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Page added on April 15, 2015

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Putting the Real Story of Energy and the Economy Together

Putting the Real Story of Energy and the Economy Together thumbnail

What is the real story of energy and the economy? We hear two predominant energy stories. One is the story economists tell: The economy can grow forever; energy shortages will have no impact on the economy. We can simply substitute other forms of energy, or do without.

Another version of the energy and the economy story is the view of many who believe in the “Peak Oil” theory. According to this view, oil supply can decrease with only a minor impact on the economy. The economy will continue along as before, except with higher prices. These higher prices encourage the production of alternatives, such wind and solar. At this point, it is not just peak oilers who endorse this view, but many others as well.

In my view, the real story of energy and the economy is much less favorable than either of these views. It is a story of oil limits that will make themselves known as financial limits, quite possibly in the near term—perhaps in as little time as a few months or years. Our underlying problem is diminishing returns—it takes more and more effort (hours of workers’ time and quantities of resources), to produce essentially the same goods and services.

We don’t measure our investment results with respect to the quantity of end product produced (barrels of oil produced, liters of fresh water produced, kilos of copper produced, or number of workers provided with sufficient education to work in high tech industries), so we don’t realize that we are becoming increasingly inefficient at producing desired end products. See my post “How increased inefficiency explains falling oil prices.”

Figure 2. The way we would expect the cost of the extraction of energy supplies to rise, as finite supplies deplete.

Wages, viewed in terms of the product produced–oil in this case–can be expected to decrease as well. This change isn’t evident in usual efficiency statistics, because some of the workers are providing new kinds of services, such as fracking services, that weren’t required before.

Figure 3. Wages per worker in units of oil produced, corresponding to amounts shown in Figure 2.

Even investment is becoming increasingly inefficient. It takes more and more investment to extract a given quantity of oil or other energy product. This investment needs to stay in place longer as well. The ultra-low interest rates we have been experiencing reflect the poor returns investments are now making.

The myth exists that prices of all of the scarce goods and services will rise high and higher, as the economy encounters scarcity. The real story, though, is that the inflation-adjusted purchasing power of common workers is falling lower and lower, especially in the United States, Europe, and Japan. Not only can these workers afford to buy less, but they can also afford to borrow less. This means that their ability to purchase expensive goods created from commodities is falling.

At some point, this lack of purchasing power can be expected to affect the financial markets, and the prices of many commodities can be expected to fall. In fact, this already seems to be happening.

The likely impact of such a fall in commodity prices is not good. If low oil prices cannot be “turned around,” they will lead to debt defaults, and these debt defaults are likely to lead to failing financial institutions. Failing financial institutions have the potential to bring down the system, because it becomes very difficult for businesses to continue if they are not supported by a banking system that allows a company to pay its employees. Workers also need the banking system to pay for goods and to save for a “rainy day.”

A big part of what has allowed the economy to grow to the size it is today is increasing debt levels. These rising debt levels play many roles:

  • They make high-priced goods more affordable to consumers.
  • They create greater demand for goods, allowing more end-product goods to be produced.
  • They create more demand for commodities required to make end-product goods, allowing the price of these commodities to rise, so that more businesses have more incentive to create/extract these commodities.

At some point, debt levels stop rising as fast as they have in the past (because of a lack of growth in purchasing power because of diminishing returns in investment), and the whole system tends to fall toward collapse. We seem to have reached this point in the middle of 2014. China was raising its total debt level rapidly up until the early part of 2014, then suddenly moderated its growth in debt level in mid 2014. At about the same time, the US scaled back and eliminated it program of quantitative easing (QE). Oil prices dropped starting in mid-2014, at the time debt levels started moderating. Other commodity prices started falling as early as 2011, indicating likely affordability problems.

We are now in the period when many people still believe everything is going well. Oil prices and other commodity prices are low—what is “not to like”? The answer is that the system in not at all sustainable—profits of oil companies and other commodity businesses are down, just as wages of common workers in developed countries are down in inflation-adjusted terms. Companies are cutting back in investment in oil production. Soon oil production will drop. With lower oil supply, the economy will face huge challenges.

