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by Steve McKinlay


Sunday Supplement, 21/11/04

It may have come as a surprise to many that the price of oil didn’t just magically stop at US$40 a barrel. As the price spiked into the mid 50s the G-7 finance leaders seemed to give up demanding the impossible — that OPEC deliver oil at $30 a barrel or less. There now seems to be little point. OPEC no longer has the spare capacity to flood the market with cheap oil — those days are gone forever.

Nevertheless we are yet to see New Zealand or indeed any OECD nation descend into an oil-price-shock-caused recession. Continuing strong economic growth in New Zealand fuelled by property goods and services markets and a strong dollar has seen continued interest rate hikes this year.

Rapid, or should I say rabid global economic expansion continues regardless. The EuroZone nations are expecting 2-3% growth and Australia is expected to ride the boom wave for at least another 18 months. There is un-stated collective attitude that consumption is good and that it will simply continue indefinitely.

The price of oil, so it seems, isn’t making a jot of difference to economic growth. In fact at the current price the opposite may be the case:

Andrew McKillop an international energy economist argues that higher oil prices in fact increase world economic growth by raising ‘real resource’ prices, through what he calls ‘the revenue effect.’ That is, any increase in revenue due to the price of a product increasing in line with the oil price is rapidly spent on purchasing more goods and services of all kinds. This phenomenon of course has corresponding inflationary effects.

Shortly after the politically induced oil shocks of the 70’s, interest rate hikes were used to combat the inflation that followed the exorbitant oil prices. As recessions set in around the world, demand subsided and the world crash-landed to abundant oil at around $18 a barrel.

As we continue to see economic growth in the face of higher oil prices we might reasonably expect the price under ever-increasing supply constraints and security concerns to extend out beyond US$100 a barrel. Only at such a price will the pro-growth impact of increasing resource costs be terminated by the inflationary effects. Unfortunately at this point, as we teeter on the edge of global recession, the time and resources available for a successful energy and economic transition will be severely limited.

Because unlike the 1970’s and 80’s the next recession will not be followed by a bargain-basement oil led recovery — there is no more cheap oil. Our economically amazing and expanding consumer driven world is approaching the all time oil production peak.

McKillop and others argue that the absolute production peak of oil will be around 90 million barrels per day, that’s 8 million barrels more than we consume now or the equivalent of Saudi Arabia’s production capacity. At the current 3% or so annual demand growth, we can expect to see peak oil occur around 2007, assuming of course that we can increase current production to this level.

To meet demand growth beyond 90 million barrels per day and taking into account an emerging depletion problem we will need to find a Saudi Arabia equivalent every year or so. An impossibility theorem matched only by the theory of eternal economic growth.

Shortly after the peak oil we will lose about 2 and a half million barrels per day to depletion each year, about 3% per annum. Structural supply deficits will rapidly emerge as the gap between available the supply and demand widens.

Economic growth is predicated upon increased consumption. To grow economically we need build more houses, drive more cars, import more consumers, grow more crops, use more electricity and buy more stuff. All of this activity is heavily reliant upon burning more oil. We cannot simultaneously grow and consume less.

Towards the end of this decade the emerging permanent undersupply of oil will at least lead to widespread economic crisis across the industrialised world. This is nothing new; many of us have experienced recession before. The challenge this time however will be to adopt different modes of behaviour. We will be compelled to make do with less of everything as a very new reality asserts itself. The economic dogma of endless growth will burn away with the last remaining barrels of cheap abundant oil.