Brace Yourself for Oil Shock Future. It Won't Be Pretty

The current drop in oil prices won't help economic growth, it sets the stage for a succession of oil shocks that may run the world economy into ground

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This article originally appeared at Peak Prosperity

Don't tell us oil's gonna be cheaper than water!
Don't tell us oil's gonna be cheaper than water!

The absolutely stunning drop in oil prices, which hit a new recent low, is really important to both track and understand

There are two issues here, one near term and one long.

In the near term, lower oil prices will help consumers have extra money for other purposes. If they're smart, they'll pay down debts and save money. If they aren't, they'll simply redirect it to other purchases.

The other side of the coin, however, is that the energy producers will take exactly offsetting losses to their revenues which will nullify any broad economic gains. If or when you read about how the lower oil prices will be a big boost to GDP, you'll be reading almost pure spin.

The only countries that receive a pure economic gain from lower oil prices will be those without any domestic oil producers. Japan and Greece should be loving the price declines, but Greece more than Japan because the fall in the yen has almost exactly matched the fall in oil. Oil is cheaper, but so is the yen; so it costs about the same amount of yen to get the same amount of oil. So, not much help for the Japanese on that score. 

The shale oil producers in the US are remarkable in several ways, but quite a few producers were simply not profitable enterprises at $100 oil. A fair number of the marginal operators are going to be complete disasters — as in bankrupt — at $63 oil.

Over the long term, say 2-3 years, these lower oil prices will spell big trouble because a lot of expensive but essential oil projects are being hurriedly shelved.

If the global oil business could not seriously advance global oil output with oil over $110 a barrel, what do we think might happen now that oil is $40 lower? Obviously, reserve replacement and additional output are both going to suffer.

The basic idea here is that, in a couple of years, the world will find itself with less oil coming out of the ground than it does today. Unless....unless oil prices recover and quickly! If they don't, and deflation has indeed taken over, the global economy is surely headed for recession. And if producers cannot find it within themselves to cut production, then the world will have too much oil, keeping prices low.

And this is how today's low oil prices are setting the stage for the next oil price shock.

All Of This Was Perfectly Predictable

Back in 2009 I wrote a fundamental report on the role of oil and the economy. You can read it here. In there I described the behavior that we'd expect to see as the world's oil supply issues ran into an over-indebted financial world and exponential economic model that could not bear the costs of the new oil.

Here's the relevant part of that report:

One reasonable prediction of how the economy and oil prices might respond to Peak Oil can be described as an "undulating plateau."

Under this scenario, a heated economy would encounter crimped supplies of oil leading to dramatic oil price hikes which would then cause the economy to contract. This would be the first cycle of the undulating plateau.

On the next leg up, the economy would benefit from lower oil prices, dust itself off and get going again, but this time with less total oil capacity available than before, due to natural decline rates in existing fields coupled to a lack of investment in new fields.

I've mocked up this behavior in a representative chart (below) to give you a visual anchor for the concept:

Economy and oil out of sync

Because there's less oil in each succeeding leg of the cycle, the economy cannot attain its prior heights - the energy simply isn't there. So you'll note in the chart above that the economy rebounds to a lesser and lesser height on each leg of the cycle.

But even as economic activity is tripping down a stairwell, oil prices will be doing the opposite, as mocked up in this next chart:

Oil swings

The oil price swings could be expected to grow larger and more volatile as time progresses. At the end, we might expect that price of oil to match its value - which I peg at around 500 hours of human labor per gallon.

Along the way, much of our social complexity shrinks, and we make adjustments to the new reality of less energy. If we do this well and elegantly, it need not be anything other than a reformulation of how we go about our daily lives. We can live closer to work and food, we can drive less, and some of us can do different things for work. However, if we manage this transition badly and inelegantly, shortages, social unrest, scarcity, and even resource wars lie in our future.

This is what is at stake.

Notice in the first chart (above) that the prediction is for the oil supply to increase for a period in response to higher prices, but then for the world economy to accelerate enough to gobble all of that oil up, and then not be able to afford the higher prices.

Where the recent past was somewhat different from that simplistic projection is that the global economy never really took off and oil prices, while elevated, did not spike. Instead it was a steady process of erosion where stubbornly high oil prices ground down the rate of global expansion to very low levels.

The second chart (above) explains where we are now in terms of oil supply and prices. There we predicted that oil prices would fall again in response to a global economic recession, but that supply would continue to trundle along higher for a brief while before falling off later on. After that, oil prices would spike higher leading to higher oil production, and so on in a  continuous  saw-tooth pattern, with the feature that supplies never quite achieve their former heights along the way.

Right now, I think that global oil supplies will be robust and possibly even climb for another 6-9 months before the fall-off in current investment drags supply down again, primarily due to the extraordinary decline rates of shale production.