Many people believe that oil prices can bounce back up again, but this really isn’t the case, because of growing inefficiency related to limits we are reaching–the need to use more advanced techniques to produce oil; the need for desalination for water in some places; the need for more pollution control equipment that doesn’t really increase the finished goods and services we are producing but instead makes goods more expensive to produce.

Each worker is, on average, producing less and less of the finished goods we really need. Whether we like it or not, standards of living will have to fall. The amount of debt workers can afford decreases rather than increases. This new reality can be expected to manifest itself in debt defaults and increasing financial system problems.

Even if oil prices bounce back up again, it is doubtful that shale oil drillers will be able to again borrow at a sufficiently high rate to increase their production again—what lender will believe that oil prices will remain high indefinitely?

The China Connection

I have trying to put the real story of energy and the economy over a period of years. Prof. Lianyong Feng of Petroleum University of China, Beijing, hired me to put together a short course (eight sessions, each lasting about 1.5 hours) on the nature of our current problems for students majoring in “Energy Economics and Management.” The course would be open to everyone choosing this major, including freshman, so I needed to assume a fairly low level of background knowledge. Actual attendees included a number of graduate students and faculty, attending the course without credit.

I put together a series of lectures, which I gave during the second half of March 2015. PDFs of my lectures are also now available on my Presentations/Podcasts page.

These lectures were videotaped by Prof. Feng’s staff, and I am in the process of making You Tube Videos from them, in addition to the original MP4 format. (YouTube videos cannot be seen in China.) My current plan is to give a brief discussion of these lectures, in future posts.

Following the lecture series, I visited several places in China, to see how the economic slowdown is playing out in China. This included visits to Northwest China (Hohhot and Hardin), Northeast China (Daqing and Harbin), and Southeast China (Wenzhou area). In Wenzhou, I visited three different companies attempting to sell electrical equipment on the world market.

From these visits, we could see how the world economic slowdown is affecting China, and how China’s own slowdown in debt growth is adding to the world slowdown. We could also see that the slowdown has not yet run its course China–growth in housing continues, even as the need for it seems to be slowing. College students are finding it difficult to find high-paying jobs in oil and other commodity sectors. The lack of growth in high-paying jobs will provide downward pressure on housing prices as well.

I plan to write a post about this situation as well.

Our Finite World



23 Comments on "Putting the Real Story of Energy and the Economy Together"

  1. Plantagenet on Wed, 15th Apr 2015 2:51 pm 

    Gail’s assertion that shale oil drillers will not be able to borrow in the future reminds me of the foolish claim that people who lost money in the 2009 housing bust would not be able to borrow again.

    And yet as we hit the 6 year limit on credit reports, folks who went bust in 2009 are indeed borrowing again and are indeed entering the housing market again.

    Greed is a powerful motivator, and black gold creates one heck of a lot of greed among the oil drillers and the people who loan money to oil drillers.

  2. Davy on Wed, 15th Apr 2015 2:57 pm 

    Planter, you are assuming normal financial markets of the past. That could end at anytime.

  3. eugene on Wed, 15th Apr 2015 3:09 pm 

    One thing I know for sure is thinking I have the answer is reassuring. Living without answers is much harder. In this chaotic mess, anyone who believes they “have” the answer is avoiding reality. But if it makes you feel better, make one up and believe it to your dying day.

  4. Floccina on Wed, 15th Apr 2015 4:00 pm 

    You need another chart: miles at a given level of comfort and prestige per dollar spent of fuel. Vehicles have gotten more efficient.

  5. Nony on Wed, 15th Apr 2015 4:29 pm 

    Gail has repeatedly shown ignorance of the most basic aspects of supply, demand, or corporate finance. You could write a good text just based on what she doesn’t know.

    $$$ will pull out of shale if the returns are not there ($50 oil) and go back when returns are there ($100 oil). nobondy gives a shit if some previous driller went BK. This is a commodity industry. And one with fast return (not deep water wait).

