Timing of the peak all-important

Strange new economic phenomena will kick in the moment oil production peaks, turning normal national finance ministry policies on their heads

The reason there is such heated debate over when exactly peak oil is due to arrive is because, at the point of the peak, the fundamental laws of economics governing oil production, consumption, and prices, will flip over to a whole new paradigm. And because oil is very much the key commodity at the root of all economic activity in the modern industrial world, the flip-over of economic laws governing oil will deeply affect, and even potentially flip over, the fundamental economic laws governing all the world’s industrial activity.

Not all economic laws governing oil or global industry will flip over. For example, one economic law that will remain immutable no matter what happens is the one that holds that the amount of global production of any product will always match the amount of global consumption. Price is the mechanism that brings production and consumption into line. If production rises higher than consumption, prices fall, which serves to both discourage more production and encourage more consumption. If consumption rises higher than production, prices rise, discouraging more consumption and encouraging more production.

This is the basic behavior of production, consumption and price of everything in our modern market-oriented economy, including oil.

But here is where things will change after peak oil. Until now, both production and consumption of oil have been free-floating numbers that respond at the same time to the same rises and declines in price. Usually, when prices have gone up, production would rise, and when prices fell, production would fall, thereby insulating consumption from most price swings. Since consumption of oil is a prime determinant of all other economic activity, the relative fluidity of the production side of the equation allowed financial ministries in national economies to ensure consumption of oil, and therefore basic economic activity, remained relatively smooth and growing.

The key difference that the phenomenon of peak oil production brings to the equation is that it caps the upward mobility of the production number, and in fact brings it down by a few percentage points unrelentingly year after year. What peak oil means economically is that the production rate will no longer be a free-floating number that industrial nations can rely on to respond to fluctuations in oil prices.

That means that the rate of consumption will be left alone to do all the moving in response to price signals. The necessary rebalancing of production and consumption rates, once peak oil has arrived, will be entirely up to the consumption side to achieve from then on.

As production will always be falling once peak oil has arrived, consumption must always fall too, to match the movement. The only way consumption will move down is through the market mechanism of price, which goes up as high as required to move consumption down the amount needed to match production.

Since consumption of oil is the key determinant of all other economic activity in the industrial nations, economic activity itself must move down every year.

Since it will be rising prices for oil that will be the mechanism that pushes consumption down, these higher prices will register as inflation in the industrial economies.

Inflation is only offset by rising unemployment through a balancing mechanism similar to that which forces consumption and production into line. According to orthodox practices in every Western finance ministry, inflation requires cuts to money supply, usually achieved nowadays through raised interest rates at national central banks. Higher interest rates, however, have the dubious side effect of reducing economic activity and employment. So just as industrial economies enter recession due to declining consumption of oil, finance ministers, alarmed by inflation (caused mostly by rising oil prices) will enact central bank policies that deepen the recession.

Because production of oil will drop again the following year, consumption will also necessarily drop, and will do so through the mechanism of still higher oil prices. Declining consumption will deepen a recession, and higher oil prices will once again ensure inflation resurfaces, requiring central banks to raise interest rates again, further crimping economic activity and further deepening the recession. Add to the problems the growing number of unemployed no longer involved in consumption of goods due to a lack of paycheques, and there will be yet more economic contraction, more unemployment, and more drains on government resources and a further depletion of government revenues. What all this adds up to is a depression.

How imminent is peak oil? Some authoritative bodies think it has already arrived. The US Army in 2005 produced a report called Energy Trends and Their Implications for US Army Installations. In this report, the US Army appears to be in no doubt about the imminence of peak oil and its implications: “Domestic production of both oil and natural gas are past their peak and world petroleum production is nearing its peak,” it states by way of introduction. “The doubling of oil prices from 2003-2005 is not an anomaly, but a picture of the future.” It goes on, “Once world demand exceeds supply, the price of oil will begin reflecting monopoly and scarcity rent. In fact, we may have already reached that point where demand exceeds supply.”

The result, it predicts, will be devastating. “The impact of excessive, unsustainable energy consumption may undermine the very culture and activities it supports,” the Army report says. And for itself, “To sustain [the Army’s] mission and ensure its capability to project and support the forces, the Army must insulate itself from the economic and logistical energy-related problems coming in the near to mid future.”

Echoing what analysts have been warning about for a few years now, the Army report says, “Once peak oil occurs, then the historic patterns of world oil demand and price cycles will cease.” Even the Army doesn’t want to think too much about what lies in the future: “After the peak is reached, geopolitics and market economics will result in significant price increases above what we have seen to date. Security risks will also rise. To guess where this is all going to take us would be too speculative.” But then it speculates: “Oil wars are certainly not out of the question.”

The severity of the depression will be solely determined by the significance of the role of oil in our economy. Anything we do that increases that role will increase the severity of the depression, and anything we do to decrease the role of oil in our economy will decrease the severity of the depression. We’re lucky though: It is only by happy coincidence that decreasing the role of oil in our economy will also decrease our emissions of greenhouse gases, and serve our legal commitments to Kyoto. As Ricky would say, we can get two birds stoned at once.