The Oil Drum

This is the summary I prepared and read at the beginning of the program:

The basic premise for our show is that the U.S. and global economy will contract in the near future. There are two main reasons for this.

The first is a crisis of credit as a result of huge debt levels in the U.S., many of which are looking poor, including mortgage backed securities linked to declining real estate markets. Being bitten by defaults following cheap credit, banks will develop more stringent lending criteria, and likely require higher interest rates on loans needed to attract investment capital. At the same time, the Federal Reserve will probably work very hard to ease credit by lowering the interest rates it controls, such as the overnight lending rate of banks. However, lowering the cost of money by the Fed will probably lead to higher inflation through weakening of the U.S. dollar, which may also put a break on the economy since the U.S. has such a large negative trade balance. Thus, the Feds hand is somewhat tied compared to other historical crises. Furthermore, as more banks fold, solvent banks will be reluctant to take on the risk of debts from banks needing capital, effectively forcing cut backs in the number of loans being made. In summary, there is a real possibility of loss of market liquidity by either deflation, or an expanding money supply with inflation rapidly eating away its purchasing power.

The second reason for an economic slowdown is higher energy costs. It looks as though oil has peaked and so the price is unlikely to decline significantly absent an economic contraction. Historically, economic growth is highly correlated with energy consumption. Energy is literally the motive force behind economic activity, such as mining, manufacturing, transportation, residential and commercial heating and cooling, and food production. While efficiency gains have cut down on the energy required per unit of economic activity, there is no precedent for an economy responding to energy contraction in any other way besides economic contraction. The rate at which prices increase or shortages develop is critically important: slow and steady price increases that are foreseeable will be more manageable than rapid and unforeseen increases and shortages. In terms of the global economy, it looks as though current energy price increases have been unexpected by governments and businesses. Until recently, for example, the International Energy Agency and the Energy Information Agency of the U.S. Department of Energy were anticipating ample supplies and low prices for oil and natural gas.

When the economy does contract, demand for oil may reduce. If demand reduction is greater than the depletion rate of oil supplies, prices will decline. This cheaper oil will signal to the market that alternatives to oil are not currently needed. On top of this, a contracting economy is a difficult environment in which to raise large sums of capital for sustainable alternatives.