Submitted by Gail Tverberg via Our Finite World blog,
Why is the price of oil so low now? In fact, why are all
commodity prices so low?
I see the problem as being an affordability issue that has
been hidden by a growing debt bubble. As this debt bubble
has expanded, it has kept the
sales prices of commoditiesup with the
cost of extraction (Figure 1), even though wages
have not been rising as fast as commodity prices since about the
year 2000. Now many countries are cutting back on the rate of debt
growth because debt/GDP ratios are becoming unreasonably high, and
because the productivity of additional debt is
falling.
If wages are stagnating, and debt is not growing very
rapidly, the price of commodities tends to fall back to what is
affordable by consumers. This is the problem we are experiencing
now
(Figure 1).
Figure 1. Author’s illustration of problem we are now
encountering.
I will explain the situation more fully in the form of a
presentation.
It can be downloaded in PDF form:
Oops! The world economy depends on an
energy-related debt bubble.
* * *
Let’s start with the first slide, after the title slide.
Slide 2
Growth is incredibly important to the economy (Slide 2). If the
economy is growing, we keep needing to build more buildings,
vehicles, and roads, leading to more jobs. Existing businesses find
demand for their products rising. Because of this rising demand,
profits of many businesses can be expected to rise over time,
thanks to economies of scale.
Something that is not as obvious is that a growing economy
enables much greater use of debt than would otherwise be the case.
When an economy is growing, as illustrated by the ever-increasing
sizes of circles, it is possible to “borrow from the future.”
This act of borrowing gives consumers the ability to buy
more things now than they would otherwise would be able to
afford–more “
demand” in the language of economists
. Customers can thus afford cars and homes, and
businesses can afford factories. Companies issuing stock can expect
that price of shares will most likely rise in the future.
Without economic growth, it would be very hard to have the
financial system that we have today, with its stable banks,
insurance companies, and pension plans. The pattern of economic
growth makes interest and dividend payments easier to make, and
reduces the likelihood of debt default. It allows financial
planners to set up savings plans for retirement, and gives people
confidence that the system will “be there” when it is needed.
Without economic growth, debt is more of a last resort–something
that might land a person in debtors’ prison if things go wrong.
Slide 3
It should be obvious that the economic growth story cannot be
true indefinitely. We would run short of resources, and population
would grow too dense. Pollution, including CO2 pollution, would
become an increasing problem.
Slide 4
The question without an obvious answer is “When does the endless
economic growth story become untrue?” If we listen to the
television, the answer would seem to be somewhere in the distant
future, if a slowdown in economic growth happens at all.
Most of us who read financial newspapers are aware that
more debtand
lower interest rates are the types of stimulus
provided to the economy, to try to help it grow faster. Our current
“run up” in debt seems to have started about the time of World War
II. This growing debt allows “demand” for goods like houses, cars,
and factories to be higher. Because of this higher demand,
commodity prices can be higher than they otherwise would be.
Thus, if debt is growing quickly enough, it allows the sales
price of energy products and other commodities to stay as high as
their cost of extraction. The problem is that debt/GDP ratios can’t
rise endlessly. Once debt/GDP ratios stop rising quickly enough,
commodity prices are likely to fall. In fact, the run-up in debt is
a bubble, which is itself in danger of collapsing, because of too
many debt defaults.
Slide 5
The economy is made up of many parts, including businesses and
consumers. The consumers have a second role as well–many of them
are workers, and thus get their wages from the system. Governments
have many roles, including providing financial systems, building
roads, and providing laws and regulations. The economy gradually
grows and changes over time, as new businesses are added, and
others leave, and as laws change. Consumers make their decisions
based on available products in the marketplace and they amount they
have to spend. Thus, the economy is a self-organized networked
system–see my post
Why Standard Economic Models Don’t Work–Our Economy
is a Network.
One key feature of a self-organized networked system is that it
tends to grow over time, as more energy becomes available. As its
grows, it changes in ways that make it difficult to shrink back.
For example, once cars became the predominant method of
transportation, cities changed in ways that made it difficult to go
back to using horses for transportation. There are now not enough
horses available for this purpose, and there are no facilities for
“parking” horses in cities when they are not needed. And, of
course, we don’t have services in place for cleaning up the messes
that horses leave.
