Monday, October 20, 2008

Peak oil and the financial crisis.

We have reached the lowest oil price for about a year – down around $70 a barrel from a peak of over $140 a barrel not so long ago. Is this a sign that the theory of peak oil, that at some point the rate of global oil extraction will peak, is false, or at least is not here yet? I suggest the recent pattern of oil prices, and the financial upheaval around the world, are signs that we are very close to the global peak of oil production. I will attempt to explain why this is the case.

First we need to catch up on some economic principles. The price of a good is a relative measure, and reflects how many other resources are required to produce it. Consider a $100 pair of shoes. The price basically represents that the shoe required $100 of other resources to produce it. Such things as labour costs, materials, rents, distribution, design, advertising, and so on. A $50 pair of shoes requires around half of the amount of inputs. When the price of shoes is on the rise, it reflects increasing requirement of inputs. Thus a rising price is a sign of increased inputs necessary for production. And this also means that these inputs to production cannot be used to produce other things.

Now consider what happened to the price of oil recently. Regardless of what you believe about hedge funds, short selling, or any other financial trickery, the trend was a steep price increase for that past two years or so. This is a sign that more resources have been needed to produce oil, and were subsequently not being utilised for other production. Thus, the total production of goods in the economy must eventually drop. This is exactly as peak oil theorists would predict.

But what of the recent price drop. Again, we have to wait and see what the trend might be in the longer term, but this is also consistent with peak oil theories. The point here is that over the long term, the relative price of oil and other commodities (apart form labour) will be relatively constant. When oil becomes more expensive, so do other goods that need energy from oil in their production. Only the overall output of the economy will fall. The price spike we have just witnessed may simply have been a speculative signal based on expectations of future growth that were never going to come true.

On another note, I keep wondering that if oil is a non-issue, why the US has made such a huge sacrifice in waging war in Iraq?

If I am right, and the rate of oil production has peaked this year, or will peak in the near future, this is not necessarily a bad thing. As long as this ‘crisis’ does not provide excuses to wage wars, we can continue living a rather luxurious lifestyle with a downward trend in production just as easily as we did on the upward slope of the past half-century. In time, technology will evolve and allow us to produce more once again. For an environmental economist, peak oil is blessing for the environment. If I am wrong a global recession is a nice rest of our environment anyway.


  1. Not a peak oil fan I must say, I think that it was just another bubble that burst. Look at commodity prices in general. This price move is driven by demand expectations, not supply.

    Also hearing of plenty of Chinese factories closing which should have a positive short term environmental impact. How much will a fall of 1% in the global GDP growth rate improve the environment I wonder? What would be the best measure of this improvement?

  2. Here's something to think about. OPEC is cutting oil output this week for the second time this year. Why would they do this when it is so obviously clear that high oil prices lead to recession? Won't this exacerbate the problem by further suppressing demand? Even at $60-70 a barrel, this is still represents a growth rate in oil prices of 8.5% since 2003.

    Also, my research over the past 18 months has lead me to believe that demand is not a driver of anything - it is supply all the way.

    Time will tell.

    A temporary fall in GGP (not the growth rate, but the output) would only be noticed at the margins - those areas waiting to be developed. But a long term decline is the best result for the environment.

    You could begin to quantify the environmental benefit by measuring air quality. At locations where factories are shutting down, it is likely to improve dramatically. There are plenty of other ways, but in the end you can never have a common measure.

  3. I agree that supply expectations influence price but I think demand expectations are a much bigger driver. OPEC cut last week and the oil price hardly budged... They increased production for the last 4years and price continued higher. Focus is on diminishing demand expectations at the moment and that is driving prices.

    Maybe in the long term your supply theory is valid but in the short term, market particiapnts arent rational, they're like sheep, and therefore we get such volatility in prices. Check out some crowd psycology and mass behaviour theories. Emotion plays a big part in market prices.

  4. I think we agree then that in the short term, expectations of demand are a driver, but in the long run, it's all about supply.