Interesting Times

by Gordon Ringoen, March 03, 2010

Second of four parts

First, let's define our GDP as a measurement of our work product in U.S. dollars.

As we learned in elementary physics, it takes energy to create work.  It takes energy to run any machine, to grow plants and it even takes about 20 watts of energy for us to think for an hour.

From this perspective, it would be easy to assume that the economy that consumes the most energy would be the one that had the largest work product or as we call it in economics, GDP.

If you agree with this line of reasoning, you will not be surprised with the following facts:

We are 1st in electricity consumption. 

We are 1st in natural gas consumption.

We are 1st in nuclear energy consumption.

We are 2nd in geothermal power usage.

We are 2nd in coal consumption.

Our most important source of energy is oil. We use nearly 21 million barrels of oil per day of the 82 million barrels of world consumption.   Coincidentally, or maybe not, our 25% of world consumption of oil is a number very similar to our 24% of the world's GDP. 

China and Japan, with a combined GDP of 53% of the U.S., consume about 61% as much oil as we do.  Japan is energy efficient but China is not.

China, the fastest growing large economy in the world over the last three decades, has increased its energy production from coal, equivalent to 34 million barrels of oil per day while increasing their oil production by 4 million barrels per day.  This immense increase in energy production and consumption has fueled its economic growth.

On the other hand, a decline in energy consumption per capita is coincident with failed states.  Zambia, Mozambique, Albania, and Afghanistan have all had significant drops in per capita consumption of energy since 1980.  We consume about 13X the energy per capita of Africa.

Energy is the most important factor of production and not capital, labor, and technology.  And, oil is the most important source of that energy.

Without energy, you not only have no economy, you have no life on earth. Imagine, if you can, what the world would be like after 90 days of no fossil fuel energy.  There would be few lights and little heat.  Water distribution and sewer service would be crippled.  There would be no transportation or goods distribution.  There would be no communications.  Government services would come to a halt.  There would be mass famine and disease.  Public services would disappear, governments would collapse, and perhaps billions of people would perish.
 
Can anyone rationally deny that the fossil fuels of oil, gas and coal, that provide 86% of our energy, are not the most important factors in our economy? 

The Economists View

N. Gregory Mankiw summarizes the popular view of economic priority in "Principles of Economics" p. 250, where he states:

"Long-run economic growth is the single most important determinant of the economic well-being of a nation's citizens.  Everything else that macroeconomists study – unemployment, inflation, trade deficits, and so on – pales in comparison."

Economic growth is of course, our increasing GDP.  Oil that we pump and consume is part of that GDP.  There is no accounting for the fact that it is a diminishing resource.  It is as if simply drilling a hole creates oil.  So, the more oil we burn the better it is for our economy.  A $60,000 Hummer that gets 10 mpg is much more important to our well being than a $30,000 Prius that gets 50 mpg.

Or, as Bernanke says in his "Macroeconomics'' text, "Ideally, for purposes of economic and environmental planning, the use and misuse of natural resources and the environment should be appropriately measure in the national income accounts.  Unfortunately, they are not."

Temporary shortages of oil are dubbed "oil shocks" and are deemed to be temporary in nature.  As Bernanke explains, "To illustrate, suppose that war abroad disrupts oil imports.  This drop in supply will drive up the price of oil. A higher price will induce domestic consumers to conserve oil and to switch to alternative sources of energy."

Mankiw also argues that oil shocks are only temporary and that the "free market" corrects any disruptions as long as government does not interfere.

In summary, energy is not an essential factor of production; it is merely a product of our labor, capital, and technology.  If we want more energy we simply produce it. Oh, how sweet it would be if it were only true.

The real world

Perhaps it is worthwhile to view the economic world from a fresh perspective.  Instead of the egocentric view that humans are the center of the universe and what matters most is what we do, i.e., … labor, what we build, i.e., … capital, and what we know i.e., … technology, we think of all living things, including ourselves, and all that we build, as instruments which harness energy to serve the purposes of sustaining life.

It takes energy to affect photosynthesis; it takes energy to fly a plane, to pound a nail, and even to think.  Nearly all of our useable energy has come from the sun either currently or stored in the form of fossil fuels.  The effective tapping into the sun's initiated energy has allowed the human population of the world to increase from 10's of millions to nearly 7 billion in the past few thousand years.  Energy is not an afterthought to our existence but is our lifeblood.

To put the importance of energy consumption into perspective, it is as if all 6.8 billion people on earth had the equivalent of 50 human slaves that work 24 hours a day, 365 days per year and require no upkeep.  On the other hand, a simple power outage like we experienced in August 2004 paralyzes our economy.

Hopefully, having established the importance of fossil fuel energy as the driving force of economies, it is elemental that we examine the continued availability of these resources, and whether their extensive use causes unintended negative consequences. And, we must examine other sources of energy available to fill our future needs while limiting the negative effects. 
 
Oil is the most important fossil fuel.  Let's look at its availability.   There can be no rational view that oil is not a limited resource.   Oil reached maximum production in the U.S. in 1970 and in 1988 in Alaska.  It has also peaked or will peak at sometime in the future in the rest of the world.  The question is when and how much is really available and at what economic cost.

First let's test our economic theories regarding oil to see if it gives any clue about its availability.  We recall that that the theory states that if prices rise, it will automatically bring on new production.  The price of oil rose dramatically from the mid $20 per barrel in 2003 to $120 average per barrel in 2008 and $70 per barrel in 2009.  Yet, world production has been flat to slightly down during this period.  Our recent experience clearly shows that this theory is wrong; otherwise production would have increased as prices rose dramatically.  An obvious explanation would be that the prices went up because demand outstripped supply and there was no additional supply that could be brought on stream.

