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Oil Limits and the Economy: One Story, Not Two

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).

Figure 1. Growth in world GDP, compared to growth in world of oil consumption and energy consumption, based on 3 year averages. Data from BP 2013 Statistical Review of World Energy and USDA compilation of World Real GDP.

Figure 1. Growth in world GDP, compared to growth in world of oil consumption and energy consumption, based on 3 year averages. Data from BP 2013 Statistical Review of World Energy and USDA compilation of World Real GDP.

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 extracted.

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 revolt.

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 per-gallon price.

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).

Figure 2. Waste product to produce 100 units of metal

Figure 2. Waste product to produce 100 units of metal

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 exceeded 3%.

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.

Filed under: Book draft, Financial Implications, Introductory Post Tagged: collapse, diminishing returns, oil limits, recession

Gail Tverberg's picture

Thank Gail for the Post!

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Rick Engebretson's picture
Rick Engebretson on Mar 22, 2014

Since I’ve read most of your postings on TEC, I thought it worth mentioning a video “Surviving Progress,” 2011, Canadian Film Board (IIRC). I don’t recall you referencing it, and it seems related to your work.

Thanks again.

Bill Hannahan's picture
Bill Hannahan on Mar 23, 2014

It is not an oil problem, it is an energy and population problem.

We froze the evolution of nuclear power plants 40 years ago; we have yet to build the Model T of nuclear power plants.

Had we frozen the population and evolved simple reliable inexpensive factory mass produced nuclear plants, energy would be abundant and cheap enough to extract carbon from CO2 in the atmosphere and make as much non fossil liquid hydrocarbon fuel as we need at an affordable price, resolving energy and climate change issues.

What is your solution Gail?

Rod Adams's picture
Rod Adams on Mar 23, 2014

@Bill

I’d say you were half right. It is an energy problem. We have an abundant source of materials with such a high energy density that they can enable all of the world’s current and predicted population to live lives with as much access to energy as modern day Americans for hundreds to thousands of years. Amazingly enough, those materials – uranium and thorium – release their incredible energy density without releasing any CO2.

I don’t believe human society will grow to an outrageous size due to that abundance, however. History tells me that population growth slows to mere replacement levels (or even a bit lower) in societies that are industrialized and urbanized with access to plenty of energy. Today, population is only growing rapidly in those places where subsistence farming is common. In subsistence agricultural areas, people have lots of babies because children can become assets rather quickly by putting them to work.

In more modern societies, raising children is an expensive, time consuming endeavor. It’s worthwhile, mind you, but most people chose smaller rather than larger families.

My solution is fission and human ingenuity. 

Gail Tverberg's picture
Gail Tverberg on Mar 23, 2014

Thanks for the suggestion with respect to “Surviving Progress.” I am not a movie watcher, so missed it.

I think that where the film and I differ relates to how much we can do about the situation. The film (as I understand it from the reviews) argues that we can save ourseleves by scaling back.

If our current situation really is the result of a physics related problem, then our ability to voluntarily scale back is very limited. Physics determines that economies with the greatest energy use are the most successful. Also, even if we scale back, there is the issue of finite resources still depleting, even if more slowly. 

Rick Engebretson's picture
Rick Engebretson on Mar 23, 2014

Actually, the movie proceeds and concludes much like you do. Vaclav Smil quite explicitly says he offers no plan. The movie was not preaching anything.

I especially liked the part with a geneticist, David Suzuki, who wondered how economists regarded extinction of butterflies (etc.) as merely an “externality.” I felt my concerns were shared by others. You might, too.

Roger Arnold's picture
Roger Arnold on Mar 24, 2014

The argument about diminishing returns misses two important realities.  One is the nature of typical resource  pyramids.  The total quantity of a resource at a given level of the pyramid increases greatly as the grade of the ore declines.  A lower grade ore may have only a tenth as much of a target resource per ton, but the amount of lower grade ore may be a thousand times greater than the amount of high grade ore.   If it’s feasible to extract the resource from the lower grade ore at all, then the supply is likely to last for a very long time.  

That’s not to say that there won’t be heavy environmental and other costs from tapping high volumes of low grade ores, but those costs won’t automatically wreck the economy.  Even if some of us might wish they would.  

