Helping America Navigate a New Energy Reality

The Impact of Peak Oil: An Alternative View

By on November 1, 2010 in Commentary

At the ASPO Conference in early October 2007, Robert Hirsch presented his view of the impact of peak oil on the economy and society. While most of his assertions are readily supportable, the historical record is nevertheless perhaps more nuanced and deserves consideration in thinking about future events.

To begin with, there have been to date arguably two peak oil recessions. The first of these, the period of the Iran-Iraq war after 1979, was artificial. Saudi Arabia decided to defend a high oil price with production restrictions, despite the fact that production capacity was largely adequate to meet global needs. As a consequence, oil production fell in a pattern similar to that which we might expect after peak oil. By contrast, the oil shock of 2008 was arguably the first, true global peak oil recession. Unlike the shocks of the 1970’s, there were no supply disruptions. The world simply ran out of spare capacity. While the oil supply did not peak in the accounting sense, for the first time, it was structurally unable to meet growing global demand. These two periods, then, tell us something about the future course of oil shocks resulting from peak oil.

US Oil Consumption: 1970 – 2009

Source: EIA

Reduced Economic Activity

In his presentation, Hirsch quotes a 2007 GAO report as saying “… an imminent peak and sharp decline in oil production could cause a worldwide recession.” This is too kind. Historically, oil shocks-when US oil consumption exceeds 4% of GDP-have always led to recession. There is no reason to use the conditional tense, and no need for an actual supply decline. All that is needed is an oil price shock, that is, a structural mismatch between supply and demand. As a result, for policy purposes, an oil shock can be assumed to lead to recession. And recession is also always associated with increased unemployment. These two findings can be taken as near-certain consequences of oil shocks, whether caused by geological or political factors.

Other effects are less certain, however, and are often associated with policy mistakes. Here are a few:

Inflation

Oil shocks are assumed to lead to inflation, but this is not necessarily the case. Inflation declined after 1979, and we are facing a near deflationary period currently. Therefore, increased oil prices imply increased prices for energy and basic commodities, but absent monetary accommodation, inflation as measured by the CPI is not the automatic outcome. We tend to associate oil shocks with inflation due to the policies of Arthur Burns, Chairman of the Federal Reserve during the 1970’s. Burns attempted to compensate for an external price shock with monetary accommodation to stimulate demand. As the shock was a real one (oil really did become more expensive), a real accommodation was necessary and monetary easing only led to inflation. In 1979, when President Carter appointed Paul Volcker as Fed Chairman to replace the hapless Burns, policy turned to real accommodation, with high interest rates forcing down both inflation and consumption. The result was a compression of oil demand in the US by more than 20% over the following four years, more than twice the drop in consumption during the recent recession. Thus, oil shocks and inflation don’t necessarily go hand in hand.

As an aside, it is an interesting to contemplate whether US monetary policy today will prove beneficial to prevent deflation or a repeat of Burns’ failed policies of the 1970’s. We should know by the end of next year.

The Victims of the Recession

Princeton professor emeritus and peak oil theorist Ken Deffeyes once famously (for those who follow this field) wrote that, when peak oil hits “you can kiss your lifestyle goodbye.” This has proved not quite the case. The recession of 2008 clearly shows that the costs of adjustment are not allocated evenly. About 8 million people lost their jobs-they are clearly carrying the cost of the recession. But for the remaining 90% of the workforce, the downturn has not been so bad. Prices of goods and housing have fallen, and gasoline is no more expensive than it was in 2007. Thus, only some of the population had to kiss its lifestyle goodbye. This is likely to be true in the future as well. However, this does not imply that the broader population will avoid sacrifice entirely, as both government services are likely to be cut and taxes, increased. Service cuts have already been implemented broadly throughout the US, and tax increases would appear in the cards. Still, the greater risk would appear to be increasing levels of structural unemployment rather than a general fall in living standards.

Importantly, adjustment is likely to be episodic, rather than chronic. Oil prices will spike, leading to recessions-but also to an overshoot on consumption, which will tend to fall more than needed to accommodate supply constraints. This in turn will lead to periods of relative calm and consolidation, as we see today.

