Guest post by Gail Tverberg of Our Finite World
The two big stories of our day are
(1) Our economic problems: The inability of economies to grow
as rapidly as they would like, add as many jobs as they would like, and
raise the standards of living of citizens as much as they would like.
Associated with this slow economic growth is a continued need for
ultra-low interest rates to keep economies of the developed world from
slipping back into recession.
(2) Our oil related-problems: One part of the story relates to
too little, so-called “peak oil,” and the need for substitutes for oil.
Another part of the story relates to too much carbon released by
burning fossil fuels, including oil, leading to climate change.
While the press treats these issues as separate stories, they are in
fact very closely connected, related to the fact that we are reaching
limits in many different directions simultaneously. The economy is the
coordinating system that ties together all available resources, as well
as the users of these resources. It does this almost magically, by
figuring out what prices are needed to keep the system in balance—how
much materials of which types are needed, given what consumers can
afford to pay.
The catch is that the economic system is not infinitely flexible. It
needs to grow, to have enough funds to (sort of) pay back debt with
interest and to make good on all the promises that have been made, such
as Social Security.
Energy use is very closely tied to economic growth. When energy
consumption becomes slow-growing (or high-priced—which is closely tied
to slow-growing), it pulls back on economic growth. Job growth becomes
more difficult, and governments find it difficult to get enough funding
through tax revenue. This is the situation we have been experiencing for
the last several years.
We might think that governments would be aware of these issues and
would alert their populations to them. But governments either don’t
understand these issues, or only partially understand them and are
frightened by the prospect of what is happening. The purpose of my
writing is to try to explain what is happening in terms that people who
are used to reading the Wall Street Journal or Financial Times can understand.
I am not an economist, so I can’t speak to the question of what
economists are saying. I do know that what economists say tends to
change from time to time and from researcher to researcher. For example,
in 2004, the International Energy Agency prepared an analysis with the
collaboration of the OECD Economics Department and with the assistance
of the International Monetary Fund Research Department (Full Report, Summary only).
That report said, “. . . a sustained $10 per barrel increase in oil
prices from $25 to $35 would result in the OECD as a whole losing 0.4%
of GDP in the first and second year of higher prices. Inflation would
rise by half a percentage point and unemployment would also increase.”
This finding is consistent with the issues I am concerned about, but I
expect that not all economists would agree with it. Oil prices are now
around $100 per barrel, not $35 per barrel.
The Tie of Oil and Other Forms of Energy to the Economy
Oil and other forms of energy are used to power the economy.
Historically, rises and falls in the use of oil and other types of
energy have tended to parallel GDP growth (Figure 1).
There is disagreement as to which is cause and which is effect—does
GDP growth lead to more oil and energy demand, or does the availability
of cheap oil and other types of energy power the economy? In my view,
the causality goes both ways. Oil and other types of energy are needed
for economic growth. But if people cannot afford oil or other types of
energy products, typically because they don’t have jobs, then energy use
will drop. And if oil prices drop too low, we will be in real trouble
because oil production will stop.
How Oil Limits Work
People tend to think of limits as working in the same manner as
having a box with a dozen eggs. Once the last egg is gone, we are out of
luck. Or a creek dries up from lack of rainfall. The water is no longer
available, so we have lost our water source.
With the benefit of the economy, though, limits are more complicated
than this. If we live in today’s economy, we can purchase another box of
eggs if we run short of eggs, assuming markets provide eggs at a price
we can afford. If the creek runs dry, we can figure out a different
approach to getting water, such as buying bottled water or hiring a
tanker to get water from a source at a distance and bringing it to where
it is needed.
Oil limits are a kind of limit we often hear concerns about. Being
able to drill oil wells at all and refine the oil into products of many
kinds requires a complex economy, one that can educate engineers working
in oil extraction and can build paved roads, pipelines, and refineries.
The economy needs to be able to produce high tech equipment using raw
materials from around the world. Thus, there must be an operating
financial system that allows buyers at one end of the globe to purchase
materials from the other end of the globe, and sellers to have the
confidence that they will be paid for contracted products.
If a company wants to extract oil, it can almost always figure out
places where this theoretically can be done. If a company can gather
together all of the things it needs—trained workers; enough high tech
extraction equipment of the right type; enough pollution-fighting
equipment, to prevent oil spills and spills of radioactive water; and
leases on land where drilling is to done, then, in theory, oil can be
In fact, the big issue is whether the extraction can be done in a
sufficiently cost-effective manner that the whole economic system can be
supported. Even if the cost of extraction “looks” fairly cheap, such as
in Iraq, or in some of the older installations elsewhere in the Middle
East, the vast majority of the revenue that is generated from oil
extraction (often as much as 90%) goes to support the government of the
country where the oil is extracted (Rogers, 2014).
This revenue is needed for many purposes: desalination plants to
provide water for the people; food subsidies, especially when oil prices
are high because food prices will tend to be high as well; new ports
and other infrastructure; and revenue to provide jobs and programs to
pacify the people so that the government will not be overtaken by
A major issue at this point is the fact that most of the
easy-to-extract oil is already under development, so companies that want
to develop new projects need to move on to locations that are more
difficult and expensive to extract (Bloomberg, 2007).