The other reality is the technololgical learning curve.  That’s perhaps a misleading name, since it’s only partly about “learning” per se.  It’s equally about the payoff from capital investment in more productive tools and equipment.  The investment is justified as production levels rise.  The cost of solar panels is a good example.  The technology for the cells used in the most cost-effective solar panels made today is very old.  They’re polycrystaline silicon PV cells.  But the cost of the polysilicon wafers from which they’re made has plunged as a result of high volume production for the solar PV market.  The wafers are being processed and assembled into panels on lines using newer and more productive processes and equipment.  

The learning curve also applies to extraction of resources.  According to data collected by the EIA and summarized in charts published here, the productivity of rigs operating in the various shale plays has increased steadily and dramatically over the last five yearsl  If it was ever true that the price of oil and gas were too low for companies operating in these formations to be making money, that doesn’t appear to be the case any more.

I’m not denying there are limits to growth.  The earth really is a finite world.  Nor am I saying that the limits are so far away that we shouldn’t be worrying about them.  On the contrary, I feel strongly that our blind pursuit of growth has been a disaster, and that we need to pay much more attention to what we are doing to the planet and to each other.  However, I think it’s a mistake to look for the limits to growth in mineral resources or even (unfortunately) in fossil fuels.  

Pinning the need for change on the idea that we’re nearing the end of our rope invites refutation, because it isn’t true.  We’ve got more than enough rope to ruin the planet and hang our children. Take the “diminishing returns” argument, for example, and that nice graph of the volume of “waste” as a function of the grade of ore.  It’s meant to suggest that there’s a “wall” that we’re about to run into, but it’s an easy argument to shoot down.  

The base of the resource pyramid rests on crustal abundance of the elements.  As we start working with “ores” not much richer in a target element than the average crustal abundance, there’s a mode change.  We forget about individual target elements, and focus instead on the whole suite of elements that can be extracted from whatever “ore” is at hand.  The “waste” from extraction of iron is input for the extraction of nickel, magnesium, aluminum, cobalt, or whatever the rock happens to contain.  Since the greatest energy input in the processing of low grade ores is generally in milling it to a powder, the marginal cost of extracting additional elements or compounds that are present is small.

We’re already close to that point.  Some of the largest mining operations in Africa extract uranium, gold, silver, copper, and other elements from ores that would be uneconomical for any single element.  They’re not yet processing “plain rock”, nor going for the lower value elements in what they’re processing, but they’re not far from it.  

I really don’t like the term “limits to growth”.  it suggests well-defined boundaries.  It implies that everything’s OK until we hit the limits, and then it’s not.  It obscures the role of choice, inviting us to ask “how far can we go” when what we should be asking is “how far do we want to go”.  What kind of world do we want to make for ourselves — because one way or the other, we are remaking the world.

We should be focusing not on the limits to growth but on the consequences of growth.  Is the world overpopulated?  If the world you’d like to inhabit is one with abundant wildlife, untouched wilderness, and open range from horizon to horizon, then too bad!  The world has been overpopulated for the past two hundred years.  But if your idea of a proper world for humans is one in which we all live in vast cities supported by industrial farms from horizon to horizon, and the only animals around are either pets, domestic livestoc, or exotic specimens in zoos, then no, the world isn’t overpopulated.  We can probably support twice our current population.  

Is the cost worth it?  What would a further doubling of the human population at the expense of all wild life on the planet actually buy us?  What do we want?

Bill Hannahan's picture
Bill Hannahan on Mar 24, 2014

Rod, I think you are half right as well.

The population issue has two parts, quantity and quality. High quality does not happen by accident; it requires a selection process, either natural or unnatural.

Nature can only be fooled for a very short span of geologic time. At some point in the future your descendents will be subject to a selection process. If you like the natural mechanisms, starvation, disease, predation and exposure, we should stay the course.

Your DNA may give them a better than average chance of surviving, but they will suffer.

Rod Adams's picture
Rod Adams on Mar 24, 2014

@Bill Hannahan

Your comment almost sounds like eugenics.

There is a big difference between the population of a creature like deer and that of the human species. Deer don’t have the ability to make plans for the future or to recognize what is happening around them and adapt before they are forced to do so,

Humans, on the other hand, can each plan, make choices, and adjust before having to wait for what you call “natural mechanisms.” Take a good look at the population trends in areas where there are plenty of resources, low childhood mortality, and plenty of education.

I’m not worried about “overpopulation” because human society has feedback mechanisms that do not require any kind forced selection process. We can each make up our mind and make choices that allow our population to achieve a relatively stable level. We also have the ability and the energy resources required to provide for whatever level seems desirable.

 

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