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KAM Tan / 79-381 (Fall 2012) 1 Macroeconomic impacts of peak oil: implications for growth in the 21st century Kevin Alastair M. Tan Carnegie Mellon University Since the emergence of our species, the fortunes of human societies have been closely linked to their energy supply. This relationship remains equally important in the present day. Despite continuous gains in energy efficiency, global energy consumption has risen exponentially, closely mimicking patterns of economic growth. In response to the meteoric rise of oil prices during the mid-2000s, there have been fresh concerns over the world’s ability to maintain a growing energy supply. Oil production has remained steady since mid-2004 (Tverberg 2012; Rapier, 86), despite record-high prices and vigorous investment. These developments, along with the rapid growth seen in newly-industrialized countries, cast serious doubts on the ability of oil producers to satiate demand (Rapier, 87). Consequently, many economists cite tight oil supply as a primary cause of the 2008 financial crisis and subsequent continued economic malaise (Hamilton et al. 2009; Tverberg 2012). Regardless of the exact timing of peak oil, the macroeconomic impacts of an inelastic oil supply are already evident; a stagnant or declining energy supply is simply at odds with our growth-based economic paradigm. It will be very difficult for alternative energy sources and efficiency gains to compensate for ever-increasing energy demand alongside declining oil production. Energy and Wealth – Historical Relationships It is important to characterize the historical relationships between energy and wealth, as it is integral in framing peak oil within a broad historical context. They key to understanding these relationships is through the concept of energy return on investment (EROI). Simply put, EROI is the ratio of the amount of usable energy acquired to the amount of effort—or energy— KAM Tan / 79-381 (Fall 2012) 2 expended in attaining it. Even the evolutionary success of the human species can be attributed to energy utilization. With the advent of bipedalism, humans only required a quarter of the energy per unit of travel compared to other primates. Additionally, the discovery of fire externalized the significant energy requirements of digestion and temperature regulation. The resultant surplus of energy was then redirected to brain function, giving rise to humans’ superior cognitive abilities (Brown et al. 2011; Hall & Clitgaard, 42-44). In pre-agricultural societies, the EROI of hunting and gathering dictated population size and standard-of-living. If the round-trip distance of gathering the required amount of food exceeded 11 miles, EROI dropped substantially, as this required an additional days’ work (Hall & Klitgaard, 44). Hunter-gatherer communities were generally placated with an EROI at or above 10kcal gained to 1kcal expended. When EROI dropped below that threshold, communities became strained; the most common resolution was migration. Periods of competition and unfavorable climate conditions dropped EROI below 10:1 with varying frequency, spurring waves of human migrations (Brown et al. 2011). The agricultural revolution dramatically raised the EROI of food. The abundance of energy enabled the formation of cities, bureaucracies, and governments—in other words, civilization. However, the pre-industrial equivalent of Jevon’s Paradox is that gains in agricultural yields will be outweighed by corresponding increases in population and societal complexity (Hall & Klitgaard, 48). The net effect was a decrease in nutritional standards for the masses, and a general deprecation of quality-of-life compared to hunting and gathering (Tainter 191). As agricultural societies grew in terms of population and GDP, they eventually reached the production capacity of their territorial environment. Thus, in order to grow further, civilizations needed to use strategies of territorial expansion and subjugation (Hall & Klitgaard, 57; Tainter, 192). While initial expansion is quite fruitful, continued expansion gradually decreases in EROI until expansion is no longer viable. As territory expands and energy supply KAM Tan / 79-381 (Fall 2012) 3 grows, Jevon’s Paradox strikes again and gains are outweighed by corresponding increases in population and bureaucratic complexity. Additionally, territorial expansions result in increased military expenditures for defense; militaries tend to dominate civilizations before they collapse (Tainter, 193). Thus, the EROI of territorial expansion eventually drops below the threshold of viability (Hall & Klitgaard, 57) The rise and fall of Roman civilization is a classic example of the outlined developmental trajectory. The Romans were very adept at maximizing energy yields from their