What does $120 oil mean for the global economy?

During the 1990’s an increase in oil prices of $10 reduced growth of real GDP by approximately one-half percent. Hence the concern after 2001 as oil rose from $20 to $40, then panic as oil rose from $40 to $80. At $120, oil prices are up 6x from the 1990’s average. Where is the global recession most economists expected if oil prices skyrocketed? (Matthew Simmons was one of the few experts who questioned this consensus, saying that rising oil prices were not necessarily poisonous to GDP.)

Or, reversing the equation: oil production has been almost flat since mid-2005. Where is the global recession Peak Oil doomsters predicted for a period of flat oil output? Since mid-2005 global real GDP has risen approximately 10%, despite Peakists’ prediction that growth was impossible without more oil.

The key to all of the above is the price of oil. The magic of prices. The response to rising oil prices comes in two forms. First, there are the conventional rapid responses to rising prices (e.g., drive less, slower economic growth). More important is the lagged effect of prices. Over months and years people change their personal behavior and business practices, and make capital investments that adapt to higher oil prices. Result: the global economy grew at almost 5%/year as growth in oil production slowed — then stopped.

What made this possible?

  1. The economic stimulus from re-cycling of funds from oil exporters to consuming nations through investments and purchases of goods/services.
  2. Reduced discretionary consumption (e.g., vacation locally instead of at DisneyWorld, moving the thermostat higher in summer and lower in winter).
  3. Capital investments that yield increased efficiency (e.g., hybrid cars, insulating buildings).
  4. Fuel-switching (e.g., electric vehicles, solar for diesel generators).
  5. Substitution, as high prices change cost structures (e.g., local goods replace far-away ones, rail transport replaces trucks).
  6. Economic stimulus resulting from alternative energy projects.

In economic jargon, the price elasticity of oil demand changes as prices rise. it just takes time. As we saw in the 1970’s, this Econ 101 dynamic surprises people. For a current example, see this Bloomberg article.

This process is just starting. Oil prices spiked in 1972. By 1979 these dynamics kicked in strongly. After 7 years of rising oil prices, global oil demand was flat for the next 14 years. After six years of rising oil prices, we might see something similar occur during the next few years.

Aprox 40% of Asia’s consumption is at subsidized prices, an expensive way for governments to mute the price signal — slowing their nations’ adaptation process. The world’s adaptation to peak oil will accelerate as these government’s are forced to reduce subsidies for oil.

A more important lesson learned

In hindsight we see that economists were wrong, but that bald statement overlooks the valuable lesson to be learned. What passes for analysis in energy research is in fact mostly inspired guesswork. Consider reports like the Robert Wescott’s “What Would $120 Oil Mean for the Global Economy” (April 2006):

If oil increased to $120 a barrel {from $60 – 70} and stayed there for a year because of coordinated terrorist attacks on oil facilities, the world’s oil bill would be about 8% of world gdp (even assuming some reduction in the quantity of oil demanded) — higher than at any time in modern history. Such oil prices would almost certainly precipitate a global recession. In addition to negative demand effects, there would be large negative supply side effects, policy effects, and confidence effects.

Meanwhile, financial markets would likely judge these attacks on global energy supplies more seriously than Iraq’s 1990 invasion of Kuwait or the 9/11 attacks, because of their continuing disruptive effects. Stock market valuations would likely fall more than they did after the Kuwait invasion or after 9/11. Given the negative confidence effects and negative supply effects, the global recession would likely be severe.

While current conditions do not match his scenario — oil prices rose over two years (not instantaneously), and have lasted only weeks (not a year) — yet it is clear that this report did not adequately weight the effects described above.

What should worry us all is that work like Wescot’s and the Oil Shockwave simulations of 2005 and 2007 are among the best-funded and executed energy forecasting projects — and are just sidewalk sketches compared to what we need. The complexity of the task and its importance to America’s future means that far more data collection and sophisticated modeling is needed to produce results that are better than guesses.

There are many confident recommendations for our response to rising oil prices — based on guesses — but few calls for more research about the problem. Perhaps too many of our experts are comfortable guessing. With each new change in the energy world they blow bubbles of froth, comforting or terrifying depending on their personal predilections.