Unemployment

Recessions, from whatever cause, tend to increase unemployment, and certainly the financial crisis was an important cause of job losses in the current downturn. (Indeed, on paper, the collapse of Lehman Brothers appears to account for 1.5% of the unemployment rate by itself.) Less well understood is the linkage between oil prices and re-employment. In April at the EIA Conference, I asked Larry Summers, then Chairman of the President’s Council of Economic Advisers, at what oil price would US oil consumption fall, and at what price would the economy be materially inhibited from re-employing the jobless. Not only did he not know the answer, he seemed unprepared for the question.

If oil supply growth is less than demand growth, as it appears to be today, then oil prices will rise until the slow-growing economies like the US begin to cede consumption to the fast-growing economies like China. As a result, we can postulate that the US and the OECD countries as a whole are energy-constrained and that, as a result, re-hiring will be more difficult than would be in the presence of cheap and ample energy supplies. Peak oil not only leads to unemployment, it makes re-hiring harder.

Rationing

Oil was de facto rationed in the 1970’s, and the policy was a failure. The major dislocation was not so much the price, as the long lines and uncertainty of filling one’s tank. By contrast, despite high oil prices, oil was not rationed in 2008, and freely available to those who could afford it. So rationing is neither a given nor is it, from an economic perspective, necessary as long as prices can adjust. But will popular pressure demand rationing anyway? It could, even if it represents a policy mistake.

War and Conflict

Oil shocks may make the strong countries weak and create an incentive for dissatisfied nations to challenge the existing system of commercial and diplomatic relations. Among the antagonists could be Russia, Iran and even the United States, as China vacuums up the world’s available oil reserves. War and conflict are not inevitable, but a given constellation of events could bring them on nevertheless, and this is perhaps the greatest risk of peak oil: not a shortage of oil per se, but a related social stress which leads to the rise of political forces which demand the securing of oil reserves through the use of military power.

Substitution and Efficiency

In general, I believe the potential for efficiency gains, fuel substitution and conservation are under-appreciated. Vehicle mileage could easily be increased 50% if consumers were motivated to purchase more efficient vehicles. Natural gas powered cars are also an entirely viable option, if the EPA could be brought to reduce compliance costs and standardize tank types. And many businesses could simply move out to the suburbs to be nearer to managers’ homes. Of course, Hirsch is right: Accommodation will take some time. But it is also true that, should peak oil actually be validated by events, both political decision-makers and industry are likely to move to a war footing, with far more accelerated and aggressive mitigation programs than we see under business-as-usual scenarios.

The Outlook for Prosperity

The world is vastly more prosperous than it was just twenty years ago. Hundreds of millions of people have been lifted from poverty, and the US enjoys a historically unprecedented level of wealth and income overall. Peak oil will represent a challenge, with some potentially difficult periods of adjustment. But not all our prosperity is built on oil. Much of it arises from telecommunications, information technology, medicine, and the know-how of myriad industries. In the worst case, peak oil would knock us back perhaps 10-20 years. But 1990 was not such a bad time to be alive. Indeed, many people across the globe live happy and productive lives on a fraction of our per capita GDP.

We have survived the first peak oil recession, not unscathed but intact. As long as we avoid major policy mistakes and understand the nature of the challenges before us, we can cope with peak oil.

Mr. Kopits heads the New York office of Douglas-Westwood, energy business consultants. The firm assists energy service providers with market research, strategy development and commercial due diligence. The author is solely responsible for the opinions expressed here.

(Note: Commentaries do not necessarily represent the ASPO-USA position.)

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  • http://www.meaker.net Mark Meaker

    Thanks for the Panglossian view of peak oil, Mr Kopits.

  • John Mack

    I agree. Stay positive.

  • Steven Kopits

    Agreed, John. An EV is not ideal for every purpose. EV’s remain both much too expensive and inconvenient. However, the oil supply is not going to zero either in the near, or even medium, future. So we don’t have to take oil completely out of transportation.

  • John Mack

    Would you want to depend on a firetruck or an ambulance powered by batteries?

    I’m not trying to be negative but batteries are a mediocre to poor substitute for gasoline powered vehicles.

    Not that Humanity has much choice.

  • Steven Kopits

    To replace a gasoline-powered car with an EV would incur an incremental cost of perhaps $20,000, say, $4,000 per year on an amortized basis. On a per capita GDP of $44,000, that’s a reduction in welfare of 10%. Not trivial, by any means, but not Germany or Britain after World War II, either. And a lot cheaper than sending your kid to college.

