Peak Oil and Economics

[John Fleming]

At a recent meeting someone asked about the economic impact of peak oil. Here’s a quick summary of what I have learned as a layman after reading about it for several years.

Inflation vs. Deflation

The most hotly debated item is whether peak oil will result in inflation or deflation. These terms relate to the balance of available money vs. goods available for purchase. The amount of available money is referred to as “money supply”. It’s an odd concept - we take money for granted as a medium for exchange and don’t usually think about there being a variable amount of it around, or that it can be subject to supply and demand.

Inflation

If money supply is on the increase (inflation), people tend to purchase goods, both because they have plenty of money and because the value of each dollar is slowly diluted by the increasing supply and people realize that tomorrow the purchasing power will be reduced. An increase in prices is commonly associated with inflation, but this is really just a symptom of extra money rather than the cause. Modern central banks try to maintain the balance at a low, positive level of inflation because this encourages people to spend rather than save, and money supply can be increased easily by lowering interest rates.

There are also advantages because the government can cheat on its obligations, for example the value of debts are eroded over time. As well, they can “print” money for their own spending as an insidious sort of tax. The government gains funds while the buying power of the populace is slightly reduced.

Inflation can spiral out of control and turn into hyperinflation where the currency becomes nearly worthless. We haven’t seen this in North America in recent times, but with weaker currencies people tend to hold savings as precious metals or stronger foreign currency rather than risk being wiped out by inflation. This sentiment explains some of the increase in the price of precious metals that we have seen over the last decade. Formerly, currencies were backed by precious metals meaning you could actually exchange currencies for a certain amount of physical gold or silver (hence Fort Knox). This helped keep governments honest to some degree, but this backing was abolished by Nixon in 1971 – something that should have been met by riots if the general public was more knowledgeable. This has resulted in a subtle change from a dollar having an actual value (representative money) to no intrinsic value (fiat money), and a dramatic increase in inflation since.

Deflation

If money supply is on the decrease (deflation), people tend to save their money because it is increasing in value relative to goods; tomorrow you can buy the item for less than today. This has the spiraling effect that economic activity is reduced and employees laid off, which results in even less economic activity. While both inflation and deflation can become self-reinforcing and spiral out of control, central banks view deflation as more dangerous and to be avoided because there is no way to counter it easily; sometimes described as “pushing on a string”. Japan was in a deflationary period through the 90’s after their real estate collapse at the end of the 80’s, but the most famous is of course the great depression.

State of the Debate

The consensus seems to be leaning toward inflationary effects from peak oil, perhaps because current government policies tend towards the inflationary. Deflationists point to falling house prices and bankruptcies in the US as signs of deflation. It’s also possible we may see something like the stagflation of the 80’s. This is a period of inflation, but with the decreased economic output characteristic of deflation.

Economists

It can be difficult to find an economist that recognizes the danger of Peak Oil because they are trained to think in terms of economic mechanisms – when one source of energy becomes too expensive, they believe that someone will develop something cheaper to take its place without regard to physical limits. They may be right to some extent as we may ramp up manufacture of liquid fuels from coal and natural gas, but this would take massive investment and result in climate suicide. Jeff Rubin is one enlightened economist, and Stephen Leeb is another; Leeb has also written a couple of books with recommendations on how to adjust your investment portfolio with the assumption of Peak Oil.Using the 70's as a model, he advising picking specific stocks that stand to gain from peak oil and to have a plan to adjust your investments if the environment turns inflationary or deflationary.

Because Peak Oil threatens “growth”, which is a fundamental underpinning of modern finance, you have to question whether financial markets as we know them will survive the crisis at all. I can imagine this risk of turmoil would be particularly worrying if you were of retirement age and ready to rely on RRSPs and pension funds.

Oil Price Volatility

Left uncontrolled, changes in supply and demand can create wild fluctuations in the price of oil. This makes it difficult for people and businesses to estimate their future energy costs (or profits in the case of energy companies). For much of the past century, oil prices have been regulated to some degree. Before OPEC, there was the Texas Railroad Commission that performed a similar role when the USA was the king of oil. It is now questionable whether OPEC has any remaining relevance, though Saudi Arabia still claims to have spare capacity at the ready. Recently we have seen some of this volatility return, with oil spiking to $150 a barrel, then falling back into the $30s.

Oil Price Spikes and Recession

There is a strong correlation between increases in oil price and past recessions; the oil crisis of the 70’s resulted in the economic turmoil of the early 80’s. If the future reflects this, then we may see a series of recessions, each failed recovery torpedoed by rising oil prices. Oil has already risen back into the $80 range following the recent crash.

In online forums, specific reactions to Peak Oil are to hoard a small emergency amount of silver or gold coins, and to get out of debt as quickly as possible to avoid any chance of bankruptcy or the bank foreclosing on your property if you lose your job.

Learn More

I hope this was helpful and may pique your interest. If so, spend some time wandering through Wikipedia as a start; it’s enlightening to understand some of these terms, the nature and history of finance and risks that we face.

[Sarah Sackville McLauchlan]

Nice! As a follow-up, I thought I'd share the fact that my church, First Unitarian Congregation of Toronto, will likely be hosting a course called Economics for the Rest of Us, starting in January (I think). It's based on a book of the same name (sorry, I forget the author), and will attempt to demystify economics so that the subject can more readily be understood by us ordinary folks. Also, COMER, the Centre on Monetary and Economic Reform, recently posted an extensive article on the evolution of the "gold-standard", which might be of interest as well. I'll try to find it and post it here.