lands, using efficacious agricultural practices and advanced technologies such as viaducts (Tainter, 128). This gave them a stark EROI advantage over surrounding civilizations (Hall & Klitgaard, 58). Nevertheless, the Romans were still restrained by the biological limits of the land. Thus, they engaged in a robust strategy of territorial expansion to maintain a growing energy supply. As they conquered land, they cultivated them to their maximum potential through the application of Roman knowledge and technology (Tainter, 129-131). Most of the additional production was exported to core regions and the state (military, food subsidies, etc.). For a time, this strategy worked quite well; large urban centers like Constantinople and Rome enjoyed per-capita GDPs equivalent to today’s upper-middle income countries (Hall & Klitgaard, 59). Eventually, the energy requirements of maintaining a vast territory— transportation, defense, bureaucracies, commodities chains—exceeded environmentallylimited production capacity, with further territorial expansions resulting in diminishing returns or outright failure. At this point, the empire was under an incredible amount of stress. It took just one Barbarian invasion to induce the collapse of Western Roman Empire, ushering in a new era colloquially referred to as the Dark Ages (Tainter, 148; Hall & Klitgaard, 59). This trajectory of growth, limits to growth, stagnation, and collapse has been ubiquitous in empires throughout the world, from the Amerindian civilizations, to the Chinese dynasties, and even the Soviet Union (Tainter, 193). KAM Tan / 79-381 (Fall 2012) 4 The Hydrocarbon Revolution: Rise of the West The fall of the Roman Empire resulted in a rapid depopulation of the European continent as life-support systems like viaducts and food distribution networks fell into disrepair Klitgaard, 67). (Hall Hydrocarbon energy resulted in a corresponding increase in GDP Source: Hall & Klitgaard & Europe was an economic and cultural backwater. For several centuries before the rise of the West, the world’s superpowers were India, China, and the Ottoman Empire (Marks, 124). Due to favorable climactic conditions, education, and technological prowess, these regions enjoyed much higher EROIs compared to Europe, as Roman knowledge and infrastructure had been long lost (Hall & Klitgaard, 67). European travelers (i.e. Marco Polo) often sought to emulate the bountiful agriculture found in these superpowers. Foreign goods—particularly from India and China—flooded European markets, as the energy-starved and primitive industries of Europe could not compete with established industrial powerhouses (Marks, 125). As Europe had little to sell to the world market, there was a millennium of continuous trade deficit, which further trapped Europe in a cycle of poverty (Tainter, 191). Europe’s economic fortunes began to change during the 16th century renaissance, which coincided with the beginning of colonialism in the Americas. The ecological richness of unspoiled American land provided European powers with high-EROI sources of energy, primarily in the form of timber, sugar, cotton, and fish (Marks, 125). However, coloniallysourced energy gains were eclipsed by the mass adoption of coal, which first began in 1750s KAM Tan / 79-381 (Fall 2012) 5 Britain (Hall & Klitgaard, 69). Coal—a product of millions of years’ worth of compressed biomass—exceeded all previous energy sources in abundance, energy density, and usability by several orders-of-magnitude. For the first time, humanity could transcend the limits to growth imposed by annual solar energy flows—limits that had plagued all successful civilizations since the agricultural revolution. The end of the “biological old regime” in Europe marked the true beginning of the rise of the West (Marks, 126). The beginnings of industrialization utilized traditional sources of energy, namely hydropower. However, the true potential of industrialization was unleashed by the adoption of fossil energy (Smil, 1-3). Due to the abundance of energy, machines became ubiquitous and could be scaled up exponentially. The adoption of fossil energy in transportation introduced rapid mobility to the masses, effectively compressing space and time. All of these factors resulted in unprecedented gains in economic productivity, socioeconomic complexity, and population size (Brown et al. 2012). This new-found energy, wealth, and technology spurred widespread and systematic European conquest of the Americas, Asia, and Africa, further fueling the West’s meteoric rise. By the mid-19th century, the West had attained unquestioned economic, geopolitical, and military dominance the world over. Regions still stuck in the “biological old regime” entered a poverty trap due to limited energy access alongside varying degrees of economic, political, and