The energy-economy trap

The fossil fuel age is not over, but the age of cheap energy is. As we turn to Arctic oil, tar sands and fracking, the world is increasingly reliant on much more expensive sources of energy. And that, say many commentators, has put the economy onto something of a rollercoaster. I’ve seen it explained several times, but Rob Hopkins and Asher Miller’s recent paper put it rather well and included this illustration, which I thought I’d highlight quickly.

 energy-economy-cycle

Essentially what happens is this.

  • Rising demand pushes up the price of oil.
  • As prices rise they become a drag on the economy. Consumers tighten their belts, and energy demand falls.
  • Falling demand for energy pushes the price back down again. At the new lower price, investments in new energy production are now no longer economic. Investments are pulled.
  • The fall in investment creates a shortage and prices begin rising again.

We may be on this cycle already, as companies pile into expensive sources of energy like tar sands when the price is high, only to make a loss as the energy price falls. With oil supplies tight and investment needing a long lead in time, this kind of volatility looks likely to continue. And with the economy so dependent on cheap energy, we could find ourselves on a cycle of recession and recovery too.

That’s the briefest of introductions, but for more, see the paper above, the Industry Taskforce on Peak Oil and Energy Security, or Jeremy Leggett’s book The Energy of Nations. It’s worth investigating a little further. If the theory is correct, this could be an important dynamic in the economy over the next few years, and it’s virtually unrecognized in government at the moment.

4 Comments on “The energy-economy trap”

  1. DevonChap November 9, 2013 at 1:38 pm #

    The weak point here is that while it mentions economic contraction caused by high oil prices, it fails to mention economic expansion caused by lower prices. That repairs the damage done by the higher oil prices and that we are richer when the price rises means we can better afford the new higher prices.

    • Jeremy November 9, 2013 at 4:44 pm #

      The reason that doesn’t work is the long lead-in time on energy infrastructure. As prices fall again, energy companies find themselves with large investments that won’t pay off, and they cut them loose, perpetuating a cycle.

      Lower energy prices might stimulate the economy generally, but the volatility is bad for the energy business.

      But this is a theory and it has by no means been proven correct. You may well be right.

      • DevonChap November 10, 2013 at 11:12 am #

        The energy business knows it is in there for the long term and tends to stick with things. Those projects that are sold during times of low energy prices aren’t stopped, they are bought cheaply by other firms who can make them pay because they now have a lower fixed investment.

        • Jeremy November 11, 2013 at 11:02 am #

          Not necessarily. If you’ve been watching events unfold in alternative fossil fuels, you can see this at work. The rush of money into and out of oil shale, for example, or fracking in Poland, is actually surprisingly swift.

          I have thought it would be better to hold things for the longer term, but the oil majors don’t seem to, writing down assets and halting investment when things get tight. I assume this is to protect share value more than anything else, and in some cases smaller companies can pick up the projects. But if something is fundamentally uneconomic outside of a price spike, it’s not really viable for anyone.

          Having said that, it’s virtually impossible to tease out the energy-economy effect described here from other events in the financial world. With low interest rates and QE, it’s likely that the flow of money is faster and more short-term than it would otherwise be. I don’t understand the complexities enough to know what’s cause and what’s effect most of the time.

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