When Economic Recovery Collides with Flat Oil Production

A theme that I commonly discuss in articles and presentations is the problem of economic recovery when oil prices are high. If the market is well-supplied and there is ample excess oil production capacity, oil prices tend to be moderate and stable, and economic growth can proceed without much headwind. However, the world has now had essentially flat oil production for several years in the face of historically high prices. This implies — and I believe it is true — that there are serious supply constraints within the system. I believe that some countries do still possess spare capacity, but that the overall amount isn’t large. I think if there was much excess capacity, we would see countries taking advantage of current oil prices by putting more oil on the market.

In the case of supply constraints, prices will tend to be high (presuming open markets) and any increased demand just puts more pressure on prices. The way modern economies tend to work is that during recessions demand for oil falls, and during recovery demand for oil increases. In a supply-constrained market this will create a strong headwind that makes it difficult for economic recovery. In a nutshell, this describes the situation that I deemed The Long Recession. Or, as I sometimes ask “How do we recover from a recession when oil prices remain at recession-inducing levels?”

Of course I am not the only one saying this. A few months after I wrote The Long Recession, CNN did a story that essentially covered the same theme, indicating that high oil prices could “complicate recovery.” More recently, a New York Times editorial by Paul Krugman discusses these issues:

The Finite World

“Well, it still feels like a recession in America. But thanks to growth in developing nations, world industrial production recently passed its previous peak — and, sure enough, commodity prices are surging again.

This doesn’t necessarily mean that speculation played no role in 2007-2008. Nor should we reject the notion that speculation is playing some role in current prices; for example, who is that mystery investor who has bought up much of the world’s copper supply? But the fact that world economic recovery has also brought a recovery in commodity prices strongly suggests that recent price fluctuations mainly reflect fundamental factors.“

Krugman also notes that Peak Oil has essentially arrived:

“And those supplies aren’t keeping pace. Conventional oil production has been flat for four years; in that sense, at least, peak oil has arrived. True, alternative sources, like oil from Canada’s tar sands, have continued to grow. But these alternative sources come at relatively high cost, both monetary and environmental.“

This is the theme I covered in my Peak Lite essays. We don’t necessarily need global oil production to peak before we begin to see peak-related problems. Oil production could even grow slightly, but as long as demand remains high the impact will be higher prices and strangled economies. How high might oil prices go? This is a topic I spend a lot of time considering. One train of thought is that the world already struggles with oil prices where they are now, and with the world still in recession it will be difficult for oil prices to advance quickly unless rampant speculation is involved. As economic recovery advances, oil prices will rise and put the brakes on the recovery.

However, over the long haul I consider the question of what people might actually be willing to pay for oil. During the price-spikes of 2008, I was living in Europe. Europeans were paying the equivalent (because of added taxes) of around $300 a barrel, and yet people continued to drive. So I think oil prices in the U.S. can ultimately rise to a very high level from today’s prices and we will continue to pay. I often ponder the question of how Americans would respond to $10 gasoline. Will we stop driving? No, we will start to reduce consumption where we can, but we will also just have to spend less on other parts of our budget.

There is another train of thought that I should mention, and that is that high oil prices could result in a severe economic depression. In that case, some believe that demand for oil will fall so far that prices will plummet back to the $30 range. If that were to happen, however, I believe demand would once again be stimulated and we would end up back where we are now, which is basically an era of permanently high oil prices — even if we do see some occasional sharp volatility on the downside.

So this is all well and good, you might think, but what to do about it? The best advice I can give to people is to minimize your exposure to significantly higher prices. Think of it like an insurance policy. Is it possible for gasoline to be $10/gallon in 5 years? Of course it is possible, and if not in 5 years then maybe 10 years. So if this is a real possibility, you have to consider what those kinds of gas prices might do to your personal budget. In my own life, I have chosen to minimize the risk by driving a fuel-efficient car and living close to my job. I also have the option to telecommute. Some will also have public transit options. Everyone’s situation will be different, but I believe it is a good idea to have a contingency plan for how you might deal with much higher prices. In fact, with oil and gasoline prices on the rise, that contingency plan can provide some relief for your personal budget today.

Krugman’s editorial noted the need to make changes, while also arguing against the notion of collapse:

“So what are the implications of the recent rise in commodity prices? It is, as I said, a sign that we’re living in a finite world, one in which resource constraints are becoming increasingly binding. This won’t bring an end to economic growth, let alone a descent into Mad Max-style collapse. It will require that we gradually change the way we live, adapting our economy and our lifestyles to the reality of more expensive resources.”

On a national and global scale, we have to work on both supply and demand-side issues. I think that consumers making personal choices will most influence the demand side, but it is government policies (or lack thereof) that will more strongly influence the supply side positively or negatively. Some level of biofuel production will help, especially those options that aren’t heavily reliant on oil or fungible fossil fuels. I think that continued expansion of tar sands production and eventual growth of coal-to-liquids (CTL) is inevitable, whether we are happy about the environmental implications or not. I also think we will continue to see growth of compressed natural gas (CNG) vehicles, particularly in fleets.

There will be no silver bullets. It is going to take contributions from many areas to traverse what I believe is going to be a difficult decade ahead; difficult largely because we will be coping with crushing energy prices. At times I think it will feel like we are being strangled, but there are choices that each of us can make to alleviate the economic burden.

R Squared Blog