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Modern Economics: Goldilocks is dead

What the death of Goldilocks looks like in practice

In the Goldilocks children’s story, there is a bowl of porridge that is just right.  Not too hot, not too cold.  Central to modern economics is a similar idea about price.  The law (sic) of supply and demand says that there is always a Goldilocks price point where supply and demand meet – the point at which consumers are happy to buy and firms can operate at a profit.

However, oil industry expert Richard Heinberg argues that Goldilocks is Dead.  Since the great crash of 2008 – and the peak of conventional crude oil production in 2005 – the energy market is no longer able to make supply and demand meet:

“During the past dozen years, the Goldilocks zone for oil steadily migrated higher. As conventional crude reservoirs depleted and production rates leveled off, drillers had to spend proportionally more to develop the capacity to pump the next marginal barrel. Oil prices soared from $30 in 2003 to nearly $150 in 2008, collapsed during the economic crisis, then clawed their way back to roughly $100—a price that was maintained through mid-2014. But the economy did not do well with oil prices at elevated levels. Despite massive bailouts, stimulus spending, and low interest rates, the recovery following the 2008 crash was anemic.”

Since 2014, the round of bankruptcies in the US energy industry and the collapse of Britain’s North Sea oil industry to the point that Marks and Spencer are now as profitable bears out Heinberg’s proposition.  But a better example of the process can be seen in the misfortunes of Tullow Oil in West Africa.

Tullow is in the news today because – so far as its bankers are concerned – it is too big to fail:

“Tullow Oil has landed a one year extension on a billion dollar debt facility as it begins the task of tackling a rising debt pile of $4.8bn after a third consecutive year of losses.”

So how did a relatively large company in what used to be one of the most profitable sectors on earth end up in such a precarious position?

“Tullow has been desperately unlucky. Having found vast quantities of oil, it then saw the rug pulled from under its feet when the price of crude plunged, just as the company was fully committed to taking on huge debts in order to develop the new fields.”

In reality, ‘luck’ has nothing to do with it.  Like just about every other chump caught up in the frenzy of an economic bubble, Tullow bet its corporate shirt on the bubble prices continuing to rise indefinitely.  And Tullow’s gullible bankers were equally happy to believe the ‘new era of prosperity’ hype that brought us fracked oil at more than $100 per barrel.  What none were prepared to see was that the people at the bottom – the consumers who have to pay for it all – were still struggling with falling incomes and an overhang of pre-2008 debt.  While oil consumption continued to rise in the developing countries, demand collapsed in the USA and Europe; causing prices to slump from mid-2014.

Had oil prices remained high, we would be celebrating Tullow Oil as a ground-breaking innovator.  But they didn’t.  Indeed, because oil price rises also inflate the price of almost everything else in the economy – which is made from or transported using oil – global demand simply cannot stand $50 per barrel oil without plunging the economy into another recession.  That leaves companies like Tullow Oil with a mountain of (possibly unpayable) debt.

Had prices remained high, Aberdeen would still be a boom town; Scotland’s Atlantic coast would be the location for the new oil and gas boom; and most of the continental USA would be being fracked as we speak.  But, of course, that didn’t happen and it isn’t going to happen.  The stark reality is that large scale oil industry projects like Tullow Oil’s developments in Ghana look increasingly risky. The heart of the problem is that oil exploration and recovery takes time; especially with the complexities of offshore drilling – nobody wants to preside over the next Deepwater Horizon disaster; which has cost BP around $62 billion in compensation and fines.

In the twentieth century, with largely stable or rising prices, investors could afford to invest in developing large or expensive new oil fields on the understanding that they would get their money back five, ten or fifteen years later.  In the twenty-first century volatile prices guarantee that it is going to be different. Although prices have crept back up since OPEC and Russia agreed to freeze production last year, at $50 per barrel they are a long way off the average annual price of $109 reached in 2012.  What this means is that large and relatively expensive developments – like Tullow Oil in Ghana – that looked profitable at $100 per barrel when the investment was made have become money sinks at $50.  That means that the global oil reserves (i.e. economically recoverable oil) that everyone thought were available back in 2012 have shrunk dramatically today – not because the oil isn’t there, but because (in the absence of sustained high prices) nobody can afford to get it out of the ground.

The worry today is that even an economy-busting rise back to 2012 price levels will not be enough to draw investors back to the energy industry.  Having had their fingers burned after 2014, and knowing that a price spike is likely to flatten demand, investors will want to see prices stabilise above at least $70 per barrel for a year or more before they return to the oil patch in numbers.  The implication, of course, is that the world is going to have to get by on a lot less oil in the not too distant future.

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