Oil and economy on the devil’s seesaw
by Peter Pogany
Oil’s rocky ride to the stratosphere seems to be over. The world price, which flirted with $150/b altitude in July, hesitated for a while, then turned around and began to tumble back to Earth like some disabled wreckage.
But this is not the development everybody hoped for -- the healthy, market-induced lessening of demand for an increasingly expensive resource, substituting away from it. The mainspring behind the turnaround is a worldwide slowdown. Recovery of lost momentum would redirect prices upward again.
We are witnessing the end of the beginning of the world’s oil problem and not vice versa.
For the first time in history, the emerging scarcity of an omnipresent resource is telegraphing to the planet’s population that nonrenewable resource constraints of growth are upon us. If all goes well it should be clear by mid-century: Resource and environmental problems that threaten global economic sustenance, social progress, and peace cannot be solved without comprehensive and strictly pursued national policies in the framework of a much closer multilateral cooperation than existed at the beginning of the century.
Hopefully, future generations, which will consider this integral understanding true beyond cavil, will appreciate the difficulty involved in arriving at it. At present, the process of collective self-enlightenment, recognition pressing toward consciousness, is in its early phase. Day is not about to break any time soon in the global cerebellum.
The severity of the oil problem is disguised as a riddle. Let’s call it the “devil’s seesaw.” This is how it would read if it were a school test:
“The price of oil goes up, the economy slows down, and the price of oil declines. After a certain period the economy recovers, things appear to go back to normal but then the price of oil goes up again, setting back economic growth. Develop and implement a program that will extricate you from this miserable impasse.”
The world is off to a frenzied start but it is running in circles. The parts mutually accuse one another for the helplessness of the whole.
Developed countries blame OPEC for the quintupling of prices during the last five years. The 12-member Vienna-based organization is allegedly not supplying enough of the world economy’s vital juice. OPEC protests its innocence by faulting speculation and the weak U.S. dollar. The so-called speculators (investors not directly related to any segment of the oil supply chain) justify their decisions to pour huge amounts of capital into oil and other commodities by pointing to the turmoil in world finances, triggered by U.S. subprime woes. But many analysts claim that the rise in the price of gasoline, which began in 2004, led to the collapse of the U.S. housing market. Namely, it put an end to the "drive till you qualify" possibility of financing the acquisition of homes built on cheap land far from urban centers.
If the excessively high costs of driving caused the housing crisis, which then arguably contributed to the weakening of the dollar in exchange markets, then the blame goes back to OPEC, along with desperate cries: More, more, more! Please! Or else! Please!
But how much more is there? The answer to this basic question is far too vague to mould public opinion.
Independent expertise, which maintains that we are already dealing with the consequences of “peak oil,” clashes with a rainbow coalition of highly influential contrarian voices. The impassioned feud has a scientific focus, and we may have to wait for decades to declare the winner, when the confusing present becomes inviolable past -- a ready subject for impartial, retrospective analysis.
In the midst of arguing about “who started it” and “how much is left” a little-noticed but critically important thought catalyzer is coming (would you believe it?) from bookkeepers.
The ledgers show that the cost of producing a barrel is on a long-term upward path. Whether it is drawing in additional reserves at currently exploited sites, going after conventional oil in hard-to-access places (e.g., deep sea, polar region), or turning in a big way to nonconventional sources (e.g., tar sands, oil shale, and a variety of oil extractable or transformable organic materials), investment requirements and elevated operating costs move on an inclining slope. This is nature’s tax, a reminder that the species’ insatiable, Leviathan-like economy faces natural barriers.
Cool it! Get prices right and you’ll be enriched beyond measure
Adherents to the reigning economic paradigm -- elevated to talismanic-theological status and adorned with the glitter of Nobel prizes -- see and hear no evil. They fervently believe that competitive private entrepreneurship will always solve nonrenewable resource problems without economic growth missing a beat.
While demand for the depleting resource is gradually curtailed in response to rises in its relative price, substitutes produced with backstop techniques become profitable. Market and technology! Efficiency and conservation! The Invisible Hand! It will take care of the future as it did of the past. By 2020 the barrel will be solidly below $70, proving hyped-up worries about oil scarcity to be an irrelevant bump on the endless road to an ever richer, cornucopian future.
Murmurs of disbelief may be heard across the globe. By now, ecologically aware economists are not alone in challenging the applicability of traditional analysis to the contemporary oil market, and, more generally, to the world’s aggregate resource cum environmental problematic. Even establishment politicians are caught giving filtered looks to economists who give testimonial support to barely qualified linear expectations amidst the entangled skein of current nonlinear (chaotic) developments. After all, the decentralized market system earned its historical reputation and broad approval by always giving consumers what they wanted, from the personal car to the iPod, but never by providing unwanted substitutes for something that just happens to be a complement for practically everything else.
