Published in ENDS Report (issue 400, p53), in May 2008.
Ten years ago the price of oil was $10 a barrel. The Economist, never one to worry about a resource shortage, thought it might drop in the near future to $5 a barrel. During the past month it rose to over $125 a barrel. Goldman Sachs recently warned the world to get ready to live with $200 a barrel.
If you had factored $100 a barrel oil into any economic model running a decade ago it would have projected an immediate and catastrophic collapse of the global economy. Economists everywhere are scrambling to explain why – until now anyway – robust economic growth has continued in the face of this huge increase.
I draw four lessons from this brief history of oil prices. The first is that economic models are far less reliable a guide to the future than climate models. The second is that prices do not always move the way you think they will. The third is that they do not always have the effects you think they will. The fourth is that economists often have difficulty assembling the words ‘I’, ‘do’, ‘not’ and ‘know’ into a meaningful sentence.
Most economic analyses assume that price spikes like this are temporary. Prices this high are a strong incentive for new investment by oil companies. It may take a while but eventually new production comes on line, markets clear and prices drop. So the theory goes. Geologists and engineers are coming to a different view.
They increasingly think that the world will struggle over the next few years to lift oil production from its current 80 million barrels a day to 100 barrels a day. They have little confidence that it will reach the 116 million barrels a day the International Energy Agency projects world demand to be in 2030. If they are right, oil prices might fall back for a while if the current loss of financial confidence leads to a slow down in global growth. But as soon as growth picks up, oil prices will resume their inexorable upward march.
The rising oil price is a primary driver behind the food price shock that has caught the world by surprise. Globally, the price of agricultural commodities increased 37% in the past year. In China year-on-year food price inflation is running at 22%. Biofuels have taken much of the headline blame for this shock. This is premature. So far, they have played a much smaller part than the oil price and some deeper structural dynamics that have been building for some time.
In 1995, Lester Brown of the Earth Policy Institute wrote about China: “With consumption climbing and the possibility that production could soon start to fall, a massive grain deficit within a matter of years appears likely.” In 2004 he pointed out that China’s grain harvest had fallen in four of the last five years, just as he had forecast. Since 2000, global grain consumption has exceeded production in six of the past seven years.
It is not that no one told us what was coming. It is just that we were not listening. The result is world grain stocks are now down to 57 days. This is a much weakened buffer against both poor harvests and large inflows of speculative cash. When Lester Brown warns us that these high prices might not stimulate the rises in production mandated by economic theory we should take him seriously.
There is more bad news. Energy and food security are two of the four pillars of prosperity – the resource foundations on which all our economies are built. The others are water security and climate security. We do not often think of climate as a resource, but a stable climate is arguably the most fundamental economic resource of all. No one has yet built a civilisation in an unstable climate.
All four pillars are now under stress. Food security relies on cheap energy to make the chemicals and pump the water necessary to maintain agricultural productivity and the transport to get the food to ever more urbanised consumers. Without water for irrigation, far less land is available for food production. Nearly a third of the world’s population live in areas suffering already from water stress. Water tables in China are dropping five feet a year. This creates greater demand for energy to pump water from ever deeper aquifers.
The extra energy to restore the diminished water and food security is now – and will remain – primarily fossil fuels. Burning these fuels will destabilise the climate. This worsens water and food stress because a warmer world makes dry areas drier and also lowers crop yields.
These interactions mean that the future political stability of China may depend on how well the US manages its increasingly stressed water resources west of the Mississippi. Poor American water management leading to lower US harvests could readily turn into large and politically destabilising price rises for food in China. In our interdependent global economy that is also our problem.
For business, the cost implications of these interactions are immediate and serious. But the strategic implications are even more important. In a lecture at the LSE in early May, Foreign Secretary David Miliband pointed out that there were two paths on which the world might develop. In one “national interest is pursued through international cooperation”. In the other we return to the pursuit of national interest through “competitive rivalry” of the kind that produced “disastrous consequences” in the first half of the twentieth century.
His argument was that the current resource crunch was “the fulcrum on which all this turns”. It was a stark message. Either we find the ways in which we can cooperatively maintain the integrity of the pillars of prosperity, or we run the risk of collapsing the globalisation that has brought prosperity to so many back into devil-take-the-hindmost protectionist nationalism. This would not be good for business.