Slide 6
When businesses start, they need capital. Very often they sell
shares of stock, and they may get loans from banks. As companies
grow and expand, they typically need to buy more land, buildings
and equipment. Very often loans are used for this purpose.
As the economy grows, the amount of loans outstanding and the
number of shares of stock outstanding tends to grow.
Slide 7
Businesses compete by trying to make goods and services more
efficiently than the competition. Human labor tends to be
expensive. For example, a sweater knit by hand by someone earning
$10 per hour will be very expensive; a sweater knit on a machine
will be much less expensive. If a company can add machines to
leverage human labor, the workers using those machines become more
productive. Wages rise, to reflect the greater productivity of
workers, using the machines.
We often think of the technology behind the machines as being
important, but technology is only part of the story. Machines
reflecting the latest in technology are made using energy products
(such as coal, diesel and electricity) and operated using energy
products. Without the availability of affordable energy products,
ideas for inventions would remain just that–simply ideas.
The other thing that is needed to make technology widely
available is some form of financing–debt or equity financing.
So a three-way partnership is needed for economic growth:
(1) ideas for inventions, (2) inexpensive energy products and other
resources to make them happen, and (3) some sort of financing
(debt/equity) for the undertaking.
Workers play two roles in the economy; besides making products
and services, they are also consumers. If their wages are rising
fast enough, thanks to growing efficiency feeding back as higher
wages, they can buy increasing amounts of goods and services. The
whole system tends to grow. I think of this as the normal “growth
pump” in the economy.
If the “worker” growth pump isn’t working well enough, it can be
supplemented for a time by a “more debt” growth pump. This is why
debt-based stimulus tends to work, at least for a while.
Slide 8
There are really two keys to economic growth–besides technology,
which many people assume is primary.
One key is the rising availability of cheap
energy. When cheap energy is available, businesses find it
affordable to add machines and equipment such as trucks to allow
workers to be more productive, and thus start the economic growth
cycle.
The
other key is availability of debt, to finance the
operation. Businesses use debt, in combination with equity
financing, to add new plants and equipment. Customers find
long-term debt helpful in financing big-ticket items such as homes
and cars. Governments use debt for many purposes, including
“stimulating the economy”–trying to get economic growth to speed
up.
Slide 9
Slide 9 illustrates how workers play a key role in the economy.
If businesses can create jobs with rising wages for
workers, these workers can in turn use these rising wages
to buy an increasing quantity of goods and services.
It is the ability of workers to
affordgoods like homes, cars, motorcycles, and
boats that helps the economy to grow. It also helps to keep the
price of commodities up, because making these goods uses
commodities like iron, steel, copper, oil, and coal.
Slide 10
In the 1900 to 1998 period, the price of electricity production
fell (shown by the falling purple, red, and green lines) as the
production of electricity became more efficient. At the same time,
the economy used an increasing quantity of electricity (shown by
the rising black line). The reason that electricity use could grow
was because electricity became more affordable. This allowed
businesses to use more of it to leverage human labor. Consumers
could use more electricity as well, so that they could finish tasks
at home more quickly, such as washing clothes, leaving more time to
work outside the home.
Slide 11
If we compare (1) the amount of energy consumed worldwide (all
types added together) with (2) the world GDP in inflation-adjusted
dollars, we find a very high correlation.
Slide 12
In Slide 12, GDP (represented by the top line on the chart–the
sum of the red and the blue areas) was growing very slowly back in
the 1820 to 1870 period, at less than 1% per year. This growth rate
increased to a little under 2% a year in the 1870 to 1900 and 1900
to 1950 periods. The big spurt in growth of nearly 5% per year came
in the 1950 to 1965 period. After that, the GDP growth rate has
gradually slowed.
On Slide 12, the blue area represents the growth rate in energy
products. We can calculate this, based on the amount of energy
products used. Growth in energy usage (blue) tends to be close to
the total GDP growth rate (sum of red and blue), suggesting that
most economic growth comes from increased energy use. The red area,
which corresponds to “efficiency/technology,” is calculated by
subtraction. The period of time when the efficiency/technology
portion was greatest was between 1975 and 1995. This was the period
when we were making major changes in the automobile fleet to make
cars more fuel efficient, and we were converting home heating to
more fuel-efficient heating, not using oil.