The loathsome truth is that there is no end in sight for growth in worldwide oil demand.
China and India carry the torch of mankind’s love affair with the automobile (projections for global car production are staggering); the chemical industry discovers new uses for refined products month after month; and there is probably no place on Earth where our sensitively interconnected global economy’s oil-hungry stomach wouldn’t growl 24/7. And lest we forgot, there will be 1.5 billion additional souls on the planet (more than one more China) by 2030. They will also demand transportation (gasoline and diesel fuel), in-house climate control (e.g., heating oil), to be clothed (man-made fiber) and to be taken care of (medical equipment, pharmaceuticals). Temptation must be resisted to list the top one thousand distilled oil products that became indispensable staples of modern civilization.
Uncertainties about available reserves and increasing expenses involved in their exploitation, obvious discrepancies between what some key producing countries intend to do based on their long-term (inter-generational) interests and what they say they plan to do, concerns about shortages and rising prices of some widely used refined products (as heavy/sour oil is being substituted for the easy-to-handle but fast-depleting light/sweet crude), ever-present geopolitical tensions that threaten to turn into “negative supply shocks” any minute – all these factors together raise serious doubts about the ability of simple market signal-response automatism to do the job.
Despite the relentless growth of demand for oil, production-augmenting investment projects lag behind requirements. This is apparently the opinion of the International Energy Agency (IEA), a trusted source of information in matters of energy for the developed countries. Ahead of the November release of its comprehensive annual report on global energy, IEA is letting the world know that it faces important shortfalls of crude oil compared to its lofty expectations about economic growth.
Is this price high enough for you? Oh, now it’s too high!
Low prices were a disincentive for reserve development during 1983-2003, but so are current high prices. They might just disable sustained economic growth at a rate that would make major commitments pay off. Volatility and unpredictability are probably the most ardent deflators of investment sentiment. And that’s exactly what oil capital must now countenance at unprecedented levels.
George Orwell’s “perpetual war” vision haunts the geopolitical scene. Three principal strong-arm players, the West, China, and Russia, strive for control over natural resources in a substratum of hundreds of fragmented and violently opposed particular interests. Combine this no-end-in-sight struggle with the expectation of new storms on the high seas of international finance, causing huge blocks of capital to slosh around in search for safe harbors, and the conclusion becomes inevitable: There will be no peace for the price of oil in our lifetime.
The mounting political pressure to develop renewable energy sources and nuclear power also threatens the profitable expansion of oil production. If the world goes solar, wind, geothermal, and nuclear, then expanding production now, undermining current price levels, which seem to be good enough to sustain profitable operations, would be bad business.
Such considerations are the bane of inherently risky, long-gestation, slow-amortization capital projects.
Whatever willingness private investors still possess is further diminished at potential investment sites. While foreign capital is locked out in some places, it is discouraged by political instability, shenanigans with licensing, and rapacious tax policies in others.
In developed countries, legislated environmental concerns keep the flow of funds into expanded oil production in check.
You call this a market?
Oil-producing nations have their own agendas. They are probably the most keenly aware that the camel that gives the golden milk will not live forever and, consequently, they are intensely strategic and tactical in drawing down geology’s grand sweepstakes prize. Not surprisingly, they are selective in accepting recommendations for exploration and development that come from the outside as the expressed willingness of international capital to finance such projects.
Investments from worldwide sources in the oil/gas industries of Iraq, Iran, Nigeria, Venezuela, and North African nations trail behind their full potential.
The sheer fact that discretionary producers of oil (i.e., those with spare capacity left) acquired enough market power to affect world prices shows that lived experience has slipped away from reassuring economic abstractions. Each oil-producing nation follows its own price strategy (i.e., tries to combine a unique and variable royalty term with its marginal costs of extraction).
To some extent, each OPEC member must subject its strategic and tactical interests to cartel regulations, and this also bears upon price and quantity. The very existence of the cartel, an archipelago of sovereign financial eldorados with 7-star ostentation, is proof that prevailing conditions in the oil business have twisted normative economic principles beyond recognition.
The declining “sanctity of contract” undermined market discipline. Some net oil exporters got into the habit of demanding the renegotiation of signed contracts if they suddenly discovered that they were not to their advantage. (According to an official French source, Kazakhstan, Venezuela, Algeria, Russia, and Ecuador have done this.)
