Peak Oil News: Oil Depletion Economics 101

Sunday, July 30, 2006

Oil Depletion Economics 101

EnergyBulletin.net

By Ronald R. Cooke

The following article has been extracted from my book "Oil, Jihad and Destiny". It looks at the basic economic considerations that must be resolved when we try to analyze oil production, consumption and pricing, or the impact these factors will have on the economy. Please note: the information contained in this article is presented without any warranty. I am publishing it to provide a basis for thoughtful discussion.

Consumption and GDP

When we buy goods and services, we are engaged in an act that will lead to their consumption. We may use (consume) them immediately (as with goods such as gasoline or services such as haircuts, etc.), sometime in the future (as we typically do with canned food, clothing, etc.), or over a long period of time (refrigerators, automobiles, etc.). We use Gross Domestic Product (GDP) as a way of measuring the dollar value of everything an individual nation, a geographic region, or the world is able to produce within a given time frame (a month, a quarter or a year).

As one may suspect, there is a relationship between consumption and GDP. As consumption rises, there is an attendant increase in the demand for goods and services that results in greater production (and hence GDP). Conversely, when consumption declines, so does GDP.

Historically, there has also been a relationship between oil consumption and GDP. In the past, the increase or decrease in GDP (which measures the production of goods and services), tended to drive the demand and consumption of oil. The more goods and services we produced, the more oil we needed in order to produce our goods and services. We used more gasoline to move things and people, we used more oil for the generation of electricity, and we used more oil as a feedstock for the production of goods (plastics, chemicals, cosmetics, drugs, and so on). If on the other hand, the consumption of goods and services declined, then GDP and oil consumption also declined.

In developing the economic impact analysis for the oil crisis scenarios described in my book, estimates of GDP are tied to estimated oil consumption and estimated oil pricing. In so doing, our formulae must account for the fact that the quantity of oil used per unit of GDP has been changing. While the mature economies of the world - like the United States - are becoming more efficient in their use of oil (using less per unit of GDP), emerging economies (such as China) have tended to use more oil per unit of GDP. We also need to include in our formulae the concept that sharp increases in the price of oil will force people to consume less oil (almost immediately because we cannot afford to pay a higher price) and sharp decreases in the price of oil will stimulate greater consumption (although this takes a longer time because lower consumption has usually been associated with recessive economic conditions that take time to improve).

There is another problem. In the past, GDP and oil consumption have tended to move in tandem (more or less - oil consumption tends to be more volatile than GDP). Changes in GDP drove changes in oil consumption. But as we move from a world economy that has enough oil to meet demand, to an economy that must deal with periodic oil shortages, then the reverse will be true.

Oil shortages (or availability), along with the price of oil, will tend to drive the growth or decline of GDP.

In addition, the price of oil will rise until there is a balance between supply and demand. But this relationship will also be more complicated than it has been in the past. There is a high probability that future oil markets will be characterized by arbitrary oil prices. It will take longer for the supply versus demand mechanism to resolve any imbalances. In addition, oil consumption for transportation will evolve from an emphasis on individual vehicles (my car) to mass transportation (including ride sharing), moderating the normal impact that the supply versus demand mechanism would have on pricing.

In determining how changes in oil production (availability) will impact the price of oil, we must also consider whether or not changes in the price of oil are based on a willing buyer and a willing seller in a market that is free to move according to negotiated supply and demand pricing; we must factor in the impact of other inflationary forces; we must include the length of time that these changes take to occur; and we must determine the status of the economy at the time these price changes occur. And finally, the price of oil and GDP tend to have an inverse relationship.

Confused? Just remember. We are moving from a world economy that enjoyed excess oil capacity to a world economy dominated by chronic, severe, and highly volatile shortages. The GDP of all nations will have a volatile response to these shortages.

Rate of Inflation

It's safe to say that increased oil prices will drive up the Rate of Inflation. Although the price of oil tends to be more volatile than the Rate of Inflation, there is a correlation. Rates will be highly volatile as periods of oil shortage alternate with months of surplus. If the price of oil were the only driver of inflation, then inflation would skyrocket. But there are other factors that must enter into our calculation. The combination of higher prices and sporadic shortages will drive an increase in unemployment, restrict consumption and disrupt both the production and distribution of goods and services. Productivity will decrease. Lower interest rates will only marginally help the economy because oil shortages will disrupt the flow and use of money in the economy. These impacts are all deflationary. Thus in our formulae for calculating Inflation, we must offset the inflationary impact of higher oil prices with the recessive impact that oil prices and shortages will have on the economy.

