Supply and Demand

Most of us who have taken any economics courses have some idea of the expected workings of supply and demand.

The theory is that in a competitive market, price will act to even our supply and demand imbalances. If supply is too great, price will drop, and more users will find themselves able to purchase the products and use them at the lower price, bringing supply and demand back into balance again.

Is oil priced too high, or is credit too unavailable?

I think what we have happening now is a mixture of (1) supply and demand of the physical product, and (2) credit issues, both of which are focusing on commodity prices of all types--oil, natural gas, coal, copper, corn, and many others. With respect to supply and demand of the physical product, when the US was busy building huge numbers of houses to keep the economy going, and workers around the world were buying many new cars, there was a great deal of demand for these commodities. Once we started building fewer houses and cars, less oil was needed for manufacture and transportation. This type of physical supply and demand is what we expect to underlay a curve of the type shown in Figure 2.

The second problem is debt, and it doesn't work as nearly as rationally. Debt, and the repayment of debt, works as long as there is a growing economy, because with the growth, there are funds for a reasonable percentage of debtors to pay back their debts with interest. When a government senses that the economy is not growing as fast as it would like, it can encourage more and more debt, to try to keep the economy going. It seems to me that since 2001, we have had a considerable amount of government encouraged debt, to try to get the economy to expand faster than its natural rate.

It is not entirely clear what the impact of the growth of credit on real GDP is. One estimate might be that an additional dollar of debt adds an additional dollar of real GDP. One could debate whether this relationship is correct, but clearly there is some impact. Using total debt amount estimates from economagic.com, this is a rough calculation of real GDP, without the inclusion of debt:

Based on the calculation shown in Figure 3, and graphed in Figure 4, there has been no real growth since 2000. Instead, we have been seeing more and more debt-based pseudo-growth.

Without real expansion, debt will eventually start to unwind--there start to be too many defaults. The debt probably would have started to unwind on its own, because of the slowed growth rate, even apart from the oil price increases. The increases in oil and food prices between 2005 and mid 2008 helped prick this debt bubble, but the underlying debt set the stage. The underlying issue that slowed the growth rate was limitations on resources. These resources are not becoming more abundant, so it seems to me that it will be virtually impossible to get the real growth to increase again to the point where it again makes sense to have very much debt. I would argue that it probably never made sense to have the level of debt that we have had in the past few years.

So what does this have to do with the supply and demand curve? Oil prices can be expected to keep dropping, as long as there is more and more credit imploding, resulting in fewer people being able to buy products made with oil. Given the huge amount of debt outstanding, and the lack of growth to make this debt "repayable", more and more defaults seem likely.

We can ask ourselves, "At what price of oil (or of gasoline) will credit stop imploding?" since the answer to that question will tell us when the price of oil can be expected to start rising again. I believe the answer is, "Whenever governments can figure out a way to get the economy to start growing fast enough so that debt (and its repayment with interest) 'works' again." I would argue that governments will never be able to make this happen. We have reached a point where resources (oil and other finite resources) are in such limited supply that the best we might be able to hope for is a level economy for a while. More likely, we are going to see decline. Because of the lack of growth, we are at a point that we need to unwind the debt we have, and learn to live without the vast majority of it.

What does this mean going forward?

To me, Figure 1 is truly scary. If the price of oil and other commodities continues to drop, we are likely to see more and more energy companies going bankrupt. Some of these may be large--we have heard rumors about the financial problems of Glencore, a large privately owned international trading company. The economies of Texas and Louisiana are likely to take major hits, as will Russia and some Middle Eastern countries. Even with the low energy prices, many of the problems the US has are likely to continue (too few houses and cars being built to "pump up" the economy, declining prices on homes and commercial property, and many workers laid off).

The amount of debt we have outstanding is extremely high. The debt shown in Figure 3 is not really all of the obligations of the US public and US government, since it excludes things like Social Security and Medicare liabilities. According to one web site, the amount of debt Americans have outstanding is $53 trillion, plus unfunded governmental promises (including Social Security and Medicare) of $64 trillion, and plus trillions of dollars of related to derivatives. Not counting the derivatives, this amounts to $386,091 per person. I don't know whether these numbers are precisely correct, but it is clear that with limited resources and a declining economy, there is no way that amounts similar to these amounts are going to be paid in full.

I am sure that the Bush and Obama administrations and other administrations around the world will try to fix the problems, but I fear many may not be successful. If they somehow are successful, the current oil price collapse may lead to a rebound, but it is likely that we will still have to face the need to unwind our debt later, even if we somehow make it past our current crisis.

I don't know whether it is necessary to go through a full economic collapse and restarting process, to get past all of this debt. I find it hard to imagine that governmental leaders will sit down, look at the situation rationally, and start thinking about how to unwind the debt. But eventually, and I fear, sooner rather than later, we will need to get rid of most of this debt, and start over again with a monetary system that is more closely tied to resources and discourages debt. It is possible that forward-looking leaders could even start the new monetary system before the old one is phase out. The new monetary system might, for example, start out as more of a rationing system for food and energy products, and eventually be expanded to cover other products as well.

I am afraid I don't have all of the answers. My problem is that when I see a trend line based on oil prices pointing almost straight down, and I can't see a good reason for prices to suddenly start rising, I start worrying that the consequences of the current price collapse could be far worse than any of us on The OIl Drum have been talking about.

These are a few of my recent posts that are related:

Impact of Credit Crisis on the Energy Industry - Where Are We Now?

An Overlooked Detail-Finite Resources Explain the Financial Crisis

Jeff Rubin: Oil Prices Caused the Current Recession

Oil Prices - A Little More of the Story

Why are oil (and gasoline) prices so low?