This article is an excerpt from Chapter 3 of Richard's new book 'The End of Growth', which is set for publication by New Society Publishers in September 2011. Given the urgency and fragility of the global economic crisis, we are serializing the draft content as Richard writes it. Access previous chapters here.
Follow Richard's writing process through Facebook and Twitter.
Before examining limits to non-energy resources, it might be helpful to consider how markets respond to resource scarcity, with petroleum as a highly relevant case in point.
The standard economic assumption is that, as a resource becomes scarce, prices will rise until some other resource that can fill the same need becomes cheaper by comparison. What really happens, when there is no ready substitute, can perhaps best be explained with the help of a little recent history and an old children’s story.
Once upon a time (about a dozen years past), oil sold for $20 a barrel in inflation-adjusted figures, and The Economist magazine ran a cover story explaining why petroleum prices were set to go much lower. The U.S. Department of Energy and the International Energy Agency were forecasting that, by 2010, oil would probably still be selling for $20 a barrel, but they also considered highly pessimistic scenarios in which the price could rise as high as $30 (those forecasts are in 1996 dollars).
Instead, as the new decade wore on, the price of oil soared relentlessly, reaching levels far higher than the “pessimistic” $30 range. Demand for the resource was growing, especially in China and some oil exporting nations like Saudi Arabia; meanwhile, beginning in 2005, actual world oil production hit a plateau. Seeing a perfect opportunity (a necessary commodity with stagnating supply and growing demand), speculators drove the price up even further.
As prices lofted, oil companies and private investors started funding expensive projects to explore for oil in remote and barely accessible places, or to make synthetic liquid fuels out of lower-grade carbon materials like bitumen, coal, or kerogen.
But then in 2008, just as the price of a barrel of oil reached its all-time high of $147, the economies of the OECD countries crashed. Airlines and trucking companies downsized and motorists stayed home. Demand for oil plummeted. So did oil’s price, bottoming out at $32 at the end of 2008.
But with prices this low, investments in hard-to-find oil and hard-to-make substitutes began to look tenuous, so tens of billions of dollars’ worth of new energy projects were canceled or delayed. Yet the industry had been counting on those projects to maintain a steady stream of liquid fuels a few years out, so worries about a future supply crunch began to make headlines.
It is the financial returns on their activities that motivate oil companies to make the major investments necessary to find and produce oil. There is a long time lag between investment and return, and so price stability is a necessary condition for further investment.
Here was a conundrum: low prices killed future supply, while high prices killed immediate demand. Only if oil’s price stayed reliably within a narrow—and narrowing—“Goldilocks” band could serious problems be avoided. Prices had to stay not too high, not too low—just right—in order to avert economic mayhem.
The gravity of the situation was patently clear: Given oil’s pivotal role in the economy, high prices did more than reduce demand, they had helped undermine the economy as a whole in the 1970s and again in 2008. Economist James Hamilton of the University of California, San Diego, has assembled a collection of studies showing a tight correlation between oil price spikes and recessions during the past 50 years. Seeing this correlation, every attentive economist should have forecast a steep recession beginning in 2008, as the oil price soared. “Indeed,” writes Hamilton, “the relation could account for the entire downturn of 2007-08. . . . If one could have known in advance what happened to oil prices during 2007-08, and if one had used the historically estimated relation [between oil price spikes and economic impacts] . . . one would have been able to predict the level of real GDP for both of 2008:Q3 and 2008:Q4 quite accurately.” 
This is not to ignore the roles of too much debt and the exploding real estate bubble in the ongoing global economic meltdown: As we saw in the previous two chapters, the economy was set up to fail regardless of energy prices. But the impact of the collapse of the housing market could only have been amplified by an inability to increase the rate of supply of depleting petroleum. Hamilton again: “At a minimum it is clear that something other than [I would say: “in addition to”] housing deteriorated to turn slow growth into a recession. That something, in my mind, includes the collapse in automobile purchases, slowdown in overall consumption spending, and deteriorating consumer sentiment, in which the oil shock was indisputably a contributing factor.”
Moreover, Hamilton notes that there was “an interaction effect between the oil shock and the problems in housing.” That is, in many metropolitan areas, house prices in 2007 were still rising in the zip codes closest to urban centers but already falling fast in zip codes where commutes were long.
By mid-2009 the oil price had settled within the “Goldilocks” range—not too high (so as to kill the economy and, with it, fuel demand), and not too low (so as to scare away investment in future energy projects and thus reduce supply). That just-right price band appeared to be between $60 and $80 a barrel.
How long prices can stay in or near the Goldilocks range is anyone’s guess (as of this writing, oil is trading in New York for over $90 per barrel), but as declines in production in the world’s old super-giant oilfields continue to accelerate and exploration costs continue to mount, the lower boundary of that just-right range will inevitably continue to migrate upward. And while the world economy remains frail, its vulnerability to high energy prices is more pronounced, so that even $80-85 oil could gradually weaken it further, choking off signs of recovery.
In other words, oil prices have effectively put a cap on economic recovery. This problem would not exist if the petroleum industry could just get busy and make a lot more oil, so that each unit would be cheaper. But despite its habitual use of the terms “produce” and “production,” the industry doesn’t make oil, it merely extracts the stuff from finite stores in the Earth’s crust. As we have already seen, the cheap, easy oil is gone. Economic growth is hitting the Peak Oil ceiling.
As we consider other important resources, keep in mind that the same economic phenomenon may play out in these instances as well, though perhaps not as soon or in as dramatic a fashion. Not many resources, when they become scarce, have the capability of choking off economic activity as directly as oil shortages can. But as more and more resources acquire the Goldilocks syndrome, general commodity prices will likely spike and crash repeatedly, making a hash of efforts to stabilize the economy.
1. “Drowning in Oil,” The Economist, March 4, 1999.
2. International Energy Agency, World Energy Outlook 1998 (Paris: IEA Publications, 1998), 78.
3. Chris Nelder, “World Will Soon Face an Oil Supply Crunch,” Energy & Capital, posted September 18, 2009.
4. Richard Heinberg, “Goldilocks and the Three Fuels,” Reuters, posted February 18, 2010.
5. James Hamilton, Causes and Consequences of the Oil Shock of 2007, Brookings Papers on Economic Activity, March 2009.
6. Joe Cortright, “Driven to the Brink: How the Gas Price Spike Popped the Housing Bubble and Devalued the Suburbs,” White Paper, CEOs for Cities
, 2008, http://www.ceosforcities.org
7. Jad Mouawad, “For OPEC, Current Oil Price Is Just Right,” The New York Times, September 9, 2009.
8. Jon Talton, “With Oil Prices Around $90, Recovery is Over a Barrel,” The Seattle Times
, December 9, 2010; David Murphy, “Further Evidence of the Influence of Energy on the U.S. Economy,” The Oil Drum
, posted April 16, 2009, http://netenergy.theoildrum.com/node/5304
; Jeff Rubin, “We Have Run Out of Oil We Can Afford to Burn,” The Globe and Mail
, October 6, 2010; “Oil Price is Risk to Economic Recovery, Says IEA,” BBC News
, posted January 5, 2011; Derek Thompson, “How Oil Could Kill the Recovery,” The Atlantic
, posted January 6, 2011.
9. Cameron Leckie, “Economic Growth: A Zero Sum Game,” On Line Opinion, posted November 25, 2010.
Image credit: Darren Wren