Can The Price Of Oil Hold Above $50 Per Barrel?

Tyler Durden's picture

Submitted by Gail Tverberg via Our Finite World blog,

Why energy prices are ultimately headed lower; what the IMF missed

We have been hearing a great deal about IMF concerns recently, after the release of its October 2016 World Economic Outlook and its Annual Meeting October 7-9. The concerns mentioned include the following:

  • Too much growth in debt, with China particularly mentioned as a problem
  • World economic growth seems to have slowed on a long-term basis
  • Central bank intervention required to produce artificially low interest rates, to produce even this low growth
  • Global international trade is no longer growing rapidly
  • Economic stagnation could lead to protectionist calls

These issues are very much related to issues that I have been writing about:

  • It takes energy to make goods and services.
  • It takes an increasing amount of energy consumption to create a growing amount of goods and services–in other words, growing GDP.
  • This energy must be inexpensive, if it is to operate in the historical way: the economy produces good productivity growth; this productivity growth translates to wage growth; and debt levels can stay within reasonable bounds as growth occurs.
  • We can’t keep producing cheap energy because what “runs out” is cheap-to-extract energy. We extract this cheap-to-extract energy first, forcing us to move on to expensive-to-extract energy.
  • Eventually, we run into the problem of energy prices falling below the cost of production because of affordability issues. The wages of non-elite workers don’t keep up with the rising cost of extraction.
  • Governments can try to cover up the problem with more debt at ever-lower interest rates, but eventually this doesn’t work either.
  • Instead of producing higher commodity prices, the system tends to produce asset bubbles.
  • Eventually, the system must collapse due to growing inefficiencies of the system. The result is likely to look much like a “Minsky Moment,” with a collapse in asset prices.
  • The collapse in assets prices will lead to debt defaults, bank failures, and a lack of new loans. With fewer new loans, there will be a further decrease in demand. As a result, energy and other commodity prices can be expected to fall to new lows.

Let me explain a few of these issues.

The Need For Energy to Operate the Economy

On a worldwide basis, it takes energy to make the economy grow. This is evident, regardless of what time period we look at.

Figure 1. World GDP in 2010$ compared (from USDA) compared to World Consumption of Energy (from BP Statistical Review of World Energy 2014).

Figure 1. World GDP in 2010$ compared (from USDA) compared to World Consumption of Energy (from BP Statistical Review of World Energy 2014).

Figure 2. Three year average growth rate in world energy consumption and in GDP. World energy consumption based on BP Review of World Energy, 2015 data; real GDP from USDA in 2010$.

Figure 2. Three year average growth rate in world energy consumption and in GDP. World energy consumption based on BP Review of World Energy, 2015 data; real GDP from USDA in 2010$.

Figure 3. World GDP growth compared to world energy consumption growth for selected time periods since 1820. World real GDP trends for 1975 to present are based on USDA real GDP data in 2010$ for 1975 and subsequent. (Estimated by author for 2015.) GDP estimates for prior to 1975 are based on Maddison project updates as of 2013. Growth in the use of energy products is based on a combination of data from Appendix A data from Vaclav Smil's Energy Transitions: History, Requirements and Prospects together with BP Statistical Review of World Energy 2015 for 1965 and subsequent.

Figure 3. World GDP growth compared to world energy consumption growth for selected time periods since 1820. World real GDP trends for 1975 to present are based on USDA real GDP data in 2010$ for 1975 and subsequent. (Estimated by author for 2015.) GDP estimates for prior to 1975 are based on Maddison project updates as of 2013. Growth in the use of energy products is based on a combination of data from Appendix A, data from Vaclav Smil’s Energy Transitions: History, Requirements and Prospects, together with BP Statistical Review of World Energy 2015 for 1965 and subsequent.

There is a small gain, over and above that added by energy growth. This gain reflects the impact of efficiency gains and technology changes. Generally, this additional gain is less than 1% per year.

In recent years, a large share of the world’s manufacturing has been moved to developing countries. This shift gives the illusion that the developed countries can get along with less energy to produce their GDP. This is not really the case. The developed countries find themselves with a need for a large amount of imported goods. Their heavily services-oriented economies tend to grow slowly. This is because, with little energy use, it is difficult for these economies to make productivity gains. I have written about this issue in What really causes falling productivity growth — an energy-based explanation.

