Thursday, December 4, 2008

Oily Chickens and Eggs

Sitting at lunch today, I had some rather profound thoughts regarding the financial crisis which has been unfolding around the world. It was in thinking about the validity of Peak Oil theories that these thoughts occurred to me.

Please bear with me, because I am just starting to work this out, and will use these pages to record my thoughts as they occur to me.

The question is this: is it possible that the beginnings of Peak Oil actually caused much of the financial distress we are encountering today?

The Cost of Energy in Layman’s Terms

Before I get to the main argument, let me go through some quick calculations.

In the United States, we consume about 20 million barrels of crude oil per day. Multiply by 365, and you get about 7.3 billion barrels of oil per year.

For the fifteen years just prior to about 2003, a barrel of oil traded at a price of just under $40 in real dollars (i.e. adjusted for inflation). In that year, the price of a barrel started climbing rather dramatically, as shown below:

The price of oil peaked just shy of $150 per barrel in the summer of 2008. That’s a rise of about $100 per barrel. Well, if we multiply that increase by the number of barrels we consume in a year, 7.3 billion, we understand that there was an economic cost to consumers of oil products in the United States of at least $730 billion per year if the price of oil were to remain at that level. These increases would be both direct (cost of auto fuel or heating oil) and indirect (increase in the cost of eggs which are transported to market with fuel).

Does that number, $730 billion, sound familiar? Doesn’t it sound like the amount of money that Hank Paulson requested from the Treasury to bail out the world financial system?

Now, please don’t get confused that these numbers have anything to do with each other – they are different things. But I mention the relationship so that you reader have some sense of the scale of the increase in the cost of oil.

In the summer of 2008, compared to all previous years, consumers in the United States were sending an additional $730 billion of annualized costs to producers of crude oil. That’s $730 billion less money that those consumers had for other things, like mortgages, car payments, tuition or earrings from Tiffany. There are about 110 million households in the United States. Do the math, and it turns out that this number is $6,636 per household per year.

That is an enormous number. The 2005 US Census estimated that median household income in the United States was just over $46,000 per year. So the increase in oil prices, by the summer of 2008, was consuming just shy of 15% of the entire income of the median American family.

Now, please also note that the American family is quite leveraged. A vast majority of the American family’s income is already pledged to other things, including mortgages, car payments, food and other such necessities. Where the heck is such a family going to get an extra $6,000?

When economists calculate the effects of increases in the cost of energy, they generally do their analyses on a net basis. In some sense, this is entirely appropriate, because the money which is spent on energy doesn’t actually disappear, it just gets rearranged. It goes from the consumers of energy to the producers of energy. It is not a surprise that Abu Dabi and Dubai are pretty fancy places these days; money has been flowing there in a torrent in recent years.

The point is that, when money flows to producers of oil, it is then invested back into the various world economies, promoting economic growth in one place or another. So the net effect of these increases in energy costs may not be that dramatic in terms of measuring global GDP growth.

However, getting back to our median household and that $6,000, I am beginning to think that the word of economists on global GDP growth may not mean much in the current context. As consumers in the United States have gotten more and more leveraged in the new century, I think that extra $6,000 of expense has become more and more dear.

In fact, I am beginning to believe that such an expense would create enough distress at the margin to increase, say, mortgage default rates up to the current level of 5.5%. And as you know (largely from my post here), that increase in mortgage default rates has rippled through our economy, creating further distress. That distress has unfolded in such a dramatic fashion as to cause the demise of the entire investment banking industry. We are in the midst of an unprecedented situation. I woke up yesterday to hear that the US government now had to bail out Citibank, to the tune of $306 billion of federal loan guarantees!

[ Side Note (don’t read this part if you don’t like economics): Another reason that economists may have underestimated the devastating effect of higher energy prices is that they generally perform their analyses taking into account inflation, as measured by a broad index like the CPI. Well, inflation tends to help consumers insofar as it makes their fixed obligations (mortgages, rents, car payments, etc.) easier to meet as prices & wages increase, but those fixed obligations stay the same. In this case, however, any inflation we’ve had is specifically tilted toward an increase in the price of energy costs, and it has not been accompanied by corresponding rise in wages. Therefore, the increased costs have imposed a true burden on consumers.]

So, I have come to the conclusion that, based on the sheer scale of the increase in the cost of energy, it is quite possible that the chain of events which has led to our current economic catastrophe could very well have started with energy costs.

A Connection to Peak Oil?

