Peakniks must embrace conventional economics

Many Peak Oil advocates - collectively known as "Peakniks" - are rightly suspicious of economists and the study of economics. In fact, the first opponents of Peak Oil were not actually oil geologists but energy economists.

The reasons why so many modern economists have it wrong about Peak Oil are actually quite simple - they do not understand the Peak Oil theory and their own economic theories and prognostications do not take into account the geological limit to oil extraction that is proved by Hubbert's Peak. The problem is essentially one of supply - oil production cannot be "ramped up" endlessly to meet demand. A good illustration for this is to pretend that oil production is like water going through a tap - at some point, despite the tap being open as wide as possible, the amount of water coming out the nozzle is getting slower and slower.

I believe that once economists understand the implications of Peak Oil, they will adjust their theories accordingly.

However, it is important that the Peakniks do not simply write off economists and the study of economics. Although confidence in the the study of economics is rightfully low amongst them, Peakniks must realise that the problem that Economists have is simply one of ignorance. The economic models that have been developed over the years are not somehow destroyed or made redundant by the spectre of Peak Oil. Economists, when they have the right information, are very valuable and can be very useful. The problem at the moment is not the economic models and theories that Economists have created over the years, but their lack of understanding of Peak Oil. Peakniks who worry about these things should therefore focus mainly on the ignorance of economists, rather than simply panning economic theories.

The reason I am saying all of this is because I see myself as understanding both sides - as a Peaknik and as a person who understands economics. And let me point out that many Peakniks need to understand basic economics.

The problem is that many peakniks have come up with what I term "Static Outcome Theory" when they look at Peak Oil. Realising that oil supplies will eventually begin to dwindle and understanding how important oil is to the modern economy, they see the world heading towards a particular conclusion. Extreme peakniks - "called Doomers" - actually see the end of western civilization altogether. Influenced by Richard Duncan's Olduvai Theory, "Doomers" view the lack of energy production caused by Peak Oil will eventually lead to a Malthusian Catastrophe - essentially a massive and prolonged population reduction.

Doomers represent a minority of Peakniks, but they are still very influential. Doomers see no answer at all to Peak Oil, and many are actually storing away food and ammunition so they can survive the coming apocalypse. The rest of the Peakniks, however, are more moderate and hold out hope that the world may be able to survive the coming Peak.

Nevertheless, when Peakniks look at the economic impact, they are essentially focused upon an end goal. "When the Peak happens, our society will end up in this particular situation" is what the Peaknik will argue. The particular situation that they argue will happen differs from Peaknik to Peaknik, but virtually all of them argue that the result will be economic chaos.

As a Peaknik myself, I also believe that Peak Oil will lead to massive economic problems. I, however, choose to use the more refined words that economists use. I would not argue that Peak Oil leads to economic chaos, but I would argue that Peak Oil will lead to a major economic realignment.

The reason I use "realignment" rather than "chaos" is simple. "Chaos" in the context of Peaknik argumentation, is a static outcome - it is a final outcome with nothing beyond it. "Realignment" infers a dynamic situation - a future beyond the major event. In other words, many Peakniks will simply point out that we are heading for a single, immovable social and economic situation called chaos. Beyond that, the Peaknik does not know what will occur. Those who understand economics, however, do have the skills and knowledge to work out what might happen. It is my understanding of economics that has allowed me to take a very "optimistic" position on Peak Oil.

Nevertheless, Peakniks need to reassess their static outcome theories, which I will now begin to address.

Static Outcome #1: Endless Hyperinflation
The economic "chaos" many peakniks argue will happen differs from Peaknik to Peaknik. Some argue that the situation will be like the 1973 and 1979 oil crises, except far worse. They see the "chaos" to be an endless bout of hyperinflation that cannot be overcome by traditional economic models. In this static view, hyperinflation causes people to invest in precious metals such as gold. Needless to say, massive unemployment and poverty will accompany this endless hyper inflationary outcome.

Much of the reasoning behind this view is based upon what I call the "Commercial Bank Money Printing Conspiracy". This is a rather popular but fatally flawed understanding of how money is created in a modern economy, and has been around for much longer than most modern Peakniks. It was developed apart from Peak Oil, but many Peakniks today seem to be embracing its flawed understanding of how money works in the modern economy.

The argument basically is that Commercial banks have the ability to print money, and rely entirely upon economic growth for their profitability. But when Peak Oil hits, and when the economy begins to contract/collapse (depending upon your POV), the bank's money printing will not match economic growth, causing a massive inflationary spiral.