Figure 4. Total amount of energy used by Commercial and Industrial Sector (excluding transportation) based on EIA Energy Consumption by Sector, divided by Bureau of Labor Statistics Total Non-Farm Employees by Year.

Figure 4. Total amount of energy used by Commercial and Industrial Sector (excluding transportation) based on EIA Energy Consumption by Sector, divided by Bureau of Labor Statistics Total Non-Farm Employees by Year.

We Run Out of Cheap-to-Extract Energy Products 

The amount of a given energy product (whether oil, coal, natural gas, or uranium) depends to a significant extent on the price available. The wide base on the triangle in Figure 5 indicates that if the price is high enough, we can extract a very large amount of any given energy resource. For example, if oil is $300 per barrel, we can extract the huge amounts of oil that would seem to make it possible for the economy to grow for the next 25 years.

Figure 5. We extract the easiest to extract energy first.

Figure 5. We extract the easiest to extract energy first.

In fact, the IEA has even made projections assuming $300 per barrel oil.

Figure 6. IEA Figure 1.4 from its World Energy Outlook 2015, showing how much oil can be produced at various price levels.

Figure 6. IEA Figure 1.4 from its World Energy Outlook 2015, showing how much oil can be produced at various price levels.

The reason why there is a problem if oil prices rise to very high levels is because wages don’t rise at the same time.

Figure 7. Reason why wages don't grow.

Figure 7. Reason why wages don’t grow.

This situation of lower and lower efficiency at extracting energy, as described above, is sometimes referred to as diminishing returns.

We can look at the problem from the point of view of the worker. He must make choices regarding which things to cut back on if energy prices rise, but his wages don’t rise. The result tends to be recession.

Figure 8. A worker must make choices, if prices of goods made using energy products rise, but his wages don't.

Figure 8. A worker must make choices, if prices of goods made using energy products rise, but his wages don’t. These choices lead to recession.

Figure 9. Examples of discretionary goods include vacations using airline travel, new homes, and new cars.

Figure 9. Examples of discretionary goods include vacations using airline travel, new homes, and new cars. Other examples might include restaurant meals and charitable contributions.

Central Banks Can Fix the Problem Temporarily

If wages are too low to buy “big-ticket” items, lower interest rates and more debt can “sort of” solve the problem. The combination makes expensive goods more affordable on a monthly payment basis.

Figure 10. Comparison of world oil supply and price, as changes are made to interest rates using QE and other changes.

Figure 10. Comparison of world oil supply and price, as changes are made to interest rates using QE and other changes.

Quantitative Easing (QE) allows interest rates to be very much lower than normal. The United States first started using QE in 2008 when commodity prices dropped very low. The combination of the US’s use of QE, and significantly greater borrowing by China to stimulate its economy, helped bring Brent oil prices back over $120 per barrel by 2011 (Figure 10).

Figure 10 shows that, over time, QE has become less and less able to hold up oil prices. The price suddenly started to fall in 2014 when the US discontinued its QE program and China cut back on its growth in debt. Oil is priced in US dollars; the US dollar rose relative to other currencies when the US eliminated its QE program, making oil relatively more expensive for these countries. As a result, citizens of these countries were forced to cut back on discretionary purchases. This is what led to falling commodity prices of many kinds (not just oil) in mid-2014.

Since 2014, other countries besides the US have maintained their QE programs. In fact, Japan and the EU have expanded their programs. Even with very low interest rates, commodity prices remain far too low for most commodity producers to be profitable. This situation could lead to catastrophe because metals, agriculture, and energy are all essential to the economy.

Figure 11. IMF Commodity Price Indices, from September Commodity Market Monthly.

Figure 11. IMF Commodity Price Indices, from September Commodity Market Monthly.

Throughout the ages, there has been a problem with diminishing returns in producing food and other energy products. The standard workaround seems to be greater “complexity.” When complexity is used, specialization and more concentrations of energy are used to try to work around problems. For example, one solution is to make more tools and other capital goods that can be used to leverage the labor of workers. Another approach is to use larger companies with more hierarchical organizations to bring together more resources. For example, if the problem is inadequate food production, perhaps an organized group can build a dam, so that irrigation can be used to produce a greater amount of food on the same quantity of arable land. A third approach is more specialized training for some of the workers.

An unfortunate impact of greater complexity is an increasingly hierarchical society. While some workers benefit, a large number of non-elite workers accrue little benefit. Instead, lagging wages increasingly make the new, better products mode possible by a complex economy less affordable.