  • Leaf

    A few good points but your analogy with 2010-1990 is flawed.
    It’s not just GDP, it’s the energy availability. 1990 may have been a period of lower GDP but it was still stable in it’s own right.

    A post-Peak Oil world is inherently instable and will give rise to huge problems in food supply which in turn will give massive social unrest, civil war in places like Nigeria and much of sub-Saharan Africa as well as rise to nationlistic movements in Europe, Israel and perhaps even the U.S.

    Another point is that the population is larger today than in 1990 so a lower GDP cannot match with the population needs, and the population is not shrinking – it’s expanding. Compounded with all of this is the increasing energy needs of China and India primarily and you begin to see how flawed that analysis is.

    To somehow think that things will be sort of like the 1990s is a massive misunderstanding of the issue and quite frankly a bit embarrassing.

  • Bill Simpson near Slidell, Louisiana

    I hope you are correct, but I doubt it.
    Pretend for a moment, that you are an oil exporter. Once it becomes obvious that world oil supply can no longer meet the demand, it doesn’t take a rocket scientist to figure out that any oil exporter can raise the price by holding oil off the market. The idea could spread, fast. Why produce all you can today, when the price is going up, weekly. So why would you sell your oil as fast as you can? Once your oil is gone, then what do you do? There aren’t many oil exporting countries that are exactly manufacturing Meccas. Sure, some make things like chemicals and aluminum, but it is generally dependent on cheap energy from their own oil and gas. So I wouldn’t count on picking up the phone and expecting another supertanker load, as long as you have the cash to pay for it, after around 2016. Peak oil hasn’t happened before. It will be permanent. It will be a different kind of oil market from in the past.
    You can’t compare peak oil to anything that has happened in modern history. There has never been a permanent transportation fuel energy shortage. The entire USA, since the end of WW II has been designed around cheap, limitless liquid fuels. Once that is no longer the case, the economy must contract. That is the definition of a recession. It will contract a lot. That will cause all kinds of problems with unemployment, real estate, banking, and eventually, political stability.
    Just look what keeping interest rates too low for too long did by creating a housing bubble. That is nothing compared to a permanent fuel shortage.
    As far as the decrease in living standard, the wealthy will, as always, feel little impact, unless fuel is rationed. I can’t see the masses sitting around passively, while only the Ferraris drive around burning up all the gasoline they like, as everyone else rides their bikes in the cold rain because those with money have bid up the available gasoline to $15 a gallon. But I could be wrong, and many people may still insist that the rich pay too much tax, while demanding that the oil companies open up all their shut off oil wells. Cable TV and talk radio can do a lot to influence public opinion.
    Finally, reflect on the big picture of energy use history. Humans have progressed by constantly moving to more concentrated, cheaper sources of energy. We moved from wood, to coal, to gas and oil. A barrel of oil can do an enormous amount of work for very little cost. Try to push your car 15 miles and see if a gallon of gasoline is worth $3. Saw up a large tree with a hand saw, instead of with a chain saw. Cut your suburban lawn with a push reel lawnmower. Still think it won’t be a big problem when that gasoline isn’t there, or when it skyrockets in cost? What will replace all that cheap work now done by oil? And how much will that fuel cost? Just where will those trillions of hours of work that oil now does, come from? Think life will be just fine without all those hours of work equivalent not being performed? I sure don’t. I think it will be a catastrophe.

  • John Mack

    Several points:

    1. Agreed higher oil prices don’t necessarily lead to higher inflation.

    2. The disappearance of people’s lifestyles won’t happen overnight to everyone. As oil prices move higher, more and more people will lose their lifestyle. But it will be a gradual process, not a “Big Bang.” As for those still able to maintain their lifestyle, I don’t see how much it’s worth when others are forced into bankruptcy and poverty.

    3. As you mentioned, in 2008 when oil prices reached $150/bbl, there was no rationing other than by price. This is in contrast to the 1970s when the government did intervene. Why the difference in response? The fact there was in the 1970s in the popular mind a tangible event which signaled an imminent increase in the gasoline price compelled people to hoard gasoline. When people are intent on hoarding, they are willing to ignore increased prices to acquire a valuable resource.

    4. I agree there are substantial efficiency gains to be had with more fuel-efficient vehicles, mass-transit, etc. However, the point is society will be in an unending energy efficiency race when oil production enters TERMINAL DECLINE. Society may increase efficiency by 20%, but with oil production declining at 4% a year, those efficiency gains will only last so long.

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