Slide 13
If we look at economic growth rates and the growth in energy use
over shorter periods, we see a similar pattern. The growth in GDP
is a little higher than the growth in energy consumption, similar
to the pattern we saw on Slide 12.
If we look carefully at Slide 13, we see that changes in the
growth rate for energy (blue line) tends to happen first and is
followed by changes in the GDP growth rate (red line). This pattern
of energy changes occurring first suggests that growth in the use
of energy is a
causeof economic growth. It also suggests that lack of
growth in the use of energy is
a reason for world recessions. Recently, the rate of
growth in the world’s consumption of energy has dropped (Slide 13),
suggesting that the world economy is heading into a new
recession.
Slide 14
There is nearly always an investment of time and resources, in
order to make something happen–anything from the growing of food to
the mining of coal. Very often, it takes more than one person to
undertake the initial steps; there needs to be a way to pay the
other investors. Another issue is the guarantee of payment for
resources gathered from a distance.
Slide 15
We rarely think about how all-pervasive promises are. Many
customs of early tribes seem to reflect informal rules regarding
the sharing of goods and services, and penalties if these rules are
not followed.
Now, financial promises have to some extent replaced informal
customs. The thing that we sometimes forget is that the bonds
companies offer for sale, and the stock that companies issue, have
no value unless the company issuing the stock or bonds is actually
successful. As a result, the many promises that are made are,
in a sense, contingent promises: the bond will be repaid, if the
company is still in business (or if the company is dissolved, if
the amount received from the sale of assets is great enough). The
future value of a company’s stock also depends on the success of
the company.
Slide 16
Governments become an important part of the web of promises.
Governments collect their assessments through taxes. As an economy
grows, the amount of government services tends to increase, and
taxes tend to increase.
The roles of governments and businesses vary somewhat depending
on the type of economy of a country. In a sense, this type of
variation is not important. It is the functioning of the overall
networked system that is important.
Slide 17
There was a very large run up in US debt about the time of World
War II, not just in the US, but also in the other countries
involved in World War II.
Adding the debt for World War II helped pull the US out of the
lingering effects of the Depression. Many women started working
outside the home for the first time. There was a ramp-up of
production, aimed especially at the war effort.
Slide 18 – From
The United States’ 65-Year Debt Bubble
What does a country do when a war is over? Send the soldiers
back home again, without jobs, and the women who had been working
to support the war effort back home again, also without jobs? This
was a time period when non-government debt ramped up in the US. In
fact, it seems to have
ramped up elsewhere around the world as well.
The new debt helped support many growing industries at the
time–helping rebuild Europe, and helping build homes and cars for
citizens in the US. As noted previously, both energy use and GDP
soared during this time period.
Slide 19
I haven’t found very good records of debt going back very far,
but what I can piece together suggests that the rate of debt growth
(total debt, including both government and private debt) was
similar to the rate of growth of GDP, up until about 1975. Then,
debt began growing much more rapidly than GDP.
Slide 20
The big issue that led to a big increase in the need for debt in
the early 1970s was an increase in the price of oil. Oil is
the single largest source of source of energy. It is used in many
important ways, including making food, transporting coal, and
extracting metals. Thus, when the price of oil rises, so does the
price of many other goods.
As we noted on Slides 11, 12, and 13, it is
the growing
quantity of energy
consumption
that is important in providing economic growth.
The natural tendency with high energy prices is to cut back on
energy-related consumption.
Increasing debt, if it is at a sufficiently low interest
rate, helps counteract this natural tendency toward less energy
usage.For example, the availability of debt at a low
interest makes it possible for more consumers to purchase
big-ticket items like houses, cars, and motorcycles. These products
indirectly lead to the growing consumption of energy products,
because energy is used in making these big-ticket items and because
they use energy in their continuing operation.
Slide 21
Many people have been concerned about what they call “peak
oil”–the idea that oil supply would suddenly drop because we reach
geological limits. I think that this is a backward analysis
regarding how the system works.
There is plenty of oil available, if only the price would
rise high enough and stay high for long enough.
