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PaulS's picture

Economic Recovery Collides with Flat Oil Production

When Economic Recovery Collides with Flat Oil Production
by R Squared Blog

A theme that I commonly discuss in articles and presentations is the problem of economic recovery when oil prices are high. If the market is well-supplied and there is ample excess oil production capacity, oil prices tend to be moderate and stable, and economic growth can proceed without much headwind. However, the world has now had essentially flat oil production for several years in the face of historically high prices. This implies — and I believe it is true — that there are serious supply constraints within the system. I believe that some countries do still possess spare capacity, but that the overall amount isn’t large. I think if there was much excess capacity, we would see countries taking advantage of current oil prices by putting more oil on the market.

In the case of supply constraints, prices will tend to be high (presuming open markets) and any increased demand just puts more pressure on prices. The way modern economies tend to work is that during recessions demand for oil falls, and during recovery demand for oil increases. In a supply-constrained market this will create a strong headwind that makes it difficult for economic recovery. In a nutshell, this describes the situation that I deemed The Long Recession. Or, as I sometimes ask “How do we recover from a recession when oil prices remain at recession-inducing levels?”

Krugman also notes that Peak Oil has essentially arrived:

“And those supplies aren’t keeping pace. Conventional oil production has been flat for four years; in that sense, at least, peak oil has arrived. True, alternative sources, like oil from Canada’s tar sands, have continued to grow. But these alternative sources come at relatively high cost, both monetary and environmental.“

We don’t necessarily need global oil production to peak before we begin to see peak-related problems. Oil production could even grow slightly, but as long as demand remains high the impact will be higher prices and strangled economies. How high might oil prices go? One train of thought is that the world already struggles with oil prices where they are now, and with the world still in recession it will be difficult for oil prices to advance quickly unless rampant speculation is involved. As economic recovery advances, oil prices will rise and put the brakes on the recovery.
There is another train of thought that I should mention, and that is that high oil prices could result in a severe economic depression. In that case, some believe that demand for oil will fall so far that prices will plummet back to the $30 range. If that were to happen, however, I believe demand would once again be stimulated and we would end up back where we are now, which is basically an era of permanently high oil prices — even if we do see some occasional sharp volatility on the downside.

So this is all well and good, you might think, but what to do about it? The best advice I can give to people is to minimize your exposure to significantly higher prices. Think of it like an insurance policy. Is it possible for gasoline to be $10/gallon in 5 years? Of course it is possible, and if not in 5 years then maybe 10 years. So if this is a real possibility, you have to consider what those kinds of gas prices might do to your personal budget. In my own life, I have chosen to minimize the risk by driving a fuel-efficient car and living close to my job. I also have the option to telecommute. Some will also have public transit options. Everyone’s situation will be different, but I believe it is a good idea to have a contingency plan for how you might deal with much higher prices. In fact, with oil and gasoline prices on the rise, that contingency plan can provide some relief for your personal budget today.
On a national and global scale, we have to work on both supply and demand-side issues. I think that consumers making personal choices will most influence the demand side, but it is government policies (or lack thereof) that will more strongly influence the supply side positively or negatively. Some level of biofuel production will help, especially those options that aren’t heavily reliant on oil or fungible fossil fuels. I think that continued expansion of tar sands production and eventual growth of coal-to-liquids (CTL) is inevitable, whether we are happy about the environmental implications or not. I also think we will continue to see growth of compressed natural gas (CNG) vehicles, particularly in fleets.

There will be no silver bullets. It is going to take contributions from many areas to traverse what I believe is going to be a difficult decade ahead; difficult largely because we will be coping with crushing energy prices. At times I think it will feel like we are being strangled, but there are choices that each of us can make to alleviate the economic burden.

R Squared Blog
The one option R Squared has not considered is reduction in demand - either through demand destruction due to high prices of energy, or because of governments action, such as rationing.
Reducing demand to 30-40% of current usage would allow all the energy to be produced by renewables. But 30-40% is a high target. It probably amounts to the equivalent of simultaneous abolition of flights, severe restrictions of private car use, strict localisation of food and thus reduction in freight and some means of rationing of energy for home heating.