What Goes Wrong?

There are several things that go wrong:

1. Non-elite workers find it increasingly difficult to buy the output of the economy. Their wages lag behind as more of the wages go to the workers with more advanced training and management responsibility. Because there are so many of these non-elite workers, their “demand” is needed if the prices of commodities are to stay high enough to ensure greater production of these commodities. With only low pay, non-elite workers find it difficult to afford houses, cars, and vacations. All of these use commodities, both when capital goods such as houses, cars, and airplanes are made, and later when these capital goods are operated. Low interest rates may not help these non-elite workers very much, because they lack money for down payments. Without as much demand, prices for commodities tend to fall.

 

2. Central banks lower interest rates, but not much of the benefit of these lower interest rates actually gets back to the buying power of non-elite workers. Instead, low interest rates tend to lead to higher prices of assets, such as land, existing houses, and shares of stock in companies. Unfortunately, these higher prices of assets do nothing for commodity prices. In order to raise demand for commodities, the buying power of non-elite workers needs to rise, so that they can buy the expensive goods that are no longer affordable.

 

3. The rate of return on investments tends to fall too low, because diminishing returns lead to ever more energy use (including human labor use) to produce energy products. Since capital goods are made and operated using energy products, the cost of their creation and operation is also raised. Each unit of debt required to finance new capital goods and new energy extraction tends to get lower returns over time. This results in the economy becoming increasingly less efficient, and productivity growth tending to fall.

 

4. Debt levels tend to rise for multiple reasons. One reason debt levels rise relates to diminishing returns with respect to energy extraction. What is needed when it comes to producing the kind of changes that underlie economic growth (for example, extraction of ores, heating of ores, and transportation of finished products to their destinations) is a particular quantity of energy, as measured in some unit of energy, such as British Thermal Units. If the cost of energy extraction is now five times as high as it was fifteen years ago, the quantity of debt needed to extract that energy may need to be five times as high. If the development process takes 10 years instead of 5, that may further increase the amount of debt required. It is not only energy products that are affected by the need for a greater amount of debt. Products made using energy products, such as cars and homes, tend to become more expensive as well. If the prices of these products rise, more debt is needed to buy them, as well.

 

5. Another reason debt levels tend to rise relates to falling interest rates, and the impact that these lower interest rates have on asset prices. With lower interest rates, the purchase of existing buildings becomes more affordable, as does the purchase of shares of stock, so prices tend to rise. Customers buy these items, in the hope that capital gains will give them greater returns than the measly returns available from fixed income investments, and likewise, from new investment in new “productive” assets such as oil wells and factories. Most of this asset-based debt is not productive debt; it is simply obtained in the hope of obtaining capital gains on existing assets as a result of ever-lower interest rates.

 

6. Relativities among currencies become more important. If the US dollar rises, either because the United States is charging higher interest rates, or because it is not using QE while other countries are, then goods become relatively more expensive outside the US. In this situation, investment tends to fall in countries with perceived lower future prospects–in other words, in countries outside of the US. It becomes harder to keep debt levels up, and thus the buying power of the world economy. Downward pressure on the price of commodities becomes greater because of the loss of debt-fueled buying power.

 

7. Growth in energy supplies can be expected to slow and eventually begin to shrink, as low energy prices lead to lower new investments. Needless to say, these lower energy supplies adversely impact GDP growth, because of the connection between energy consumption and GDP growth. The countries likely to be affected first by low oil prices are oil exporters such as Venezuela and Nigeria. Many people will not make this connection, because they consider only the apparently beneficial impact of low fuel prices for oil importing countries.

Essentially, the problem being encountered is a physics problem. The economy is a dissipative structure. As it grows, it needs an increasing amount of energy to operate. If the energy is not available, it becomes increasingly subject to collapse. See my post, The Physics of Energy and the Economy.

At some point, we can expect to reach a Minsky Moment. Such a moment involves a major drop in asset prices. We have already reached the corresponding drop in commodity prices that comes with diminishing returns, because fewer non-elite workers are able to buy goods made with commodities, and because of the higher US dollar.

Figure 12. Stylized Minisky Cycle from Wikipedia.

Figure 12. Stylized Minsky Cycle from Wikipedia.

