In the past, business cycles were primarily influenced by interest rates and credit creation. Today however, they are also influenced by peak oil. This article briefly explains what peak oil is, and why it impacts the business cycle.
What is peak oil?
Over the past 100 years mankind has become increasingly dependent upon cheap and ever growing supplies of energy, most notably oil. Since its discovery in 1859 oil production, meaning the extraction and refining of oil, has increased almost every single year.
Since oil is a finite non-renewable resource, however, its rate of production cannot be increased indefinitely. At some point the rate at which oil is produced will reach its geological limit and we will see the peak in global oil production followed by its terminal decline. This moment is referred to as “peak oil”.
Although the significance of peak oil cannot be underestimated, it’s important to note that it does not mean that we are about to “run out of oil”, it simply means that we are running out of easy to extract, cheap oil, and that we can no longer increase the quantity of oil produced.
Conventional wisdom holds that the peak in world oil production will occur many years in the future allowing for a timely transition to alternatives sources of energy. However the International Energy Agency (IEA) together with a host of other authoritative voices, predict that peak oil will occur as early as 2013 to 2015 – something which would have a profound effect on all our lives.
Peak oil and the business cycle
As the supply of oil becomes increasingly constrained, its price will tend to remain high. Under such conditions the determining factor in price becomes demand, and this is where the early effects of peak oil are beginning to show themselves.
The process by which the oil price influences the business cycle can be summarised as follows:
As global economic activity begins to increase, so too does the demand for oil. As oil demand picks up, so the price of oil begins to increase.
Over time, higher oil prices then feed through into the cost of living and of doing business. Eventually, as global spare oil capacity diminishes, the price of oil begins to spike.
The higher cost of energy forces consumers and businesses to cut back their spending reducing economic activity. As economic activity falls, so too does the demand for oil and gradually its price begins to fall.
According to the World Bank, a sustained $50 increase in oil prices could reduce global GDP by around 1.3%, while the IMF calculate that a $10-a-barrel increase in the price of oil would reduce US GDP by 0.5%.
The bottom line
I believe we are entering an era defined by relatively short periods of economic growth terminated by a spike in the price of oil and followed by a return to slower growth or recession.