Economic growth: a zero sum game

Understandably growth, growth and more growth is the mantra of politicians, economists and media commentators the world round. However, what if future growth is just not possible? The recently released World Energy Outlook (WEO) from the International Energy Agency (IEA) did not go so far as to say that future growth is no longer possible, but it does suggest that at the global level future economic growth is now a zero sum game. In short, China and India’s gain is the OECD’s loss.

From the WEO 2010 Executive summary (p. 6):

All of the net growth [in oil demand] comes from non-OECD countries, almost half from China alone … . Demand in the OECD falls by over 6mb/d.

So what is the big deal? If you are an economist, this is not a problem, because increased efficiency in the use of oil will allow growth to continue while demand falls - problem solved. In the real world however, this is the least probable outcome. A more likely result is that a six million barrel a day (mb/d) decline in OECD oil demand will result in a corresponding drop in OECD GDP. Let’s explore why this will be the case.

First some background. It wasn’t so many years ago that the IEA scoffed at the idea of peak oil. The IEA simply predicted a rate of future economic growth and calculated the volume of oil required to meet this growth, resulting in widely optimistic projections such as oil production of 116 mb/d a day in 2030 according to the 2007 WEO. An interesting trend has however occurred over the last few years. Each year the WEO has become more pessimistic in its view of future oil production, this year being the most pessimistic yet with production in 2035 being only 99 mb/d and crude oil production having already peaked. Even this subdued forecast is likely to be optimistic. One of the IEAs mandates is economic development; it is therefore rather difficult for the IEA to suggest there is insufficient oil to allow growth to continue. The IEA has got around this little problem by suggesting that the oil intensity of the OECD economies will improve significantly over coming decades, as shown in Figure 1:

Figure 1: Projected oil intensity in the 450 scenario

There is no doubt that improvements in the oil intensity (defined as the quantity of oil consumed per unit of GDP, the lower the better) can be made, but the difficulty of this challenge should not be under estimated, particularly given current circumstances. Many OECD nations have ageing populations, are heavily in debt, virtually all are dependent on oil imports with some notable exceptions (Norway and Mexico) and have in many instances outsourced much of their manufacturing industries to developing nations.

Take the United States for example. Drowning under government and private debt, with “real” under and unemployment at about 22 per cent, with nearly a quarter of mortgage holders “underwater” and consumers paying down debts, the result is reduced oil consumption due to fewer people transiting to work, fewer goods being exchanged and fewer holidays being taken (see Figure 2).

Reducing the oil intensity of an economy will require significant capital investment, something that in the weakened economic state of many OECD nations is unlikely. Reducing oil intensity is also subject to diminishing returns, each increment of improvement in oil intensity will become increasingly expensive and difficult to achieve. In this context, significantly reducing the oil intensity of the economy would be a monumental achievement.

Perhaps history can provide an example of a more likely future scenario; the 2007-2008 oil price spike being such an example.

Increasing demand combined with flat oil production from 2005 onwards led to the oil price reaching US$147 a barrel in July 2008. At this price, oil (among other factors) induced a recession. The recession resulted in falling demand (demand destruction, see Figure 2) and hence a collapse in oil prices. It also led to significant cuts in oil/gas/renewable energy investments (future supply destruction). This cycle is likely to repeat itself in the years ahead with each cycle increasing in intensity as demand destruction leads to future supply destruction. For this reason, many of the actions that could potentially assist in reducing the oil intensity of the economy, such as electric vehicles, are likely to be subject to the law of receding horizons.