Why the Economy Can't (and Won't) Really Stabilize as Long as We're Dependent on Oil

It's the price of oil, not interest rates, that is the real control knob of economic expansion or contraction.

In 2007, just before the initial debt crisis that heralded in the Great Recession, world demand for oil, for the first time ever, exceeded supply [1]. As a result, in 2008, oil prices hit unprecedented levels near $150.00 per barrel. This, combined with hugely over-leveraged banks that were unable to withstand the economic headwind, precipitated and catalyzed the financial crises that followed.

To understand why, it's necessary to remember that in the present world economy, oil is almost literally everything: electricity, transportation, agriculture, plastics, chemicals of all types, etc., ad infinitum. So what happens at $150 per barrel, for example, is that trans-oceanic shipping (a large container ship can consume more than 350 tons of fuel per day [2]) of all but highest-margin merchandise becomes unprofitable and stops. Agriculture -- both fertilizers and pesticides are made from oil -- becomes very expensive and food prices rise accordingly, further slamming the brakes on the economy as people devote a larger fraction of their resources to sustenance, and in the case of the poorest societies on Earth, political instability ensues as people get hungry (indeed, food riots in Mexico, Africa, Haiti, and many other places were shockingly commonplace from 2007-2009, and were still occurring in 2010 [3]). The price of anything containing plastic goes proportionally up. Oil at $150 per barrel means gasoline prices in the US exceed $4.00 per gallon, meaning folks living close to the edges of their means -- or most Americans -- now have to cut somewhere else, decreasing demand for products and services that power the economy, and in the case of those closest to the edge, mortgage payments begin to slip.

In short, we're massively over dependant on oil. Oil is everything. The overreliance on potatoes by the Irish in the 19th century is trivial by comparison.

Until renewables provide a large enough proportion of our energy needs to reduce demand for oil to the point that its price can remain more or less permanently manageable, our economies will be chained to its cycles of boom and bust. When the world economy is going gangbusters, oil use will spike, oil's price will spike, and economic contraction if not crash is unavoidable. The ensuing recessions or even depressions will dampen demand such that oil prices plummet, the world economy once again becomes cheap to run, and recovery ensues. Recovery will precipitate increased demand for oil and the cycle will repeat itself.

Following the crash of 2008-2009, oil fell from its economy-crushing heights all the way down to $33.00 per barrel. Now, as recovery begins to take hold, we're back above $91.00 per barrel, and as of this writing, climbing. The counter argument that oil prices can be brought back into check by simply asking OPEC or other oil producing entities to crank open the spigot are, unfortunately, uninformed [4, 5]. Oil producing nations were running flat-out in 2007-2008, and still, in a hot economy, demand exceeded supply. And, even if producers could easily increase production, it's naïve to think that they would do it just because we asked. Oil, being everything, is the most powerful lever on Earth at present, and nations and corporations, not even necessarily those we would define as 'enemies,' can and do use that lever to press their advantages. In addition, blaming the 2008 oil price spikes on 'speculators,' as opposed to fundamentals of supply and demand, is easily debunked [1, again], and is like saying oil companies are responsible for the fact that there's oil in the ground in the first place. Do they do everything they can to exploit that situation for a profit? Hell yes. Were they the cause of those conditions? No. Speculators and other investors merely observed and capitalized on the existing situation.

Thus, the economic cycles of our age. Forget interest rates -- from 2007 until we can permanently depress the price of oil, the driver of economic expansion and contraction will be defined by dollars per barrel. It's a simple function of supply and demand, it touches everything, and it's the same the world over. Worryingly, last August, Goldman Sachs reported that already, with the recovery just gaining momentum, world oil demand may again have exceeded supply [6]. And just this morning, Fatih Birol, chief economist at the International Energy Agency, told the Financial Times that oil prices are entering the "danger zone" and threaten to derail the fragile global economic recovery [7].

I'll discuss solutions in later posts (and in a sense every post is about the solutions), but for now suffice it to say that we have to stop using oil everywhere that a non-oil alternative exists. Now, fortunately, baby steps are being taken to actualize these non-oil alternatives. Solar, wind and other renewables are providing more electricity than ever (but still only a tiny fraction of totals), there's an emerging focus on local(ish) farming (as opposed to trans-hemispherical strawberries), there's an emergence of lower-chemical agricultural methods, and the first real attempts at electric vehicles are finally arriving in showrooms, to cite a few examples.

From our perspective as portfolio managers, this is fantastic, welcome news, but it is only the meekest beginning on the path toward ending our dangerous economic vulnerability to oil prices. We believe these small beginnings will rapidly advance into the next great technological revolution, and this, more than anything else, defines our investment thesis. When things are most dangerous, opportunity abounds for one simple reason: capital and other resources must flow to the solutions. Evolve or perish.

Garvin Jabusch is the cofounder of Green Alpha Advisors, LLC and manages The Sierra Club Green Alpha Portfolio -- a unique blend of Green Alpha Advisors' Next Economy universe and the Sierra Club's proprietary green-investment guidelines.