It need not be so. We have the talent to assemble multi-disciplinary teams (e.g., chemists, geologists, mathematicians). We either have or can buy most of the data needed. A key piece the CIA could probably acquire: what are the reserves from our Middle Eastern allies.

The cost would be trivial, as government projects go, and would provide a foundation for planning and investment to prepare for Peak Oil — whenever it happens. Conceptually this would be like the creation of the great National Income and Production Account “flowcharts” in the 1930’s, which are the foundation for today’s economic reporting and analysis systems.

The elephant is great and powerful, but prefers to be blind.
David Halberstam, The Best and the Brightest (1972)

Please share your comments by posting below, relevant and brief please (max 250 words). Too long comments will be edited down (very long ones might be deleted). Or email me at fabmaximus at hotmail dot com (note the spam-protected spelling).

For more information about Peak Oil

  1. When will global oil production peak? Here is the answer! (1 November 2008)
  2. The most dangerous form of Peak Oil  (8 April 2008)
  3. The world changed last week, with no headlines to mark the news   (25 April 2008)
  4. Peak Oil Doomsters debunked, end of civilization called off  (8 May 2008)

Here is an archive of my articles about Peak Oil.

Here are other resources about Peak Oil.

Click here for all posts discussing good news about America’s future.

7 thoughts on “What does $120 oil mean for the global economy?”

  1. Marcus Vitruvius

    Two comments, actually:

    First, I think you only address one third of the economic situation, the United States’ and the West’s third. The other thirds are the struggling non-oil economies, and finally, the oil-exporting economies.

    Second, I agree with the need for a greater understanding of these problems. But I don’t think the solution will come through having more data and more experts, but through new approaches. Specifically, I think we need much better computational modeling of these problems. This will NOT be an easy problem.
    Fabius Maximus replies: I do not see the basis for your comment. These dynamics apply to developed, emerging, and 3rd world nations — although not equally well, esp in 3rd world nations. I specifically mention the Asian controls on oil product prices (many oil exporters also have these, but are less likely to remove them).
    I esp do not understand your second comment. To whom do you look to develop “better computational modeling” if not to the multi-disciplinary teams I mentioned, consisting of mathematicians, geologiest, and so forth?

  2. Computer models instead of (and not based on) data? Do we want a repeat of the global warming?
    Fabius Maximus replies: I do not understand your comment. I said ” We can buy the data; the CIA could probably acquire much of the vital data on reserves from our Middle Eastern allies.” As for the rhe rest of the information needed, we have excellent data on production and consumption of data for the developed world. Some data for the emerging nations (little or none for the poorest, but they have little weight in the global economy). This would largely be a data collection and modeling exercise, to a large extent modifications of the existing global macroeconomic models.
    I tweaked the text for greater clarity about this, as it is a critical point. As Baduin says, we do not want to go down a blind alley as has climate research (although it is slowly emerging, as science tends to be self-correction).

  3. Fabius,

    I see this as a good thing, if our leaders take advantage of it. We need to transition NOW! to alternative energies, and not when we have passed peak oil. As you have indicated before, it will take a generation to do this in forms of the logistics required. We use to much oil, to much thoughts of entitlement for everyone, eat too much (why so many are obese), waste a lot. We need to mass transit more, ride bikes and walk, eat less, and start being responsible.

    Fabius Maximus replies: I agree on all points. We are on the clock, and the natural economic adaptation processes are insufficient. Public policy measures are needed. I hope we do the necessary research and planning first, rather than inspired guessing leading to fire-ready-aim.

    1. re: (FM) [GREEN] “Public policy measures are needed.”

      Such as those that Jerry Brown pioneered in the late 1970s? And everyone else in the USA ignored, but the Germans made central to their system? And a deeper paradigm shift in culture is needed. Oh wait, it is already happening, just on the postmodern margins (Integral theory, spiritual/natural capitalism, LOHAS, etc.). (additional background: Ivan Illich “Vernacular Values”, Whole Earth Catalog, 1980?)