According to oil industry consultant Steven Kopits, the cost of one
major category of oil production expenses increased by an average of
10.9% per year between 1999 and 2013. In the period between 1985 and
1999, these same expenses increased by 0.9% per year (Kopits, 2014) (Tverberg, 2014).
When production costs are higher, someone loses out. It is as if the
economy is becoming less and less efficient. It takes more people, more
energy products, and more equipment to produce the same amount of oil.
This leaves fewer people and less energy products to produce the goods
and services that people really want, putting a squeeze on the economy.
The economy tends to grow less quickly because part of the goods and
services available are being channeled into less productive operations.
The situation of the economy becoming less and less efficient at producing oil is called diminishing returns.
A similar problem exists with fresh water in many parts of the world.
We can extract more fresh water, but it takes deeper wells. Or we have
to ship in water from a distance, using a pipeline or trucks. Or we need
to use desalination. Water is still available but at a higher
Diminishing Returns is Like a Treadmill that Runs Faster and Faster
There are many ways we can reach diminishing returns. One
easy-to-illustrate example relates to mining metals. We usually extract
the cheapest-to-extract ores first. An important cost consideration is
how much waste material is mixed in with the metal we really want–this
determines the ore “grade.” As we are gradually forced to move from
high-grade ores to lower-grade ores, the amount of waste material grows
slowly at first, then dramatically increases (Figure 2).
We know that this kind of effect is happening right now. For example, the SRSrocco Report indicates
that between 2005 and 2012, diesel consumption per ounce of refined
gold has doubled from 12.7 gallons per ounce to 25.8 gallons per ounce,
based on the indications of the top five companies. Such a pattern
suggests that if we want to extract more gold, the price of gold will
need to rise.
The economy is affected by all of the types of diminishing returns
that are taking place (oil, fresh water, several kinds of metals, and
others). Even attempting to substitute “renewables” for nuclear and
fossil fuels electricity production acts as a type of diminishing
returns, if such substitution raises the cost of electricity production,
as it seems to in Germany and Spain.
If the total extent of diminishing returns is not very great,
increased efficiency and substitution can act as workarounds. But if the
combined effect becomes too great, diminishing returns acts as a drag
on the economy.
Oil Increases are Already Higher than the Economy Can Comfortably Absorb
For oil, we can estimate the historical impact of increased
efficiency and substitution by looking at the historical relationship
between growth in GDP and growth in oil consumption. Based on the
worldwide data underlying Figure 1, this has averaged 2.0% to 2.4% per
year since 1970, depending on the period studied. Occasional years have
The problem in recent years is that increases in the cost of oil
production have been much higher than 2% to 3%. As mentioned previously,
a major portion of oil extraction costs seem to be increasing at 10.9%
per year. To make this comparable to inflation adjusted GDP increases,
the 10.9% increase needs to be adjusted (1) to take out the portion
related to “overall inflation” and (2) to adjust for likely lower
inflation on the portion of oil production costs not included in Kopits’
calculation. Even if this is done, total oil extraction costs are
probably still increasing by about 5% or 6% per year—higher than we have
historically been able to make up.
According to Kopits, we are already reaching a point where oil limits are constraining OECD GDP growth by 1% to 2% per year (Kopits, 2014) (Tverberg, 2014). Efficiency gains aren’t happening fast enough to allow GDP to grow at the desired rate.
A major concern is that the treadmill of rising costs will speed up
further in the future. If it is hard to keep up now, it will be even
harder in the future. Also, the economy “adds together” the adverse
effects of diminishing returns from many different sources—-higher
electricity cost of production, higher metal cost of production, and the
higher cost of oil production. The economy has to increasingly struggle
because wages don’t rise to handle all of these increased costs.
As one might guess, when economies hit diminishing returns on
resources that are important to the economy, the results aren’t very
good. According to Joseph Tainter (1990), many of these economies have collapsed.
Why Haven’t Governments Told Us About these Difficulties?
The story outlined above is not an easy story to understand. It is
possible that governments don’t fully understand today’s problems. It is
easy to focus on one part of the story such as, “Shale oil extraction
is rising in response to higher oil prices,” and miss the important rest
of the story—the economy cannot really withstand high oil (and water
and electricity and metals) prices. The economy tends to contract in
response to a need to use so many resources in increasingly unproductive
ways. We associate this contraction with recession.
We have many researchers looking at these issues. Unfortunately, most
of these researchers are focused on one small portion of the story.
Without understanding the full picture, it is easy to draw invalid
conclusions. For example, it is easy to get the idea that we have more
time for substitution than we really have. Financial systems are
fragile. The world financial system almost failed in 2008, after oil
prices spiked. We are still in very worrisome territory, with many
countries continuing a policy of Quantitative Easing and ultra low
interest rates. We may have only a few months or a year or two left for
substitution, not 40 or 50 years, as some seem to assume.
Of course, if governments do understand the worrisome nature
of our current situation, they may not want to say anything. It could
make the situation worse, if citizens start a “run on the banks.”
The other side of the issue is that if governments and citizens don’t
understand the full story, they may inadvertently do things that will
make the situation worse. They certainly won’t be looking long and hard
at what collapse might look like in the current context and what can be
done to mitigate its impacts.