elsewhere in the economy.

When the inequality sign points in the opposite direction, i.e., interest rates are relatively low, the incentive goes into reverse: Scale back and wait until the opportunity cost of sitting on the reserves -- (1 + i) -- rises.

The “Hotelling Rule” proposes that competition among the owners of nonrenewable resources will tend to equate the opportunity cost of production now and production later via the market rate of interest. That is, the condition (1 + i) = λ (t + 1) / λ (t) will pave the optimal path to emptying reservoirs.

To appreciate this theory, it is important to note that economists like to equate high real (inflation adjusted) interest rates with prosperous times. Productive capacity and purchasing power are growing. The world produces and earns more; capital continues to flow into new machinery, equipment, buildings, infrastructure, and intangible productive assets. Growth calculus even equates a summary, symbolic rate of real interest with the “steady state” tempo of global expansion, determined by the combined increase of population and productivity.

Beautiful minds conceived all this, but after the insatiable Leviathan has gone through a trillion barrels of oil and, in close relationship with this devastating throughput, an unsalvageable international monetary-credit system begot astronomic quantities of worthless payment obligations, winds blow differently.

“Peak Oil” renders “Hotelling” obsolete.

Since both theories predict a decline in the rate of oil output over the long run, they seem to be compatible. But this is mere appearance.

The “Hotelling Rule” has practical relevance only if the low and diminishing supply of the nonrenewable resource in question does not constrain economic growth and if strong competition prevails among suppliers. Short of allowing oneself to remain hypnotized be the internal consistency of neoclassic algebra -- along with sound-bites attesting to the titanic lore of markets and man’s unlimited engineering genius -- one can see that these conditions are absent from the contemporary economic scene.

The actual and prospective supply of oil does act as a growth constraint and the past decade has revealed that OPEC can act more in a concerted fashion than previously believed.

The absence of conditions required for the Hotelling Rule has shrunk the mixed economy’s policy space. Keynes, the system’s philosophical sire, considered the rate of interest an “independent variable” in the hands of central banks. But if the state of the economy can worsen as a result of reduced flows of oil, central banks have no choice but to reduce interest rates through increasing the money supply in order to stimulate recovery. There goes the independence of “the independent variable” and the meaningfulness of the real rate of interest as a long-term growth indicator. High real rates are as likely to imply expansion as contraction, good news or bad news.

To repeat, the mixed economy and the global system based on it presume that firm- or industry-level investment decisions do not alter general economic conditions. All particular judgments about investing in real capital (machinery, equipment, etc.) are guided by what the same amount of money would expect to yield if it were invested elsewhere, including the financial sector. That is, economic agents depend on comparative (present value) calculations in which the prevailing or expected market rate of interest is independent from their actions.

Things have become very different in our brave new, post-Hotelling, post-Keynesian world. Decisions made in the boardrooms of OPEC forcefully affect both the global economy’s critical resource and the market rate of interest, nominal and real.

Oil is king but, as Hemingway mused, “how happy are kings?”

Monopoly power means an ability to influence the price. But in the sunset phase of the petroleum age this simple one-step has turned into a roundelay. The price will have an impact on the rate of interest that will loop back to the price. In theory, major oil producing nations could control this interwoven dance, but in practice they cannot. Even if monopoly power can be preserved as oil depletion proceeds, the chain of causalities along the “price-interest rate-price” circle is too uncertain both in terms of time and effect.

Prices set too high could catalyze “post-peak-characteristic” structural transformation in the world’s energy base, devaluing reserves. And while sovereignty over how high the ceiling can go has been reduced, the floor is rising. The inevitable increase in the marginal cost of production tends either to reduce the “rent” (price minus marginal cost) or lead to the error of setting prices cripplingly high.

To recap the same dilemma in an alternative way, if the oil monopoly over-boosts the “rent” it destroys opportunities to invest profitably in the rest of the world. If it wants to feed global prosperity in order to maintain and expand opportunities for investing export revenues, it would hasten the end of the bonanza, reducing the time budget available for transiting to an economic structure no longer dependent on oil export revenues.

In this all-around dangerous Odyssey, the monopoly tries to navigate the whirlpool between the Scylla of overcharging (and harming itself indirectly through damage caused to the global economic environment) and the Charybdis of undercharging (suffering direct harm through forgone revenues). The thickening fog of uncertainty may require modifying the tactic daily, but the overall strategy has constant components. Exhaust nature’s one-time gift as slowly as possible and forestall net oil importers’ momentum toward greening their energy base.

Consequently, the oil monopoly must lull the rest of us into believing that the Earth, in general, and itself, in particular, have enormous riches of untapped reserves -- much more than claimed to be the case by independent (i.e. not oil money supported) expertise.

Such self-regarding course of action is logical and judicious from the monopoly’s standpoint. Yet it defies imagination how widespread, unfounded expectations for affordable long-run oil supplies will not lead to an all-engulfing catharsis, a Wagnerian finale to our reckless materialistic disposition and correspondingly deficient economic and social structures.

The specter of segmented rationality haunts the world just when it needs collective vision more than ever.

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