Much of this oil is non-conventional oil–oil that cannot be
extracted using the inexpensive approaches we used in the early
days of oil production. In some cases, non-conventional oil is so
viscous it needs to be melted with steam, before it will flow
freely. Some of the unconventional oil can only be extracted by
“fracking.” Some of the unconventional oil is very deep under the
ocean. Near Brazil, this oil is under a layer of salt. If prices
would remain high enough, for long enough, we could get this oil
out.
The problem is that in order to get this unconventional oil out,
costs are higher. These higher costs are sometimes described as
reflecting
diminishing returns–more capital goods are
needed, as are more resources and human labor, to produce
additional barrels of oil. The situation is equivalent to the
system of oil extraction becoming less and less efficient, because
we need to add more steps to the operation, raising the cost of
producing finished oil products. The higher price of oil products
spills over to a higher cost for producing food, because oil is
used in operating farm equipment and transporting food to market.
The higher cost of oil also spills over to the cost of almost
anything that is shipped long distance, because oil is used as a
transportation fuel.
You will remember that increased efficiency is what makes an
economy grow faster (Slide 7, also Slide 37). Diminishing returns
is the opposite of increased efficiency, so it tends to push the
economy toward contraction. We are running into many other forms of
increased inefficiency. One such type of inefficiency involves
adding devices to reduce pollution, for example in electricity
production. Another type of inefficiency involves switching to
higher-cost methods of generation, such as solar panels and
offshore wind, to reduce pollution. No matter how beneficial these
techniques may be from some perspectives, from the perspective of
economic growth, they are a problem. They tend to make the economy
grow more slowly, rather than faster.
The standard workaround for slow economic growth is more
debt.If the interest rate is low enough and the length of
the loan is long enough, consumers can “sort of” afford
increasingly expensive cars and homes. Young people with barely
adequate high school grades can “sort of” afford higher education.
With cheap debt, businesses can afford to buy back company stock,
making reported earnings per share rise–even though after the
buy-back, the actual investment used to generate future earnings is
lower. With sufficient cheap debt, shale companies can create
models showing that
even if their cash flow is negativeat $100 per
barrel oil prices ($2 out for $1 in) and even more negative at $50
per barrel ($4 out for $1 in), somehow, the companies will be
profitable in the very long run.
The technique of adding more debt doesn’t fix the underlying
problem of growing inefficiency, instead of growing efficiency.
Instead, as more debt is added, the additional debt becomes
increasingly unproductive. It mostly provides a temporary cover-up
for economic growth problems, rather than fixing them.
Slide 22
A common belief has been that as we reach limits of a finite
world, oil prices and perhaps other prices will spike. In my view,
this is a wrong understanding of how things work.
What we have is a combination of
rising costs of production for many kinds of goodsat
the same time that
wages are not rising very quickly. This
problem can be temporarily hidden by a rising amount of debt at
ever-lower interest rates, but this is not a long-term
solution.
We end up with a conflict between
the prices businesses needand
the prices that workers can afford. For a while, this
conflict can be resolved by a spike in prices, as we experienced in
the 2005-2008 period. These spikes tend to lead to recession, for
reasons shown on the next slide. Recession tends to lead to lower
prices again.
Slide 26
The image on Slide 26 shows an exaggeration to make clear the
shift that takes place, if the price of oil spikes. When the price
of one necessary part of consumers’ budgets increases–namely the
food and gasoline segment–there is a problem. Debt payments already
committed to, such as those on homes and automobiles, remain
constant. Consumers find that they must cut back on discretionary
spending–in other words, “Everything else,” shown in green. This
tends to lead to recession.
Slide 27
If we look at oil prices since 2000, we see that the period is
marked by steep rises and falls in oil prices. In Slides 27 – 29,
we will see that changes in the price of oil tend to correspond to
changes in debt availability and cost.
In 2008, oil prices rose to a peak in July, and then dropped
precipitously to under $40 per barrel in December of the same year.
Slide 27 shows that the United States began its program of
Quantitative Easing (QE) in late 2008. This helped to lower
interest rates, especially longer-term interest rates. China
and a number of other countries also raised their debt levels
during this period. We would expect greater debt and lower interest
rates to increase demand for commodities, and thus raise their
prices, and in fact, this is what happened between December 2008
and 2011.
