Economics of Oil

It occurred to me I needed a page specifically explaining the economic significance of oil pricing.  I’ve gone over some of this elsewhere on this site and the blog, but It seemed like a page on oil economics would be useful.  In his book, The Big Flatline (The End of Growth in Canada), Jeff Rubin explains that there’s still plenty of oil left in the crust of our planet.  My back of the envelope calculation is that we’ve harvested at most 1/5 of what’s known.  But the conventional, easily extractable resources, like the massive Ghawar field in Saudi Arabia that provides 5% of the world’s oil, are either near, or in many cases past their peak and into decline.  Unconventional oil resources, like the Bakken Shale in North Dakota or the Anthabasca Tar Sands in Canada are only feasible oil sources if the price of oil is high enough to justify the higher expense of extraction.  Similarly for the oil fields under the seafloor off the coast of Brazil or under the frigid waters of the Arctic.

That sets up an untenable situation for the advanced economies of the Organization of Economic Cooperation and Development; the U.S., Europe, and Canada.  Those economies developed in an era of cheap petroleum.  To continue growing, they need petroleum as a fundamental transportation fuel and source material for an array of plastics and petrochemicals.  Expensive petroleum raises the cost of transportation and everything that depends on cheap, quick transportation.  It forces individuals to spend more of their incomes on transportation and anything, like food, made more expensive by the indirect effects of higher fuel and petrochemical prices.  In a consumer-driven economy like the U.S., where about 70% of GDP is based on consumer spending, that’s a significant stress.  An analysis by the Peak Oil Task Force in 2010 claimed that when the cost of oil reached 4% of U.S. GDP, a recession tended to follow.  I’ve seen somewhat higher estimates from other sources.  A frequently cited paper by James Hamilton, a noted economist at UC San Diego, tracked economic downturns since the beginning of the petroleum age in about 1859.  He marked 10 economic downturns in the U.S. economy since then.  Ten of those downturns followed “price shocks” (spikes) in the cost of oil.
High oil prices generate underlying stress.  Then a trigger event, like the mortgage bubble of 2008, precipitates the actual downturn.  Most people, including most economists and financial experts, focus on the trigger event, not the underlying stress, as the “cause” of the downturn.  In the case of economists, ecological economist David Stern has claimed that economics started to use a class of mathematical models that didn’t include the cost of energy, specifically oil.  This was because oil had become so inexpensive in the early 20th Century that it wasn’t necessary to include it’s cost for the models to work reasonably well.  It seems since the turn of this century, that assumption is breaking down as the cost of oil continues in to rise.  That’s because the supply of cheaply extractable oil is insufficient to meet demand.  It’s been noted by many analysts that oil production seemed to plateau in 2005.  The New Economics Foundation wrote an excellent discussion of geologic versus economic peak oil.  They foresee an intersection of economic adaptation curves and oil price curves in 2014, after which serious disruption may occur.
Several authors talk about the possibility of an oscillation pattern.  The cost of oil stresses the economies of the OECD nations.  A trigger precipitates a recession.  Economic contraction causes “demand destruction” for energy, which causes the price of oil to drop.  The economy does at least a partial recovery, which causes more demand for energy, price increase, stress, trigger, and another recession.

Comments are closed