All I will say about this is that this understanding of money creation is fatally flawed. Commercial banks do have the power to create money, but they are exceptionally limited in how much money they can actually create. A good illustration of how this works would be to compare the bank's ability to create money with an accountant's ability to create invoices. An accountant can only create as many invoices as can be matched by the debtors who are on the ledger. The accountant could choose to create invoices that are not matched on the ledger, but that would be stupid - no one would pay them and he would eventually lose his job. In the same way, Banks can only create as much money as the economy itself chooses to create. If a Commercial Bank chose to create money apart from this, then they would have their banking license stripped by the Central Bank.

Many Peakniks nevertheless would argue that a continual state of hyperinflation is a serious possibility, regardless of whether they believe the "Commercial Bank Money Printing Conspiracy" - but such an understanding would be more rooted in a misunderstanding or ignorance of how monetary policy is used in price stability. It would be well worth the effort of Peakniks to examine how monetarism gained influence during the 1970s, and how people like Paul Volcker, Allan Greenspan's predecessor at the Federal Reserve Bank, was able to use monetary policy to kill the rampant inflationary pressures from the 1970s. Many Peakniks would argue that lower inflation was due to a collapse in oil prices from about 1981 onwards, but are probably unaware that this collapse was caused by a major world recession that had its basis in Paul Volker's actions at the Federal Reserve.

Static Outcome #2: Endlessly high oil prices
Peakniks are right when they argue that the price of oil will go up because the supply of oil will be restricted as Hubbert's Peak begins to kick in. Nevertheless, Peakniks may not realise that the price of oil does also depend greatly upon demand. Demand, like supply, is not constant. If the demand for oil drops, then so will its price.

Many Peakniks would counter this by arguing that oil is the backbone of the modern economy. We can do without Coca Cola, but we can't do without oil. This is a half-truth, and it results in the belief that the demand for oil is actually a continual demand. In other words, oil is not subject to the normal fluctuations of the marketplace since demand is essentially constant and rising. Peakniks may even believe that, even while the world economy begins to contract, the demand for oil will just continue to increase. Moderate Peakniks may understand that there will certainly be peaks and troughs caused by market fluctuations, but would still argue that the price of oil will, over time, get higher and higher and higher.

And the reason, of course, is that many Peakniks see high prices in comparison to what they are today. If oil gets scarce, the price of oil gets higher, therefore the future oil price will be very very high because supply will be so low. It's a simple equation, and it has some truth in it, but it will not really reflect what will happen.

Statistics pretty much show that the demand for oil drops during a recession. The only way oil can continue increasing in price is if there is economic growth to push demand higher. Oil demand is NOT a constant.

I need to reinforce this point because some Peakniks may somehow think that I do not realise the massive importance that oil has in our society. Oil, they would argue, is more than just pumped into your car. It is also used for chemical feedstock to produce plastics and to produce fertilizers and other chemicals that are vital to maintain current agricultural output. Oil, in other words, is also directly responsible for the quantity - and cheapness - of the food we eat. In this sense, oil is an integral part of the "Green Revolution" and any scarcity of oil will, in fact, result in a loss of farm productivity. Moreover, we can't just suddenly reduce the demand for food - if food supplies drop because of Peak Oil, then the result will be mass starvation.

All this is true and I accept most of these arguments. However I would like to point out that, while oil is definitely needed to keep farm productivity at the current rate, a substantial majority of oil is still used to pour into our fuel tanks. It is this sector of oil usage that is capable of a reduction in demand. All I am pointing out here is that, even if oil production dropped to 50% of what it is now, there would still be more than enough to keep food being produced. Given a choice between cars and food, the majority would choose food. So while oil demand for agriculture is a constant, oil demand for other sectors is quite flexible - and is in those other sectors (transport, polymers etc.) that demand can be reduced without causing world-wide starvation. The market itself will ensure that this will occur.

Certainly, as a Peaknik myself, I do see the price of oil climbing to exceptionally high levels. Nevertheless, predictions of $1000 per barrel are just simply outrageous. The reason being that I believe that the scarcity of oil, over the long term (decades), will not be reflected by an ever-increasing oil price, but through other economic indicators.

Static Outcome #3: Endless unemployment
As a Peaknik I am convinced that the coming scarcity of oil will lead to a major economic readjustment - and that one of the results of this adjustment will be major unemployment levels. No one can ever accurately predict what these levels may be, but it is obvious from my point of view that the readjustment will be at least as bad as the 1930s depression - at least. Therefore I would argue that unemployment levels during this readjustment will reach levels never before experienced by anyone living in this current generation.

But my study of economics shows that unemployment has a cyclical nature to it, and that when a recession is over, employment levels begin to increase. Therefore I also see that, while Peak Oil will eventually cause massive unemployment, the economy will also eventually learn to adjust, leading to increased employment.

It is quite inconceivable that massive unemployment levels would remain on a permanent basis. Even Western Europe, for all the complaints over the seemingly permanent 10-12% unemployment rates that afflict nations like France, Germany, Italy and Spain - these nations still have 88-90% of the workforce employed.

