The oil price ledge

Energy consumptionIt is a narrow space that separates the lowest cost at which oil can be sold and the highest price that an economy can afford to pay. And it’s getting narrower.

Our economy runs on oil, and the cheaper the oil, the better it grows. The relation is even clearer in the negative case: of the six economic recessions we’ve had since 1973, all of them were correlated with spikes in oil prices.

The biggest recession, in 2008, came in the wake of the biggest price spike. It was also arguably the first price rise due to long-term structural supply problems, considering the fact that the world’s production of conventional crude stopped growing in 2005. Ever since then, oil has been on the proverbial “bumpy plateau.” In contrast to the steady 2 to 3 percent annual growth of years previous, oil production has stayed at around 75 million barrels per day, showing minor fluctuations but no growth.

The result is an odd up-and-down economic cycle that has a lot to do with the fact that global oil supply is now essentially flat. It’s worth noting that supply is flat for geological reasons that trump neoclassical economic wisdom.

The bumpy economic cycle goes like this:

  • as the economy grows, demand for oil increases;
  • more demand on the same amount of supply drives up price;
  • which slows the economy;
  • which reduces demand;
  • which reduces oil price;
  • which increases demand;
  • Rinse, repeat.

It’s possible to get a numerical handle on all this, as some observers of the oil patch have started to do. The crucial factor they identify is energy expense as a portion of the Gross Domestic Product. Historically, when we spend about 9 or 10 percent of our GDP on energy, we get a recession — the economy slows way down, or stops growing altogether.

Total expenditure on energy at any given time ties very directly to the going price, because demand for oil is very inelastic, i.e., people are going to buy a given amount of oil at almost any price. They just go ahead and pay more, because they’ve really gotta have it. (In the case of oil, a 10 percent price rise results in just 2 percent less demand.)

What we get, then, is something we may have sensed all along: there is a price of oil at which our economy stops growing. Bang. Period. Like clockwork. A little under that price, it grows just a little; a little over, it stops. According Chris Nelder, one of the aforementioned observers, the economy starts to falter at $90 per barrel, and stops growing at $120, as it did in 2011.

The problem is that oil is getting more expensive to produce. Worldwide, the average cost to extract a barrel of oil is between $85 and $90. The spread between this cost and the economy-killing price point is a very narrow ledge that the industrial world now perches on, and getting narrower as oil becomes harder and more expensive to obtain.

This oil price ledge is so crucial that one of Nelder’s colleagues, oil journalist Chris Skrebowski, has offered an economically functional definition of peak oil: we’ve arrived at it when “the cost of incremental supply exceeds the price economies can pay without destroying growth.”

Now that’s something you can keep an eye on.

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