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April 27, 2015

Balance Economic Needs in A World with Limits

By Gail Tverberg

We live in a world with limits, yet our economy needs growth. How can we expect this scenario to play out? My view is that this problem will play out as a fairly near-term financial problem, with low oil prices leading to a fall in oil production. But not everyone comes to this conclusion. What were the views of early researchers? How do my views differ?
In my post today, I plan to discuss the first lecture I gave to a group of college students in Beijing. A PDF of it can be found here: 1. Overview of Energy Modeling Problem. A MP4 video is available as well on my Presentations/Podcasts Page.
Many Limits in a Finite World
We live in a world with limits. These limits are not just energy limits; they come in many different forms:

All these limits work together. We can work around these limits, but the workarounds are higher cost–for example, substituting less polluting energy resources for more polluting energy resources, or extracting lower grade ores instead of high-grade ores. When lower grade ores are used, we need to process more waste material, raising costs because of greater energy use. When population rises, we must change our agricultural approaches to increase food production per acre cultivated.
The problem we reach with any of these workarounds is diminishing returns. We can keep increasing output, but doing so requires disproportionately more inputs of many kinds (including human labor, mineral resources, fresh water, and energy products) to produce the same quantity of output. This creates higher costs, and can lead to financial problems. This phenomenon is one of the major things that a model of a finite world should reflect.
Economists Views
Economists developed their views of the economy long ago, when limits seemed to be far in the distance. Thus, the models they built do not reflect the expected impact of limits. They are missing variables that would be needed to adjust for changes in the economy’s behavior as limits are reached.
3 Economists put together models
4 Economy will adapt
The story in Slides 3 and 4 tends to be true if we are far from limits, but is it really true when we are close to limits? Perhaps diminishing returns as we approach limits changes the results.
5 What is the real story
World Oil Situation as We Approach Limits
Perhaps we can get some indication of how diminishing returns are affecting the economy by looking at historical oil supply and prices. Up until 1970, US oil production grew quite steadily.
6 US oil production
After 1970, oil production suddenly began to decline. Oil companies did not expect such a decline; they assumed that oil production would rise endlessly. Once oil production began to decline, oil companies quickly began trying to find ways to fix their problems. One of these approaches was quickly to ramp up production in areas that they knew contained oil, but hadn’t previously been drilled. These included Alaska (northern United States), Mexico, and the North Sea. Oil production in these areas is now in decline.
Several ways were also found to reduce oil usage. These included change from oil to alternate fuels for electricity generation and home heating, and offering smaller, more fuel-efficient cars. With this combination of approaches, oil prices were brought down, most of the way to the $20 level (Slide 7).
The inflation adjusted level of oil prices is important because oil is the single largest source of energy use in both the US and world economy. If oil prices are cheap, it easy to grow food cheaply, and manufacturing and transport can be done cheaply. Because of this, the economy tends to grow. If oil prices rise, economic growth tends to slow, because the cost of many types of goods (including oil products, food, and building new homes) tends to rise faster than wages. It becomes more expensive to replace infrastructure such as roads and pipelines as well. The higher cost of oil effectively acts as a “tax” inhibiting economic growth.
7 World oil supply
Oil prices again reached a high level in the early 200os as we again began to reach limits of the amount of oil that could be extracted at the then-available price. This time we weren’t able to cut back on world demand, so prices tended to stay high. Instead, the big change made was in oil supply, with higher oil prices enabling (after a several years time-lag) greater production both from US oil from shale formations (called “tight oil” in Slide 6 above) and from the oil sands in Canada.
The question becomes: can the economy really function adequately on $100+ barrel oil? Or do the negative feedbacks from these high oil prices have too adverse an impact on economic growth?
8 Now oil price is too low
Slide 8 shows more detail regarding production and prices for recent years. We see that oil prices were generally rising up until mid 2008, and then dropped steeply. Prices rose again after several types of economic stimulus were added. More government spending was added, interest rates were dropped to very low levels and a program called quantitative easing (QE) began.
Prices stayed at a level a little over $100 barrel from January 2011 though mid-2014. More recently, oil prices have dropped to a little more than half of their previous level. This decline in oil prices appears to correspond to a time when world debt is not rising as rapidly: the US stopped its QE program, and China’s debt no longer rising as rapidly. Thus, some of the economic stimulus that helped hold oil prices up is disappearing.
The problem we are now encountering is not the high price problem that economists thought would bring on more supply. Instead, we are encountering a problem with oil prices that are too low for oil producers to make a profit. Such low oil prices can quite possibly bring down world oil production, because investment in oil production is no longer profitable. A person might ask: Is the low price situation we saw in 2008 and are encountering again in 2014-2015 what diminishing returns really looks like? Is the problem we encounter as we reach limits one in which oil prices drop too low, rather than rise too high?
