Peak Oil Economics

As nations and corporations consider energy strategies for the future, their beliefs about the current recession’s causes will prove critical. Is the recession the result of a normal business cycle? If so, then life will return to normal as asset and commodity bubbles are squeezed out of the economy. The price of oil will remain manageable, airlines will fly unimpeded, U.S. consumers will soon be looking for ever-more-powerful SUVs, and governments can afford to ignore fossil fuels in formulating policy.

Or, as a number of oil-market analysts have suggested, was the recession in part a consequence of “peak oil”—that is, an oil supply structurally unable to keep up with demand? If so, then the world is on notice that crude oil has entered its twilight years. Fundamentally new approaches to transportation will be required to maintain accustomed standards of living.

In the absence of new solutions over the short to medium term, periods of prosperity will be punctuated by recurring oil-price shocks and painful recessions as the world adjusts to an oil shortage.

Which thesis does the evidence best support?

It’s just a recession

By 2008, the gap between supply and expected demand equaled the output of Saudi Arabia.

The current recession is generally presented as a debt crisis. The Chinese savings glut, combined with a U.S. monetary policy that was, perhaps, too loose, allowed a bubble to develop in asset values, most notably in housing prices. Unscrupulous financial institutions compounded the situation by issuing poor-quality mortgages. When the housing bubble collapsed, the fall in prices and the inferior quality of many mortgages caused the failure of the banking sector, leading to the worst recession in at least half a century.

The recession, therefore, should be considered primarily a financial crisis.

Nevertheless, analysis by economist James Hamilton supports a more nuanced view. Hamilton, well known for his macroeconomic analysis of oil markets, attributes a substantial portion of the current recession to oil prices. Indeed, at August 2008, oil prices could explain virtually the entire downturn. Of course, Hamilton’s analysis suggests that other factors—like the mortgage crisis and the failure of Lehman Brothers—mattered, but oil prices clearly contributed to the downturn.

However, was it a peak-oil recession or merely a boom-bust cycle as seen so many times before in the oil and gas business? In a typical boom cycle, supply increases, but not as fast as demand, and scarcity pricing emerges. Prices continue to rise until consumers, investors and lenders are no longer willing to underwrite price levels, and the bubble pops. For key sectors of the economy—for example, oil and housing—a bubble’s burst is accompanied by a general collapse in demand—a recession—which serves to cool prices and restore market balance. At the same time, long-lead-time investments are coming online and supply is surging, exacerbating the situation.

Oil’s role

Today, there are no “bulls” in oil, only those who are somewhat more optimistic and those who are decidedly pessimistic. Understanding the industry’s restrained mood requires an understanding of the business since 2004.

Until late 2004, the oil supply had paced economic activity, and prices had fluctuated within relatively narrow ranges. In the third quarter of 2004, however, the oil supply stalled and continued flat through 2007, achieving only modest growth through the first half of 2008. Through almost four years, the oil supply grew only 2% in total. By the first half of 2008, a volume equal to the entire production of Saudi Arabia was missing compared with the quantity anticipated based on observed GDP growth, even allowing for normal efficiency gains.

Oil prices alone would have sent the U.S. into recession.

Nor have recent developments been particularly comforting. Peak global petroleum liquids (including unconventional and biofuels) production of 85.7 million barrels per day, set in May 2005, has been exceeded only in two months subsequently.

Non-OPEC production peaked in May 2005 and has not revisited that level since.

Looking forward, there are few oil-production bulls. Some analysts, including those of several major investment banks, believe that the July 2008 production number of 86.7 million barrels of oil per day will represent “practical peak oil.” They argue that given the recession’s adverse impact on investment in oil production, by the time the oil industry begins to ramp up again, accelerating production-decline rates from existing wells will dominate new production additions.

Other observers, including the Energy Information Administration (EIA), some oil companies and Douglas-Westwood, do not discount the potential for oil supply (including unconventional and biofuels) to grow to around 100 million barrels per day at peak.

By mid-2006, both European and Japanese consumption were dropping, with major U.S. declines following.

The EIA, in particular, estimates petroleum liquids at 106 million barrels per day in 2030 (although the agency has progressively reduced its forecast from 118 million barrels per day in just the last three years).

Demand, on the other hand, has enormous potential. China alone could increase its demand from some 8 million barrels daily to nearly 45 million daily by 2030 if it follows the path of South Korea at similar stages of development. The other BRIC countries—notably India and Brazil—could increase their consumption by 12 million barrels daily over 2005 levels. And importantly, if invisibly, the other non-OECD countries could increase their consumption by nearly 28 million per day. This may seem surprising, but other non-OECD countries include all of Africa and the Middle East, all of South America excluding Brazil, and Pakistan, Indonesia, the Philippines, Vietnam and the rest of Indo-China.

These countries’ oil demand rarely merits comment in the press, but collectively, they represent a population nearly as large as China and India combined and the lion’s share of world population growth to 2030.

Therefore, even if the advanced countries were assumed to hold consumption flat over the period, global oil demand might be expected to nearly double to 160 million barrels daily by 2030, assuming oil supply is available at affordable prices. By any reasonable measure, demand is likely to outstrip supply by a wide margin.