military subjugation—regions now referred to as the “developing world” (Marks, 205-7) Neoliberalism – Energy, Debt and Growth In the decades following World War II, widespread reforms of economic liberalization, financial deregulation, and privatization have brought with it a new economic and geopolitical paradigm commonly referred to as “neoliberalism.” The resurgence of laissez-faire ideology was a response to widespread stagflation in the developed world. The perceived inefficiencies KAM Tan / 79-381 (Fall 2012) 6 of Keynesian economics and the welfare state were blamed as the primary cause of economic malaise; thus, these systems were eschewed in favor of the private sector and market forces (Hamilton et al. 2009). Aided by the efforts of transnational institutions such as the International Monetary Fund, World Bank, and World Trade Organization, the world’s markets— particularly in the developing world—had become much freer by the end of the 1980’s. This had the effect of accelerating the currents of globalization, bringing about a new level of economic integration and interdependency throughout the capitalist world—the mass delocalization of commodity chains (Hall & Klitgaard, 191-192). With economic liberalization and relaxed labor laws, neoliberalism spurred the deindustrialization of high-income countries. Freer markets made it viable for rich-world companies to access the low-cost labor and commodities markets of the developing world. Furthermore, the erosion of labor protections and deunionization made it much easier to outsource (Hall & Klitgaard, 193). In effect, this externalized much of the energy costs of developed nations, as energy-intensive industries such as manufacturing were outsourced to developing nations (Smil, 88). Thus, economies increased their dependence on oil, as transportation distances grew exponentially. The green revolution is also thought to be a derivative of neoliberal currents (Marks, 186). The green revolution increased agricultural productivity by 200-300%, resulting in a corresponding increase in world population. This was possible primarily due to the use of hydrocarbon energy inputs in agriculture: fertilizers, pesticides, mechanized farming techniques, and increasinglydelocalized food chains. Thus, Tight correlation of food and oil prices. Source: UN FAO KAM Tan / 79-381 (Fall 2012) 7 food prices became tightly coupled with oil prices (Hall & Klitgaard, 385-6). Overall, neoliberalism increased the “energy overhead” of economic activity. Neoliberal deregulation of the financial industry has caused it to become the dominant force in shaping the world economy Source: Hamilton et al. 2009 (Hamilton et al 2009). “No matter where you are in the world, you can’t do anything big without the approval of Wall Street” (Hall & Klitgaard, 191). Deregulation has facilitated the availability of credit, both public and private. The advent of complicated financial instruments such as derivatives serve as robust mechanisms of credit creation through the speculation or hedging of the value of other assets, called underliers. Underliers are a combination of commodities and other financial products such as mortgages, stocks, and bonds—in other words, the creation of credit through debt (Hall & Klitgaard, 197-9). Consequently, debt levels in rich countries have skyrocketed, often exceeding value of national GDPs two-or-threefold. Much of the economic growth seen in the neoliberal era can be attributed to debt (i.e. deficit spending), and its consequences have been felt in the form of financial crises and austerity measures (Hamilton et al. 2009). Mainstream economists cite economic growth as a reliable apparatus for sustaining high debt loads, as growth facilitates the relatively painless distribution of debt to the rest of the economy (Hall & Klitgaard, 195). Thus, the assumption of indefinite economic growth serves as a postulate for the contemporary financial system—debt would not be fundable without it. In a world with an expanding energy supply, this postulate has held true. However, the looming specter of peak oil questions the ability of the world’s energy supply to fuel the KAM Tan / 79-381 (Fall 2012) 8 requisite economic growth. Is the debt-based growth of the neoliberal era analogous to the overexpansion seen in agricultural civilizations reaching their energetic limits? Can the world economy transcend Jevon’s paradox and grow despite steady or declining energy consumption? Perhaps more so than any other time in history, the neoliberal era has created an economic system that is incredibly sensitive to fluctuations in energy supply. Macroeconomic Impacts of Energy Scarcity Though still raising some contention, the causal relationship between energy supply and economic growth has been well established by a plethora of historical, economic, and