IMF: the economic impacts of oil scarcity

It’s a bit difficult to talk about “peak oil” without being written off as some sort of conspiracy theorist. I guess perhaps it’s because the supply of relatively cheap oil is so deeply embedded into the operation of our modern economy and society that people struggle to consider what life might be like with oil doubling or tripling in price within a relatively short time period. But with petrol prices nearing $2.20, it’s probably worthwhile having a bit of a think about the economic impacts of rising oil scarcity. Interestingly, the International Monetary Fund has dedicated a whole chapter of its 2011 World Economic Outlook to the subject of oil scarcity – so it’s obviously something exercising their minds too. It is well worth a read (PDF version here).

A summary of the chapter is included below:

The persistent increase in oil prices over the past decade suggests that global oil markets have entered a period of increased scarcity. Given the expected rapid growth in oil demand in emerging market economies and a downshift in the trend growth of oil supply, a return to abundance is unlikely in the near term. This chapter suggests that gradual and moderate increases in oil scarcity may not present a major constraint on global growth in the medium to long term, although the wealth transfer from oil importers to exporters would increase capital flows and widen current account imbalances. Adverse effects could be much larger, depending on the extent and evolution of oil scarcity and the ability of the world economy to cope with increased scarcity. Sudden surges in oil prices could trigger large global output losses, redistribution, and sectoral shifts. There are two broad areas for policy action. First, given the potential for unexpected increases in the scarcity of oil and other resources, policymakers should review whether the current policy frameworks facilitate adjustment to unexpected changes in oil scarcity. Second, consideration should be given to policies aimed at lowering the risk of oil scarcity.

The concept of peak oil relates to a point where approximately half the world’s oil has been pumped out, and it becomes increasingly difficult to to up the amount of oil coming out of the ground. Generally, each oil well follows a natural ‘bell shaped’ production curve due to the geological composition of oil and the need to pump water (or gas) into the well after a certain point to keep the pressure up. Aggregate up all the oil wells of the world and the result is a general bell curve for oil production. The question is where we fit on that curve now, and how far away is the top of the curve – the point at which we can no longer increase the level of production, no matter how hard we try.

If you look at oil supply levels over the past few years, it’s interesting to see the dramatic increase in demand up until around 2005, and then a major levelling off in the five years since then. Obviously the global economy has had some rocky times over the past few years – but the argument that it seems at the very least difficult for oil production to exceed 75 million barrels a day appears plausible.

So peak oil relates to supply issues – that after a certain point the natural geological characteristics of oil mean that we reach a ‘supply ceiling’. However, demand is also very important – as if our demand for oil keeps on increasing then that just makes the job of producing enough oil to meet supply particularly difficult. It’s quite helpful to then look at changing demand levels in various major areas of oil consumption around the world over the past few years: Changes over the last couple of years are particularly interesting – with per capita oil usage in the USA and the rest of the OECD reducing quite a lot, whereas per capita usage in China continues to boom, regardless of rising prices. Despite this, per capita usage in China is still a tenth of the US, giving us a clue that China has a lot of potential growth remaining. Growth that will probably have to come at the cost of other countries if we take the 75 million barrel ‘limit’ as being credible (which I generally do).

So, now that we’ve established that it seems there’s a pretty obvious oil supply crunch coming (or perhaps that it has already arrived), let’s go back to the IMF report and have a look at what the potential economic effects of increasing oil scarcity might be. The main findings of the report are summarised below:

The increases in the trend component of oil prices suggest that the global oil market has entered a period of increased scarcity. The analysis of demand and supply prospects for crude oil suggests that the increased scarcity arises from continued tension between rapid growth in oil demand in emerging market economies and the downshift in oil supply trend growth. If the tension intensifies, whether from stronger demand, traditional supply disruptions, or setbacks to capacity growth, market clearing could force price spikes, as in 2007-08.

As for the effects on the global economy, the simulation analysis suggests that the impact of increased oil scarcity on global growth could be relatively minor if it involves primarily a gradual downshift in oil supply growth rather than an absolute decline. In particular, a sizable downshift in oil supply trend growth of 1 percentage point appears to slow annual global growth by less than ¼ percent in the medium and longer term. On the other hand, a persistent decline in oil supply levels could have sizable negative effects on output even if there is greater substitutability between oil and other primary energy sources. At the same time, in the medium term, the oil-induced wealth transfer from oil importers to exporters can increase capital flows, reduce the real interest rate, and widen current account imbalances.