The price of oil futures contracts also gives us some insight as to production capacity.  Historically, while we had excess oil production capacity, the "spot price" (current price of oil per barrel) of oil exceeded the futures price in what is called "backwardization" (future price lower than spot price).  In the early part of this decade futures prices for two years into the future were consistently about 80% of the "spot price."  This indicated that there was excess oil supply as compared to demand.  It discouraged bringing on new production.  Importantly, this "backwardization" of oil futures prices reversed in 2007 to "cantango" (futures prices higher than spot price) as the futures prices began selling at a 20% premium to the "spot price."

The "cantango" of futures pricing, combined with rising "spot prices," and no increase in production would indicate to an oil investor, that there is a shortage of capacity at least in the short to intermediate term and it raises questions about the longer term. 

Let's put aside market anecdotal evidence for now and look at the actual oil forecasts.  The U.S. Energy Information Administration (EIA) forecasts that oil consumption will increase from the current 82 million barrels per day to 110 million barrels per day in 2030.  Their forecast is basically a demand forecast tied to increased population and economic growth.  They essentially follow the economists theory that if there is demand at a favorable price, the supply will follow.  More specifically, any supply increases necessary to meet demand will come from OPEC countries, particularly Saudi Arabia.  This is a convenient place to plug any shortfall because we have no verifiable data on oil reserves in Saudi Arabia.  They claim that they have all of the oil necessary for a thirsty world but it would seem prudent for them to claim that to be so, even if it weren't true.  Any admission by them that their 40-60 year old fields are on the downward slope of production might invite oil hungry powers to invade them.

In any event, we know that in the rest of the world, there is verifiable data that production is declining at a rate of about 6.7% per year.  Our own North Slope fields are declining at about 4% per year.  The production has slowed to the point that it now takes about two weeks for oil to travel the pipeline from Prudhoe Bay to Valdez while it used to take only four days.  The North Sea fields are declining at an even faster rate. 

At current rates of decline of existing fields, it would take new discoveries equivalent to Saudi Arabia every two or three years to meet our needs.  New discovery rates have been in decline since 1964.  There has not been a major discovery in the world in more than 30 years.  Twenty years ago there were 14 fields that produced more than 1 million barrels per day; today there are two.  There has been only one discovery with production capacity greater than 500 thousand barrels per day since 1980.

Although Saudi Arabia has not produced data about its oil production since 1982, there have been more than 200 independent reports by Saudi's petroleum engineers which would indicate that their fields are moving toward the terminal stage.  Moreover, they may have crippled their overall production potential by over-production in the past.  Many of the reports by experts in the field are in conflict with the claims of the Saudi government.  In any event, whenever peak production is reached, it can be expected that there will be rapid decline thereafter.  Saudi overall production declined from 20005-08 while well production dropped 25%.  An excellent analysis of the Saudi oil capacity is to be found in "Twilight in the Desert" by respected petroleum analyst Matt Simmons.

Looking at the larger picture, many geologists think that we have already consumed about 50% of the available oil.  And, we have exploited a much higher proportion of the low cost oil.  Some think that the world reached "peak oil" (maximum world production) production in 2005; others think it is now peaking, and the most optimistic is that it will not peak for another 20 years.  While the EIA predicts production to be 110 million barrels per day by 2031, the American Society of Petroleum Engineers newsletter predicts 58 million barrels per day.  Other analysts forecast as little as 40 million barrels per day for world production. 

In December 2009, the IEA, in its carefully watched annual report, for the first time, made their forecast for "peak oil."  In a business as usual environment, with no major discoveries, they forecast "peak oil" in 2020.

On the other hand, British Petroleum scoffs at these forecasts as too pessimistic.  Instead of total availability of 2-2.4 trillion barrels of oil remaining, they forecast that there might be 4 trillion barrels remaining to be tapped.  If BP were right, it would add about 20 years till we reach peak production.

There are optimists like Cambridge Energy Research Associates (CERCA), which think we can squeeze out an additional decade or two before we reach "peak oil."  They follow the economic theory that higher prices will result in new technology that will increase our oil production.  Again, they concentrate on the machines (capital, labor, and technology) and not on the energy necessary to drive them, which will be discussed shortly.

Though we hope that the more optimistic projections will be more accurate, they all show that there is a critical shortage of oil in the not too distant future.  In the sweep of history, a 20-year window is insignificant.

There is one more reason to be concerned about our dependence on oil.  The world's major economies are slowly but surely on a course to make us pay for our profligate consumption.  Because the U.S. dollar is the world's primary reserve currency and all oil has been traded in dollars, we have been able to pay for our oil by simply creating credit.  We have been getting oil, in effect, by giving the world Treasurys in return.  As the position of the dollar diminishes as the world's reserve currency, our dollar is depreciated because of huge federal and trade deficits, and oil being traded in other currencies; our purveyors will begin requiring valuable goods and services in return.   Unfortunately, we don't produce enough of what they want at competitive prices.  In short we are going to have to begin paying for oil in current production instead of it being financed by foreigners.  This will be painful for our economy.

Let us summarize for a moment, the leading economists and the government view that labor, capital and technology are the principle factors of production. This theory not only lacks logical sense, it does not stand up to even casual observations of the real world economy.  The presumption that the non-renewable resource of oil has no supply constraints as long as the price is allowed to rise is simply absurd.  And, finally, rather than supporting their claims with reason and data, they simply dismiss the real world situation and justify their position by relying on the dubious political claims of Saudi Arabia that there is plenty of oil for everyone for as long as necessary.  So, this in summary is The U.S.'s Plan A for energy, supported by toady economists.  There is no Plan B.  This farcical situation would be comical if it were not so tragic.

Tomorrow: We're running out of fossil fuels