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In the Keynes zone

There was something Pavlovian about the establishment media reporting of OPEC+ production cuts last weekend.  After all, throughout the 164 years since Colonel Drake sank his oil well in Pennsylvania, every time an oil cartel has monopolised the oil trade, production cuts have resulted in higher oil prices.  So it was, for example, that Jemma Dempsey at the BBC made the unconscious psychological connection between production cuts and higher prices:

“Oil prices have risen after Saudi Arabia said it would make cuts of a million barrels per day (bpd) in July.  Other members of Opec+, a group of oil-producing countries, also agreed to continued cuts in production in an attempt to shore up flagging prices.

“Opec+ accounts for around 40% of the world’s crude oil and its decisions can have a major impact on oil prices.  In Asia trade on Monday, Brent crude oil rose by as much as 2.4% before settling at around $77 a barrel.”

This though, was an example of something the BBC are all too fond of accusing others of disseminating… misinformation.  That $77 per barrel was more or less where the oil price had settled at the end of the previous week.  And far from ushering in higher oil prices – something that OPEC+ clearly intended – the result has been a further decline.  Two-day’s on from Dempsey’s report, and the Brent Crude price has fallen to $75.56 per barrel.

It is also worth noting that the current production cut comes after a similar cut in March failed to stop the price of oil from falling.  And this, in turn, might suggest that we are witnessing something highly unusual.

Contrarian economists down the years have pointed to the essential role of energy in the economy.  Perhaps most famously, in 1996 Julian Simon pointed out that:

“Energy is the master resource, because energy enables us to convert one material into another.”

More recently, Steve Keen has observed that:

“Capital without energy is a statue, labour without energy is a corpse.”

Despite the volumes of tosh trotted out by establishment media and green energy corporations about non-renewable renewable energy-harvesting technologies (NRREHTs) and “peak oil demand,” even in the UK, which leads the world in per capita wind energy, oil remains our biggest energy source.  Moreover, since the UK is heavily dependent upon importing manufactured goods and energy-intensive resources (including food) a large part of our oil consumption occurs in other people’s countries:

Notice also that despite spending billions of pounds expanding our offshore wind farms, wind – along with NRREHTs more generally – still accounts for just a tiny fraction of our energy consumption.  Indeed, insofar as we have phased out a fossil fuel, it is coal.  And we have all but eradicated coal through a combination of offshoring, cutting consumption, and massively expanding our domestic consumption of gas.

World consumption – which includes the western consumption that occurs in third countries – is even less favourable to the NRREHTs narrative.  With the exception of hydroelectric dams – which cannot be expanded much further because the best locations have already been dammed – NRREHTs account for less than six percent of total energy.  And since NRREHTs cannot be manufactured, transported, deployed or maintained without the use of fossil fuels, it is still correct to say that fossil carbon is the master resource.  Moreover, because of its flexibility, of all of the fossil carbons, oil remains the most important:

Understandably then, in a global economy which remains highly dependent upon fossil fuels in general and oil in particular, when the OPEC+ cartel cuts production, this ought to cause prices to rise.  This is because for the past 164 years, production has been (relatively) limited while demand has been limitless.  That is, on every occasion that the global oil industry has over-produced, there has been more than enough demand in the wider economy to absorb the additional oil.

This though, began to change around the turn of the century.  Inevitably, the oil industry began by extracting the easy deposits first.  Nobody, for example, was about to try to drill into the seabed, several miles below the surface when all one had to do was to knock a pipe into the ground in Pennsylvania, Oklahoma or Texas to recover the same volumes at a fraction of the price…  price being an approximation of the energy cost of producing the oil – both the direct energy and that embodied in the tools, machinery, infrastructure and even the labour required to make it all work.

In 2005, global conventional oil production peaked – coincidentally, the same year that the UK became a net importer of oil and gas.  With demand outstripping supply, the price of oil rose.  And because oil remains ubiquitous, higher oil prices fed through into a general increase in prices as the economy adjusted to the new conditions.

Central bankers responded to rising prices with interest rate rises which were designed to trigger a recession in the belief that this would bring prices down.  In this, they succeeded beyond their wildest dreams, setting off the biggest banking and financial crash since 1929, and ushering in the economic depression which persisted through the decade between the Crash and the Covid.

During that decade, the once-and-done US shale bubble served to obscure a fundamental reversal of the importance of oil supply and demand in the global economy.  As a result of near zero percent interest rates which also encouraged corporate share buy-backs, investors faced a search for yield.  In this environment, fracking appeared to offer returns on investment far greater than could be found in safer investments.  And so, the frackers began spending billions of dollars of other people’s money to produce millions of dollars’ worth of new – and highly temporary – oil.  Indeed, the nature of fracked shale oil, with its rapid decline rate, led inevitably to over-production in the post-crash economy, causing global prices to plummet despite OPEC+ production cuts.

