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The impact of peak oil: An alternative view

At the ASPO Conference in early October 2007, Robert Hirsch presented his view of the impact of peak oil on the economy and society. While most of his assertions are readily supportable, the historical record is nevertheless perhaps more nuanced and deserves consideration in thinking about future events.


To begin with, there have been to date arguably two peak oil recessions. The first of these, the period of the Iran-Iraq war after 1979, was artificial. Saudi Arabia decided to defend a high oil price with production restrictions, despite the fact that production capacity was largely adequate to meet global needs. As a consequence, oil production fell in a pattern similar to that which we might expect after peak oil. By contrast, the oil shock of 2008 was arguably the first, true global peak oil recession. Unlike the shocks of the 1970’s, there were no supply disruptions. The world simply ran out of spare capacity. While the oil supply did not peak in the accounting sense, for the first time, it was structurally unable to meet growing global demand. These two periods, then, tell us something about the future course of oil shocks resulting from peak oil.

US Oil Consumption: 1970 - 2009

Source: EIA

Reduced Economic Activity

In his presentation, Hirsch quotes a 2007 GAO report as saying “… an imminent peak and sharp decline in oil production could cause a worldwide recession.” This is too kind. Historically, oil shocks-when US oil consumption exceeds 4% of GDP-have always led to recession. There is no reason to use the conditional tense, and no need for an actual supply decline. All that is needed is an oil price shock, that is, a structural mismatch between supply and demand. As a result, for policy purposes, an oil shock can be assumed to lead to recession. And recession is also always associated with increased unemployment. These two findings can be taken as near-certain consequences of oil shocks, whether caused by geological or political factors.

Other effects are less certain, however, and are often associated with policy mistakes. Here are a few:

Inflation

Oil shocks are assumed to lead to inflation, but this is not necessarily the case. Inflation declined after 1979, and we are facing a near deflationary period currently. Therefore, increased oil prices imply increased prices for energy and basic commodities, but absent monetary accommodation, inflation as measured by the CPI is not the automatic outcome. We tend to associate oil shocks with inflation due to the policies of Arthur Burns, Chairman of the Federal Reserve during the 1970’s. Burns attempted to compensate for an external price shock with monetary accommodation to stimulate demand. As the shock was a real one (oil really did become more expensive), a real accommodation was necessary and monetary easing only led to inflation. In 1979, when President Carter appointed Paul Volcker as Fed Chairman to replace the hapless Burns, policy turned to real accommodation, with high interest rates forcing down both inflation and consumption. The result was a compression of oil demand in the US by more than 20% over the following four years, more than twice the drop in consumption during the recent recession. Thus, oil shocks and inflation don’t necessarily go hand in hand.

As an aside, it is an interesting to contemplate whether US monetary policy today will prove beneficial to prevent deflation or a repeat of Burns’ failed policies of the 1970’s. We should know by the end of next year.

The Victims of the Recession

Princeton professor emeritus and peak oil theorist Ken Deffeyes once famously (for those who follow this field) wrote that, when peak oil hits “you can kiss your lifestyle goodbye.” This has proved not quite the case. The recession of 2008 clearly shows that the costs of adjustment are not allocated evenly. About 8 million people lost their jobs-they are clearly carrying the cost of the recession. But for the remaining 90% of the workforce, the downturn has not been so bad. Prices of goods and housing have fallen, and gasoline is no more expensive than it was in 2007. Thus, only some of the population had to kiss its lifestyle goodbye. This is likely to be true in the future as well. However, this does not imply that the broader population will avoid sacrifice entirely, as both government services are likely to be cut and taxes, increased. Service cuts have already been implemented broadly throughout the US, and tax increases would appear in the cards. Still, the greater risk would appear to be increasing levels of structural unemployment rather than a general fall in living standards.

Importantly, adjustment is likely to be episodic, rather than chronic. Oil prices will spike, leading to recessions-but also to an overshoot on consumption, which will tend to fall more than needed to accommodate supply constraints. This in turn will lead to periods of relative calm and consolidation, as we see today.

Unemployment

Recessions, from whatever cause, tend to increase unemployment, and certainly the financial crisis was an important cause of job losses in the current downturn. (Indeed, on paper, the collapse of Lehman Brothers appears to account for 1.5% of the unemployment rate by itself.) Less well understood is the linkage between oil prices and re-employment. In April at the EIA Conference, I asked Larry Summers, then Chairman of the President’s Council of Economic Advisers, at what oil price would US oil consumption fall, and at what price would the economy be materially inhibited from re-employing the jobless. Not only did he not know the answer, he seemed unprepared for the question.

If oil supply growth is less than demand growth, as it appears to be today, then oil prices will rise until the slow-growing economies like the US begin to cede consumption to the fast-growing economies like China. As a result, we can postulate that the US and the OECD countries as a whole are energy-constrained and that, as a result, re-hiring will be more difficult than would be in the presence of cheap and ample energy supplies. Peak oil not only leads to unemployment, it makes re-hiring harder.

Rationing

Oil was de facto rationed in the 1970’s, and the policy was a failure. The major dislocation was not so much the price, as the long lines and uncertainty of filling one’s tank. By contrast, despite high oil prices, oil was not rationed in 2008, and freely available to those who could afford it. So rationing is neither a given nor is it, from an economic perspective, necessary as long as prices can adjust. But will popular pressure demand rationing anyway? It could, even if it represents a policy mistake.

War and Conflict

Oil shocks may make the strong countries weak and create an incentive for dissatisfied nations to challenge the existing system of commercial and diplomatic relations. Among the antagonists could be Russia, Iran and even the United States, as China vacuums up the world’s available oil reserves. War and conflict are not inevitable, but a given constellation of events could bring them on nevertheless, and this is perhaps the greatest risk of peak oil: not a shortage of oil per se, but a related social stress which leads to the rise of political forces which demand the securing of oil reserves through the use of military power.

Substitution and Efficiency

In general, I believe the potential for efficiency gains, fuel substitution and conservation are under-appreciated. Vehicle mileage could easily be increased 50% if consumers were motivated to purchase more efficient vehicles. Natural gas powered cars are also an entirely viable option, if the EPA could be brought to reduce compliance costs and standardize tank types. And many businesses could simply move out to the suburbs to be nearer to managers’ homes. Of course, Hirsch is right: Accommodation will take some time. But it is also true that, should peak oil actually be validated by events, both political decision-makers and industry are likely to move to a war footing, with far more accelerated and aggressive mitigation programs than we see under business-as-usual scenarios.

The Outlook for Prosperity

The world is vastly more prosperous than it was just twenty years ago. Hundreds of millions of people have been lifted from poverty, and the US enjoys a historically unprecedented level of wealth and income overall. Peak oil will represent a challenge, with some potentially difficult periods of adjustment. But not all our prosperity is built on oil. Much of it arises from telecommunications, information technology, medicine, and the know-how of myriad industries. In the worst case, peak oil would knock us back perhaps 10-20 years. But 1990 was not such a bad time to be alive. Indeed, many people across the globe live happy and productive lives on a fraction of our per capita GDP.

We have survived the first peak oil recession, not unscathed but intact. As long as we avoid major policy mistakes and understand the nature of the challenges before us, we can cope with peak oil.

Mr. Kopits heads the New York office of Douglas-Westwood, energy business consultants. The firm assists energy service providers with market research, strategy development and commercial due diligence. The author is solely responsible for the opinions expressed here.

(Note: Commentaries do not necessarily represent the ASPO-USA position.)

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