Peak Oil Peak Oil, Falling Oil Prices, and the Global Economic Crisis By Ryan McGreal

Published December 20, 2008

In a comment yesterday, a regular RTH reader pointed out that we haven't written much about peak oil since oil prices have been falling. I have been planning to write about this for some time, but a seemingly unending cascade of big news items keeps diverting my attention, including local political events (our principal mandate at RTH), the spiraling economic crisis, and harrowing federal politics.

However, the criticism is valid. Aside from an update in August, we haven't really covered oil prices. What are we to make of Peak Oil theory with oil trading below $40 per barrel? One commenter asked why oil prices were historically low during the 1990s, a period of rapid economic growth, including growth in the sales of fuel-inefficient SUVs and rapid growth in China.

1990s: Strong Growth, Low Prices

There are a few reasons for the comparatively low oil prices of the mid-1990s, but the main reason is that the conventional oil producers still had room to grow their rates of production, i.e. how much oil they could produce within a given time period, or how quickly they could get the oil to market.

Daily oil production was considerably lower in the 1990s. For conventional crude only (excluding non-conventional oil), daily production increased from about 60 million barrels per day (mbpd) in 1990 to a plateau of about 73 mbpd that started in 2004 and has continued ever since.

When "swing producer" countries like Saudi Arabia could still ramp production by an additional 2 mbpd on short notice, confidence remained high among oil traders and futures speculators that supply would continue to be able to meet rising demand. This allowed prices to fall and remain low for several years after the first Gulf War.

Further, a higher proportion of total oil production was conventional, which is much cheaper to produce, per barrel, than non-conventional oil like deepsea, oilsands, and so on, so oil producers were able to pass their lower production costs on to customers.

2000s: Steady Run-Up in Oil Prices

Starting in 1999, however, oil prices rose steadily until a peak of $147 per barrel in mid-2008. This corresponds with a levelling-off and plateau in conventional oil production against contining demand growth.

Now, anyone who has taken first year economics can tell you what happens when the demand for something keeps growing while supply growth slows and then stalls: the price goes up.

One result of higher oil prices this decade is that it has created a market for non-conventional oil - and we see a corresponding growth in production in, e.g. the Alberta Oilsands.

As such, non-conventional oil has increased somewhat as a share of total production, as conventional oil has not been able to keep up with demand by itself.

However, the capacity for the rate of non-conventional oil production to keep increasing is limited. There's just no comparison between sticking a derrick in the ground, and shovelling millions of tonnes of greasy sand and injecting them with millions of gallons of steam to melt off the oily kerogen, then catching the kerogen and catalyzing it in a refinery to produce synthetic crude.

Drag on the Economy

Meanwhile, steadily rising oil prices have been an increasing drag on the rest of the economy. Since oil is a component in the price of nearly everything else, the last few years have been characterized by rising materials and industrial inputs costs (look at the rise and fall of commodity futures over the past two years - it tracks closely with oil), widespread consumer price inflation, and building pressure to increase interest rates.

At the same time, a recklessly deregulated finance industry was busy setting up a multi-trillion dollar land mine in the form of millions of aggressive mortgages at very low - but variable - interest rates that would only represent a sound investment if house prices continued to increase.

The mortgage providers lowered the barrier to entry with zero money down mortgages, negative-amortization (paying less than the interest on the principal for the first two years), and "no-doc" deals for people with iffy credit.

Millions of those mortgages were made to people with poor credit and insecure incomes, who could barely afford them but didn't want to be left out of what seemed like a fool-proof scheme to make money from nothing.

'Zero Accountability' Finance

This provided cover for an economic "boom" that did not translate into rising personal incomes. In fact, real (inflation adjusted) median household incomes fell and then stagnated starting in 2000, and consumer spending shifted from income to debt (at temporarily low rates), including home equity lines of credit (HELOCs) that allowed people with mortgages to trade their rising house value for cash.

This became a new economic bubble to replace the burst dot com bubble of the 1990s, but with the added dimension that the new bubble was in core consumer assets and essential public infrastructure rather than being confined to the stock market. Worse, the housing mania became the biggest financial bubble in history.

The new banking rules allowed finance companies to obfuscate and dilute the risk of these mortgages until it didn't seem like anyone was accountable for anything. Banks rolled up their mortgages and sold them to finance companies, which bundled them into securities and sold them to other finance companies, which sold them to investment funds.

At the same time, they hedged their bets by dealing in "Credit default swaps", which are a kind of bet on whether a mortgage will default.

And of course, all these transactions were highly leveraged, meaning most of the investment was with borrowed money.

Rising Marginal Price of Oil

Getting back to oil prices, they rose steadily during the 2000s but really took off at the start of 2008, rising from $100 per barrel to peak at $147 per barrel in the summer.

Many people at the time blamed futures speculators for driving up the cost, but this hypothesis isn't borne out by the evidence. A purely speculative price increase should have led to rising oil inventories, but that didn't happen.

Instead, it looks as though the dramatic price increase was due to the rapidly rising marginal cost to produce an additional barrel of oil when the global rate of production was maxed out at around 85 mbpd (total oil).

