Recession: We are hitting an economic growth ceiling caused by limited cheap oil

People wonder what has been happening recently, with wildly gyrating financial markets and government debt problems. It seems to me that we are bumping up against an economic growth ceiling, brought on by a limited supply of cheap oil. As a result, we appear to be headed back into recession. Debt deleveraging can be expected to play an important role as well, and may cause this recession to be much worse than the last one.

Connection with Cheap Oil

Economists tend to believe that economic growth can continue, essentially forever. We are now reaching a reality check, with the recent severe recession and the economy’s apparent inability to rebound from that recession.

There are many reasons to believe that at least part of our continuing recessionary problem has to do with oil prices. For one thing, we know that food prices tend to rise with oil prices (Figure 1), and that food is a major expenditure for much of the world’s population. The association between oil prices and food prices arises partly because oil is used to grow and transport food. Now that food is being used to produce biofuels, there is a connection in the opposite direction as well: high demand for oil tends to lead to high demand for food crops that substitute for oil, thus further acting to raise food prices.

Figure 1. Food prices measured by FAO Food Index seem to rise and fall with oil prices, measured by Brent Oil Price (Data, FAO, EIA)

Another connection between oil prices and recession comes from looking at the historical record. James Hamilton has shown that 10 out of the last 11 US recessions were associated with spikes in oil prices.

We also know, based on logic, that recession is likely to arise from a spike in oil prices. This happens because people’s salaries generally don’t rise when oil prices rise and, as mentioned previously, food prices tend to rise at the same time as oil prices. Since food and commuting expenses are necessities,  workers tend to cut back on discretionary spending when oil prices rise. Businesses are affected by cuts in discretionary spending and  lay off workers. Those former workers also cut back on spending, and some former-workers default on loans. The result is a recession.

It is logical to expect that at some point, oil prices would become more expensive, even after inflation adjustment. We live in a finite world. We extract the easy (and cheap) to obtain oil first. At some point, we can expect this easy-to-obtain oil to run short. When this happens, we are faced with extracting increasingly expensive oil. We seem to be reaching this point now.

What happens when there is a shortage of cheap oil?

If there is not enough of a particular substance (nitrogen in the soil for fertilizer, flour for a batch of cookies, or inexpensive oil to run the economy), there three ways the shortage can theoretically be handled:

1. Shortage eliminated by substitution of another substance

2. Shortage eliminated because higher prices stimulate additional supply

3. Shortage not eliminated; smaller quantity of the end product produced

Economists tell us that with oil, we should expect that either (1) or (2) will resolve the shortage situation. In fact, we know that in “real time,” this is not happening. Oil prices gyrate wildly, but remain far above levels of the early 2000s. Even broadly defined oil supply (including natural gas liquids, biofuels, coal-to-liquid, and gas-to-liquid) is not, in practice, adding enough to world fuel supply to keep prices down (Figure 2, below). This occurs because world oil production, however defined, is close to flat, regardless of price. At the same time, demand from China, India, and countries that export oil, like Saudi Arabia, is increasing rapidly.

Figure 2. World oil production in million barrels per day, versus Brent oil price, based on EIA data.

It seems to me that what really happens in the case of a shortage of inexpensive oil is much closer to Option 3 – “Shortage not eliminated; smaller quantity of the end product produced.” In this case, “inexpensive oil” is the necessary ingredient, and the “world economy” is the product produced.

We can see how Option 3 works by looking at the “nitrogen fertilizer shortage” and “flour for a recipe” shortage examples:

Nitrogen Fertilizer Example. What happens with growing crops is that the yield is reduced, if there is a shortage of an essential nutrient. Thus, lower nitrogen availability would tend to lead to less corn yield per acre. This situation is well-known, and has a name attached to it–Liebig’s Law of the Minimum. It states that growth is controlled not by the total amount of resources available, but by the scarcest resource (limiting factor).

Flour for Recipe Example. What happens in baking is very similar to the Liebig’s Law of the Minimum. If a baker discovers that he has only three cups of flour, and a chocolate chip cookie recipe calls for four, he finds a need to make a smaller batch. The smaller batch uses fewer eggs, less shortening, and less chocolate chips. So if the baker was planning to use a full package of chocolate chips, for example, he finds he has some left over.

It seems to me that the world economy operates on a similar basis. It doesn’t care about our good intentions for substitutes some time in the future. It cares about what is available at prices that customers can afford, now. Thus, the issue is more one of a shortage of cheap oil, than it is one of a shortage of oil in general.

As an example of how high-priced oil can lead to cutbacks in employment, suppose the price of asphalt is too high for a state to repave the same number of miles as in the past. The state may choose to repave fewer miles. The workers who would previously have laid the additional asphalt end up out of work.

As another example, customers are faced with high oil prices for commuting as well as high food prices, and as a result, cut back in going out to restaurants.  If their cutbacks lead to the lay off of restaurant workers, this is another example of high oil prices leading to reduced employment.