Peak Oilers were nodding their heads as the price of oil started to really skyrocket in 2006, saying “I told you so!” Conversely, however, as the price of a barrel has come back down to just over $50 per barrel in November, 2008, others have been reiterating their contention that the unprecedented run on the price of oil was due to the exploding existence of financial speculators in the marketplace, and as the asset bubble has burst and these speculators have disappeared, the price of oil has come back down to normal market prices.

I don’t know which of these two scenarios is correct. But anyone who knows me knows that I am intrigued, if not completely convinced, by the theories of Matthew Simmons and his fellow Peak Oilers.

As such, I have a competing theory for what has been going on in the world markets lately, given that it’s possible that the current financial crisis was set in motion by the spike in energy prices. And the conclusion is not pretty.

Let me explain.

It has been thought for some time that demand for oil is generally quite price inelastic. It has been shown in several studies with extensive historical data that the consumption of oil is highly insensitive to changes in price. The price of oil can go up fairly dramatically without really affecting people’s demand for it. This seems to comport with reality; in the United States, until about midway through 2008, even though the price of oil was rising fairly dramatically, people’s consumption patterns did not really change all that much. We still need our gasoline to get to work.

In fact, if one looks at the recent statistics, the theory is pretty much borne out:

The chart above shows supply of crude oil products from the U.S. DOE. It shows that, although the price of oil started to spike starting as early as 2003, consumption patterns were not really affected until sometime in the middle of 2008. This suggests that oil consumption, within some parameters at least, is indeed relatively unaffected by the price.

Here’s where it starts to get tricky, because, like most problems in macroeconomics, we are presented with a bit of a chicken and egg problem.

Most economists would probably contend that the unprecedented rise in oil prices in recent years was an anomaly, and that the reduction to $50 in the second half of 2008 is proof. Although most will admit some connection, they’ve dissociated the vast majority of the decrease in the price of energy from the recent economic distress.


But what if the rise in price was actually caused by real, Peak Oil, demand-curve economics? What if the world demand for oil was actually bumping up against the physical constraints of pumping an additional barrel of oil from the ground, and plain old supply-demand theories could actually explain 100% of the rise to $147/barrel? Certainly there’s plenty of data on the demand side of the equation to support this claim.

We’ve already established that demand for oil is relatively price inelastic. So the increasing price wouldn’t automatically quash demand.

But one thing we do know, with utmost certainty – one thing that all economists would agree upon – is that the demand for oil is highly correlated with economic activity. When economic activity ceases – as it has now – the demand for oil, and energy in general, plummets. Less tankers traverse the seas to deliver goods. People fly on airplanes less. Families stay home for vacations, instead of driving to Vermont. Power plants deliver less juice to manufacturing plants.

Is it possible that economists have gotten the chicken and egg reversed? What if Peak Oil issues actually created most of the increase in energy costs? What if those energy costs increased in unprecedented ways, such that, for the first time in history, they actually became an economic burden on the average American household just when it was most leveraged? That $6,000 per year we calculated at the beginning of the article sure seems like a lot of money, doesn’t it?

What if Peak Oil caused a rise in the price of energy, and because of the inelasticity of demand, that price didn’t come back down until the price of oil itself had caused enough of an economic cycle to cause significant demand destruction?

The implications of this point of view are simply chilling. It suggests that the limits to our future growth, indeed the extent to which we are going to be able to pull ourselves out of this financial mess, are dictated primarily by the supply of cheap energy.

Get growing again, and the price of oil goes up again. Soon enough, the world can’t maintain the economic dislocation from energy costs, and we’re back in an economic cycle.

Furthermore - and this is probably a topic for another day - because of the relative inelasticity of oil demand and the way that such dynamics exhibit themselves in the marketplace, it suggests that we might be in for quite a bit more volatility in our economic cycles than we have ever experienced, at least since the Great Depression. The latest events unfolding around the world seem to confirm at least this part of the theory.

These are cloudy thoughts I am having. If you’ve read this far, I appreciate your patience, as I’m unsure of them myself. I just wanted to get them down in writing so that I could test my thoughts against history as it unfolds over the next several years and decades. Obviously, I will revisit all of these thoughts from time to time and update as appropriate. Please feel free to comment, though save any ad hominem attacks for other blogs.

1 comment:

mfinlay said...

I found an article from Forbes back in June of this year headlined "Sky-High Oil Will Make U.S. Go Broke".

It calculated the same 15% of disposable income number that I did.

However, the the article was aimed at speculators, which it claimed were responsible for the rise in prices.

Link here:

I am putting together a post right now with animated supply-demand curves which explain my theory in a bit more detail.