Oil Depletion and Economic Instability

A common assumption by the Peak Oil crowd is that a decline in the world's oil supply will lead to economic instability, possibly on a global scale. Unfortunately, those who put forward this argument rarely justify it beyond expressing a first-principles feeling that "Oil is in everything," or "Oil is the primary driver of economic growth." As a counter to their pessimism, economists typically point out that the energy intensity of the GDP (the amount of energy it takes to make a dollar of GDP) has fallen since the 1970s and should continue to do so into the future. The underlying fact that producing an extra dollar of GDP always takes more energy is their own tacit, unexamined assumption. A recent Peak Oil book by David Strahan called The Last Oil Shock (which I cannot recommend highly enough) contains a pointer to an analysis that supports the worriers and discredits the economists' optimism. I'll paraphrase the ideas here.

The standard economist's position has been based on a theory developed by Robert Solow in 1956. In Solow's analysis economic growth was driven by two factors, capital and labour, both of which were quantified financially. 70% of the money flow in the world goes to labour as salaries, 30% goes to capital as rent, dividends etc. Solow used some equations called Cobb-Douglas equations to map the growth function of an economy as labour and capital increased. He got nice curves, but when he tested his theory using historical data he found that it under-predicted the observed economic growth by two thirds. In other words, economies grew three times as fast as his theory predicted. The discrepancy was never explained (or even much discussed for that matter) but Solow was awarded the Nobel Prize for Economics in 1987 anyway.

Two physicists, Reiner Kummel and Robert Ayres, independently observed the global economic slowdown following the oil shocks of the 70s and 80s and wondered if the role of energy in the economy was being under-valued. Their analysis convinced them that the price of oil (which was used by Solow in his analysis) underestimated the productive contribution of oil by a factor of ten. In other words, to truly reflect the contribution of oil to the economy, it should be priced about ten times higher. They developed their own economic model that started from Solow's work but incorporated their findings about oil's productive contribution, and found that their predictions matched observed economic growth perfectly. In other words, for the role of oil to be properly reflected in a purely financial economic model, it would have to be priced at over $300 per barrel (they did their analysis when oil prices were much lower than they are now).

It looks as though economic growth is actually being driven by four factors, the most important of which is energy supply. The other three are energy efficiency, capital and labour. If any of the four increase an economy will grow, but energy supply has by far the largest influence.

What does this imply for a post-peak world? Well, the models by Kummel and Ayres predict that for every 1% increase in energy inputs you get about a 0.7% increase in GDP on average. The immediate implication is that a reduction of 1% in energy will cause a corresponding 0.7% drop in GDP. So if the the world's oil supply were to decline by 30% (as would happen in ten years of a 4% annual decline), the global GDP would lose 23% of its value.

Of course, this is a linear extrapolation, and doesn't take into account such things as the effects of investor psychology in the context of a permanently contracting global economy. The realization that the economy is in permanent decline will have a dramatic impact on investors' willingness to fund capital, thereby worsening a bad situation by reversing another of the four crucial growth factors. In addition, there is much speculation that a third of these factors, energy efficiency, may not be able to keep growing because efficiency improvements are asymptotic and we have already picked much of the low-hanging fruit. That leaves labour, of which there is likely to be a growing under-utilized pool.

Much of the mitigation of this scenario depends on alternative energy now. Kummel and Ayres' work did not differentiate between types or uses of energy, so a growth in non-fossil energy supply will help somewhat. We need to keep in mind, however, that the proposed replacements have much lower net energy (EROEI) than oil, natural gas and coal. That means that more of the economic growth they provide will stay within their sectors of production, and less will be available for making refrigerators, televisions, tractors or combines.

Then there is the ever-present problem of scale. Replacing that 30% drop in oil production with ethanol (which only contains two thirds of the energy of oil) would require the net production of just over half a trillion gallons of ethanol per year. When you factor in the net energy consideration mentioned above, you end up with a gross production requirement on the order of one and a half trillion gallons of ethanol per year. That's more ethanol than the oil we are currently producing, just to replace 30% of that oil.

We are in a lot of trouble, people.

© Copyright 2007, Paul Chefurka

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