We are waiting now for asset prices to fall to a level corresponding to what these assets can really produce. When this happens, the big drop in commodity prices will transfer back to the corresponding asset prices. For example, the price of land used to extract oil and gas should at some point drop to reflect the lower prices available for these commodities in the marketplace. The price of agricultural land should drop to reflect the lower prices of commodities that can be grown on them, such as wheat, cattle, and hogs. The price of land used to extract metals should drop to reflect the low value of metals. This drop in asset prices doesn’t happen immediately, because everyone assumes that prices are going to bounce back up, and that the system will perform as it always has.

When prices of commodity-related assets drop to a level that reflects their true economic value, we can expect a huge number of debt defaults. This, of course, happens because these assets have been used as the basis for a large amount of debt. It will be difficult to save the financial system, because there will be huge defaults both on bank loans and on outstanding bonds. Banks, insurance companies, and pension plans will all be affected.

Can the Price of Oil Rise above $50 per Barrel?

I am doubtful that the price of oil can rise very high, for very long. Our oil price problem is part of a much larger problem–a slowing economy with low prices for a large number of commodities, including oil. The price of oil can perhaps briefly rise as high as $75 per barrel, but such a high price cannot hold for very long. Rising oil prices tend to lead to recession for oil importing countries, and recessions tend to bring commodity prices back down. The world clearly could not support a price of $100 per barrel before the crash in prices in mid-2014. Once we understand the reason for our low-price problem–diminishing returns and the economy’s tie to the use of energy–it is clear that there is no way out of the problem over the longer term.

In the not-too-distant future, our low commodity price problem is likely to become a low asset price problem. Once this happens, we will have a huge debt default problem. It will also become harder to obtain new loans, because defaults on existing loans will have an adverse impact on the ability of banks to make new loans. Interest rates required by bond markets are likely to spike as well.

The lack of new loans will tend to depress demand further, because without new loans it is difficult to buy high-priced goods such as cars, homes, and factories. As a result, in the long run, we can expect lower commodity prices, not higher commodity prices. Oil prices may ultimately fall below $20 per barrel.

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Id fight Gandhi's picture

This article lol. Formating and photos used are terrible

offwirenews's picture

pics look like a pp presentation at a corporation for new employees

TBT or not TBT's picture

Can the $ hold itself to 1/50 of a barrel or will it sink?

Loftie's picture
Loftie (not verified) johngaltfla Oct 11, 2016 10:29 PM

"what “runs out” is cheap-to-extract energy"

BS. Oil will NEVER run out. It's abiotic. Scientists just lie.
http://wp.me/p4OZ4v-2M

Arnold's picture

It's gonna be Okay.

Da Chinks will be able to sell refined product all over Asia Pacific for less than the cost of the crude no matter what it is.

They will continue to have too much inventory of everything,

It is a good old American Rockefeller technique.

offwirenews's picture

depends on if there are new and unique rumors planned

larz's picture

Is there a good reason to take an IMF prediction and analysis seriously?

Infield_Fly's picture
Infield_Fly (not verified) Oct 11, 2016 8:18 PM

depends on how many more unaccounted for tankers yellen can shove up her cunt!!!

1980XLS's picture

Hallway can fit lots of HotDogs

Codwell's picture

It can hold higher than $50 if the dollar devalues.

Crawdaddy's picture

Here we go again with this IMF nonsense. Fuck them and the whore of Babylon they road in with. Our problems begin to be solvable once we see bullshit front organization like the IMF being broken into a thousand peices and thrown into the wind the way JFK wanted to do with the CIA.

Where would that get you? Like someone commented the other day on here, "Back and to the left, back and to the left"...

Yen Cross's picture

  NO. This spike in the $usd with bond yields moving higher, and equites moving lower [shity earnings] doesn't inspire any reason for me to hold fiats.

    I laugh when I see bond yields drop along with equites. If the Fed. lifted rates even 25bps before the end of the year , you're going to see some serious carnage in the equity and bond markets.

mosfet's picture

Show all the charts you like but the fact remains that Oil had no problem what-so-ever holding onto $50 thru a huge run-up in Dollar this week.  What do you think it's gonna do once the Dollar starts falling?  All OPEC needs to do now is to release the occasional feel good headline about cooperation and plans moving 'forward' - while quietly increasing pumping capacity.  And when mid November arrives everyone will be tripping over themselves to bid it up in advance of a meeting where a freeze and some cuts are all but a sure thing.  From there all they have to do is 'talk' about cutting every time US rig counts increase.  And when their jawboning looses some steam all they have to do is cut a little bit to reestablish dominance.  OPEC controlled price before their 'self-imposed' glut, and they still control it now.  And frackers will be estatic to not have to lift a finger for OPEC to reinflate prices for them.