Emerging economies

How will the world cope? Understanding how the world has compensated since oil production stalled in 2004 provides a clue. For example, oil price rises averaging 25% per annum served to dampen demand. In addition, demand was sustained through much of 2007 and 2008 by continued draws on inventories, which fell to critically low levels. But perhaps most importantly, emerging countries began bidding oil away from the advanced consumer economies.

In the U.S., consumption peaked in early 2005 but settled in just below that level. European consumption peaked later, in mid-2006, but began falling soon thereafter. Japanese consumption, ever difficult to interpret, fell through most of the period. But by mid-year 2006, both European and Japanese consumption dropped in earnest, with major U.S. declines following after mid-year 2007.

The emerging economies will bid away the advanced economies’ oil supply.

By late 2007, by virtue of their own conservation, the advanced economies were contributing almost 1.5 million barrels per day to the emerging economies. The primary source of new supply for the developing countries had become not the oil-producing states, but rather the advanced consumer economies.

This, then, may be the pattern to anticipate in an era of “peak oil”—a time when available increases in supply may not be sufficient to power the aspirations of all nations. When this happens, prices will rise as the fast-growing economies bid away the incumbent users’ existing supplies.

How might this look in practice? Oil-supply growth to 2030 is uncertain, with estimates ranging from about 93 million to 106 million barrels daily. The accompanying chart uses 100 million per day as indicative. Clearly, demand will have to adjust to available supply.

By 2030, China will have nearly completed its “motorization” process, and we project that the country’s per-capita oil consumption at that time will roughly equal three-quarters of South Korea’s or half of the U.S.’ per-capita consumption today.

Only a recession caused U.S. consumers to yield their oil consumption.

If the countries’ per-capita consumption is further adjusted for forecast populations, then China’s oil consumption should be about twice that of the U.S. in 2030. But given that available supply will be less than desired, China’s, the U.S.’ and other countries’ consumption will have to be allocated pro-rata into a limited supply of 100 million barrels per day. This implies that the consumption of advanced countries must fall, just as it did after 2006.

For the U.S., consumption will have to decline by approximately 1.5% per annum, or about 2.3% on a per-capita basis annually. This implies total U.S. consumption of about 14 million barrels daily by 2030, down by a third from its peak of near 21 million daily in 2005, comparable per capita to Japan or Korea today, and still ahead of current European levels.

If we accept the notion that the U.S. will have to reduce consumption by about 1.5% per year to make room for growing economies like China and India, then the experience in the period after the oil supply stalled in late 2004 can suggest how demand might evolve. As the accompanying chart shows, demand did not fall smoothly and continuously. Despite high and rising prices, the U.S. consumer hung in for a grim death, and consumption was little changed until the recession hit in late 2007. This behavior is consistent with the much-noted demand inelasticity associated with oil consumption.

To all appearances, a sharp and traumatic recession was required to bring consumption levels in line with predictions, and the entire requirement—and more—was achieved in just a few months. This suggests one model of demand accommodation in the era of peak oil: global GDP growth—primarily in the developing world—continues for several years, the oil supply/demand balance becomes increasingly tight as incumbent consumers resist changes to accustomed behaviors, and oil prices rise.

When oil consumption exceeds the recession threshold, which we estimate at the cost equivalent of 4% of GDP in the U.S., a recession ensues, and developed economies rapidly shed large shares of oil demand. By rights, this share of oil should be quickly seized by the emerging economies during and immediately following the recession. As a consequence, the developed countries should anticipate being “locked out” at lower levels of consumption. The model predicts, for example, that U.S. consumption will top out at 19.0- to 19.5 million barrels per day, about 5% to 7% below earlier peaks, and never see 2007 levels again.

The lock-out can happen by two mechanisms: Emerging economies can recover before developed ones (due, for example, to excessive debt incurred by developed economies in attempting to defend accustomed standards of living), leading to oil consumption increases in emerging economies and increasing the price of oil to levels exceeding the tolerance of developed countries.

Earlier Douglas-Westwood analysis suggests that the U.S. economy cannot tolerate oil above $80. Indeed, the “lock-out” price per barrel of crude before the recession was about $70 for Europe and $75 for the U.S. Therefore, given that oil has been trading in the $70 range in recent times, the prospect of a coming lock-out for the OECD countries appears entirely plausible.

Alternatively, advanced economies could experience the recently-coined “peak demand,” where consumers abandon oil because they lose faith in its reliability, and therefore look for alternatives. But this would appear less likely, as there are few alternatives to gasoline- and diesel-powered vehicles, and arguably consumer behavior is more influenced by actual price than by theoretical blandishments.

In the end, the recession of 2008 was about more than oil. But oil played a material part. For the first time in history, spare oil-production capacity—even with the best intentions of the key oil producers—simply ran out. Production was unable to keep pace with demand—by a quantity equal to the output of Saudi Arabia. At the same time, advanced-country consumers resisted yielding their oil consumption levels to fast-growing emerging economies—not only for months, but for years. Only a severe recession induced advanced countries to reduce consumption; when they did, consumption fell at a pace not seen since the oil crises of the 1970s.

In the era of peak oil, sharp and painful recessions may prove the chief means by which oil consumption is transferred from the rich to the poor. If so, then this may be considered the first peak-oil recession, and more will follow.