Guest post by Gail Tverberg of Our Finite World:
We know the world economic pattern we have been used to in years
past–world population grows, resource usage grows (including energy
resources), and debt increases. The economy grows fast enough that
paying an interest rate a little higher than the inflation rate “works”
for both lenders and borrowers. Borrowers are able to handle the
required interest rate, because their wages are rising fast enough to
buy homes and cars at prevailing interest rates. Unemployment is not too
much of a problem because jobs grow with population and resource usage.
Governments do fairly well, too, because they can tax the growing wages
of the population sufficiently to get enough taxes to pay the benefits
they have promised to constituents.
This model “works” fairly well, as long as the economy is growing
fast enough–population continues to grow and resource extraction
continues to grow as planned. In a finite world, we know that this model
cannot work forever. At some point, we can expect to start reaching
What do these limits look like? I would argue that in the case of resource extraction, these limits look like increasingly high cost of extraction.
We need to extract resources from increasingly deep locations, in
increasingly out-of-the way places, using increasingly more energy
intensive techniques. For a while, improved technology is sufficient to
keep costs down, but eventually the cost of extraction begins to rise.
Some of the rising cost may even be taxes, because the country where the
extraction is located needs higher taxes to keep a growing population
properly fed and housed, so they do not rebel and disrupt production.
When the cost of extraction begins to rise, it is as if we are
pouring more manpower and more resources of many types (steel, fracking
fluid, jet fuel, electricity, diesel fuel) into a deep pit, never to be
used again. When we put more resources in, we get the same amount of
resource out, or even less than in the past. If we want to continue to
increase the amount we extract, we have to further increase the quantity
of resources used in extraction. I have referred to this issue as the Investment Sinkhole problem. Obviously, if we put more manpower and other resources into this pit, we have less for other purposes.
A recent example of resources hitting limits is oil. World oil prices
started increasing about 2004 (Figure 1). Analysts say that these rising prices are related to rapidly increasing production costs. Oil company presidents say that we extracted the cheap to extract oil first, and most of it is now gone. Recent reports of major oil companies say profits are dropping, despite high oil prices.
Oil is an important commodity because it represents about 33% of the
world’s energy supply. It is the world’s primary transportation fuel. It
is a very important fuel in agriculture, operating farm equipment,
transporting fertilizer, running diesel irrigation pumps, making
herbicides and pesticides, and transporting goods to market. Therefore,
if oil prices rise, food prices are likely to rise well. In fact, since
nearly all goods are transported, an oil price rise affects nearly all
goods and quite a few services.
There are really two issues when the cost of oil extraction rises:
1. If the sales price of oil rises, to what extent will this increase adversely affect the economic growth oil importing economies? Rising
oil prices mean that the salaries of workers do not go as far, so they
must cut back on discretionary goods. Profits of companies will also
fall, because it is hard to raise prices of goods, without reducing the
quantity sold. In my view, the run-up in oil prices since 2004 explains
pretty much all of the “Great Recession’s” impact on oil importing
economies. See my article Oil Supply Limits and the Continuing Financial Crisis. In the next section, I show evidence that oil price increases have had a very adverse impact on GDP growth of oil importers.
2. While the cost of oil extraction is expected to continue to rise, can the sales price of oil really increase to match this higher extraction cost? If
oil price can’t rise because of affordability issues (low salary
growth, low growth in debt, or cutbacks in government transfer
payments), then there is likely to be a crisis of a different kind. Oil
exporters will find that oil prices are not high enough to cover their
costs, and will cut back drilling to what is profitable. In fact,
countries that are producing oil mostly for themselves, such as the US,
are also likely to see their oil production drop, because prices will
not be high enough to justify new investment. In such a situation, both
oil importers and oil exporters are much worse off, because most of our
systems are dependent on oil, and less oil will be available.
The Federal Reserve now is discussing the possibility of stopping quantitative easing.
If this is done, I expect it will have a very adverse economic effect:
long-term interest rates will rise and asset prices are likely to fall.
If commodity prices fall as well, then we could find ourselves in the
scenario outlined in the preceding paragraph, in which oil prices drop
lower than the cost of production for many producers.
Relationship between Oil Consumption Growth and GDP Growth
If we look at a history of growth in energy consumption and world
economic growth, it is clear that energy growth, and for that matter oil
growth, tend to move together.
