The Economic Implications Of Peak Oil

by: Jason Tillberg

Peak oil came and went. It was acknowledged by the International Energy Agency, the IEA, in their World Energy Outlook 2010 Executive Summary, where on pg. 6 of their report, they write:

Crude oil output reaches an undulating plateau of around 68-69 mb/d by 2020, but never regains it's all time peak of 70 mb/d reached in 2006, while production of natural gas liquids (NGL's) and unconventional oil grows strongly.

When we add unconventional oil output and natural gas liquids to conventional crude oil output, production has not grown much since late 2004.

Click to enlarge.

Chart from a brilliant report I read on ZeroHedge.

This video explores these concerns about peak oil:

Unconventional oil, like oil found deep underwater or in tar sands, takes more energy to extract, thus reducing the EROEI or Energy Return On Energy Invested and that is contributing, and may well continue to contribute, to higher energy costs. Of course, there is a point where it would take more energy to get the energy source and at that point, the motors of the world will stop.

Something happened from 2004 and onward. These two charts below, one of the food price index and the other of regular gasoline price, speak volumes as to the implications of this peak of world liquid fuel production.

Both of these charts go back to 1990 and both show that as long as oil production was increasing, the prices of food and gasoline were kept in check, even declining in both nominal and real dollar or inflation adjusted terms.

This opens up a can of worms with respect to what do we do about this. How can we hedge in this environment? How can we save for retirement if the cost of energy and food is going to run up like this?

Look at this recent headline from Reuters about food prices:

Food Inflation Seen Back on the Table As Prices Rise

World food prices are likely to rise for a third successive month in March, and could gain further beyond that, with expensive oil and chronically low stocks of some key grains putting food inflation firmly back on the economic agenda.

These implications of peak oil are critical to civilization. They are critical to how we grow the physical economy of production and consumption. They are critical to how we can preserve wealth or future buying power of food, energy and all other services, which require energy as well.

Americans have already reduced consumption as per the two charts below. We've reduced our oil consumption and we're driving less as this is likely a result of higher prices stifling demand.

Trying to beat these high oil prices may well contribute to being less productive. The idea of riding one's bicycle to work versus driving one's car means a longer commute time, which means less time spent doing other productive things like either working and getting a wage or spending time with family. Or using wood to heat your house versus burning oil (like I did this year). Burning wood is certainly cheaper, but is far more labor intensive and time consuming. Growing one's own food in the back yard may well save some money at the grocery store but also takes time and energy - well worth it, in my opinion.

The good news is that we're a creative species. New discoveries and inventions continue to help make us more productive. See this chart below showing year over year % change in nonfarm business sector output per hour:

Output per hour or productivity of workers has been continually growing, like a runner getting into better and better shape.

The bad news is that the runner should be able to run a faster per mile pace in a 26.2 mile marathon, but the marathon course is getting harder and harder to run because, like the charts of food and gasoline prices, the course is getting steeper and steeper to run up on account of peak oil.

Thus, despite being a more productive worker or a runner that's in the shape of his life, real disposable income is the same as it was in October 2006, the same year conventional oil peaked!

I live in upstate NY. These parts were first settled by the first Americans in the very late 1790's and early 1800's. Back then, life in here were incredibly tough. The "economy" (i.e. production and consumption) was barely enough to keep the settlers alive, let along stay warm in the winter.

Shipping a ton of flour from Buffalo to Albany by horse and wagon, through broken Indian trails and between stumps of trees that were cut down would take 4 horses, 2 men and 32 days.

On October 26th, 1825, America's first super highway was completed, the Erie Canal, and now, 30 tons of flour could be moved from Buffalo to Albany, a distance of 362 miles, with 4 men and 2 mule in less than 6 days. The cost to move a ton of goods went from being $100 to about $4. The economy boomed upstate NY after the completion of the Erie Canal. Production and Consumption went up, as did wages and standards of living.

It's the concept of innovations and the creation of tools like the Erie Canal that provide the greatest boost to the physical economy, the greatest boost to standards of living and the greatest boost to helping people rise up from poverty.

It requires far less energy to transport goods over a pool of water than on a wagon pulled by 4 horses through broken, winding trails.

This concept is what is known as energy flux density. So long that we can increase energy flux density, standards of living can rise without the increase in oil production. That's where the greatest hope comes from to how we can overcome this situation of no more cheap oil. If we fail to innovate and invest in new tools that give a higher energy flux density, standards of living will fall as they have been in the aggregate since 2006.

Productivity output per hour simply contributes, or should at least, to higher standards of living. See this chart below of real inflation adjusted GDP per capita in the U.S. since 1960:

Real GDP per capita peaked in 2007. It was 2007 when we peaked in consumption of oil at 22 mb/d. We are now consuming approximately 18 mb/d five years later. The only way that we as a nation, can go back to that same level of real GDP per capita, that same level of standard of living per capita, is if we can be productive and efficient enough while using less oil or less total net energy. Therein lies the greatest challenge we face today. All previous recessions, when real GDP per capita went down, always recovered and went back above the previous high. But so did world oil production and so did output per hour or productivity of workers.

In conclusion, specifically to the implications of peak conventional easy to get oil, without a new form of cheap, dense energy, in the aggregate, real GDP per capita reached in 2007 will be a peak. This means that maintaining standards of living is going to be more challenging and force us to be ever more creative.

The answer to these problems lies in making the necessary investments in the physical economy that gives us tools to be more productive and efficient. It can be as simple as replacing incandescent light bulbs in your home with LED light bulbs that consume far less energy per lumens or light given off. That's your energy flux density. Apply that same concept to how we run our cars, run our factories, run our computers and we'll be just fine with respect to peak oil. It's easier said than done however, so we all must put our thinking caps on and ask ourselves, how can we be more efficient and productive with the same amount of energy we put in or with less energy?

For example: How can I heat my house while using less energy? Beef up your insulation and or invest in new windows. How can I reduce my grocery bills? Invest in a new cook book and invest your time to learn how to cook more meals at home, and grow some of your own food. We're all engineers now!

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.