  6. apneaman on Wed, 15th Apr 2015 4:41 pm 

    Nony-marm. you should start your own blog and show Gail how it’s done. There’s a million to one ratio of corns to doomers. You’ll be a star for real in no time….instead of just in your imagination.

  7. J-Gav on Wed, 15th Apr 2015 4:54 pm 

    Davy – I like it when you’re short and to the point. Those “normal financial markets” you refer to are indeed poised to shatter within the next year or two.

    Who other than a self-aggrandizing lunatic would want to be POTUS in these circumstances?

    Looks like it’s time to batten the hatches.

  8. apneaman on Wed, 15th Apr 2015 5:05 pm 

    Davy – I like it when you’re short and to the point too, but I also like your Harry Potter length essays as well. The only thing there missing is an intermission 😉

  9. dave thompson on Wed, 15th Apr 2015 6:14 pm 

    The limits to growth are now apparent.

  10. Plantagenet on Wed, 15th Apr 2015 6:15 pm 

    Daver, you are assuming the end of the world is imminent. Predictions of that sort are heard frequently, but have a very low success rate.

    Cheers!

  11. Dave Thompson on Wed, 15th Apr 2015 7:00 pm 

    Plantagenet,The limits to growth being apparent as they are and have been for some years now, is not a doomer prediction. The wheels of the industrial cart of civilization creak on, with the limits to growth being the laws of physics and mother nature setting the wise ape strait on who runs the show.

  12. Perk Earl on Wed, 15th Apr 2015 7:12 pm 

    Don’t look now, but Brent is back up over $60. and WTI over 55 at 56.06

    Is it on a run to higher prices or just a temporary upward shift?

    http://www.bloomberg.com/energy/

    Crude Oil (WTI) USD/bbl. 56.06 -0.33 -0.59% May 15 19:32:30
    Crude Oil (Brent) USD/bbl. 60.32 +1.89 +3.23% May 15 14:46:05

  13. Davy on Wed, 15th Apr 2015 7:13 pm 

    Yea guys I feel bad sometimes preaching and tossing word salad around in a copious buffet all you can eat salad bar. What I have done is make the paragraphs as small and cute as possible for skimming. I hope that helps. Sorry but I am a prophets of doom.

    Planter did I ever say the end of the world was imminent? No. I have always clarified it as the end of the world as we know it may be over. IOW BAU is on its death rattle. Planter, I guess you don’t believe in change. I bet you never let go of the idea that happiness is never ending. All will be well with technological progress I am sure is what is at the back of your mind.

  14. Cloud9 on Wed, 15th Apr 2015 7:58 pm 

    It looks to me like we are witnessing a momentary convergence of hot money that rushed into oil in a zero interest environment and demand destruction in the overall market. While we can take some solace in the fact that the oil will still be in the ground after the shale oil bubble finishing popping. The owners of that hot money specifically insurance companies and pension funds will not be too stable once their investments are swallowed by this current bubble. I know the Fed can conjure trillions with a mouse click but at some point the final bubble pops taking down the government with it. I don’t know where this is going short term but long term the bell curve of production and economic will plot the outcome.

  15. shortonoil on Thu, 16th Apr 2015 8:34 am 

    Production costs are increasing, and Gail is certainly correct on that issue. Unfortunately, she uses constant 2005 dollars which makes her production cost graph look a lot steeper than it actually is. Between 2015, and 2016 the average cost of production will increase about $14/barrel.

    The real threat is two fold; production costs are increasing, and consumer affordability is declining:

    http://www.thehillsgroup.org/depletion2_022.htm

    The result is a death grip on the petroleum industry, and the highest cost producers will be phased out first: shale, bitumen, ultra deep water, and high sulfur extra heavy. As pressure on producers increases, from the top coming down as the bottom goes up, they will scramble to raise funds in any way possible. We are witnessing this now as Middle Eastern producers are beginning to liquidate their Petro Dollar holdings to raise funds, and US Major step up borrowing to record levels. With $1.7 trillion per year, and increasing now getting ready to leave the world’s financial system to cover productions losses, how long that system can be maintained is the question? This will be real money leaving the system, not CB printed fiat.

    http://www.thehillsgroup.org

  16. Pops on Thu, 16th Apr 2015 9:17 am 

    Oil is priced on the margin, but utility is linear.

