Part 3: The ‘Oil Economy’ Begins to Crumble

The Global Implications of Oil Price Renormalization, Part 3: The ‘Oil Economy’ Begins to Crumble

Offshore Oil by Greg Locke © 2013 - www.greglocke.com

White Rose offshore oil project, Henry Goodridge, Photo by Greg Locke © 2008. www.greglocke.com

JIM MCNIVEN  
December, 2014  

 It has been 155 years since a commercial quantity of ‘rock oil’ was found. Through much of that time, uses for its refined liquids gradually expanded, from lighting to fuel oil to gasoline and the automobile. Gradually petroleum became the energy source of choice, though coal and natural gas were large competitors. During World War II, the Allies recognized that control over oil reserves was critical to success on the battlefield, but it was not until the 1970s that the world realized that oil supplies and prices were now one of the determinants of prosperity. 

In the early 2000s, a 15-year period of price stability was broken and the world went through a decade and more of gyrations in both oil prices and economic growth. Now the price has fallen by 25 per cent or more and there is the probability that it will not rise for a number of years. The rise of United States oil production to the point where that country may not become a net importer for a number of years has pushed the world’s producers into oversupply, just when many other producing governments have become extremely dependent on this revenue for various policy reasons.

Now, some 50 years after oil prices began to dominate world thinking, the broader situation is starting to change. First, we are starting to slide into what might be called ‘the electric economy’. By this, I mean that the core economic form of energy is electricity and its production is coming from sources that are more diverse than ever before. Here are some examples.

Across the economy, social function after social function is being subsumed into the broad internet. We see this most obviously in terms of communications, such as cellphones and products like Facebook, Twitter, Netflix and music streaming. The wired world also is expanding into production via 3D ‘printing’, into automobiles, both in terms of electric vehicles and in terms of the electronics that govern steering, braking and even actual driving. Now there are discussions of the ‘internet of things’, where household functions, such as heating and refrigeration, may be linked to programmed responses. Such an economy may still use petroleum products, but not in the intensive manner as, say, in the 1970s. 

Of course, a lot of electricity is generated by petroleum products, but even here, there is change in the works. Alternative energy sources, such as wind and solar, have grown 20-fold from a small base over the past 20 years while oil production has grown 25 per cent. The World Energy Organization expects energy alternatives to grow another 4-fold in this decade, while petroleum production increases 18 per cent. The price for electricity from some solar and wind sources is now competitive with some coal and oil-produced electricity, even without subsidies.

The relative size of today’s production from all these sources is not the question to ask. What is important has to do with congestion theory. It does not take much change in the number of drivers trying to cross a crowded bridge to go from a free flow of traffic to a traffic jam. Similarly, it does not take a large injection of technologically sophisticated alternative sources to cause a kind of energy ‘traffic jam’ where oil production growth falters as alternatives prove economic and prices stay low for a long time. While the present price decline might interfere with new installations of relatively expensive alternative energy facilities, the technological forces behind the industry will continue to search for more cost efficiencies to be deployed when next the oil price rises.

There is another subtle force at work in the global economy that hardly existed when oil prices rose around the turn of the century. That is the spread of aging demographics in nearly all developed countries. As larger proportions of people in Europe, Russia, Japan, Canada and Australia—and soon China— begin to retire, their incomes will decline. Pensions as a rule do not pay as well as salaries. These pensioners will either cut back on consumption or will dis-save to replace the missing income. In both cases, the prospect of deflation emerges. Rather than declines from oversupply at high prices, prices decline because structural demand declines. Japan has been in this situation since the mid-1990s and the rest are following. Again, it does not take a large proportion of the population to reduce its consumption to create deflation. We have no idea how to live with deflation.

Energy requirements in many economies are also affected by the continuing dissociation between GDP growth and energy usage. This has been going on for decades, but when it is combined with the deflationary effects of demographic change, it can affect energy pricing. Given the need to choose between a tank of gasoline or access to Netflix, what shall a senior do? These things sound trivial on the surface, but if they affect nearly half the population in countries that consume most of the world’s oil production, they can add up.

Finally, for as long as the U.S. is able to be nearly self-sufficient in oil, or at most self-sufficient with the help of Canada and Mexico, the ‘almighty’ dollar is going to be almighty again. Japan is trying to devalue the yen as we speak; other countries may imitate it, but no matter. The dollar will appreciate anyway and this will challenge the rest of the world’s producers and consumers. Oil is sold in U.S. dollars and any generally serious appreciation in the dollar will lead to further pressures on producers to lower their prices. In fairness, lower oil prices will constitute an incentive to consume more over time.

All in all, the international arrangements that have characterized the ‘oil economy’ for the past 50 years are not collapsing, but they are beginning to crumble. Alternative energy technologies, the internet of things, aging societies and the rise of new production in the United States have all begun to change the traditional arrangements around the production and sale of this commodity. There are other forces at work, such as the existence of huge shale gas fields in China, that should go into the new mix as well, but maybe we can come back to those later.

Copyright © 2014 James D. McNiven

Contact: j.mcniven AT dal.ca

Click here to return to Jim McNiven’s page.

Related reading:

To understand the global oil market, it helps to grasp the history and makeup of the commodity. In North America, from time immemorial, the Indians in the Western Allegheny area had skimmed oil seepage off the surface of the water and used it as a medicine. The settlers called it ‘Seneca oil’ after the local tribe, and used woven cloths or skimming boards to get the seepage off the water’s surface. Some entrepreneurs began to bottle and sell it as a cure-all. According to one version, “se-nay-kah’, as it was pronounced, oil entered the American popular vocabulary as ‘snake’ oil.

Part 2: The nasties and pleasantries of the decline in oil prices

Attempts have been made since 1859 to control the price of oil — or, rather, the price of its refined product, be that kerosene for lighting or, later, gasoline for autos. The first one to try was John D Rockefeller with his development of the Standard Oil Trust in the 1860s and beyond. OPEC, or the Organization of Petroleum Exporting Countries, is the latest attempt, dating back to the 1960s, and is based on the export of oil by the global low-cost producers, in particular Saudi Arabia. In effect the Saudis, as price leaders, try to keep the price stable by varying their own production and pricing, so as to discourage its partners from overproduction or short-term greed. Generally, when prices are high their cheating is rampant, and when prices are low their cheating is rampant. Well, here we go again.

 

Jim McNiven

James McNiven has a PhD from the University of Michigan. He has written widely on public policy and economic development issues and is the co-author of three books. His most recent research has been about the relationship of demographic changes to Canadian regional economic development. He also has an interest in American business history and continues to teach at Dalhousie on a part-time basis.  Read Jim McNiven’s bio

 

 

 

 

 

 

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