Engine trouble
A rise in the cost of extracting energy will hit productivity
Oct 21st 2010
MANY factors were responsible for the industrial revolution. But the use of fossil fuels was clearly vital in driving a step change in rates of economic and population growth. So the current rise in the cost of extracting such fuels should be the subject of considerable concern.
Until the 18th century mankind’s output had been restricted by the amount of physical force that humans (and domesticated animals) could exert and by the amount of wood that people could chop down. Fossil fuels delivered a massive productivity boost.
In a recent article for the Cato Institute, Matt Ridley, a former journalist at The Economist, argues for the importance of coal in allowing the industrial revolution to be sustained. “Fossil fuels were the only power source that did not show diminishing returns,” he writes. “In sharp contrast to wood, water and wind, the more you mined them the cheaper they became.” A further advantage was that coal supplies were so large. By 1830, Mr Ridley estimates, Britain was consuming coal with an annual energy output equivalent to 15m acres of forest, about three times the size of Wales.
In the 20th century oil replaced coal as the cheap fuel of choice. It has had an enormous impact, most noticeably in transport. Think about how much of your daily activity depends on energy—the commute to work, the heating and lighting for home and office, the steel and bricks needed to construct both properties, the transport costs involved in delivering your food to supermarkets (and the energy used to cook it), and so on.
It was only natural for mankind to exploit the cheapest energy sources first, such as easy-to-extract oil reserves under Saudi Arabia. The problem now is not that the world is running out of energy but that the new sources of energy are more expensive to exploit.
The key ratio is “energy return on energy invested”. Analysis by Tim Morgan at Tullett Prebon, a broker, estimates that oil discovered in the 1970s delivered around 30 units of energy for every unit invested. By itself this was well down on the returns from oil discovered in the 1930s, which were nearer 100-to-1. Current oil and gas finds, such as undersea reserves, may offer a return between 16-to-1 and 20-to-1. The return on sources such as tar sands and biofuels like ethanol are in the single digits.
Tar sands and biofuels represent only a small part of global energy use. Nevertheless, to the extent that conventional sources of energy production are declining, the high marginal cost of new sources of energy will slowly drive up the average cost. Andrew Lees of UBS, writing in “The Gathering Storm”, a new book, argues that the global ratio of energy return on energy invested is around 20, corresponding to energy’s 4-5% share of global GDP. Mr Lees thinks the ratio might fall to five over the next decade, implying that energy’s share of GDP could quadruple. That is probably too extreme a forecast. Nevertheless, the direction of change seems clear. If the world were a giant company, its return on capital would be falling.
The first big oil crisis was in the 1970s when the OPEC export embargo was followed by stagflation. By the 1990s, with oil down at $10 a barrel, the economic impact of fuel costs tended to be downplayed. Developed economies had moved from being manufacturing-based to being service-based, it was argued: the volume of GDP produced for a given unit of energy had accordingly increased. Yet the surge in the crude price to $147 a barrel in July 2008 undoubtedly played its part in exacerbating the recent recession, acting as a tax on Western consumers at a time when confidence was already low.
That rise in energy prices was driven by demand, however. A surge propelled by the costs of extraction would be a negative productivity shock for the global economy. That would be a particular problem for Europe, which is also facing significant demographic pressures. There will be a decline in the number of people of working age (15-64) in France, Italy and Germany over the next decade. If there are fewer workers, GDP growth will depend on productivity improvements.
It is possible that some new source of cheap and abundant energy might be developed—the cost of solar panels could be reduced substantially, for instance. The same high energy prices that might crimp economic activity would have the effect of stimulating investment in alternative-energy sources. But there could still be an uncomfortably long period in which the world has to cope with higher energy costs. That is a headwind the global economy could do without.
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