It is perhaps at this point that a simple economic model can be drawn up to explain things better. Imagine you are living in an Amish community - albeit one that has no contact at all with anyone outside. The Amish community represents the world economy and everyone living in the world. Now let's say that one day a tornado rips through our Amish community and destroys every single house. Suddenly the entire Amish community is homeless and has suffered great economic and social loss. Of course, that tornado represents Peak Oil. After the tornado, what would the Amish do? They would band together and help rebuild their community. Everyone is gainfully employed (as they rebuild), but everyone has, at the same time, experienced a great deal of economic loss.

It is therefore entirely reasonable to assume, despite the continual onset of Peak Oil, that the massive unemployment it causes will have a temporary nature to it. No doubt the world economy will be permanently changed as a result of the peak, but there will still be a need for labour, and for production, and a demand for consumption. The world may be "poorer" because of Peak Oil, but this won't necessarily lead to permanent, massive unemployment levels.

Of course the Amish/Tornado model I have just proposed does not fit exactly - but then, nor will any "model" or illustration. Peak Oil is a continual problem while the tornado appears once and is gone. Nevertheless I would argue that the result is the same.

One thing that many people believe today is that economic growth and employment go hand-in-hand. Peak Oil, it is assumed, will lead to a continual and debilitating economic decline. Since unemployment only drops during economic growth, it is assumed that unemployment will be massive and permanent.

But, again, this assumption does not take into account "Steady-state economics" - which would probably argue that it is possible to have an economy that is neither growing nor declining, but still able to keep people employed.

There is an historical precedent to this - the Black Plague in Europe. The Plague devastated huge parts of Europe, leading to a massive reduction in population. Yet there is no evidence that I am aware of which shows that ordinary Europeans at the time had massive unemployment problems.

We need to remember that unemployment is actually a modern phenomenon that came along with the Industrial Revolution. Increases in productivity led to both cheaper prices and the obsolescence of many traditional industries. The industrialised world became urbanised as a result. Since the Industrial Revolution, the world economy has been continually growing. This means that current thinking about unemployment is wedded to the notion that the economy must always be growing in order for unemployment to be low. Theoretically, I can see no reason as to why the phenomenon of ultra-low unemployment that we see in the pre-industrialized world (which was essentially a steady-state economy, or growing at a very low rate) cannot exist in an industrialized world that has been rocked by Peak Oil.

What will happen?
It is difficult to know whether the current high oil prices we are suffering is the beginning of the Peak. Certainly I have seen evidence from OPEC that Light sweet crude has peaked, while total oil supplies have continued to grow. To me this indicates that "The Peak" is still a few years off, but then I may be making this assumption based on the wrong information (can we really trust OPEC?)

We are already seeing the results of high oil prices. Already monetary policy has been tightened in the last two years in almost every major industrialised economy to pre-empt inflation. What is going to happen when the peak is reached?

The first thing is obviously a sustained increase in the price of oil. With demand still high and supply unable to meet demand, prices will begin to rise.

Secondly, as the price of oil rises, so will inflation. Inflation is essentially the devaluing of money in relation to all goods and services that are produced. With oil supplies becoming less reliable, and with so many parts of the economy reliant upon the price of oil for factoring in to end costs for goods and services, inflation itself will begin to rise.

Thirdly, in response to a growing inflationary threat, central banks like the US Federal Reserve will begin to tighten monetary policy - they will raise interest rates. Raising interest rates increases the value of money since the central bank is creating a demand for them. The reason why interest rates are increased is to prevent inflation from breaking out. Interest rates are inflation killers. Unfortunately, higher interest rates are also economy-killers. Increased interest rates mean that people will borrow less and save more. Since much of the western economic system is based upon "borrowing and spending", interest rates will simultaneously punish both those who borrow (by making it more expensive) and those who spend (by making saving more attractive than spending).

Which leads, fourthly, to a recession. There will be a period of "negative economic growth" (which, to me, is essentially an economic decline). Bankruptcies, growing unemployment and mortgage foreclosures will accompany this.

The recession will, sixthly, lead to a drop in demand. The price of goods and services will begin to decrease - including the price of oil.

Seventh, with a decrease in prices, interest rates will then begin to fall, thus making it easier for people and businesses to borrow and spend again.

Eighth, this increase in consumption will lead to a drop in unemployment.

Ninth, this drop in unemployment will lead to economic growth and an increased demand for goods and services.

And, finally, tenth, this increase in demand for goods and services will lead to increase in the price of oil again.

After the tenth point, you can simply go back to point one - the situation starts over again.

