Scenario: News
Newspaper for 1st June 2015

Yes, but what do you really think?

By presenting scenarios, this website avoids taking a position on when the oil peak will be reached and whether or not governments will prepare properly for it and, when it happens, handle it well. Nevertheless, the individual members of the Feasta team have their individual opinions on these questions, and we are quite frequently asked what they are and, more importantly, what our advice is to those responsible for running businesses. Here then, is how one member of the team, answers such questions:

High energy prices are good for the world economy. The conventional wisdom that high energy prices slow economic growth and are thus a bad thing is completely wrong. It’s true that high prices might, possibly, slow growth temporarily in wealthy, highly-energy intensive countries but they accelerate it in poorer ones. Andrew McKillop puts it like this:

Higher oil prices operate to stimulate first the world economy, outside the OECD countries, and then lead to increased growth inside the OECD. This is through the income or revenue effect on oil exporter countries, then metals, minerals and agro commodity exporter countries, many of them Low Income (GNP per capita below $400/year). Almost all of these countries have very high marginal propensity to consume. That is any increase in revenues, due to prices of their export products increasing in line with the oil price, is very rapidly spent, mainly on purchase of manufactured goods of all kinds.

In other words, higher energy prices lead to higher commodity prices which lead to higher incomes for some of the poorest people in the world, who quickly spend their extra earnings back in the rich countries. McKillop’s article from which the above quotation was taken was circulated among Feasta members in February 2003 and his predictions about the effects on commodity prices have proved right, as this graph from the (Irish) Central Bank’s Quarterly Bulletin No. 3, 2005, shows.

Rising energy and raw materials prices are inflationary. Ah, there’s the rub. Manufacturers who pay more for these inputs will have to pass the extra cost on. Some of the rises they’ll need will be pretty large and economists are beginning to wonder why they are not happening already. ‘AeuIt’s competition from China’ say some. ‘AeuIt’s because firms bought their supplies forward’ say others, adding that, when the forward contracts expire, the prices will go up.

The trouble is that, when the higher prices of manufactured goods do emerge and begin to push up the Cost of Living Index, the world’s central banks will treat them as if they were producing an ordinary inflation rather than bringing about a necessary re-adjustment to a new regime in which energy and materials prices are permanently high. The banks will try to choke off the inflation by pushing up interest rates but, as higher interest rates are themselves inflationary, the cost of money will have to go very high and do a great deal of damage to the world economy before the demand for energy begins to decline and its price to fall. In the turmoil, lots of projects will be cancelled and many firms will close their doors, particularly those which already have heavy debts.
The central banks’ action will be a serious mistake because several rounds of price increases are required before the costs of the things we buy can reflect the changes in the relative costs of the labour materials, energy and capital which went into making them. The increasing scarcity of oil and gas demands new price relationships and it is very painful to establish those if many prices have to fall rather than all prices going up but by varying amounts. 

High energy prices are also essential for the transition to renewable energy. With some exceptions, governments around the world have been remarkably reluctant to use subsidies, taxes and prohibitions to bring about a rapid shift from fossil energy sources to renewable ones. Instead, they are relying on the market to achieve the transition for them. This can only happen if fossil energy prices get high and stay that way. In the months since oil prices reached $60 a barrel, it has cost you half the amount to heat your house with wood pellets than with oil, but very few people yet realise this and it will take years for many to switch fuels. We need to be convinced that cheap fossil energy is a thing of the past before we’ll invest to adapt our oil furnace or put our savings into companies that operate wind turbines or biogas digesters.

The central banks will throw the world into a recession. This is what I think is the most likely outcome of the present rise in oil prices. It will not be the prices themselves that bring about the fall, but the banks’ reaction to them. So Goldman Sachs, with its prophesy of an oil price ‘spike’ (that is, a rapid rise, and an equally rapid fall) reaching over $100 a barrel might well be right.

So what should well-informed businesses do? Basically, the opposite to everyone else. First, cancel any expansion plans. Second, clear their debts so that their banks have no hold on them. They should sell whatever they can now, at the top of the market, and become cash-rich. They should then wait until energy prices bottom out and use their cash mountain to invest in renewable energy projects or anything else that will do well in an increasingly energy-scarce world.