[emersonbiggins]

"All money goes somewhere."

Simple statement, believable enough, but it absolutely must be WRONG. Right? After all, if the production costs of crude oil are invariably going up as extraction and quality rates are spiraling downward, the money can't simply be "disappearing into the hole," as one would say. Yet, the added costs of extraction, along with the aggravation of the supply/demand constraint, are assumed to commence wreaking havoc on the economy. But why is that? Is the added cost of production and the market premium not also making its way into the larger economy, thereby negating the overall increase in cost? Unless I am to believe that the added cost is going directly into the coffers at XOM, never to be reinvested in capital projects or, indeed, the greater economy, ever again, then why should we worry how much oil (or anything, for that matter) costs? After all, the money is not simply disappearing, right?

Anyways, I'm probably having an out-of-body moment Bernanke moment right now - "inflation's good."

Please, someone apprise me of what can only be considered a fundamental misunderstanding of economics, because that is what I am suffering from right now.

[cube]

$this->bbcode_second_pass_quote('emersonbiggins', '"')All money goes somewhere."
...

[emersonbiggins]

$this->bbcode_second_pass_quote('cube', '
')sorry if my argument sounds disjointed....but have to go now....

[americandream]

$this->bbcode_second_pass_quote('emersonbiggins', '"')All money goes somewhere."

Simple statement, believable enough, but it absolutely must be WRONG. Right? After all, if the production costs of crude oil are invariably going up as extraction and quality rates are spiraling downward, the money can't simply be "disappearing into the hole," as one would say. Yet, the added costs of extraction, along with the aggravation of the supply/demand constraint, are assumed to commence wreaking havoc on the economy. But why is that? Is the added cost of production and the market premium not also making its way into the larger economy, thereby negating the overall increase in cost? Unless I am to believe that the added cost is going directly into the coffers at XOM, never to be reinvested in capital projects or, indeed, the greater economy, ever again, then why should we worry how much oil (or anything, for that matter) costs? After all, the money is not simply disappearing, right?

Anyways, I'm probably having an out-of-body moment Bernanke moment right now - "inflation's good."

Please, someone apprise me of what can only be considered a fundamental misunderstanding of economics, because that is what I am suffering from right now.

[BigTex]

I think there is a zero sum game element to the issue you are raising. If we assume that at any given moment there is a certain amount of "value" to be spent on whatever we want to spend it on, if energy prices are higher, then we have less left over to spend on other things.

This raises the issue of whether the extra money I am putting into Exxon's pocket doesn't just trickle down through the economy in other ways that causes the net effect to be the same. I think this happens only when Exxon realizes a larger profit because of rising energy prices. If Exxon's expenses are rising just as fast as retail prices, then its profit may not be increasing in the way that rising prices might suggest.

But isn't Exxon generating economic benefits by all of their expensive exploration and production, even if their profits are not increasing? Yes, I suppose, but the only beneficiaries would be Exxon's new employees and oil services contractors. If expenses are rising as fast or faster than revenue, then the stockholders are unlikely to see any benefit, and the retail customer is suffering as prices continue to rise.

The situation above is not unlike defense spending during the cold war. Instead of higher prices, there were higher taxes to pay for all of the weapons. Instead of the employees and contractors of Exxon, the winners were the defense contractors. Some would say that this economic activity was good, even though nothing all that useful to society was produced. I don't know, it seems counterintuitive to say that spending money on something you hope to never use is better than spending money on something that you hope to use fully for the common good (infrastructure, education, etc.)

Getting back to rising energy prices and expenses of production, I suppose that from an economic perspective, there SHOULD be an economic benefit to the drilling frenzy we are sure to see in the next few decades, but I think the real determinant of whether there is any point to this particular economic activity will be whether it is able to produce enough oil to meet the requirements of the continued functioning of industrialized economies (at a price that buyers can afford to pay).

I can envision a scenario where Exxon is spending $200 per barrel to extract the oil, but finding that many businesses simply cannot operate at a profit if they have to pay more than $200 per barrel to purchase the oil. This would lead to demand destruction, which would lead to price reduction, and when the price per barrel falls below $200 in my example, Exxon is out of business, and the businesses that couldn't make a profit with oil over $200 per barrel may find that they can't make a profit with oil at $190 per barrel either.

This is when we're really in trouble.

There are probably some holes in my reasoning. Feel free to fill them in.

[Madpaddy]

It's not just that is costs more in pure financial terms to get the oil out of the ground. It cost more in labour and resources.

That extra capital in terms of labour and resources is in fact disappearing into the ground.

[cube]

I'd also like to add that there is a difference between economic activity and economic wealth. For example if my car should break down, costing me $1,000 in repair bills that would be an example of an:
1) economic activity
but certainly not something that adds
2) economic wealth

Wealth is being transfered no doubt and it also adds to the GDP. I lose a $1,000 and the auto repair mechanic gains a $1,000 but this is not a zero sum game. This is a net negative result on the system IMHO....much like how throwing rocks at windows may create construction jobs but that certainly does not benefit society.

Getting back to oil, as commodities become more difficult to extract/produce no doubt there will be a lot of money changing hands. A greater number of engineers and drill crews will be employed to manage more sophisticated equipment. A greater number of steel mills and construction crews will be called upon to devise ever larger drill rigs that can drill deeper.

This extra economic activity may create wealth for a select group of individuals but the overall effect on society is negative.

my 2 cents

[emersonbiggins]

$this->bbcode_second_pass_quote('BigTex', 'I') think there is a zero sum game element to the issue you are raising.

[CrudeAwakening]

DELETED the poorly thought-out ramblings of an addled brain.