Oil is like Gold with the distinction that virtually every goverment on the planet wants/needs it to go UP (i.e more taxes, secured bank loans, higher stock prices, etc), so guess where it's headed?

Yen Cross's picture

  What part of lack of demand are you missing? Last week we saw oil move lower on a $usd selloff.

 Correlations are broken, and volume sucks. This is just a bunch of machines playing "hot potato" with every ALGO driven headline that crosses the tape.

  BTFR  [buy the fucking rip] . </sarc>

mosfet's picture

Hi Yen,

You're right, there's been some fall-off in demand for Oil.  But Increasing demand has managed to do the opposite for Gold & Silver prices since 2013.  In fact new bull market in PMs seems to have more to do with central bank actions, world events and headlines vs demand.  Look at the plunge in their prices this week while demand for physical soars.  You're also right...it is algo & headline driven but paper speculators are running the show for now.  Aa for techinical analysis, I see it fail so often that even a broken clock seems punctual by comparison.  A long way down the road fundamentals should take hold, but only after currencies have devalued to the point where most raw commodities inc. Oil have skyrocketed in price.

Yen Cross's picture

    You make some very good points. They make logical sense.

  The primary concern I have is the expansion of global central bank [balance sheets]

   When you look at global GDP forcasts, and hidden taxation, inflation--- I want to buy some stock in Sikorsky.

    I'd hardly call $100.00 retrace in gold a purge. Oil got purged, if you want to draw comparisons.

 

jmack's picture

Then about the time the physical starts taking off...elon musk or jeff bezos  drop a 200 metric ton asteroid that is 20% gold, right on top of your head...lol.

sinbad2's picture

Manipulating the gold price is affordable for the US, manipulating oil prices is very expensive.

silverer's picture

I'll yield my oil to some other good citizen. I plan on basically not driving my vehicle between Thanksgiving and March. I'll put maybe 100 miles on it, pretty much like last year. It's my way of saying "thank you" to the oil traders.

jmack's picture

This presumes no world war where oil producing areas and assets are under constant attack.

cognitive dissident's picture

face it folks, we cannot possibly know the correct answer to the title of this article --- at least not until we hear from "Gartman the Infallible" --- after which profits will again fall like young lovers into each others arms.

c'mon fartman, we know you're dying to sound douchey and "be seen"... 

Arnold's picture

Be sure to ask him about his Aluminun play, too.

cognitive dissident's picture

will do --- even if it means I have listen to chubby McPink-fag drone on and on as he "generously" insists on a precious metals update, namely his pleasantly long, paper gold position -- arbitraged in Yen terms, of course.

Can there be any doubt that Gartman's enormous jockey shorts all exhibit worn, blown out elastic waistbands, in addition to admittedly faint but undeniably permanent sepia-tinted stripes exactly where you'd expect to find the occasional skidmark -- as opposed to self-styled fecal tattoos?

Schlepprock lives gang, he just calls himself D-Garts, and his streak of consecutive, completely incorrect, money losing calls and stated "positions" remains unbroken, or in a word, PERFECT. 

sinbad2's picture

Is the price of oil low, or is the price of the dollar high?

King Tut's picture
King Tut (not verified) sinbad2 Oct 11, 2016 11:09 PM

yes

JailBanksters's picture

It will hold wherever Bankers feel they can make more money.

Bankers make money when it drops and when it rises.

As long as it's a controlled drop or rise, they don't care.

 

Kirk2NCC1701's picture

Wait till they raise the price of paired Brass+Pb.

x marx the spot's picture

Gail at it again with this cart-before-the-horse/water-flows-uphill explanation of today's low energy prices being somehow caused by the high cost of energy production. Was this an attempt to explain why printed money keeps stopping at the pockets of a 'lucky' few, or is she just cracked out wants to use this rad clipart she forgot she had?

Youri Carma's picture
OPEC ‘the new FED’, talking the markets.
Elco the Constitutionalist's picture
Elco the Constitutionalist (not verified) Oct 12, 2016 5:03 AM

Oil is a function of competing geopolitical powers. It has nothing to do with supply/demand or other economic concepts, except tangentially.