So I'm not looking for signs of falling supply to begin until mid 2015 at the earliest, more like towards the end of 2015.

But the second prediction in that chart is that with each successive round of price spikes and drops, we will see slightly less and less oil coming out of the ground. This is because the new finds are not capable of entirely overcoming the losses from depleting reservoirs.

Given the current rates of decline in existing oil fields, the world needs to bring online approximately 4 million barrels per day of new production each year just to stand still!

Over the past 9 years the level of investment in new oil projects has mushroomed from $300 billion per year to well over $700 billion.


Since 2005, the globe has tossed some $3.8 trillion into getting more oil out of the ground, and with the exception of the US shale plays, it's getting exactly the same amount of oil as it did back in 2005.

This is serious stuff, and it really deserves far better analysis and treatment than we are currently seeing in the western press, which mainly seems to be running marketing copy for Wall Street firms and oil companies.

The first signs of a major slowdown in oil spending are now all over the news. This opening salvo is almost certain to become larger as time goes on:

More than $150 bln of oil projects face the axe in 2015

Dec 5, 2014

LONDON, Dec 4 (Reuters) - Global oil and gas exploration projects worth more than $150 billion are likely to be put on hold next year as plunging oil prices render them uneconomic, data shows, potentially curbing supplies by the end of the decade.

As big oil fields that were discovered decades ago begin to deplete, oil companies are trying to access more complex and hard to reach fields located in some cases deep under sea level. But at the same time, the cost of production has risen sharply given the rising cost of raw materials and the need for expensive new technology to reach the oil.

Now the outlook for onshore and offshore developments - from the Barents Sea to the Gulf or Mexico - looks as uncertain as the price of oil, which has plunged by 40 percent in the last five months to around $70 a barrel.

Next year companies will make final investment decisions (FIDs) on a total of 800 oil and gas projects worth $500 billion and totalling nearly 60 billion barrels of oil equivalent, according to data from Norwegian consultancy Rystad Energy.

But with analysts forecasting oil to average $82.50 a barrel next year, around one third of the spending, or a fifth of the volume, is unlikely to be approved, head of analysis at Rystad Energy Per Magnus Nysveen said.

"At $70 a barrel, half of the overall volumes are at risk," he said.


Looking at the above chart, we see that the oil companies had managed to identify a series of projects that had the potential to deliver another 4 million barrels per day of incremental production to the world that would be in full swing in ~ 10 years.

That's the exact amount we'd need to offset the declines.And now, roughly half of those projects just don't pencil out.

It is this dynamic that will cause the world to find itself short of oil in the future.

Meanwhile...debts and claims on the real world continue to grow. This tension is what makes me so sure that there's a very large, enormous financial accident lying ahead in the future. The math is just so obvious, the conclusions so easy to arrive at, that eventually the world will figure this out and those with paper claims will do everything possible to dump them in favor of holding actual tangible assets.


This is part one of the next stage of the succession of oil shocks that will plague the world for a very long time.

Prices that are too low will cause oil projects to be abandoned. Oil prices that are too high will cause the debt-burdened world to either grow far too slowly to support the massive piles of debt that the banking system requires, or to fall into recession.

This dynamic of a steadily falling ceiling (the price of oil the economy can afford) and a steadily rising floor (the price oil projects need to go forward) is Peak Oil 101.

It was all perfectly foreseeable and so is what happens next.

I don't know when, but there will come a moment when the world realizes that the trillions and trillions of dollars worth of paper claims in the form of currency, bonds, and derivatives only have value in relation to the actual things they can buy.

At this magic moment in time, the scales will fall off the world's eyes and it will realize that oil is the king of economic energy sources. And that less oil means less real wealth for all those claims to go chase.

Without the economic growth that oil provides, you cannot make a reasonable case for constantly expanding the debt loads of a society.

The logic of constantly expanding debts only works with the assumption of perpetual future growth.


Once the reality of no future growth sets in, then literally the entire game has to change, overnight, to accommodate the new reality.

But what are the chances of that? Almost none. The central banks of the world are all conspiring to keep financial assets elevated simply so that bank lending can continue at the pace to which they have all become addicted.

Politicians cannot bring themselves to admit any of this, if they are even aware of it at all.

So the prediction is that none of this gets any realistic attention until circumstances literally will not permit us to look the other way any longer. However, that will be an exceptionally disruptive period of time and I am not really looking forward to it, although I would actually prefer to have it come sooner than later because it only grows larger and more destructive the longer we put it off.

At any rate, the immediate thing to watch is the damage that these low oil prices inflict on the oil industry and whether or not that causes any contagious effects elsewhere in the markets.

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