Note Added 30 July: I have been rather lazy in my use of the expression peak oil, as has been pointed out here.
Peak oil is defined as the point at which production is about to go into actual decline, which means that prices would actually rise. By contrast I have discussed peak oil as the point at which reserves are being exhausted faster than they can be replenished, or more efficiently extracted, which is not strictly correct, but which reflects the arguments of many peak oil proponents. In other words they claim that we have reached the peak for these reasons.
I have had some comments/questions posted, so I thought I would answer these over my next couple of posts.
The first is a question in response to my post; 'The Economic Collapse is Starting'. The question is as follows:
'What connection do you see between the 'credit crunch' and high oil prices? While I can see that the housing bubble and our lack of wealth creation were ultimately unsustainable, are we also witnessing a genuine 'peak oil' effect?'
It is certainly an interesting question, and one I have not thought about directly before. As such I will give my best stab at an initial answer. Perhaps with further reflection I may have a more developed answer, but for the moment this is a first attempt.
I attended a talk on the subject of peak oil recently in which it was suggested that we had already reached the peak, and that it was all downhill from here. On the other hand I saw a video of a very interesting talk by Bjorn Lomberg in which he pointed out that we have had peak oil scares since the 1930s[i]. Whilst agreeing that, in principle, easily pumped out of the ground oil is finite, no one is really certain when it will reach a peak or run out. Furthermore, there are many sources of oil that may become more economic with improved technologies, and that oil is (primarily) just an energy source with a potential to be substituted by other energy sources (again, with the proviso that technological development can make such sources economic).
Let’s assume for the moment that the doomsters are right, and that we have reached peak oil. Would this explain the recent spike in oil prices?
The first point to make is that reaching peak oil is a long way away from running out of oil. Regardless of the peak there is still enough easily accessible oil to last the world for decades on current consumption levels. As such, why would reaching a peak cause a spike in prices now? Such a spike could only be the result of hoarding oil against the day when supplies run out. With decades of oil left to be pumped such speculation would, to say the least, be rather premature.
The second point is to ask the question of how expensive oil actually is. The Economist recently ran an article that pointed out that, whilst expensive, oil is not as expensive as we imagine - if inflation is taken into account[ii]. However, since that article, prices have continued to rise. There is no question that oil is now relatively expensive, though still not as relatively expensive as many think. A better way of looking at oil prices is to view the recent low prices as being one of the foundations of economic expansion over the last two decades as there was too much oil capacity compared with demand, and that oil prices are now adjusting to the expansion in the world economy.
As such, one reason for the relatively high price is quite straightforward. The overall output of oil has declined in the face of world economic expansion, though the decline has nothing to do with peak oil[iii]. In short, it is no different from the bottlenecks that have created high prices in many other commodities (an interesting example of such a bottleneck is the lack of capacity for tyres for the heavy earth movers used in mining). What we are now witnessing is that the world has reached capacity/bottlenecks in many commodities and, regardless of the so called ‘credit crunch’, growth was going to slow whilst capacity in commodity industries caught up with demand. Oversupply has turned into under-supply, leading to higher prices, and higher inflation as a result.
Another reason for the high oil price is the fall in value of the $US, as oil is priced in $US. It is here that the problem becomes more complex and I am not sure that I can do justice to this in a quick reply. The fall in the $US is the result of a rebalancing of the world economy. When a currency devalues, it actually makes a country economy poorer, as the cost of imported goods goes up, which is an indirect form of wealth reduction. The U.S. (and U.K.) is becoming poorer.
The relative increase in oil prices is just one facet of the reduction in wealth of the U.S. The U.S. has funded economic expansion (not growth) through borrowing, and the result is that whilst appearing to grow richer, the country has become poorer. The fall in the value of the dollar is recognition that the U.S. is no longer selling enough goods or services to support the value of the U.S. currency. Countries such as China already have a massive dollar surplus, but the U.S. is not producing enough goods or services for the dollars to have utility – there are not enough goods and services at competitive prices to buy. As such the value of dollars has fallen.
Only through relative impoverishment can the U.S. regain its competitive position in the world economy. Quite simply, the U.S. economy as a whole had ceased to be competitive in global markets. The only way out for the U.S. is to reduce its cost base, and that means reducing labour costs, and the costs of managing its infrastructure and government. Devaluation (making everyone in the U.S. poorer), is one process of making this adjustment. As such, high oil prices are partly the result of the devaluation of the U.S. currency, and that is the direct result of the lack of competitiveness of the U.S, economy.
Does this relatively high oil price have any relation to the so called ‘credit crunch’? I do not like the expression credit crunch, as it has taken on the status of being like a force in its own right – disconnected from the causation. The causation is that financial institutions plunged into ever more reckless forms of lending. The lending (inevitably) went wrong, leaving banks with battered balance sheets, and creating a loss of confidence in their ability to manage risk. Of particular note is the lending has been into consumer/mortgage debt, and this debt drove so called ‘economic growth’ (expansion) in many western economies. The credit crunch is therefore not the result of high oil prices, but the result of foolish lending.
