Energy Costs and the Economy
George Mobus teaches computer science to undergraduate and graduate students at the Institute of Technology, Computing & Software Systems at the University of Washington, Tacoma.
His background is quite broad: He has a PhD in Computer Science, an MBA in Decision Science, and a baccalaureate in Zoology (with substantial coursework in math, chemistry, and oceanography) from UW Seattle. His academic focus has been Biology: Specifically, evolutionary, cognitive, neuro-psychology — how the brain works to produce the mind and how did it come about through evolution.
He blogs at Question Everything, where this piece was originally published:
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Why Do Prices Go Up?
I’ve hammered on this issue many times, but it seems that it needs even more exposure now. Oil price has been hovering around the $90 – $95 price range for several months now. That range isn’t really hard since there are many grades of oil (light sweet to tar sands gunk) that have a range of prices based on the desirability, a function of how easy it is to refine the oil to high demand products like gasoline and diesel fuels. I haven’t seen anything resembling a weighed average price, by type and volume say, but you can see the general trend by tracking prices of any of several sources. For example Brent Blend (North Sea source) was running in the high $90s a few days ago. Tapis crude (from Malaysia and traded in Singapore for Asian markets) was running over $100 on that same day. And West Texas Intermediate (USA, most often quoted benchmark price) was running just over $90. Here is the problem. The price of oil is a major cost factor in everything else in the economy.
Way back in March of 2008, when the price of WTI went over $100 I wrote What’s wrong with this picture? in which I dissected the cost accounting of a supply chain from a basic material extraction (from natural resources) through intermediate processing and component forming, up through final product production. What I was trying to show is that while energy costs recorded for each enterprise in the chain were relatively small in dollars, that the fact is every stage along the way energy inputs were necessary to get to a final product. In point of fact all work must have energy inputs, and thus all inputs to production ultimately resolve to energy. This includes labor, materials, and overhead, which allocates costs to historical expenditures for physical plant assets as well as current operating expenses. Extractive industries are generally very energy intensive even when the energy is that of human labor (e.g. miners).
The energy costs (in joules or BTUs if you prefer) accrue at every stage. In this blog I want to explicate this aspect just a bit more and examine the way in which rising costs of fossil fuels propagate throughout the economy and contribute to inflation, i.e., the rising costs of all products, not just, say, gasoline. But, insidiously, inflation is not the only impact we will see from rising energy costs. These are just a natural reflection of a simple biophysical economic fact. The supply of net energy to do all useful work is already in decline. This is because the amount of energy that is consumed in the extraction of fossil fuels has been steadily increasing while the rate of production (esp. of oil) has been decreasing. We have already passed the peak of net energy, so we are able to do less real work (as opposed, say to fantasy financial services work done on Wall Street and by gambling bankers – not all bankers, just the greedy ones). It appears now that we have passed the global peak of extraction of conventional oil, and we have certainly reached the point where new production is only for high energy cost oils (e.g. from deep water drilling or tar sands). Readers would do well by reading postings in The Oil Drum and The Energy Bulletin for starters. You will find other blog pointers in my blog roll to the left. All of these are examining the peak oil phenomenon and exploring the implications for macroeconomics.
The graph below, supplied by Wikipedia (have you made your donation yet?), shows the general trend of WTI prices from 1996 to 2008. As can be seen in the graph, oil prices basically increased by five times in that period. Eventually it reached a top of $147 and some change and then tumbled back down to $40+ when the demand for oil plummeted and triggered the 2009 recession. For a good overview of the oil production vs. price history see Gail Tverberg’s “Will 2011 be a rerun of 2008?” on The Oil Drum.
Graph 1. WTI price trends 1996 to 2008 (1994 is a typo – source Wikipedia.
Clearly the price signal has been on a more or less steady climb for the decade. There is no oil embargo to explain this, only the twin effects of peaking production and falling energy return on energy investments (EROI) which translates into higher costs of production.
But the really bad news is that oil is an input to everything else in the economy, either directly or indirectly. Its cost increases are most readily and quickly felt in the transportation sector. But oil is also used as chemical feedstock for plastics and other derived products. It is simply everywhere in one molecular form or another. As I said transportation systems rely very heavily on oil in the form of gasoline and especially diesel. The latter is a major input to the extraction industries, even for coal (I’ve been trying to assess the magnitude of this relationship as it might have a great impact on coal production costs).
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