ecological studies, which generally conclude that the capacity to increase energy consumption is a prerequisite for economic growth (Brown et al. 2011; Tverberg 2012; Hirsch et Wealth and energy consumption have a strong relationship: spread is due to differing customs and climates. Source: Hamilton et al. 2009 al. 2005; Rapier, 11; Hall & Klitgaard, 34; Tainter, 37). Throughout the history of humanity, “most metrics of wellbeing, such as GDP and literacy, were all positively correlated with, and caused by, energy consumption” (Brown et al. 2012). Since World War II, eleven out of the twelve global recessions were preceded by oil price shocks (Tverberg 2012). In the age of petroleum, growth seems to stop when oil expenditures exceed ~6% of GDP, whether in individual countries or the entire world (Hall & Klitgaard, 378). Compounded by the volatility KAM Tan / 79-381 (Fall 2012) 9 Petroleum expenditures exceeding ~6% of GDP stops economic growth. (Source: Hall & Klitgaard) induced by neoliberal reforms (i.e. financial deregulation), prominent economists point to the record-breaking oil shock of 2006-2008 as the primary cause of the financial crisis and Great Recession. The general consensus is that meaningful economic growth—at least in advanced economies—will not occur unless there is a substantial increase in oil supply (Hamilton et al. 2009). Energy price shocks induce negative feedback loops of dampened economic activity that spread quickly throughout the world economy (Brown et al. 2011). The neoliberal delocalization of economies results in increased sensitivity to transportation costs, which are even more pertinent in the United States, which is almost wholly dependent on automobile transportation. Due to the green revolution, food prices have become tightly coupled to oil prices. The 2006-2008 oil shock caused the largest food crisis in recent memory; millions were pushed into in water-stressed regions such as the Sahel, while developed nations saw unprecedented use of food subsidy programs, and even desperate acts food scavenging (Hall & Klitgaard, 269). Also, production costs will rise as prices soar for basic commodities such as metals and plastics, which tend to be very petroleum-intensive, not to mention that industrial KAM Tan / 79-381 (Fall 2012) 10 production is energy-intensive in itself (Hamilton et al. 2009). The price of oil alternatives will also soar, as demand shifts towards them. The impact of an oil shock will propagate throughout the global economy, acting as a robust inflationary pressure, resulting in higher interest rates and more expensive credit. Increased energy expenditures results in capital flight, as oil expenditures generally do not feed back into the economies of oil consumers (Hall & Klitgaard, 271). Thus, the discretionary spending of consumers is set to decrease due to higher costs, less credit, and asset devaluation (real estate, etc.), which will quickly stall economic growth and contract the labor market, dampening economic activity even further. State finances will also become strained due to general inflation, shrinking tax revenues, and increased use of social welfare services (Hamilton et al. 2009). As seen with previous oil shocks, inherent weaknesses in economies and governments tend to be revealed, resulting in price crashes, currency devaluations, political upheaval, and social unrest (Hall & Klitgaard, 280). In the United States, recession-inspired social and political movements, such as #Occupy and the Tea Party, have been visible but fairly benign. The same does not hold true in the rest of the developed world, which has seen dramatic shifts in political power along with endemic social unrest. Supply Estimates and Production Forecasts Since the 2006-2008 oil shock, prices have remained at near historical highs; an astonishing feat given the world’s continued economic malaise. Despite vigorous investments in oil exploration, world oil production seems to have hit an apparent production cap of around 75 million barrels-per-day (mbd) in place since mid-2004 (Murray & King 2012). With a production cap in place, demand eventually outpaces supply, and price will increase until it results in demand destruction (i.e. recession). Once oil prices drop sufficiently, demand will KAM Tan / 79-381 (Fall 2012) 11 begin to increase in response to economic growth, repeating the cycle once more. Thus far, there are no indications of an end to this pattern of volatile price swings, despite signs of adaption to higher oil prices, such as gains energy efficiency Declining rates of oil production growth. (Source: Tverberg 2012) (especially in transportation) and utilization of alternative energy sources (Tverberg 2012). The apparent production cap in oil production may be resultant of the lower EROIs of the remaining oil