In fact, agencies such as the International Energy Agency use
projected GDP growth in estimating future demand for energy products,
including oil. Energy supplies don’t grow quite as rapidly as GDP,
partly because of efficiency gains, and partly because the world economy
is becoming more service oriented. In general, new services don’t
require as much energy as new manufacturing.
Growth in oil usage would also be expected to mirror GDP growth, but
at a slightly lower rate of increase than growth of energy use in
general. This is the case because oil is the most expensive of the major
energy products. Consequently, there is a strong incentive to switch to
cheaper energy products or to increase efficiency.
Effect of High Oil Prices on GDP of Oil Importers
If we look at the data, it is striking how handicapping high oil
prices are to oil-importing countries (Figure 3). Consumption by
countries that have historically been the biggest importers of oil, (US,
EU-27, and Japan) started dropping about same time oil prices were
started to rise.
At least part of the reason for this drop is because oil is an
expensive energy product. With the run-up in prices, goods made using
oil products became increasingly high cost to make and transport. With
these higher costs, goods became less affordable to the country’s own
citizens as well as less competitive in the world marketplace.
During the same period, annual growth in inflation adjusted (“real”)
GDP for the EU, US, and Japan combined dropped significantly below the
rest of the world (Figure 4, below).
In fact, if we look at groupings of countries as shown in Figures 5 –
7, we can see a dose-related response, with countries deriving the
highest percentages of their energy consumption from oil having the
poorest economic results.
Figure 5 shows the percentage of energy consumption coming from oil
in 2004, for several country groupings. (2004 is about the time that the
oil price run-up started.) Figure 5 indicates the PIIGS1 and
Japan had the highest percentage of their energy supply from oil, and
China had the lowest percentage. The US, the EU-27 minus PIIGS, and
India were in between.
We can also look at economic growth for the same groups of countries.
The countries with the lowest proportion of oil use, and thus least
affected by the run-up in oil costs since 2004, have had the greatest
GDP growth in the 2005 to 2011 period. In fact, the GDP growth
percentages for the period 2005-2011 (shown in Figure 6 below) follow
exactly the reverse pattern shown in Figure 4.
In Figure 6, part of the high growth in India and China relates to
increased globalization. Countries around the world compete on wage and
benefit levels as well as on the price of energy. China and India have
lower wages than the developed countries, so could increase their share
of manufacturing for this reason as well. More liberal treatment of
pollution control may also be a factor in their increases.
Not too surprisingly, growth in oil usage follows the pattern of economic growth (Figure 7, below).
It should be noted, too, that for the PIIGS, it is not just one large
country with a high percentage of oil consumption in 2004 that is
dominating the group result in Figure 5. All of the
PIIGS had high oil consumption percentages in 2004: Greece, 62%;
Portugal, 61%; Ireland, 61%; Spain, 52%; Italy, 49%. In fact, the
country with the worst problems (Greece) had the highest oil consumption
percentage in 2004.
I might also mention that economist James Hamilton found that 10 out of 11 United States recessions since World War II were associated with oil price spikes of 25% or more.
What Goes Wrong in the Expected Model, When Oil Prices Remain High?
In the first paragraph of this post, I outlined an expected model of
how the world might operate, if economic growth remains high. Slower
economic growth would be expected, if resource limits start having an
impact on economic growth.
What happens if oil prices remain high? I think the answers is fairly
different for businesses, compared to consumers. Businesses can mostly
shake off the impact of higher oil prices, by cutting back on the amount
produced (and thus cutting the number employed), or by shipping
production to a lower cost part of the world (again cutting back the
number of US workers employed), but workers don’t have the benefit of making changes of these types.
They can drop out of the workforce and apply for government benefits,
but this does not really fix their lack of jobs, and the low growth in
wages for those who do have jobs.
Because wages of workers are still adversely affected, even years
after an oil price rise, and because the cost of goods now reflects the
higher price of oil, consumers continue to find that their budgets are
stretched. Some can afford to purchase a higher-mileage automobile, but
most cannot–their budgets are still stretched, and some have dropped out
of the work-force completely. The government can try to cover up this
situation with artificially low interest rates for homes and cars, and
with higher transfer payments using deficit spending. Unfortunately, the
government programs don’t really fix the underlying problem, namely a
lower percentage of the population with jobs, and wages of those with
jobs not rebounding by much. Because there is no real fix for the
underlying problem, the economy doesn’t really bounce back.
Quantitative Easing, and the Unwinding of Quantitative Easing
One way the government hides our current financial problems is with quantitative easing (QE).
