A person might think that oil prices would be fairly stable. Prices would set themselves at a level that would be high enough for the majority of producers, so that in total producers would provide enough–but not too much–oil for the world economy. The prices would be fairly affordable for consumers. And economies around the world would grow robustly with these oil supplies, plus other energy supplies. Unfortunately, it doesn’t seem to work that way recently. Let me explain at least a few of the issues involved.
7. The world really needs all existing oil production, plus more, if the world economy is to grow.
It takes oil to transport goods, and it takes oil to operate agricultural and construction equipment. Admittedly, we can cut back world oil production with lower price, but this gets us into “a heap of trouble”. We will suddenly find ourselves less able to do the things that make the economy function. Governments will stop fixing roads. Services we take for granted, like long distance flights, will disappear.
A lot of people have a fantasy view of a world economy operating on a much smaller quantity of fossil fuels. Unfortunately, there is no way we can get there by way of a rapid drop in oil prices. In order for such a change to take place, we would have to actually figure out some kind of transition by which we could operate the world economy on a lot less fossil fuel. Meeting this goal is still a very long ways away. Many people have convinced themselves that high oil prices will help make this transition possible, but I don’t see this as happening. High prices for any kind of fuel can be expected to lead to economic contraction. If transition costs are high as well, this will make the situation worse.
The easiest way to reduce consumption of oil is by laying off workers, because making and transporting goods requires oil, and because commuting usually requires oil. As a result, the biggest effect of a cutback on oil production is likely to be huge job layoffs, far worse than in the Great Recession.
8. The cutback in oil supply due to low prices is likely to occur in unexpected ways.
When oil prices drop, most production will continue as usual for a time because wells that have already been put in place tend to produce oil for a time, with little added investment.
When oil production does stop, it won’t necessarily be from high-cost production, because relative to current market prices, a very large share of production is high-cost. What will tend to happen is that production that has already been “started” will continue, but production that is still “in the pipeline” will wither away. This means that the drop in production may be delayed for as much as a year or even two. When it does happen, it may be severe.
It is not clear exactly how oil from shale formations will fare. Producers have leased quite a bit of land, and in some cases have done imaging studies on the land. Thus, these producers have quite a bit of land available on which a share of the costs has been prepaid. Because of this prepaid nature of costs, some shale production may be able to continue, even if prices are too low to justify new investments in shale development. The question then will be whether on a going-forward basis, the operations are profitable enough to continue.
Prices for new oil development have been too low for many oil producers for many months. The cutback in investment for new production has already started taking place, as described in my post, Beginning of the End? Oil Companies Cut Back on Spending. It is quite possible that we are now reaching “peak oil,” but from a different direction than most had expected–from a situation where oil prices are too low for producers, rather than being (vastly) too high for consumers.
The lack of investment that is already occurring is buried deeply within the financial statements of individual companies, so most people are not aware of it. Dividends remain high to confuse the situation. By the time oil supply starts dropping, the situation may be badly out of hand and largely unfixable because of damage to the economy.
One big problem is that our networked economy (Figure 1) is quite inflexible. It doesn’t shrink well. Even a small amount of shrinkage looks like a major recession. If there is significant shrinkage, there is danger of collapse. We haven’t set up a new type of economy that uses less oil. We also don’t have an easy way of going backward to a prior economy, such as one that uses horses for transport. It looks like we are headed for “interesting times”.