The idealized upward sloping supply curve of oil, which is supposed to intersect the downward-sloping demand curve to determine the equilibrium price, has turned into a cloudy scatter of manipulated dots. If there is a downward-sloping demand curve, you are not encouraged to calibrate it. By the time you have rolled up your shirtsleeves it has moved and changed shape.
Based on the widely used 3.5-percent annual growth rate, the world economy is expected to be 113-percent bigger and to consume 45-55 percent more energy by 2030. If you believe that there is a trend underway for renewable sources to assume an increasingly decisive share, now is the time to take a deep breath.
The invisible right hand doesn’t know what the invisible left hand is doing.
Despite encouraging partial successes, goose-bump making TV and newspaper reports, conference summaries of organizations and associations promoting the renewable energy and/or nuclear reactor business on the web, the world’s overall reliance on fossil fuels (oil, natural gas, and coal) is expected to be around 86 percent in 2030 -- the same as now. (This projection is based on numbers published by the U.S. Energy Administration Agency. It represents the so-called “reference scenario” that screens out both optimistic and pessimistic assumptions.)
One basic condition for the spread of renewable energy is indeed missing. For solar, wind, hydro, biomass, and geothermal sources to spread, their prices will have to be lower than energy generated from fossil fuels for a very long period and reliably so. This condition is not being assured. Conventional energy producers are powerful (the whole world depends on them) and they do not like the idea of losing customers, one industry and one nation at a time. Seeing roof panels multiply like cloned bacteria is the stuff of an oilman’s nightmare.
The most significant wielders of market-power may even attempt to set back substitution away from their products (i.e., fend for the long-term value of their unexploited reserves) by temporarily abstaining from short-to-medium run revenue maximization. They could achieve this by guiding prices so as to curb the enthusiasm for and profitability of investments in renewable energy sources. There is, of course, no other evidence for such conduct than motive and opportunity -- resource jingoism and crude realpolitik.
Public policy inadvertently perpetrates the stalemate. While recent U.S. legislation, for example, gives increased support to energy produced from renewable sources and nuclear power, it also provides incentives for the domestic oil and gas industries across the entire vertical chain (i.e., exploration, development, production, and transportation). So that no energy branch would be left behind, taxpayers even found a way to improve the income statements of coal-fired power producers.
It seems that the profit motive to spread reliance on renewable energy sources is entangled in a covert conflict with the profit motive that wants to restrict such a structural transformation. Hopefully, it will not come to trading naked blows as one invisible hand tries to pull the world out from its oil age while the other tries to keep it there.
Vexing, humbling, alarming situation
Political leaders berating people for their “addiction” to oil, economists advising them to “leave it before it leaves us,” and pundits denigrating the economy’s blood by calling it “black goo” are so many indications that the international community does not want to know the results of its lab test.
When well-intentioned academic organizations and think tanks inundate the public discourse about natural resources and the environment with advice to “curb,” “mandate,” “develop,” “promote,” “embark,” and “establish;” when they advocate bold and vigorous collective action and call for political courage to eliminate oil dependence, they overlook the importance of firm-level profitability, which is directly linked to employment. If the negative effect on business is of considerable scale, you can rest assured that the proposed measure will never see the light of day or will be diluted, postponed, or stopped. The boat refuses to be rocked, the transformative push is held back.
Public authority in mixed economies is trapped on a fallow policy terrain. Tax and subsidy policies, commendable and partially successful as they may be, cannot generate the momentum for decisive resource transition. Traditional measures of stimulus may even do less than simply fail to produce the expected results. If the supply of such a centrally important resource as oil cannot be increased in the medium-run, stepped-up government spending, tax cuts, and easy money policy will jack up prices, adding to inflation and exacerbating economic problems and social tensions.
In short, specific policy tools are not sharp enough and the general tools are too blunt. Government is caught between doing a little more than nothing and a little less than causing outright harm.
The riddle called the “devil’s seesaw” is diabolical because the solution is that we don’t have one. The tendency of other exhaustible material resources (e.g., metals) to create their own seesaw effects on the world economy, amplifying or interfering with the oil-related up and down movement, is of additional concern. Frightful environmental developments may one day also contribute to this dynamic deadlock. They would recede with economic deceleration and come back with reacceleration.
Where to look for the monster who invented this frustrating game? It must be hiding in the big picture.
~~~~~~~~~~~~~~~ Editorial Notes ~~~~~~~~~~~~~~~~~~~
Peter Pogany is an economist and author of the book "Rethinking the World." Other articles by Pogany on Energy Bulletin.
-BA
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