In 2008, huge stimulus efforts were required to bring oil prices were brought back up to the $100+ level. Perhaps one point raised by economists (Slide 3) was correct: Maybe there is a connection between economic growth and oil demand. Perhaps the issue as we reach limits is that world economic growth sinks too low, and it is because of this slow growth that wages stagnate, debt stops rising quickly, and oil (and other commodity) prices drop too low.
Now let’s look at what some early energy researchers have said.
M. King Hubbert 
Many believers in Peak Oil theory consider M. King Hubbert to be the originator of their theory. It seems to me, though, that Peak Oilers have inadvertently picked up some of the economists’ theories, and mixed them with Hubbert’s theories.
9. M. King Hubbert
10 M. King Hubbert Model
11 Model applies when there is perfect replacemnt12 Hubbert understood need for perfect replacment
13 Believers in peak oil
It seems to me that the only way a Hubbert Curve might happen is if oil prices stay high, as we approach limits. That way, as much oil as possible can be extracted. If oil prices fall too low, then the decline may be much quicker. If low oil prices are a problem, above ground problems such as governments of oil exporting nations collapsing, or rising debt defaults leading to bank failures, may be a problem.
Dennis Meadows and Donella Meadows
Dennis Meadows led early computer modeling efforts at MIT regarding limits of a finite world. His wife, Donella Meadows, led the write-up effort regarding this model in a 1972 book called “Limits to Growth”. The model looked at physical quantities of resources, expected amounts of pollution, and expected population trends. The base model suggested that the world would start reaching limits in roughly the current timeframe.
16 Meadows Limits to Growth
In fact, more recent analyses suggest that the base model is more or less on track.
I don’t think that we can count directly on this analysis, however.
18 How will the situation work out
Charles Hall
Prof. Charles Hall has been one of the recent thought-leaders with respect to oil limits and how they might play out. He started work in the early 1970s as an ecologist, studying the energy patterns of fish. When he read about the possibility of energy shortages that might occur in the 1972 book Limits to Growth, he tried to adapt an approach used for studying energy patterns of fish to the world of energy production. The result was new way of measuring the efficiency of a particular energy product, called Energy Return on Energy Invested (EROEI).
20 Energy Return on Energy Invested
This idea was an advance when it was first developed, but it has a number of practical difficulties. One of these difficulties is that its usefulness is tied to a particular view of how oil limits will affect us, namely that prices will rise, and this will allow a slow transition to alternative fuels that are less favorable in terms of EROEI. On Slide 21, this is Item (2).
21 Two different modelsAt this point, it is my view that the EROEI approach to analyzing energy products can be misleading and needs updating. Energy extraction is much more complicated than the energy use of fish swimming upstream. The EROEI approach, besides being tied to the Peak Oil view of how limits will occur, is difficult to calculate. Different researchers get quite different answers, when analyzing the same energy product.
Furthermore, EROEI looks at a piece of energy costs (those involved with production at the well head), but how this piece relates to the total varies from one type of energy to another. It lumps together cheap energy and expensive energy. There are several other issues as well, with the result being that in practice, low EROEI doesn’t necessarily correspond to expensive to produce, and high EROEI doesn’t necessarily correspond to low cost to produce.
I should point out that the same problem exists with a wide range of similar metrics including Life Cycle Analysis, Energy Payback Period, and Net Energy. In practice, what seems to happen is that if an energy type is high-priced, the use of one of these metrics is used to justify its production, anyhow. Low EROEI (for example, of biofuels) does not seem to be a barrier to production, even though it was the hope of Prof. Hall and other EROEI researchers that this would be the case.
My Involvement in Energy Analysis
25 What exactly is the story
26 Correctly forecast 2008 collapse
I became acquainted with Prof. Lianyong Feng in 2009, when he attended the Biophysical Economics Conference in Syracuse, New York, held by Prof. Charles Hall, and heard me speak.
27 Photo of Gail Tverberg, Charles Hall, Prof. Feng
How Do Oil Limits Really Affect the Economy?
This is the question I have been working on. I will try to explain some of my findings in the next several sessions.
Early researchers were handicapped because the issue of oil limits crosses many different fields of research. They took approaches from their own areas of study, and worked with them. These approaches offered partial insight into the problem, but didn’t completely answer what might happen in the future.
It was not obvious to early researchers which parts of economists’ theories were wrong. I have had the benefit of seeing how the system works in practice in several periods: in 1973-1974, in 2008-2009, and now in 2014-2015. I have also been fortunate enough to find a number of recent studies that add new insights as to how the system really works. So I have taken a step back and developed at the least the start of a new theory, which is different from EROEI theory. This is what I will discuss in the next few sessions.
A little explanation behind this series of lectures and my four week stay in China is perhaps in order. When I was in China, Prof. Feng discussed with me some of his intent behind asking me to give this series of lectures. Prof. Hall is now retired, and there is no obvious replacement for him. Prof. Feng would like me to take a more active role is figuring out in which direction energy research should now be headed, both for his own staff, and for others around the world. A better understanding of how the system works could theoretically help researchers everywhere.

Courtesy Gail Tverberg, Founder of Our Infinite World (EconMatters author archive Here)

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters. © EconMatters All Rights Reserved | Facebook | Twitter | Free Email | Kindle
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