IMF study: Peak oil could do serious damage to the global economy

The world isn’t going to run out of oil anytime soon. But there’s still concern among various geologists and analysts that our oil supply won’t grow as quickly or as easily as it used to. We’ll have to resort to harder-to-drill oil to satisfy our crude habits. More expensive oil. That would push prices up. And high oil prices could act as a drag on growth.

These spigots are getting mighty squeaky… (Associated Press)

This, at any rate, is the basic idea behind “peak oil.” And there’s some reason for worry. Between 1981 and 2005, world oil production grew at a steady pace of about 1.8 percent per year. All was well. But starting around 2005, oil production appeared to plateau. And, since demand for oil kept rising, especially in countries like China and India, that caused prices to soar. Oil doesn’t get much cheaper than $100 per barrel these days. And that, some economists worry, has acted as a drag on growth around the world.

So how bad would it be if peak oil was really upon us? That’s a question that two IMF economists try to tackle in a new working paper, “Oil and the World Economy: Some Possible Futures.” (pdf) The authors, Michael Kumhof and Dirk Muir, don’t make any definitive predictions about how the oil supply will evolve. Rather, they try to model a number of different scenarios in which oil does become more scarce and the world tries to adapt.

The paper itself offers an interesting look at how the world might cope with higher oil prices, so let’s take a look at the various scenarios:

1) Oil production grows very slowly or plateaus. This is the baseline scenario that Kumhof and Muir use. They assume that oil grows by about 1 percentage point less each year than its historical average. So, let’s say, oil grows at a steady 0.8 percent per year rather than the 1.8 percent annual average between 1981 and 2005. This isn’t a temporary oil disruption like the one we saw in 2008. It’s a persistent, long-term supply shock.

What would happen? Oil prices, the IMF model suggests, would gradually double in 10 years and quadruple over 20 years. Regions that import oil on net, such as Europe and the United States, would see a small hit to growth—about 0.2 to 0.4 percentage points each year. Countries that export, like Saudi Arabia, would get a lot wealthier.

2) Oil production grows at a slower rate, but the world adapts fairly easily. In this scenario, oil production declines, but countries start switching to electric cars or fueling their vehicles with natural gas. Vehicles and manufacturers become more efficient. In economist terms, the “elasticity” of demand quickly increases.

Under this scenario, the United States and Europe take just a small hit to growth, about 0.1 to 0.2 percentage points per year. Japan and Asia actually get a boost to their economy, since they can adapt to higher oil prices and export more stuff to oil-producing countries in the Middle East. All told, this is a fairly happy outcome.

3) Oil production grows at a slower rate, but the world can’t find substitutes. As the IMF authors note, it’s not assured that the world can quickly adapt to steadily increasing oil prices. Oil is, after all, quite valuable and hard to replace. Electric cars may not catch on. It’s tough to build infrastructure for natural-gas vehicles. The chemical industry might struggle to find substitutes for oil as feedstock. The oil substitutes that result turn out to be lower-quality. In this scenario, wealthy regions like Europe, the United States, and Japan take an annual GDP hit of 0.4 percent to 0.6 percent. That starts to hurt.

4) Oil turns out to be far more important than most economists had assumed. The Energy Information Administration estimates that petroleum purchases make up just 3.5 percent of the U.S. economy. Looked at from that angle, expensive oil shouldn’t do too much damage. But, the IMF authors note, several books and articles have pointed out that this understates how crucial oil is to the functioning of a modern economy. Many key technologies contain materials or use fuels derived from crude.

If, in fact, oil is much more important than many economic modelers have assumed, then the blow to growth from even a modest plateau in oil could be quite large—lowering growth rates by up to 1.2 percentage points over the next two decades.

5) Oil production starts shrinking rapidly. This is the doomsday scenario. Some studies have suggested that global oil production is currently on a plateau and will soon start shrinking in by around 2 percent per year. Existing wells will dry up. The world will increasingly rely on oil from places that are more expensive to develop, such as Canada’s tar sands. What happens then?

Nothing good. According to the IMF’s modeling, prices could increase by 800 percent over two decades. Growth rates in Europe and the United States would be reduced by at least a full percentage point—and much more if oil turns out to be more important than we thought. “Relative price changes of this magnitude would be unprecedented,” the authors note, “and would almost certainly have nonlinear effects on GDP that the model is not able to capture adequately.” Yikes.

In any case, these scenarios aren’t easy to model—especially since nations might respond in unpredictable ways. (If crude output started shriveling, some oil producers could start restricting exports. Or fuel subsidies could affect demand elasticity. ) All told, however, the IMF authors say it’s quite possible that a decent-sized decline in oil production could have “dramatic” effects that could prove very, very difficult for the world to adjust to.

Washington Post