The drop in prices in 2014 corresponds to the time that the US
phased out its program of QE, and China cut back on debt
availability. Here, the economy is encountering less cheap debt
availability, and the impact is in the direction expected–a drop in
prices.
Slide 28 – From
The United States’ 65-Year Debt Bubble
If we go back to the steep drop in oil prices in July 2008, we
find that the timing of the drop in prices matches the timing when
US non-governmental debt started falling. In my academic
article,
Oil Supply Limits and the Continuing
Financial Crisis, I show that this drop in debt
outstanding takes place for both mortgages and credit card
debt.
Slide 29
The US government, as well as other governments around the
world, responded by sharply increasing their debt levels. This
increase in governmental debt (known as
sovereigndebt) is part of what helped oil and other
commodity prices to rise again after 2008.
Slide 30
We often hear about the drop in oil prices, but the drop in
prices is far more widespread. Nearly all commodities have dropped
in price since 2011. Today’s commodity price levels are below
the cost of production for many producers, for all of these types
of commodities. In fact, for oil, there is hardly any country that
can produce at today’s price level, even
Saudi Arabiaand Iraq, when needed tax levels by
governments are considered as well.
Producers don’t go out of business immediately. Instead, they
tend to “hold on” as best they can, deferring new investment and
trying to generate as much cash flow as possible. Because most of
them have no alternative way of making a living, they often
continue producing, as best they can, even with low prices,
deferring the day of bankruptcy as long as possible. Thus, the glut
of supply doesn’t go away quickly. Instead, low prices tend to get
worse, and low prices tend to persist for a very long period.
Slide 31
In 2008, we had an illustration of what can go wrong when the
economy runs into too many headwinds. In that situation,
the
price of oil and other commodities dropped dramatically.
Now we have a somewhat different set of headwinds, but the
impact is the same–the price of commodities has dropped
dramatically. Wages are not rising much, so they are not providing
the necessary uplift to the economy. Without wage growth, the only
other approach to growing the economy is debt, but this reaches
limits as well. See my post,
Why We Have an Oversupply of Almost Everything
(Oil, labor, capital, etc.)
There is some evidence that the Great Depression in the 1930s
involved t
he collapse of a debt bubble. It seems to me
that it may very well have also involved wages that were falling in
inflation-adjusted terms for a significant number of wage-earners.
I say this, because farmers were moving to the city in the early
1900s, as mechanization led to lower prices for food and less need
for farmers. I haven’t seen figures on incomes of farmers, but I
wouldn’t be surprised if they were dropping as well, especially for
the many farmers who couldn’t afford mechanization. Wages for those
who wanted to work as laborers on farms were likely also dropping,
since they now needed to compete with mechanization.
In many ways, the situation that led up to the Great Depression
appears to be not too different from our situation today. In the
early 1900s, many farmers were being displaced by changes to
agriculture. Now, wages for many are depressed, as workers in
developed economies increasingly compete with workers in
historically low-wage countries. Additional mechanization of
manufacturing also plays a role in reducing job opportunities.
If my conjecture is right, the Great Depression may have been
caused by problems similar to what we are seeing today–wages that
were too low for a large segment of the economy, thus reducing
economic growth, and a temporary debt bubble that tended to cover
up the wage problem. Once the debt bubble collapsed, demand for
commodities of all types collapsed, and prices collapsed. This
problem was very difficult to fix.
Slide 32
When we add more debt to the economy, users of debt-financing
find that more of their future income goes toward repaying that
debt, cutting off the ability to buy other goods. For example, a
young person with a large balance of student loans is unlikely to
be able to afford buying a house as well.
A way of somewhat mitigating the problem of too much income
going toward debt repayment is lowering interest rates. In fact, in
quite a few countries, the interest rates governments pay on debt
are now negative.
Slide 33
If the cost of producing commodities continues to rise, but the
price that consumers can afford to pay does not rise sufficiently,
at some point there is a problem. Instead of continuing to rise,
prices start to fall below their cost of production. This drop
can be very sharp, as it was in 2008.
The falling price of commodities is the same situation we
encountered
in
2008(Slide 27); it is the same situation we reached at the
beginning of the Great Depression back in 1929. It seems to happen
when wage growth is inadequate, and the debt level is not growing
fast enough to hide the inadequate wage growth. This time around,
we are also challenged by the cost of producing commodities rising,
something that was not a problem at the time of the Great
Depression.
