Cheap oil, complexity and counterintuitive conclusions

It is a staple of oil industry apologists to say that the recent swift decline in the price of oil is indicative of long-term abundance. This kind of logic is leading American car buyers to turn once again to less fuel efficient automobiles–trading efficiency for size essentially–as short-term developments are extrapolated far into the future.

The success of such argumentation depends on a disability in the audience reading it. The audience must have amnesia about the dramatic developments in the oil markets in the last 15 years which saw prices reach all-times highs in 2008 and then after recovering from post-crash lows linger at the highest average daily price ever from 2011 through most of 2014. And, that audience must have myopia about the future. It is an audience whose attention has narrowed to the present which becomes the only reference point for decision-making. History is bunk, and what is, always will be.

The alternative narrative is much more subtle and complex. As I’ve written before, the chief intellectual challenge of our age is that we live in complex systems, but we do not understand complexity. How can cheap oil be a harbinger of future supply problems in the oil market? Here’s where complexity, history and subtle thinking all have to combine at just the right intellectual temperature to reveal the answer.

Cheerleaders for cheap oil only seem to consider the salutary effects of low-priced oil on the broader economy and skip mentioning the deleterious effects of high-priced oil. They seem to ignore the possibility that the previously high price of oil actually caused the economy to slow and thereby dampened demand–which then led to a huge price decline.

If this is the primary driver behind cheaper oil, then cheaper oil in this case is not a sign of abundance, but of lack of affordability for many of the world’s people. It suggests that there is an oil price speed limit now in effect for the world economy above which it cannot grow for long.

If the ultimate significance of high-oil-prices-turned-to-low-oil-prices is a worldwide recession, then we will have a better idea whether such a price speed limit applies. The past does not offer much hope that it’s different this time. Economist James Hamilton has documented that 10 of the last 11 recessions were preceded by a significant rise in oil prices.

This time around we haven’t had a spike in prices, but rather persistently high prices above $100 a barrel for more than three and a half years prior to the oil plunge. This produced a different kind of pressure on the economy, but pressure nevertheless.

The Chinese economy is slowing down. The European economy is stagnant. Russia is or shortly will be in outright recession. Canada is teetering on the edge of recession and it seems Australia might go there, too. Japan continues its stagnant ways despite record monetary stimulus.

Cheap oil in its own way may be presaging, not a period of abundance, but one of austerity. That austerity has already hit the oil industry itself as it undergoes deep cuts in personnel and exploration and development spending.

The big question now is: Can oil be both abundant and cheap in the long run? Or are we living through the first period in history in which oil can only be “abundant” at high prices?

Of course, it’s only abundant if you can afford it. So, demand for oil would likely remain subdued under a high-price scenario suggesting that we’ve burned through the cheap stuff and must find alternative low-cost energy sources or possibly suffer ever worsening recessions until we do. We can only hope that the 2008 crash is not a prelude to even deeper recessions ahead.

This would also suggest that we are perilously close to a ceiling on oil production mediated by a combination of affordability, geology and the limits of technology. The risk is plain, and yet, it is faith that sustains the optimists in a rock-solid belief that the future will be like past–until, of course, it isn’t.

But faith isn’t a good basis for energy policy, even if it seems to have worked in the past. An intellectually honest consideration of all the complexities of our energy situation reveals risks to adequate oil supplies worldwide from here on out that we can only ignore at our peril.

resource insights