Unfortunately, the steadily rising price of oil, with its attendant price inflation, drag on the economy, and pressure on interest rates was the stomping foot that set off the land mine planted by the mortgage finance bubble.

Over the past year, the subprime crisis of 2007 gradually morphed into a more generalized global economic crisis, with economic failure across the board: the rapid and catastrophic deleveraging of shaky investments, major finance firms collapsing under the weight of worthless hedge funds and mortgage backed securities, banks tightening credit under a newfound perception of risk, personal assets dissolving, house prices falling, stock prices falling, consumer confidence collapsing, wholesale and retail sales declines, and rising unemployment.

It has become a vicious cycle, a self-reinforcing feedback loop of contracting economic activity. Itt will receive another big shudder in 2009 as the next wave of negative amortization mortgages resets to much higher monthly payments, driving still more people into foreclosure and dumping more unwanted houses onto an already devastated real estate market.

The result for the economy has been unfolding before our eyes: the finance industry on the verge of collapse, the Big Three automakers teering on the edge of bankruptcy, a steady tattoo of plant closure and layoff announcements, rising retail bankruptcies, stalled development projects, falling government revenues at all levels, and the return of deficit spending.

Peak Oil Predicts Falling Oil Prices

Now is anyone surprised that oil prices have collapsed in the past few months? Demand for oil is way down, since people can no longer afford to consume.

Far from contradicting the peak oil theory, falling oil prices are an expected result of the super-spikes caused by demand trying to grow against a flat rate of production.

On May 16, 2005, I wrote:

The next five or ten years will offer extreme price volatility for energy, particularly oil and natural gas, as demand bangs repeatedly off the production peak and then crashes under grueling price spikes.

On June 16, 2005, I wrote:

Nearly every reserve assessment not based on suspect USGS data puts the peak somewhere between now and 2010. In fact, there likely won't be a discrete peak per se. It will probably stretch over several years as volatile prices squash demand periodically. We appear to be entering that jagged plateau now, as described by analysts at Goldman-Sachs and CIBC World Markets. ... [T]he global economy, powered as it is by cheap, abundant oil, will inevitably go haywire as the supply starts to contract.

On August 22, 2005, I wrote:

[I]f the oil infrastructure can continue bringing oil to market fast enough to meet market demand, then the economy will continue to tick along as it has. If, however, the rate of oil production maxes out but demand keeps growing, then the price of oil will keep rising until it gets high enough to push demand down to what the industry can provide. ... So far, rising oil prices haven't brought on a recession in North America, but there are plenty of reasons to suspect that growth here must stall sooner or later.

Can there be any doubt that we are now in the thick of that "extreme price volatility" (the oil price increased from $100 to $147 in six months and then fell to less than $40 in the next six months), or that the economy has gone "haywire"?

Oil Industry Information Shortage

As a final note, we should not discount the the non-trivial fact that accurate field-by-field reserve and production rate assessments are notoriously lacking, leading to a certain amount of guesswork regarding actual production capacity.

During the 1990s, when countries like Saudi Arabia could "turn on the taps" at short notice and production from the North Sea was still increasing, oil markets experienced a rosy, and even possibly over-confident, sense of oil's long-term prospects.

OPEC's quota rules encouraged member countries to overstate their reserves, which looked great on the books and seemed borne out by the industry's seemingly effortless ability to supply markets.

Further, the economy as a whole was taken up with an irrational sense of "weightlessness", a myopic sense that the old economic rules no longer applied - as evidenced in part by the dot com bubble that seemed like a magical money machine right until it collapsed overnight.

(I still remember a colleague snapping up Nortel shares at $120 each while loudly proclaiming, "It's going all the way to 200 bucks, baby!" Literally a few weeks later, he lost a bundle. Now, trading at the equivalent of about 2 cents per share - they did a 10:1 stock merge a few years ago - Nortel is finally crawling into bankruptcy.)

As oil prices started creeping up in the early 2000s, analysts started taking a closer, more rigorous look at just how much oil there really is, and just how fast producers can bring it to market.

The picture is still not entirely clear, since many of the biggest oil producers are state-run and keep their numbers to themselves, but the emerging picture - particularly Twilight in the Desert Matthew Simmons' landmark analysis of Saudi Arabia's future as a swing producer - has been an industry straining the limits of production.

Unfortunately, even to this day, many analysts and most of the public still doesn't understand the role that peak oil has played in this deepening global recession.

Ryan McGreal, the editor of Raise the Hammer, lives in Hamilton with his family and works as a programmer, writer and consultant. Ryan volunteers with Hamilton Light Rail, a citizen group dedicated to bringing light rail transit to Hamilton. Ryan wrote a city affairs column in Hamilton Magazine, and several of his articles have been published in the Hamilton Spectator. His articles have also been published in The Walrus, HuffPost and Behind the Numbers. He maintains a personal website, has been known to share passing thoughts on Twitter and Facebook, and posts the occasional cat photo on Instagram.

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