The analysis in this chapter suggests that oil scarcity will not inevitably be a strong constraint on the global economy. However, the risks it poses should not be underestimated either. Much will ultimately depend on the extent and evolution of oil scarcity, which remain uncertain. There is a potential for abrupt shifts, which would have much larger effects than more gradual shifts.

The chapter concludes that policymakers should strengthen measures to reduce the risks from oil scarcity as a precautionary step and to facilitate adjustment if such shifts are larger than expected or materialize in an abrupt manner. Policies need to be complemented with efforts to strengthen social safety nets, because higher oil prices could lead to shifts in income distribution and to increased poverty.

In short, it would appear as though the effects of increasing oil scarcity on the global economy could be either very significant or somewhat manageable, it all depends on whether oil supply decreases gradually or dramatically, and how prepared we are for the changes that increasing oil scarcity is likely to bring.

The IMF modelling on the economic impact of decreasing oil supply results in a large number of graphs – which all together are a little too complex for me to fully understand. However, the general trend seems to be that reduced oil supply has a clear negative effect on the global economy: A number of variation on the base scenario are also analysed, including what might happen if the reduction in oil supply was faster than expected (the GDP reductions are far greater) or if there’s an increasing use of oil substitutes (which mitigates some of the effects) and so on.

The IMF interprets the results as showing that oil scarcity may or may not have a relatively benign effect on the global economy – depending on the speed at which it happens and the extent to which we are prepared for it.

The analysis shows that the constraints on global growth in the medium to longer term from gradual and moderate increases in oil scarcity—those involving lower trend growth rather than sustained declines—could be relatively minor. In particular, a sizable downshift in oil supply trend growth of 1 percentage point appears to slow annual global growth by less than ¼ percent.

Such benign effects on output, however, should not be taken for granted. Important downside risks to oil investment and capacity growth, both above and below the ground, imply that oil scarcity could be more severe. Moreover, unexpected increases in oil scarcity and resource scarcity more broadly might not materialize as small, gradual changes but as larger, discrete changes. In practice, it will be difficult to draw a sharp distinction between unexpected changes in oil scarcity and more traditional temporary oil supply shocks, especially in the short term when many of the effects on the global economy will be similar. In addition, it is uncertain whether the world economy can really adjust as smoothly as the model envisages. Finally, there are risks related to the scope for the substitution away from oil, on both the upside and the downside. The adverse effects could be larger, especially if the availability of oil affects economy-wide productivity, for example by making some current production technologies redundant.

Therefore, the state of oil scarcity needs to be monitored carefully; the global economy is still in the early stages of the new era of maturity in major oil-producing economies.

I have underlined a section that I think is of particular interest – the difficulty in distinguishing between oil supply shocks that are the result of non-scarcity reasons (such as the most recent spike in prices that occurred due to conflicts in Libya) and those that do relate to scarcity (I would argue the July 2008 price spike was predominantly scarcity related). This isn’t surprising, as what we have now is a much reduced “buffer zone” between supply and demand levels. If something in the oil supply system gets disrupted then nobody else can simply ‘make up the difference’, because chances are they’re already pumping at around full capacity.

The IMF paper has this to say about policy recommendations to reduce the effects of the worse-case scenario:

Regarding policies aimed at lowering the worst-case risks of oil scarcity, a widely debated issue is whether to preemptively reduce oil consumption— through taxes or support for the development and deployment of new, oil-saving technologies—and to foster alternative sources of energy. Proponents argue that such interventions, if well engineered, would smoothly reduce oil demand, rebalancing tensions between demand and supply, and thus would reduce the risk of worst-case scarcity itself.

There are, however, several issues that need to be addressed before policy interventions to reduce oil consumption are implemented. Such interventions come at a cost, and their net benefits need to be evaluated. For example, lowering oil consumption through higher taxes could reduce growth and welfare during the period before serious scarcity has emerged. The calculations to establish costs and benefits are complex. This is mainly because the net benefits ultimately depend on the probability of significantly higher scarcity and the present discounted value of expected costs that the higher scarcity would impose, which are hard to quantify.

I wonder what the IMF would think of our government’s current transport priorities, with this issue in mind. Raising fuel taxes to build more motorways seems to contradict most of what the paper seems to be suggesting.

The paper is generally an interesting read – and it’s good to see ‘mainstream economics’ organisations starting to recognise the impact of oil scarcity and rising fuel prices on the economy.

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