[kuidaskassikaeb]

What oil does in economic terms is increase worker productivity, by substituting energy for human labor. Productivity is, as you know, the output of a worker per unit time. Productivity is calculated basically by dividing the sum total of goods by the hours worked. So if you lower productivity, while keeping the total hours the same, you lower the amount of stuff, and workers will get less of it. A business can make money if it pays, on average, the worker less than he produces. So real wages will have to fall. Also there are some things, like aluminum, that simply can’t be made without gobs of energy.


I will repeat my self. Increasing the price of oil or decreasing its supply will make human labor cheaper in comparison to energy from fossil fuel. So human labor will replace some of the energy from fossil fuels. This will lower the output per hour of those workers lowering the amount of stuff for society. Also the typical persons wages will command less energy, which will also suck. The investment used to find more oil will also have to come out of some other use, thus depriving that part of society of that investment.

[CrudeAwakening]

Ok, let me see.. I think the problem stems from a confusion between the stock of money in an economy, and the flow of money within the economy. It is really income, and its distribution, that greases the wheels of the economy, rather than the amount of money per se.

A healthy economy requires money to circulate widely enough to support enough industries and jobs to enable people to exchange the product of their labour for the necessities of life. As prices of goods change, people's spending decisions tend to change, and the flow of money is diverted from one sector of the economy to another.

If gas prices rise and our driving habits don't change, we spend more money on gas and less on other things. We cut back on more frivolous purchases. Advertisers have to work harder to persuade us to part with our money. As our income becomes spent in other sectors of the economy, those sectors deprived of our income suffer loss of earnings, potentially leading to increased unemployment.

Similarly, industries whose cost structure is sensitive to oil prices will suffer if they cannot pass increased costs on their customers, and to the extent that they can pass these higher costs on, inflation results.

So the income redistribution arising from higher oil prices has very real effects on the economy, and all the more if the general price level is affected in the process.

Well, that's my simplistic take on things, anyway.

[Ming]

MadPaddy and cube have already presented the best answer.

Just imagine that the same effort (capital spent) is only able to extract half the amount of oil. That is a direct impoverishment for the aggregate economy.

If you dont think that idea is clear enough, a simplification would be to imagine that:
The same effort extracts the same amount of oil, but then half of it burns in the storage tanks: would that burning be a zero sum for the overall (world) economy?

Another point of view:
Oil is an external input to the world economy (and something extremely useful for mankind), at the moment.
If it disappears, it will be bad for that world economy…
If it only can be produced in limited quantities (and, additionally, those small quantities require a larger proportion of the economic activity of the mankind to extract - an investment that otherwise could be directed to other production activities), that is a serious overall impoverishment…

(Edited to correct the last paragraph.)

[MrBill]

Good, thoughtful answers. Thanks.

Higher commodity prices whether it is energy, base metals or agricultural commodities are a wealth transfer from consumers to producers. That is true. With free trade and no barriers as well as free floating exchange rates and zero capital controls everything would assumedly come back into balance as producers used their export revenues to buy other products from those importers. But life rarely works so smoothly.

The fact is that pegged currencies and import barriers do inhibit trade in goods and services, so they effectively block those self-correcting mechanisms between investment and consumption.

Ironically, in another post there is an example of conspicuous consumption in the form of a $2 million automobile. Actually that is a good thing. The reality is that many oil exporters do not know what to invest their money in. Some have started up sovereign wealth management funds to address the problem of investing so much wealth. That is also good. Otherwise you would have oil producers sitting on idle capital (or funding unsustainable current account deficits elsewhere). That part of the wealth transfer from consumers to producers. At least when they waste their money on conspicuous consumption they are putting that money back into the economy to generate more jobs. One $2 million automobile makes up for a lot of Fords, Chevys and Dodges that those oil sheiks probably do not want in any case.

It is besides the point that they could also choose to do something more constructive with that wealth like fund public institutions and useful infrastructure projects for the benefit of their own people, but that is their choice I suppose (also with long-term consequences).

Also we have to focus on marginal costs versus marginal benefits as well as profits versus costs.

If a barrel of oil costing $70 in our current energy mix (including other sources of energy) generates, say, $700 in economic benefit then the more oil you use the more economic value you create. As the cost of oil rises from $70 as the economic benefit of more expensive oil in your energy mix falls then your marginal benefit decreases.

If you could generate $700 in economic benefit by using half as much $70 oil then that would be an increase in productivity and lead to higher standards of living as that capital saved can be deployed elsewhere in the economy to create jobs. But at some point your marginal cost equals your marginal benefit, as demand outstrips supply, and below that point exploring, drilling, extracting, transporting, refining and distributing petroleum products no longer makes economic sense because it does not generate any extra benefit. At that point, as Ming suggests, you will substitute cheap labor for expensive energy (and living standards will fall).

As for cost versus profits this is key. Yes, it costs more to drill a hole a mile down than one a few hundred feet. That generates only temporary economic benefit in terms of wages and equipment costs. However, if no oil is recovered because it is a dry well then those are sunk costs. They reduce the firms profits and then there is less capital to invest in further projects in a vicious circle. No future wages or subsequent equipment purchases. Obviously the value of the oil recovered has to outweigh its costs otherwise it is pointless and ultimately self-defeating to extract $100 oil that you can only sell for $70 at current market prices.

[emersonbiggins]

Great answers, all, and kudos to MrBill and Ming, among others, for succinct answers to this question. I failed to realize that capital flows account for [distributed] wealth, rather than merely the presence of capital within the greater economy.

[darren]

$this->bbcode_second_pass_quote('emersonbiggins', 'G')reat answers, all, and kudos to MrBill and Ming, among others, for succinct answers to this question. I failed to realize that capital flows account for [distributed] wealth, rather than merely the presence of capital within the greater economy.