March 7, 2008

How fast does the economy decline as oil production declines? In his latest report, drawing on various sources, Robert Hirsch reasons that the correlation is 1:1. A 2.5% annual decline rate will shrink the global economy by 25% in 10 years. Other reports substantiate that ratio.

Introduction

I've been doing research to bracket the economic effects of a power down/energy descent scenario and these papers give me what I'm looking for. In all cases, see the papers for the complete discussion but I've summarized what I'm interested in below. I recommend reading all four reports but in a pinch you could skip the Sill and Ayres ones.

Hirsch

Hirsch uses at 1:1 correspondence between oil decline and GDP decline by using Deutsche Bank's high number (2.5) and the ratios of the impact to the GDP to oil decline from the oil shocks of the 70's on the low end (0.7 and 0.6). He reasons that unity (i.e. a 1 to 1 correlation) is the correct order of magnitude to use in estimates. He also discusses various shortage scenarios and projected peak and plateau fall-off dates.

Ayres and Warr

They demonstrate what classical economics fails to do because it does not include an energy input. Classical economics addresses capital, labor and resource inputs but does not have a factor for energy. Ayers and Warr calculate a perfectly intuitive 0.7 for elasticity of demand (see Figure 10) using curve fitting when they introduce energy converted to useful work, and the correlation is excellent. This is in line with Hirsch's ratios. Apparently there has been no significant push back from economists even though their paper essentially jettisons the prevailing economic theory. (It appears that people knew the current theory was broken it just took a while to figure out how to fix it.)

Sill

Sill surveys previous oil shocks and comes up with a loss to the GDP of up to 1.4% over four quarters given a 10% price increase or a 10% production shortfall. Note that this is quite a bit different than the Ayers and Warr number but shocks are transient events, not sustained declines. Therefore in my thinking I treat Sill's numbers as applicable only during very sudden oil contraction.

Rubin

There are three major points from his January 08 report. First, many major oil megaprojects are delayed, which means oil will not be entering the market as quickly as the oil megaprojects database first indicated (http://en.wikipedia.org/wiki/Oil_megaprojects). In fact, I've been watching the 2008 projection and it has been slowly but steadily moving down as projects get delayed (retrieved March 6, 2008). 2008: 6842 2009: 7089 2010: 3785 2011: 4258 2012: 5124 2013: 282 2014: 430 2015: 592 Incidentally, the value for 2013 -- well within our average horizon of six years -- still has not moved appreciably up. Second, Rubin uses an annual global decline rate from existing fields of almost 4 mb/d. Third, the smaller amount of new production that will be entering the market will mostly be used domestically by the oil producing countries. Given all the above, see Table 1 on page 4 for the new production projected to be available to OECD countries. Not much. The projected result? $150/barrel in 08 but we aren't going to fall off the plateau just yet.

Conclusions

The literature points to an economic impact on the order of magnitude of unity. The good news is that it isn't a 10 to 1 ratio. The bad news is that it is clear that beyond the first year where some efficiency and voluntary curtailment might buffer the situation, our GDP will decline at approximately the rate oil declines. In reality, easy initial efficiency measures and curtailment will already have occurred due to the high prices leading up to the decline i.e. they are occurring now. See Rubin's report for more on that. Thus I think it would be unwise to expect any future buffer from efficiency or voluntary curtailment like how California managed to shave 11% off its electricity use voluntarily during the blackouts. In other words, I'm confident in the math to publicly say that a 1% decline in oil consumption will equal approximately a 1% decline in GDP once we fall off the oil production plateau we're on. Naturally this will not continue to zero and I do not have any research yet that can give us a feel of how long that relationship will hold (until we reach 25% from peak? 50% from peak?). My operating assumption is that the relationship will hold long enough to cause a major economic discontinuity. With the annual oil decline rate expected to range between 2% and 5% (see Hirsch, 2008) and the Oakland Peak Oil report using 2.6%, we will have a massive unemployment and homelessness problem on our hands. It also seems reasonable to expect that a great deal of wealth will be destroyed during the decline, as is happening now in the current credit crunch, but on a larger scale.