Slide 34
If we think about the situation, having prices fall behind the
cost of production is a disaster. We can’t get oil out of the
ground, if prices are too low. Farmers can’t afford to grow food
commercially, if prices remain too low.
Prices of assets such as the value of farmland, the value of oil
held by leases, and the value of metal ores in mines will fall.
Assets such as these secure many loans. If an oil company has a
loan secured by the value of oil held by lease, and this value
falls permanently, there is a significant chance that the oil
company will default on the loan.
The usual belief is, “The cure for low prices is low prices.” In
other words, the situation will fix itself. What really happens,
though, is that everyone is so afraid of a big crash that all
parties make extreme efforts to avoid a crash. In fact, there is
evidence today that banks are “looking the other
way,” rather than taking steps to cut off lending to shale
drillers, when current operations are clearly unprofitable.
By the time the crash does come around, it is likely to be a
huge one, affecting many segments of the economy at once. Oil
exporters and exporters of other commodities will be especially
affected. Some of them, such as Venezuela, Yemen, and even Iraq may
collapse. Financial institutions are likely to find themselves
burdened with many “underwater loans.” The usual technique of
lowering interest rates to try to aid the economy doesn’t look like
it would work this time, because rates are already so low.
Governments are not in sufficiently good financial condition to be
able to bail out all of the banks and others needing assistance. In
fact, governments may fail. The
fall of the former Soviet Union occurred when oil
prices were low.
Once there are major debt defaults, lenders will want to wait to
see that prices will stay consistently high for a period (say, two
or three years) before extending credit again. Thus, even if
commodity prices should bounce back in 2017, it is doubtful that
producers will be able to find financing at a reasonable interest
rate until, say, 2020. By that time, depletion will have taken its
toll. It will be impossible to make up for the many years of low
investment at that time. Production is likely to continue falling,
even if prices do rise.
The indirect impact of low oil and other commodity prices is
likely to be a collapse in our current debt bubble. This collapsing
bubble may lead to the failures of banks and even governments. It
seems quite possible that these indirect impacts will affect us
most, even more than the direct loss of commodities. These impacts
could come quite quickly–in the next few months, in some cases.
Slide 35
Stocks, bonds, pension programs, insurance programs, bank
accounts, and many other things of a financial nature seem to be
very “solid” things–things that we can expect to be here and grow,
for many years to come. Yet these things, directly and indirectly,
depend on the ability of our system to produce goods and services.
If something goes terribly wrong, we may find that financial assets
have little more value than the pieces of paper that represent
them.
Slide 36
I won’t try to explain Slide 36 further.
Slide 37
Slide 37 illustrates the principle of increased efficiency. If a
smaller amount of resources and human labor can be used to create a
larger amount of end product, this is growing efficiency. If more
and more resources and labor are used to produce a smaller amount
of end product, this is growing inefficiency.
The other part of the story is that simply automating processes
is not enough. Instead, the economy must also produce a
sufficiently large number of jobs, and these jobs must pay high
enough wages that the workers can afford to buy the output of the
economy. It is really the health of the whole interconnected system
that is important.
Slide 38
Our low price problems are here now. That is why we need very
cheap non-polluting energy products now, in large quantity, if
there is any chance of fixing the system. These energy products
must work in today’s devices, so we aren’t faced with the cost and
delay involved with changing to new devices, such as cars and
trucks that use a different fuel than petroleum.
Slide 39
Regarding Slides 39 and 40, we are sitting on the edge, waiting
to see what will happen next.
The US economy temporarily seems to be in somewhat of a bubble,
now that it does not have QE, while several other countries still
do. This bubble is related to a “flight to quality,” and leads to a
higher dollar, relative to other currencies. It also leads to high
stock market valuations. As a result, the US economy seems to be
doing better than much of the rest of the world.
Regardless of how well the US economy seems to be doing,
the underlying problems of rising costs of producing commodities
and prices that lag below the cost of production are still present,
making the situation unstable. Wages continue to lag behind as
well. We should not be too surprised if the economy starts taking
major downward steps in the next few months.