supply. Oil fields that are the easiest to develop (ones with the highest EROIs) are often consumed first, with order of field development generally coinciding with desirability (Rapier, 94). For example, the two “megafields” of Saudi Arabia and Mexico were discovered in the 1940’s and have been the largest oil fields found to date. These megafields contain very high-quality oil that takes comparatively little effort to extract. However, production from these fields has peaked due to the geophysical dynamics of oil extraction, namely the reduction of internal pressure as more oil is extracted from the field (Rapier, 97). As the most desirable fields are depleted, production shifts to less desirable fields that tend to be smaller in size and contain lower-quality oil. More recent discoveries also tend to be more inaccessible, such as deep sea or Arctic oil production. Producing from these locations is technically challenging and costly, both in monetary and energetic terms (Rapier, 97-99). Since the 2000’s, there has been an investment boom in “unconventional” sources of oil, such as tar sands or shale oil. These sources contain oil that is extremely difficult to process, being in the form of amorphous solids or oily rocks. Extraction and processing of these sources is much more difficult and energy-intensive, as it is more akin to metal mining than oil drilling. Extraction involves the use KAM Tan / 79-381 (Fall 2012) 12 of bulldozers, dump-trucks, and other heavy machinery (Smil, 204-205). Processing is very energy and water-intensive, and results in enormous amounts of environmentally-hazardous waste products (Rapier, 88). As a result, the EROI of unconventional oil sources is very low, sometimes approaching 3:1, which is the minimum thermodynamically viable EROI for biological systems (Brown et al. 2011). Thus, oil production from newer sites may not be able to counteract declines in old sites. It is striking that four-fifths of today’s oil production still comes from fields discovered before 1970 (Smil, 189). Peak oil critics cite comparisons of estimated ultimately-recoverable oil reserves versus consumption patterns. Many publications show that the volume of oil reserves vastly outweighs consumption by an average of 40 years (Smil, 187). However, reliable data on oil reserves is hard to come by, as estimates are usually conducted by oil producers using opaque and non-standardized methodologies. Many also speculate that reserve estimates are manipulated for political or economic reasons. During the mid-1980’s, many OPEC countries doubled or even tripled their reserve estimates, despite little change in rates of new discovery (Smil, 188). Leaked documents authored by leading OPEC geologists state that Middle Eastern oil reserves are overestimated by 50-100%. Furthermore, in several geological conferences, the former head geologist of Saudi Aramco has expressed his belief that global oil reserves are overestimated by 20-30% (Rapier, 85). Credibility is hard to assess, as gains could be had by either over or underestimating oil reserves. Scientific institutions often use forecasting techniques based on the “Hubbert KAM Tan / 79-381 (Fall 2012) 13 Curve.” Hubbert was an eminent geologist USGS who fit production patterns onto a normal distribution (Smil, 188). curve He accurately predicted peak oil production Disparity between production-based versus reserve-based oil forecasts. (Source: Rapier) of individual oil fields to entire countries, including the United States—however, his model is not infallible, and cannot account for unexpected events such as war, revolution, or recession (Smil, 190). Production-based forecasts predict global peak within 2010-2020, while reserve-based forecasts predict peak beyond 2050 (Rapier, 87). Growth in the 21st Century? There has been a sharp disparity in economic performance between the developed world and newly-industrialized countries (NICs) since the Great Recession. While most highincome countries have yet to recover, NICs are once again enjoying rapid and sustained economic growth. Though meaningful growth is still only enjoyed by a minority in the developing world, the pace and scale of “the rise of the rest” is still unprecedented. Modern middle-class lifestyles have become attainable for billions around the world. This is one of humanity’s greatest achievements, but unfortunately, the specter of peak oil knows no bounds. Industrialization is a very energy and resource-intensive process. While per-capita energy and KAM Tan / 79-381 (Fall 2012) 14 resource consumption in NICs is still miniscule compared to rich nations, their populations are much larger and continue to grow. Compounded with their adoption of modern energyintensive lifestyles (cars, meat, etc.), global demand for energy and oil is set to double by 2035 (EIA 2012). This