[1] http://www.eia.doe.gov/emeu/steo/pub/special/2007-oil-prices.pdf
[2] http://www.gizmag.com/shipping-pollution/11526/
[3] http://en.wikipedia.org/wiki/2007%E2%80%932008_world_food_price_crisis
[4] Christian Schmollinger and Shigeru Sato: "Al-Naimi Says Saudi Oil Output Below Target; Stockpiles to Fall", Bloomberg, April 25, 2009
[5] "Crude Oil The Supply Outlook", Report to the Energy Watch Group, October 2007, EWG-Series No 3/2007
[6] http://peakoil.com/production/bloomberg-goldman-says-oil-demand-may-have-exceeded-supply/
[7] http://www.guardian.co.uk/business/2011/jan/05/oil-prices-threaten-global-economic-recovery

General Reference:
Matthew R. Simmons: "Twilight in the Desert. The Coming Saudi Oil Shock and the World Economy", John Wiley & Sons, Inc., Hoboken, 2005.

Comments

[Claudia]

Great points you make Garvin. Have you seen the Oil Imports Map from Rocky Mountain Institute? Fascinating to see exactly where our oil comes from - who knew we were so dependent on Canada, for example?!

Check it:

http://move.rmi.org/features/oilmap.html

[Garvin Jabusch]

Thanks Claudia, cool map. American progress has a similar one I like to show during presentations. http://www.americanprogress.org/issues/2008/05/oil_imports.html
The good part about getting 100mm+ barrelsday from Canada is that at least the $$ spent doesn't fund a hostile (well, not yet, lol) regime, and it does't require the same massive supertanker emissions to get it here. The bad part about Canadian oil is how much of it is derived from extremely dirty tar sands.
No matter how you slice it, replacing oil with renewables where it's commercially practical to do so is clearly the way to go.

[Garvin Jabusch]

This Bioscience article provides a fascinating addendum to the 'we're gonna need a ton of renewable energy to keep economies afloat and even growing' theory. Here's NSFs synopsis:

A study published in the January 2011 issue of BioScience establishes macroecological correlations across countries and over time between per capita gross domestic product and per capita energy use. The authors infer a causal linkage. Correlations between these same two measures and measures of life-style quality lead the authors to believe that energy production would have to increase several-fold to support a still-growing world population in the current U.S. lifestyle.

Here's the link to the article:

http://www.aibs.org/bioscience-press-releases/110107_study_finds_energy_limits_global_economic_growth.html

[Jean Leroi]

Hey Garvin, cool article. i could not agree more about the myth of "scheming" speculators being behind the 2008 $150 oil price. If you looked at the exchanges at the time, the open interest overall was decreasing as the prices shot higher - meaning that speculators in aggregate were getting "out" (much of it at a loss from short bets!) I fear that major behavioral changes for the better in the US will matter little (sweet tart in the ocean?) - as long as major net oil consumer nations like China and India continue to grow 5%+ yearly without needing to answer to the same regulatory pressures. A Beijing trafffic jam is an almost unquantifyable sight - if you have ever seen one ? "tertiary" fuels - like ethanol are also bullsh*t i feel, due to displacement of food producing acreage - aggravating food prices in turn, and at the base of it, the fact that most/all so called "bio fuels" use oil at the refinery stage. Ditto for battery production (and the eletricity generation needed to "fuel" them, and hydrogen production! We need a magic pill on a scallable/storable/self-sustaineable basis. 'Don't know of one. I look fwd to carrying on the conversation over some wood fired/farm distilled apple jack!

[Garvin Jabusch]

Merci, M. Leroi.

Yeah, honestly, folks such as yourself with the wherewithal to take even a short look at the underlying data knows better than to believe the 'speculator' story. And you're right again that both population growth and rising affluence are having a huge effect on oil demand, which, of course is the real basis of price increases. I do think that as the (for the moment) largest economy and as by far the largest per capita consumers of petroleum products, the US could lead by example and furthermore could create a lot of value and wealth by leading the world in cleantech. Unfortunately, for now, we've ceded that lead to China. And, you're correct again in that small behavioral changes won't matter too much; what I mean by 'leading in cleantech' is major, disruptive change, such as converting the entire passenger car fleet to EVs. On that, it's true that battery production is energy intensive. But the final EVs are so much more efficient than gas-burners that it's still worth doing. Further, once we have an electric fleet, we at least have the possibility of powering them with renewables. But here again, China is leading the inexpensive EV business with BYD, which will begin selling cheap cars into the US market in early 2012. These are all topics I tackle in upcoming blogs. I gotta get to work on one on biofuels, too. There's a current study about deriving fuels from land unusable for crops that could change the conversation. I'm still not a huge fan of the whole topic, though, except for some specific uses and only when the source crops don't in any way hit global food supplies. http://www.wired.com/autopia/2011/01/study-weve-got-plenty-of-land-for-biofuels/

[Garvin Jabusch]

The Economist is making essentially the same argument today. They stop short of concluding that we need to get off oil, though.

http://www.economist.com/blogs/freeexchange/2011/01/energy_prices