This economic cycle is well known to all economists. However, I need to point out that, because oil supplies are still hard to procure (due to the Peak), the recovery will not, in real terms, match the level reached in the previous cycle. What I am pointing out here is that, although the economic cycle will continue throughout the post-peak years, there will be a structural decline so long as oil remains an integral part of the world economic system. Since modern economies appear to be getting better and better at preventing inflationary pressures through pre-emptive monetary policy, I would assert that the "structural decline" will be experienced as very low year on year GDP figures, and a decline in GDP per capita figures in nations that, on paper, are still growing economically.

But, of course, once the peak has been reached, and once governments, businesses and ordinary people finally understand the reason why this has occurred, the market itself (with a lot of government intervention) will seek to reduce its own reliance upon conventional oil supplies. While oil will still be pumped out of the Middle-east and the Gulf of Mexico, more and more alternative sources of oil - such as oil shale, tar sands and coal liquefaction - will become a market priority. Wasteful energy consumption that we see happening today in the form of Four Wheeled Drives (SUVs), badly insulated houses that rely upon fossil fuels for heating and/or cooling, as well as other things, will be curtailed.

EREOI and market prices
Peak Oilers speak of something called EROEI - Energy Returned On Energy Invested. It is essentially the idea that it would be stupid to use up, say, 10 barrels of oil in expended energy in order to recover, say, 8 barrels of oil. Peakniks are very strong on this subject, and it is one reason why so many believe that the so called "Hydrogen economy" mooted by many environmentalists will just not work, along with a whole host of other forms of alternative energy. The argument is that it is useless to be in a situation in which you lose more energy than you gain. It is a very powerful argument and it is also very true.

Peakniks who don't understand economics will point out that EROEI is the thing that needs to be examined - not price. So when an oil company decides to invest money in tar sands, they should not do so because it is economically viable, but only if it has a realistic EROEI. There is no point, they would argue, to divert economic resources into an energy source that returns less energy than the amount invested. Therefore, the argument goes, the decision must not be made on price but upon science.

All this is true, except that many Peakniks don't realise that, the more expensive energy becomes, the more an EREOI is reflected in the price the market is willing to pay. In a world awash in cheap energy - as we are at the moment - EREOI can mean quite little. Let's take the Athabasca Tar sands in Alberta, Canada. While it is obvious that this stored petroleum is massive, very little has been invested in the area in the last 25 years. The reason was simple - the price of oil was too low, and the cost of extracting oil from tar sands was too high. What is also obvious to those in the know is that the EREOI of traditional oil fields is much higher than the tar sands of Athabasca - thus making traditional oil fields more energy efficient than extracting oil from tar sands. In other words, the market price for oil and EREOI are actually linked together.

The upshot of this is that Peakniks should not need to worry too much about EREOI and not spend time slamming economics and businesses for their focus upon price rather than science. When energy becomes scarce, this is reflected in market prices. The market will not invest anything into any energy project with a negative EREOI simply because the cost invested will not match the money returned. In this sense, money and energy are essentially linked.

The Future
As energy becomes more expensive - since oil scarcity will make it so - the economy will adjust in order to cope with the increased cost. Fuel efficient cars, increased public transport, increased medium and higher density living will typify a society and an economy that will be trying to save money on energy costs. It remains to be seen whether solar and wind power, as well as other alternative forms of energy, will be viable. The use of disposable plastic will decrease as plastic prices increase, which means an adjustment in the way in which many people purchase certain goods.

The future is not bright, but nor is it bleak. Peak Oil will transform our world's use of energy way beyond out lifetimes. Historians will look back on this period and note that our values and economic activity were linked quite obviously to cheap energy in the form of oil. But the changes that we will eventually face will not come suddenly and rapidly, but slowly and painfully. Peak Oil was never about the world suddenly running out of oil (as some anti-peak oilers so ignorantly believe), but about the massive economic and social changes that will result from an ever-decreasing source of energy.

In the meantime, Peakniks must continue to warn people about the coming danger. It is not the end of the world - despite the protestations of "Doomers" - but it is a serious challenge to our way of life. The earlier we realise the Peak is coming, the better prepared we will be for the changes that will inevitably occur. What Peakniks must not do is dismiss economics and treat it as though it no longer applies. Instead, Peakniks must try hard to understand how economics works, and get a basic framework that includes monetary policy and the importance of supply and demand. Moreover, they must be very wary of promoting false and misleading theories, including the popular "Commercial Bank Money Printing Conspiracy" that I mentioned above. Peakniks are unlikely to convince those in power of the truth or Peak Oil if their understanding of economics is fatally flawed. Those in power are more likely to listen to truth coming out of the mouths (or websites) of those who have a sound understanding of more than just the physics of Hubbert's Peak.


© 2005 Neil McKenzie Cameron, http://one-salient-oversight.blogspot.com/





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