  4. Are you actually suggesting that “global recession” is not a prospect at the moment?

    You’re right about “guesswork”, but I dont share your confidence in a more “scientific, inter-disciplinary study. For one thing, these “expert” projects are always co-opted, if not actually funded, by special interests and their control of the legislative/administrative process. Change on the grand social scale necessary in this case is not a matter of the mind, but of the heart. It’s not about coming up with the right answers, but about the general conditions that will make people change their way of behaving.
    Fabius Maximus replies: I do not know if a ‘global recession” is coming soon. If so, I doubt high oil — or high commodity — prices will cause it. Why should it? Changes in prices re-distribute growth, income, and wealth. This is disruptive, but not destructive. To the extent that oil producers save more than oil consumers (true for the rich Middle East states, but not producers in general), their increase savings are a slight drag on the global economy.
    Preparing for peak oil is like fixing dams or building new sewage systems. While changes in peoples’ hearts might be significant over the long term, hard work can make a difference in the here and now. Sitting around waiting for changes in “general conditions” is imo irresponsible, and leads to unneccessary suffering.

  5. Here’s hoping (though hope is not a strategy) that fusion advancements are accelerated (pun intended).

    Unfortunately, U.S. research for fusion is being cut: See “FY 2009 Budget Request for the Office of Science and Perspectives“, Fusion Energy Sciences Advisory Committee Meeting (19 February 2008) — Slide 7:

    …The FY 2008 Omnibus Bill funding eliminated all US contributions to the ITER project, retaining only $10.6M for ITER R&D – Overall FES rises from $286.5M to $493.1M:

    – Calls into question the US commitment to fusion energy and U.S. credibility as an international partner; and

    – Increases the possibility that fusion will become a “donor” for shorter term priorities that do not address the Nation’s long term energy needs…
    Fabius Maximus replies: Thank you for posting this. I have cross-posted this on my May 4 post about the Polywell: “Fusion energy, too risky a bet for America (we prefer to rely on war)

  6. Fabius: not knowing how old you are, I risk condescension in writing that we have been here before: in 1973 and 1979. I was a graduate student at the time, specializing in environmental policy and science. Many texts hit the bookstores at the time addressing what Peak Oil – not a term of the times, but addressed nonetheless – would do.

    As you point out, Peak Oil effects are lagged. However, there also are insidious complex systemic effects that some astute authors like Barnett in “The Lean Years” (1979) that will complicate problem solution, if not make the problem insoluble. The complexity begins with the fact that our entire economy, from consumer goods to foodstuffs, is petroleum based. For example, the very keyboard I am typing on is plastic – a petroleum based material; the screen you are reading this comment on contains a great deal of plastic as well.

    The lagged effect of oil price increases will influence both private and public consumption (just what does one think “composites” in advanced wings are composed of?) in terms of reduced purchases and substitution. Ah, but here complexity enters further: substitutes for most petroleum based products are hard to find and typically more expensive. Even if they are possible, production of substitutes will take time to enter the market as we have reduced our manufacturing capabilities (offshoring and such.) Oh, but wait, another effect – we have maxed out our private credit, as witnessed in our most recent financial meltdown; our public credit is becoming shaky as alternatives to investment in dollars starts becoming attractive (like Euros.)

    I haven’t even begun to explore other N-order effects from this one domino, the Peak Oil price phenomenon, but I think the case is made that we are only at the beginning of a very complex and risky national security period in which our leaders should consider how we can “gracefully” degrade to a sustainable level of living from our current unsustainable level. What would happen if we decided to go “rogue,” e.g. take what we want from whomever thru use of military force?
    Fabius Maximus replies: Yes, that reply does exhibit quite a bit of condescension. Esp. as I have written 24 posts on the subject of Peak Oil, discussing these and other relevant dynamics — refering to some of the excellent studies by experts of these things.

    Also, nice of you to tell me about the debt problem. Note the 15 articles about this listed under “end of the post-WWII economic regime.” In fact, a new post on this very topic went up yesterday: “The most important story in this week’s newspapers.”

    Of course, writing 40 posts — well over 40,000 words — does not makes me right . After all, “on the Internet nobody knows if you or I am a dog.”

    An easy way to investiate these things before posting such a comment is to check the menu bar. The reference pages list articles by topic. The “category” list shows the number of posts in each, and goes to the actual articles. The tag and the category clouds not only do this, but also show the relative frequency of posts on each subject.

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