Peak Oil and the Financial Crisis: Where Do Oil Prices Fit In?

The Financial Times and Wall Street Journal have gone into full crisis mode with live blogs continuously reporting unfolding events.

Equity markets are falling and London oil prices have been flirting with $100 a barrel for the first time since February. Talk of recessions, depressions, and even collapse of the euro zone is everywhere. There seems to be general agreement that a Greek debt default is inevitable. This is to be followed by insolvency of many European banks, which in turn will lead to the possibility of debt defaults by Italy and Spain. These countries, of course, are too big to be bailed out by the rest of EU, which is what has everybody worried. Economic contraction in Europe - perhaps even a major contraction - looks likely.

There is growing concern that defaults in Europe would quickly engulf Wall Street financial institutions and that even the great Chinese growth engine could be hurt seriously by declining exports. Our concern here, however, is just where oil supply and oil prices fit into all this gloom and doom.

Even though NY oil prices have fallen by some $38 a barrel since peaking in April, gasoline and diesel in the US are still retailing for 70-80 cents a gallon more than last year. There is growing recognition among researchers that oil prices above $90 a barrel clearly cause significant economic damage in the US and other OECD countries. Additional dollars going into fuel tanks are not spent on other goods and services; hence discretionary consumer spending will contract and will continue to do so until oil prices fall significantly below $90 a barrel. In the winter of 2009, oil prices fell to circa $60 a barrel following the summer's oil price spike to $147 a barrel. This spectacular drop in oil prices did as much or more to quickly bring the country out of recession than the government's stimulus.

As could be expected the recent drop in oil prices has already brought forth mutterings of unhappiness from within OPEC. Unlike three years ago, many of the OPEC producers are threatened with popular unrest. In the case of the swing producer, Saudi Arabia, the immediate response to the Arab Spring has been a massive increase in social spending to keep potential dissenters satisfied with their lot. This increased spending, however, means that the Saudis now need to receive on the order of $90-$100 for their oil to afford increased social spending. They are more likely to agree to an OPEC oil production cut to maintain $90-100 oil even if a major recession engulfs much of the world.

If some of the more dire speculation about what might happen should come to pass, there is simply no telling where the world and oil prices and production might go. We know that U.S. oil consumption has recently been registering a decline of roughly four percent over last year. China, however, continues to grow its economy in excess of nine percent a year which requires an annual increase of five or six percent in oil consumption. For now it looks as if things are going to have to get a lot worse before there is a significant decline in global oil demand. All this seems to suggest that short of a major depression in which the global GDP actually declines rather than increases, oil prices do not appear headed for a lengthy slump. While the normal speculative excesses and overshoot may briefly send prices below the current costs of new production, this situation is unlikely to obtain for long.

There is a definite possibility, if not a likelihood, that the innumerable debt crises when coupled with high and ever increasing energy costs could evolve into a major economic depression. Such a depression would result in large declines in the GDP of many if not most countries.

One would expect that countries with small populations and large oil exports would be solvent for a while but many of these would be vulnerable to food or water shortages as global trade contracts. A major depression in which un- and under employment moved well into double digits would obviously result in a major drop in oil consumption as many would be forced to curtail their driving through shear economic necessity. With economic activity down by double digits, commercial use of oil products would fall and with it oil prices. Obviously producers would cut production both to support prices and to prevent gluts of unsalable oil from developing.

The permanently falling oil prices that would result from a global depression would set up a new dynamic for the oil industry. Production from our currently active oil fields is dropping at about four percent a year. In the future, most new oil will come from very expensive to find and produce offshore oil and heavy oil deposits. Leaving out the drop in costs that would be likely in a major depression, new oil will have to sell for $60 to $90 a barrel or it would be uneconomical to produce. Unless costs of production drop dramatically, the likelihood of enough oil from newly drilled fields coming into production to replace that lost through depletion does not seem good.

The last great depression lasted for a decade and was only ended by World War II. The next depression will be different. Oil and other fossil fuels will not be relatively cheap as they were in 1940 and is some cases may even be in short supply. Should the current economic situation spiral on down into something similar to the 1930's and last for an indefinite period, at least two races are likely. This first will be cost of producing new oil from expensive, difficult places vs. its selling price; and the second will be between the demand for oil and the amount available. It should make for an interesting decade.

By. Tom Whipple

Source: Post Carbon