The interesting feature of the foolish lending is that the banks chose to lend into the consumer market, rather than using the money to expand manufacturing and other productive business. This is a reflection of the fundamental lack of competitiveness in the U.S. (and U.K. economy). The fact that lending to high risk consumers (sub-prime) was judged a better investment than investment into business says much about the dire state of the competitive position of the U.S. economy.
The credit crunch and high oil prices are linked in a couple of other respects. The boom that has been supported by the debt money-go-round has expanded demand for goods and services, and this demand has been the source of strained capacity in commodities. Furthermore the boom in oil prices has seen the accumulation of vast reserves of capital in some of the big oil producers. This accumulation has seen sovereign wealth funds, for example, bailing out the banking system with injections of capital (e.g. Abu Dhabi's sovereign wealth fund invested $7.5bn in Citigroup). In this respect the high oil prices are supporting the banking system and ameliorating the effects of the credit crunch.
On the other hand, the inflation caused by high oil and other commodity prices is a further downward lever on consumer spending, thereby speeding the rebalancing of the Western economies towards relative impoverishment (note the use of the term relative). The situation, as it now stands, is that the world is entering into a period of (at least) a lull in growth, or possibly economic contraction. The cause for the contraction is a combination of capacity constraints, and the problems of the banking system, resultant from the bursting of the credit bubble. The two causes are separate but related (which sounds contradictory?) but are coming together at the same time, creating a double whammy. However, the problems with commodity prices are going to be temporary. The fall back in world economic growth that is taking place is going to reduce demand for commodities, just as more capacity for many commodities is coming on stream (though the mining companies and oil producers have been more cautious in their expansion than in past booms). For example Saudi Arabia has agreed to increase production, though not by a very large amount. Also, high oil prices are already spurring action to reduce demand, for example leading governments to reduce fuel subsidies and car manufacturers to switch away from manufacturing ‘gas guzzlers’.
Having said that demand for commodities will fall, as the world economy slows, a counter-effect will be the ongoing readjustment of the U.S, economy, with continued pressure on the dollar for some time. Whether the increase in supply will outstrip any further weakening of the dollar becomes the question. My own view is that the increase in supply will see oil falling back in price in about six month’s time. My best guess, and it is no more than that, is that in two year’s time, oil will be back to about $US60-70 a barrel. This is based upon the provision of a small increase in capacity, a drop in demand, set against a further weakening of the dollar. Lots of ‘ifs’ - which is why it is a best guess.
What I am saying is that there is a relationship between oil prices and the ‘credit crunch’, but not in the respect that high oil prices have caused it. The idea that ‘peak oil’ is reflected in the price is unlikely in the extreme. The high oil prices stem from the underlying weakness in the U.S. economy and (temporary) problems of capacity. The credit boom may have fuelled the world economy and high oil prices, but the credit crunch will see oil prices fall back. What we are actually seeing is one of the mechanisms of economic rebalancing in action.
I have perhaps answered the question in a very indirect way. I hope that the answer makes sense. As I said, it is an interesting question. It raises some interesting points. For example, the way in which the world economy has come to a period in which bottlenecks have started to constrain growth and also, more interestingly, the rebalancing of economic power from West to East. The rise of the importance of sovereign wealth funds (including the Asian ones) is just one example of the rebalancing, the fall in the value of the dollar another. I have not mentioned the rise of the Euro, the status of the RMB, or the Gulf States’ currency pegs, and many other factors in this picture. The problem here is that any question starts to open up many more questions, and it is impossible to cover them all in short answer. As such, for what it is worth, I will leave the question there. Perhaps with greater reflection I will be able to offer a better answer, but hope that this suffices for the moment.
[i] Sorry, I have hunted for a link but can not find one. In place of this, I have quoted a paper abstract below, though this lacks the punch of Lomberg's discussion:
'Predictions of imminent oil shortages have been made throughout the 20th century. Although all previous predictions have been false, in recent years a new generation of predictions based on the Hubbert model have become ascendant and attracted media attention. The Hubbert model assumes that a resource is limited and finite. Although conventional oil supplies are finite, it has proven difficult to estimate the size of the ultimate resource. Over the last 50 years estimates of the size of the world’s conventional crude oil resources have increased faster than cumulative production. The estimated size of the ultimate resource base will continue to increase in the future as unconventional fossil fuels come on line. Oil production from Canadian tar sands has already begun.'
Oil: Are We Running Out? by David Deming
http://www.energycrisis.com/deming/aapg_oil.pdf The important points are that peak oil has been predicted for many years. Oil is a finite resource, but the peak....every time it happens, it doesn't. This is not to say that we have not reached the peak of relatively easily extracted oil. In the simplest terms the boy has cried wolf many times. Is it real this time? No one can be certain.