We also have to include the deflationary impact of unemployment on regional demand and GDP. Over the last two decades, over 60 percent of displaced white collar workers found new jobs that paid less than they were making before becoming unemployed. For white or blue collar workers living in the highly developed economies of the industrialized world, either the Political or the Production Crisis discussed in my book will exacerbate this problem. Lower pay means lower oil consumption and a declining GDP.

In the economic impact analysis used for the Best Case, Production and Political scenarios described in my book, the Rate of Inflation has been tied to the rate of change in the world price for oil as well as a calculation of unsatisfied oil demand. It works this way. The demand for a scarce commodity will drive up its price. As the price of oil goes up, changes in consumer spending choices gradually reduce real demand. This in turn reduces the upward price pressure on the commodity. As long as real demand (how much oil we would consume if it were readily available) exceeds actual consumption, the difference is called unsatisfied demand. All three scenarios reflect greater volatility in the Rate of Inflation because we are moving from a world economy that enjoyed excess oil capacity to a world economy dominated by chronic, severe, and highly volatile shortages. This volatility will drive corresponding changes in unsatisfied demand and inflation as consumers adjust to shortages by bidding up the price of oil based products.


Unemployment

Any oil crisis will drive up the rate of unemployment. Primary factors include: a decrease in consumption of goods and services, the horrific disruption of transportation and a fear driven decrease in capital spending. In the Best Case scenario described in my book, oil shortages create a mildly recessive condition in the economy. The Production Crisis drives us into a long period of chronic recession that alternates with intervals of mild economic recovery. The Political Crisis scenario describes an economy that plunges into a depression.

Future estimates of unemployment must include a consideration for persistent oil shortages and the resulting volatility of oil prices. The annual change in oil consumption is therefore a better guide to estimated unemployment than the price of oil. We can assume that in periods of restricted supply, nations will consume all the oil they can get up to the point where there is sufficient oil to sustain current economic activity. The level of economic activity will be directly proportional to available oil supplies. Oil consumption and unemployment have an inverse relationship. As oil consumption increases, unemployment will decrease - and vice versa.

For example, if a nation has sufficient free cash flow, consumer demand, and non-oil resources to increase its GDP by 1.3 percent for a given year, then its oil consumption also needs to increase by 1.3 percent (ignoring the impact of changes in energy efficiency). If there is a surplus of available oil, then a growth rate of 1.3 percent is achievable. However, if there isn't enough available oil to permit the potential increase in consumption, then economic activity must grow at a slower rate. If the shortage is severe enough, economic activity will be forced to decrease.

I relied on an inspection of how unemployment has acted in previous recessions (and the depression of 1929) in order to make an educated guess of the projected rate of unemployment that will occur in an oil crisis. Hopefully, there is a really good econometric model on a big computer somewhere that can be used by a really smart economist to improve on the results of my humble calculations.


Global Impact

Although this report only deals with the economic impact of an oil crisis on the United States, these calculations could be duplicated for every nation on this planet

Any oil crisis will have a global reach, sparing no nation from its pain and hardship. The industrial nations of North America, Europe and the Pacific Rim will be hit the hardest because they have the most energy intensive economies.

In making assessments of global oil consumption, we have to factor in the rapid economic growth of nations such as China and India, increasing demand in third world countries, recognize the interaction of regional economies (consumption in America creates jobs in China, and so on), and make some assumptions about the development of alternative forms of energy that will eventually reduce the demand for oil. The oil crisis described in the Best Case and Production scenarios may also produce a panic in world financial markets. The Political Crisis will definitely cause these markets to collapse.

There is one other factor that we must consider when we make an estimate of how an oil crisis will impact global production and consumption.