    The first 50mmb/d is worth much more than the second.

    The current economy can’t afford 100mmb/d at $100/bbl.

    It could afford, say; <80mmb/d @ >$100/bbl

    Which is convenient since “use less to pay more” is the direction we are headed.

  17. Davy on Thu, 16th Apr 2015 11:02 am 

    Pops, good way to look at it other than I feel the system cannot use much less without a systematic failure. How quick that failure is produced is beyond prediction. There are multiple scenarios but the direction seems clear.

  18. apneaman on Thu, 16th Apr 2015 11:42 am 

    Davy, the system is failing more people everyday. How close are we to complete breakdown? TPTB are so far gone, so disconnected that I sometimes struggle to believe it. You can read about past collapses and shake your head at the sheer stupidity and convince yourself that those people were somehow different or less than us. They lacked some special understanding or technology that we posses. And that’s exactly what they thought about the civilizations that collapsed before them. Can’t happen here. I can picture some citizen in a tavern, in the last year of the western Roman empire, expressing fear of the dire news of corruption, poverty and barbarians being branded as an alarmist. I can clearly imagine one of his drinking buddies mocking him and saying stop worrying “they will think of something”.

    The numbers are staggering: US is ‘world leader’ in child poverty

    “America’s wealth grew by 60 percent in the past six years, by over $30 trillion. In approximately the same time, the number of homeless children has also grown by 60 percent.”

    http://www.rawstory.com/rs/2015/04/the-numbers-are-staggering-us-is-world-leader-in-child-poverty/

  19. Davy on Thu, 16th Apr 2015 12:45 pm 

    Yea, Ape Man, I am know in these parts (PO forum) as Doomer Davy. Even I the doomer have to pinch myself sometimes and remind myself that this normal is not normal. It seems so strange that everything we know and are comfortable with could break down rapidly. A slower collapse will still be profoundly painful. Personally I feel we have been is a slow collapse at least since 08.

    This is a surreal world and it requires focus to remain a doomer in the face of a complete disconnect with reality of the majority of the remainder of the global population. I guess many could give a shit because they are already in collapse mode but even these folks may have hunger in store soon. When all is said and done most likely hunger will be the biggest killer.

  20. apneaman on Thu, 16th Apr 2015 1:21 pm 

    Davy, what do you see and hear in the area you live in? The main skid row in Vancouver has grown enormously in the last 15 years and people I know who do charity work(food bank) say it gets worse every year. In addition, I notice a growing level of apathy, denial and a kind of cruelness towards each other in everyday life. I’m not just referring to internet sparring, but face to face indifference and rudeness in public.

  21. Davy on Thu, 16th Apr 2015 2:11 pm 

    Ape Man, here in the Ozarks people were poor before. Many had a brief spell of some descent opportunities. Growth came late to this backward area. Now it is back to allot of poor people living marginal lives with subsistence living. There is a core group of prosperous people. Then there are rich people who have their farms here. Cattle farmers are doing well lately.

    Now days of course there is the government to help out. I am seeing a divide of those who are too proud to take handouts and those who would rather not work and take handouts. Cost of living is low around here and people have much lower expectations. People are still very friendly and community oriented. Drugs are a problem but have been for years.

  22. Craig Ruchman on Thu, 16th Apr 2015 2:40 pm 

    “Between 2015, and 2016 the average cost of production will increase about $14/barrel.” looks like the game is just about over.

  23. apneaman on Thu, 16th Apr 2015 3:04 pm 

    What could possibly go wrong?

    5 biggest banks now own almost half the industry

    http://www.cnbc.com/id/102589832


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