Oily Origins of the Economic Crisis

In an article some months ago I suggested that “perhaps this crisis is simply an unconscious recognition of this inconvenient truth?” – namely, the peaking of oil extraction and all that it implies for the continued survival of a financial system built on assumptions of continuous economic growth. In other words, the fashionable approach of focusing on exotic financial instruments, regulatory failures, etc, if a case of mistaking the forest for the trees.

The Oil Drum had a nice graphical summary. According to the author, Gail the Actuary, the chain of causation runs thus: rising oil prices -> inflated asset values -> booming phantom wealth -> high energy costs undermine real economy -> more and more bubbles pricked -> banking crisis -> credit crisis -> cascaded economic failure -> oil demand destruction -> oil prices plummet -> so do ever costlier long-term investments in oil extraction -> economic recovery at lower level -> rising oil prices. Cycle repeats itself to oblivion.

This explains the extreme severity of the crash – record GDP growth at a time of plateaued oil extraction in the 2005-2008 period was patently unsustainable, so a very big “correction could not have been unexpected.

And it is quite a correction.

As of the September-November average, global industrial production was plummeting at an annualized rate of -13% and merchandise trade by a truly remarkable -43%. And it is obvious the collapse accelerated since then…

Already far worse than during even the worst month of 2000-2001, the last and only global slowdown for which the IMF has data.

Already far worse than during even the worst month of 2000-2001, the last and only global slowdown for which the IMF has data.

But this is not a strictly economic post, or meant to be long / detailed (I’ll post that kind of thing within the next few weeks). So on to the next point about the oil connection…

Another Oil Drum blogger, Phil Hart, wrote about the dramatic rise and fall in oil prices in terms of simple supply and demand curves. I’ve had the same thoughts tumbling about in my head but unfortunately didn’t come to writing about them in such detail…

Oil demand and supply.

Oil demand and supply.

His thesis is that because of the geological limits to oil supply, the marginal cost of providing ever more oil is generally low until it reaches some point – say, 85mn barrels a day – and then veers off into the sky (i.e. becomes very inelastic). Demand is also inelastic, since modern society basically runs on oil. Hence there comes a time when the demand curve reaches a point when its intersection with the supply curve – i.e., the market price – starts rising exponentially.

Exponential rise in oil prices; all exponents in a finite environment will eventually overshoot and collapse.

Exponential rise in oil prices; all exponents in a finite environment will eventually overshoot and collapse.

Supply can no longer be expanded to any significant extent, despite the market signals. All we managed was a precarious plateau, the big rate of natural decline of existing oilfields being compensated for by remoter and lower-EROEI sources. The strain got too big, we slipped up and are now falling to a lower plateau – at an annualized rate of at least negative 13% of global industrial production…

PS. Is it also a coincidence that possible the hardest hit major industry was the automobile sector, with production plummeting by up to 50% in most countries? Particularly when you consider that they are the sector that is most tightly linked to cheap supplies of oil products?

Calculated Risk compiled a graph of the fleet turnover (total vehicles divided by annual sales) to give a historical value for the number of years required to totally refurbish America’s car fleet – from hovering at 13-15 years, it soared to an historically unprecedented 27 years. Projecting this forward, the size of the fleet will decline AND age simultaneously since most vehicles don’t last anywhere near 27 years on the road.

Since most vehicles won’t last this long, unless situation turns around the size of the fleet will decline AND age simultaneously. (But of course it won’t, because of impending energy shortages).

This is a completely rational development from a peakist perspective, of course. Even though generally more fuel efficient on paper, a lot of energy needs to be spent manufacturing them; since these initial energy costs have already been spent in old vehicles, it makes sense to prolong their lifespans instead of trying to increase the turnover of the fleet. So unless oil magically remains cheap and plentiful in the years ahead, or hybrids / battery-powered vehicles become far more successful than they are currently, expect the cars on our roads to gradually get older, creakier and dirtier like in Third World places – albeit with much better, cheaper and more intelligent electronics (due to Moore’s Law and its siblings).

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