trajectory seems incongruous with the world’s biophysical realities. While production from individual oil fields can be forecasted to a reasonable degree of accuracy, forecasts for global oil production are fraught with uncertainty. Any number of unexpected events could dramatically influence oil production: economic shifts, climate change, geopolitical conflict, or even the adoption of a revolutionary energy source. However, within academia and the scientific community, there seems to be a convergence in research and opinion that alludes to the relative imminence of peak oil, and the severity of its consequences (Murray & King 2012; Brown et al. 2012; Hirsch et al. 2005; Rapier, 45). The assumption held by Smil and others—that the last half of our remaining hydrocarbon supply will be of comparable benefit to the first half—is fundamentally flawed. Our remaining hydrocarbon supply is will feature much lower EROIs than what we have enjoyed, as production costs increase with difficulty of extraction and processing (Rapier, 99). Additionally, rapid economic and population growth will increase demand for some time to come. Developing nations are at a natural advantage in ‘bear’ energy market, as much lower percapita energy consumption cushions the economic impact of high prices (Tvelberg 2012; Hall & Klitgaard, 321). The United States is in one of the worst positions during a period of energy scarcity, as automobile dependence and low-density urban planning compounds the impact of energy prices. Studies commissioned by energy departments and militaries around the world have concluded that peak oil “presents the world with an unprecedented risk management problem” and that a successful transition away from oil requires ten-to-twenty years of intense preparation before peak oil hits (Hirsch et al. 2005; Rapier, 100) KAM Tan / 79-381 (Fall 2012) 15 Humanity owes its ascent to advantageous evolutionary changes (bipedalism) that enabled our bodies to use energy much more efficiently. The discovery of fire and cooking externalized much of our metabolic energy needs, enabling dramatic increases in brain volume and intelligence relative to other primates. Agriculture provided the abundance of energy needed for humans to move beyond sustenance. As fewer people need to work the land, specialization of labor was made possible, laying the foundations for the development of complex civilization. In the “biological old regime,” civilizations that reached their biophysical limits to growth invariably stagnated and collapsed. Modern civilization has overcome these limits with the use of condensed energy sources: initially with the use of coal, then with oil and natural gas. As our fuels increased in energy density and EROI, humanity sustained growth at an exponential pace. With a growing population, mass industrialization in developing countries and a growth-based economic paradigm, Jevon’s paradox is unlikely to be overcome. Humanity’s continued growth and prosperity is contingent upon the adoption of abundant, energy-dense, high-EROI sources of energy. The twenty-first century finds humanity at the crossroads: coercive action could put us on a path of sustainability and prosperity, while continued inaction will inevitably lead to societal and ecological collapse, global depopulation, and unimaginable strife—the realization of the Club of Rome’s Limits to Growth. KAM Tan / 79-381 (Fall 2012) 16 References Brown, James H., William R. Burnside, Ana D. Davidson, John P. DeLong, William C. Dunn, Marcus J. Hamilton, Jeffrey K. Nekola, and Jordan G. Okie. "Energetic Limits to Economic Growth." Bioscience January 61.1 (2011): n. pag. Print. Hall, Charles A. S., and Kent A. Klitgaard. Energy and the Wealth of Nations: Understanding the Biophysical Economy. New York, NY: Springer Verlag, 2012. Print. Hamilton, James D. "Causes and Consequences of the Oil Shock of 2007–08." Brookings Papers on Economic Activity 2009.1 (2009): n. pag. Print. Hirsch, Robert, Roger Bezdek, and Robert Wendling. "Peaking of World Oil Production: Impacts, Risks, Management." US Department of Energy (2005): n. pag. Print. Marks, Robert. The Origins of the Modern World: A Global and Ecological Narrative from the Fifteenth to the Twenty-first Century. Lanham: Rowman & Littlefield, 2007. Print. Murray, James, and David King. "Oil's Tipping Point Has Passed." Nature 481.January (2012): n. pag. Print. Rapier, Robert. Power Plays: Energy Options in the Age of Peak Oil. New York: Apress, 2012. Print. Smil, Vaclav. Energy at the Crossroads: Global Perspectives and Uncertainties. Cambridge, MA: MIT, 2003. Print. Tainter, Joseph A. The Collapse of Complex Societies. Cambridge, Cambridgeshire: Cambridge UP, 1988. Print. Tverberg, Gail. "Oil Supply Limits and the Continuing Financial Crisis." Energy 37 (2012): n. pag. Print.