QE lowers longer-term interest rates, such as those that affect the
price of mortgages. QE also lowers the interest rate the government pays
on its own debt, helping to government to have closer to a balanced
budget. The lower interest rates tend to increase stock market prices,
and to raise prices of homes2 and farms, because investors
seek investments that provide better yields than the absurdly low rates
available on bonds. This doesn’t really fix the underlying problem,
The government can also try to induce banks to lend more money out,
but if buyers don’t have high-paying jobs, it becomes increasingly
difficult to actually get the money available for lending into the hands
of potential buyers. Waiting for several years doesn’t really fix the
situation either–the accumulated deficit just gets worse, and the
bubbles blown by QE become larger. None of this fixes the underlying
problem of high oil prices.
If the government tries to back off from QE, we will see longer term
interest rates rise. This will make mortgage rates rise, and cut back on
the number of buyers of homes. Rising interest rates are likely to
bring back the problem of falling home prices, and reduce the number of
new homes built. Car sales may also fall, as interest rates on loans for
new cars rise.
The suddenly higher interest rates are likely to make the stock
market fall, because with higher yields, bonds will become more
attractive investments in comparison to stocks. As interest rates rise,
the value of bonds can be expected to drop as well, because this is the
way bonds are priced–the higher the available interest rate, the lower
the resale price of the bond.
The declining values of stocks and bonds, and for that matter,
houses, is likely to be a problem for citizens, because they will
realize that their savings are worth less. The “wealth effect” will work backwards. People will realize that they are poorer than they were before, and spend less.
The decline in the value of stocks and bonds is likely to be a
problem for banks, pension plans, and insurers–and for that matter, any
kind of institution holding large amounts of stocks and bonds. The exact
impact will depend on the accounting rules for the particular
institution. If market value is used for stocks and bonds, institutions
holding them will show large capital losses, perhaps putting them below
Part of the capital losses may be covered up by special accounting rules, such as allowing bonds to be valued at amortized cost
rather than market value. But there may still be an adverse impact on
capital, possibly putting some institutions below regulatory limits.
Also, if an institution needs to sell a bond or stock that is valued on
its balance sheet for more than it is really worth, it will incur a
The removal of QE will also mean that the interest rates the
government pays on its own debt will rise. This is will push up needed
tax rates, putting further pressure on the consumer.
With lower asset values and higher tax rates, debt defaults are
likely to become more of a problem again. Banks may cut back in lending
as well, especially if their capital ratios fall too low.
The Effect on Oil Prices
values of most investments dropping lower and tax rates rising, my
concern is that the sales price of oil will drop lower, causing a severe
cutback in world oil production. This issue is really one of affordability
of oil. Economists would call this inadequate “demand” for oil. Of
course, people will still need to eat food and need oil for commuting,
but this doesn’t come into economists’ definition of demand–demand is
only how much people can afford, not what they need.
So we really are in a quandary. If oil prices stay high,
recessionary effects can expect to continue for oil importers. In
addition, China, India, and other developing countries are increasingly
becoming oil importers, so they themselves can increasingly expect to be
affected by high oil prices. Furthermore, these same countries find
demand for their manufactured goods is reduced because of economic
problems of the Eurozone, Japan, and possibly the US.
If oil prices drop, they will be too low for oil companies to
make new high-cost investments. A drop in oil production will take
place gradually, as existing wells continue to produce, but new ones are
not added. The impact of this lower oil production may be quite severe.
The collapse of the Former Soviet Union in 1991 seems to have been
caused by too low oil prices, as I showed in How Oil Exporters Reach Financial Collapse. I also talked about the low price issue in Low Oil Prices Lead to Economic Peak Oil.
All countries are likely to be affected by this drop in
production–importers because the lack of availability of oil for import,
and exporters because of the lack of revenue from oil exports.
Even if we sail through our current set of problems,
we can count on meeting them again in a few years, because the cost of
oil extraction can be expected to keep increasing. If oil prices rise
again, oil importers are likely to see a large increase in unemployment,
and a squeeze on profit margins of businesses. Banks may again fail.
Government will face a new round of problems, similar to those in 2008,
or even worse, without having fixed their previous set of problems.
 Acronym for Portugal, Italy, Ireland, Greece, and Spain, the
countries in Europe with the most financial problems in the past few
 Many of the buyers for houses are institutional investors, planning to rent the houses out.