Global oil production – including unconventional oil – finally peaked in November 2018.  However, the arrival of SARS-CoV-2 and the ensuing lockdown insanity undermined so much demand around the planet, that even though oil production is 2.5 million barrels a day lower than in 2019, we continue to face over-production (in reality under-consumption).  Which is one reason why, of course, OPEC+ is still attempting to cut production.  But there is more to this.  Prior to 2005, it had been possible for most of the time to arrive at a “Goldilocks” oil price which allowed oil corporations to profit without undermining the wider economy.  Only during artificial oil shocks – such as the 1973 OPEC embargo and the 1979 Iranian revolution – did we get a glimpse of what might happen to advanced industrial economies if the price of oil rose too high.

In this environment, economists have generally accepted the view that if oil production falls, oil prices will just go on increasing.  For example, a 2012 paper for the International Monetary Fund anticipated an oil price above $200 per barrel by 2020 – since a lower price would make it impossible for the oil industry to remain profitable given the higher cost of recovering the remaining deposits.  Gail Tverberg – an insurance actuary specialising in risk from the energy industry – has been one of the very few people to consistently challenge the prevailing economic orthodoxy when it comes to energy and oil.  According to Tverberg, as we finished burning through the cheap and easy oil deposits, so we hit an economic limit (which, in reality, is an energy cost limit) beyond which there is no longer a Goldilocks oil price.  If the price falls too low – as it did in 2015 and again during lockdown – production becomes unprofitable.  This is especially true when it comes to investing in new production – whether developing new deposits or building and/or refurbishing refineries.  If, on the other hand, prices spike upward – as they did prior to the 2008 crash and again in 2022 – there is insufficient demand in the economy and so businesses and households switch consumption away from discretionary goods and services in response.

This process was outlined by Frank Shostak from the Mises Institute:

“If the price of oil goes up and if people continue to use the same amount of oil as before then this means that people are now forced to allocate more money for oil. If people’s money stock remains unchanged then this means that less money is available for other goods and services, all other things being equal. This of course implies that the average price of other goods and services must come off.

“Note that the overall money spent on goods does not change. Only the composition of spending has altered here, with more on oil and less on other goods. Hence, the average price of goods or money per unit of good remains unchanged.”

To some extent this has been distorted by state, business and household borrowing, which creates an additional stock of currency in the short-term but at the cost of a further drain on the economy later on, as interest and repayment costs are deducted from our collective demand.  Moreover, as Tverberg points out, in western oil-based economies, the price of oil does not simply have to provide a profit to investors but must offer enough of a surplus to underwrite government borrowing with tax receipts.  For example, at the height of UK North Sea production, ten percent of UK government income came from oil.  Thus, at the same time as higher oil prices push governments – under pressure from electorates – to subsidise energy prices, the hit to tax receipts raises the cost of doing so… perhaps to the point that the stability of a currency may be undermined.

Over the past decade, we have witnessed a see-sawing as the economy responds to rising oil prices by lowering overall demand to the extent that oil prices fall again:

The broader problem being that we have entered a death spiral in which oil prices can no longer increase to a point which makes further investment in production viable but nor can prices fall to a level at which a new round of economic growth can begin.  Instead, almost all of the “growth” recorded in official GDP data today is merely the financial transactions resulting from increased borrowing.

In summary then, whereas the 164-year-old dynamic involved rising demand pushing oil prices up to the point that further production became viable, today we are in a new phase in which the higher cost of oil is crushing demand, causing disinvestment from further oil production.  The end result would be higher oil prices but for the fact that higher prices crush economic demand even further, causing recession and depression.

Missing from this picture though, is the dimension of time.  Businesses don’t immediately raise their prices in response to a rising oil price any more than households cease buying a range of discretionary goods and services.  Most often, we respond by trying to absorb the additional cost.  When this fails, we may seek some kind of efficiency saving.  And beyond this we will likely borrow to make up the difference… all in the expectation that prices will fall again soon.  It may take months or even years of higher prices – compounded by rising interest rates – before households pare their spending down to essentials, and businesses – who until recently were struggling to find workers –begin cutting their workforce.

We have already seen a string of indicators – failing banks, inverted yield curves, fewer hours being worked, an explosion in home-working, and business surveys predicting lower future demand – pointing to a deflationary recession, even as central bankers are still obsessing over inflation, and as governments continue to promise a soft landing.  The recent failure of OPEC+ production cuts to generate a higher oil price is yet another indicator of an unfolding downturn – and because the rising energy cost of recovering oil will continue to increase, it is also an indicator of a prolonged depression as we will struggle to regenerate demand in the aftermath of the gathering downturn.

Central bankers are labouring under the illusion that they are in control, and so can steer a course back to prosperity.  Even more laughably, the politicians think the state is in charge, and so engage in borrowing, and tax-and-spend policies which they believe will bring inflation down in a good way

Perhaps proving that we shouldn’t rely upon the opinions of economists, John Maynard Keynes lost a fortune in the 1929 crash.  The experience prompted him to utter his famous line:

“Markets can remain irrational longer than you can remain solvent.”

What the OPEC+ failure to raise prices is telling us is that those who determine policy are as irrational today as they were in the months and years prior to 1929.  And that inflation is about to come plummeting down in a bad way – and just like Keynes back then, pretty soon we are all going to lose our shirts… it is only a matter of time.

As you made it to the end…

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