People

In making production assumptions, it can be assumed that as the price of oil increases, limited additional production will come on-line to satisfy demand. Thus, if Middle Eastern producers restrict production, the resulting shortages will drive up the price of oil and this in turn will stimulate additional production in the Pacific Rim, North America, EurAsia, Africa and South America. This has been the traditional economic response to shortages. But we must modify our production assumptions based on social responses as well as the limitations of elasticity discussed above. Environmental concerns will act as a drag on new production, exacerbating oil shortages and prolonging the recessive impact of an oil crisis. Islamist influence will have a negative impact on production and transportation in the Caspian, North African, West African, and Pacific Rim oil fields. The transition to alternative fuels is also both a technical and a cultural challenge. And of course, if our cultural problems can not be constrained, regional or world war is always a possibility.

1929

The last comparable economic shock to the world economy occurred in 1929. Severe deflation dropped the American Consumer Price Index (CPI) by over 23 percent to a low of 13 in 1933. The years 1934 through 1940 were characterized by modest changes to the CPI. Unemployment increased by 728 percent, from 1.55 million in 1929 to 12.83 million in 1933. America did not reach a full employment economy until 1942 - 13 years after the collapse of the economy in 1929. American Gross National Product (GNP) plummeted 9.4 percent in 1930, 8.5 percent in 1931, 13.4 percent in 1932, and 2.1 percent in 1933. It bounced back from 1934 through 1937, was negative again in 1938, and then increased through the years of WW2.

By 1932, industrial stocks had lost 80 percent of their value, 40 percent of the banks had failed, and international trade had fallen by more than 60 percent.

If a Political Crisis occurs - like the one described in my book - the world will suffer the same kind of devastating economic volatility that it did in 1929. If oil production simply fails to meet consumer demand over a long period of time (there is no political crisis), then the Production scenario becomes more likely. In both cases, however, the economic trends will be irreversible unless we humans develop a suitable alternative energy system.

Interest Rates

In the above discussion, I stated that lower interest rates will only marginally help the economy because oil shortages will disrupt the flow and use of money in the economy. The reverse is also true. Although the American Federal Reserve (or its international counterparts) can try to contain inflation by raising interest rates, the availability and price of oil have a structural impact on the world economy. Higher prices will tend to exacerbate inflation, irrespective of the Federal interest rate policy. History shows that lower oil prices ease the upward pressure on inflation.

A gradual decline in the availability of oil will tend to be inflationary because consumers have time to adjust their spending habits as they encounter higher fuel and product prices. However, a sudden - and very large - decline in oil shipments could cause a short period of intense inflation (as consumers scramble to buy available oil based products), followed by a longer interval of deflation (as economic activity rapidly declines). It would appear that under depressive economic conditions, Federal interest rate policy will only have a modest impact on the outcome.

Conclusion

After weeks of trying to model world oil production and consumption, after spending hundreds of hours trying to develop and test formulae to predict American GDP, unemployment and inflation based on changes in world oil consumption and production, I concluded it is impossible to develop a conclusive business case from an analysis of available data.

Why? There are many reasons. Here are two of the most important.

* Some of the essential data is unknown, or unknowable. For example, how much oil will Saudi Arabia produce over the next 20 years? What is the projection for Iraqi oil production? And so on.
* It became very clear that past oil market behavior may not be a good predictor of future oil market performance. Historically, the interaction of production, consumption and pricing occurred in a market that had excess production capacity. That may, or may not, be true in the future.


We are forced, therefore, to use the scenario approach to our analysis of future oil market trends.

Scenarios are not predictions. Rather, they permit us to make, and then test, a hypothesis. We will then be able to challenge the assumptions, encourage debate about the model, and profile the probable result of our analysis. Scenarios are tools that give our evaluations focus, permit us to deal with the unexpected, and characterize the results of dynamic circumstances.

Based on its own alternative set of internally compatible assumptions, each scenario can be constructed with due attention to the associated economic and cultural constraints. These assumptions drive the values shown for each data series. We can then assign a probability value to each scenario we construct. High probability scenarios give us a clue to the future of the oil market.

After constructing several alternative scenarios, it became abundantly clear they all produced results that were strikingly similar. Every scenario produced higher rates of inflation and unemployment with declining GDP. The only real difference was in the timing and degree of severity.


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