Our dependence on oil puts a glass ceiling on economic recovery

November 12, 2012

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Why the oil industry today is like banking was in 2006

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By swisscan

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The era of cheap oil is rapidly coming to an end, ushering in ‘economic peak oil’ – the point at which the cost of incremental supply exceeds the price economies can pay without significantly disrupting economic activity at a given point in time.

In a new report out today we explore the impact of sustained high oil prices on current prospects for economic recovery. We argue that economic prosperity is predicated on the availability of cheap oil. This is not just based on simple correlations. In recent years a number of economists have begun to re-write the very foundations of macroeconomic theory, demonstrating that energy plays the most important role in economic growth. This is supported by warnings in the past year from the IEA, IMF and G7 that high oil prices have likely been constraining economic growth and economic recovery from the recession.

So while figures released by Office of National Statistics in October showed a return to GDP growth in the last quarter, oil price volatility and future sustained high oil prices means that this is likely to be shortlived. Contrary to recent reassurances that the world faces no problem in terms of its continuing dependence on, and use of fossil fuels, especially oil, we are in danger of repeating the catastrophic complacency that characterised the banking sector up until 2006.

Unless nations prepare to break the relationship between fossil fuels and their economy, this will prolong or prevent recovery from the current economic crisis, in effect, placing a glass ceiling on recovery.

Optimistic views on the potential for a new boom in oil production are flawed, and based on generous assumptions relating the to the rate of decline of production from existing oil fields and the potential production capacity of oil fields in Saudi Arabia and Iraq; assessments of the level and duration of flow from new, unconventional sources; and the costs of new production capacity.

This ‘last gasp’ attempt by the oil industry to hold onto the anachronistic oil age is not surprising. For every barrel of oil an oil company sells, it must discover another, otherwise its total reserve would diminish, and with it, the overall share price. When an oil industry analyst asked Lee Raymond, former ExxonMobil CEO what kept him awake at night, Raymond declared ‘reserve replacement’. But the scramble and sheer desperation for ‘reserve replacement’ has led to corruption, human rights violations in oil rich developing nations, environmental damage beyond climate change concerns, and the neglect of what sustained high oil prices from unconventional sources actually mean for the economy.

In the past decade, growth in oil production has plateaued, yet consumption in non-OECD nations continues to grow. No new sources of low-cost supplies are known. Optimism about shale oil and other unconventional sources of oil and gas fails to recognise that the additional supplies represent a higher cost. As oil is priced by the cost of incremental supply and this is a high cost, significant falls in oil prices can only occur if there is a major recession or depression, similar to that seen in the second half of 2008.  Indeed, the IMF has argued that slowing the rate of decrease in oil production can only be achieved by a potential doubling of the price of oil over the next decade.

Although some oil importing countries may be better able to accept higher prices for oil. In mature high-consuming economies like the USA and the UK, oil prices greater than $90 per barrel will have a significant economic impact. However, industrialising economies, such as China, are thought to be able to tolerate prices in the $100–110 per barrel range.

China’s tolerance is higher because the value of oil is higher there. The economic benefit of the first car in a family, for example, is much greater than that of the third. Similarly the productivity gain from the first truck in a commercial fleet is greater than that of the twentieth. Industrialising economies such as China and India, therefore, have a higher marginal productivity from an extra barrel of oil than in more developed economies.

The higher price tolerance of developing economies suggests that by paying above the comfort level of richer nations for oil, they could render those richer economies stagnant.

In short, there is little scope and ability to quickly substitute oil-derived transport fuels. The relatively straightforward substitution of heavy fuel oil and heating oils has already been mostly done while the hard task of substituting transport fuels has barely begun.

The only option to soften the impact of high oil prices that is likely to meet the magnitude of the challenge is a transition to a low-carbon economy, something that the current coalition government is struggling to achieve, and the Conservative Party appear to be divided on.

The real driver of ‘economic peak oil’ is the impact of rising oil prices on liquid fuel for the transport sector. Transport fuels link all elements of the economy. If every linkage costs more due to sustained high oil prices, all costs will increase, the economy will slow, and inflation will rise. Given this, we argue that the current economic crisis is neither an oil crisis nor an energy crisis, but a crisis about the cost and availability of transport fuels – gasoline, diesel, jet kerosene, and ship bunker fuel. These liquid fuels account for up to 80 per cent of all oil usage, and in the USA it is 80–85 per cent. So how can these be substituted?

Switching to electricity for vehicles is not yet economic, and is only really applicable alternative for surface transport. Biofuels are actively promoted, but only really function as ‘fuel extenders’ making orthodox fossil fuels go further. Also there is a zero-sum conflict over whether finite agricultural land should grow crops for food or for fuel. So-called second- and third-generation biofuels offer a partial solution, but are not yet economic. The use of natural gas for transport in places like Pakistan, India, Brazil, Iran, and other emerging economies is becoming widespread. All such transitions, however, take significant time and investment. Meanwhile, transport demand is growing strongly, particularly in Asia, Africa, and South America. There is an existing global fleet of over 930 million vehicles that run on gasoline and diesel.

A transition to a low carbon economy requires political leadership and policy certainty to create a long-term, sufficient and consistent incentive structure for renewable energy. Adaptive responses such as investment into mass public transit systems, more efficient vehicles, demand management and people travelling less due to home working will also all help.  

Our report is a valuable antidote to all those who casually talk of $200 oil without asking themselves what the economic impact will be when every transport linkage in our economies costs significantly more.

Tags: economic recovery, Fossil Fuels, peak oil