Thus, high oil prices tend to lead to economic contraction affecting other variables of the economy, such as employment. We can think of this economic contraction at high oil prices providing a ceiling on economic growth. When we hit this ceiling, the economy tends to bounce back downward, until equilibrium is again reached.

Government involvement

When the oil price spike of 2008 hit, governments responded with increased spending. This increase in spending mitigated the immediate crisis, but in practice, moved quite a few of the oil-induced problems from the private sector to the governmental sector.

Figure 3. Average quarterly oil price and US Federal External Debt, based on EIA and Federal Reserve data.

At the time oil prices hit their peak and started declining in mid-2008, US government debt levels began rising rapidly (Figure 3), because of higher “entitlement” spending and stimulus payments. As a result of this increased spending in 2008-2011, governments are now finding themselves dealing with debt downgrades, fights over debt limits, and a need for raising taxes or cutting benefits.

Debt deleveraging

We don’t think about it, but economic growth is important in the ability of borrowers to repay debt with interest. Because of this relationship, if we hit a ceiling on economic growth for any reason, debt deleveraging is likely to quickly become a problem.

If the future is better than to day, it makes sense to borrow, even if the borrower has to repay the loan with interest. Investment opportunities are likely to look good, and even with interest, debt repayment is likely not  to be a problem (Figure 4, Scenario 1).

Figure 4. Two views of future growth

If we start reaching a situation where the future is no better than,  or worse than, the present (Scenario 2 of Figure 4), then the existence of debt makes much less sense, because there are fewer investment opportunities, and because debt repayment is likely to be much more difficult.

If we look at what has actually happened to the amount of US debt outstanding (Figure 5), loans in the private sector have fallen since the time oil prices hit their high in 2008, at the same time that governmental debt has risen. The rise in government debt has not been sufficient to keep total debt growing, however.

Figure 5. US Domestic Debt, split between government debt (external only) and non-governmental debt. Based on Federal Reserve Z.1 data. Excludes Foreign Debt.

There seems to be evidence that debt levels may fall further in the future. The Wall Street Journal recently showed this graph (Figure 6) showing that investors are now demanding higher yields to invest in commercial mortgage-backed securities.

Figure 6. Wall Street Journal graph showing that investors are now demanding higher yields, in order to offer securitized mortgage-backed loans.

Increasing debt is beneficial because it helps enable job growth and economic growth in general. For example, if a person takes out a car loan to buy a new car, this loan helps make possible the employment of  people in the automobile manufacturing sector. Fewer loans lead to less building of new cars, and thus less employment, and less “economic growth,” as it is calculated in GDP.

If individuals and businesses fail to take out additional new loans, and instead repay (or default on) old loans, the lower level of debt will further add to the drag on the economy that high oil prices provide. Thus debt deleveraging tends to add to the tendency toward recession.

Where we are now

There are really two ways of slowing the economy–(1) high oil prices and (2) less debt availability. What seems to have happened in 2008 and may be happening now in 2011 is that there is a “hand-off” between the two.

What seems to happen is that initially, oil prices rise in response to rising oil demand and limited supply. But in not too long, high oil prices start interfering with the credit market–causing more debt defaults, and causing lenders to become more cautious in making loans and buyers to be more cautious about buying big new purchases. If we look at US Consumer Credit Outstanding, we find that it peaked in the same month that oil prices hit their maximum, that is July 2008 (Figure 7). This interference with credit, and the resulting deleveraging, helped act to bring oil prices down, and continued the recession.

US Consumer Credit Outstanding

Figure 7. US Consumer Credit Outstanding, based on Federal Reserve Z.1 data.

In 2008-2009, the recession was resolved when oil prices dropped low enough that the economy could start expanding at least a little. It is not clear to what extent this can happen in another recession. One issue of concern is that while we started with a great deal of cheap oil, the cheap oil has been mostly extracted. At some point, oil prices may become too high for people to afford, but too low to cover the costs of the companies extracting the oil. When this happens, we will have a real problem, because it will no longer make economic sense to continue extracting oil. Oil prices won’t be able to drop low enough, for long enough, to get us out of the recession.

Now, in 2011, high oil prices and reduced reported economic growth make it look as though we are again bouncing against an economic growth ceiling caused by oil price limits. Prices seem to have reached a maximum in April or early May, and if the 2008 pattern repeats itself, we will soon be headed deep into recession.

The debt deleveraging issue discussed above has the potential to be much worse this time around, now that governments have nearly reached the limit of debt they can take on. Governments are sufficiently in debt themselves that they find it difficult to add more debt. There may even be defaults on governmental debt in some parts of the world. The fact that economic growth rates seem to be down long-term may add further to deleveraging.

We don’t know how all of these issues will play out, but between high oil prices and deleveraging, the evidence would seem to suggest the possibility of an even-worse recession in 2011-2012 than the last time around.

About Gail Tverberg


26 Responses to Recession: We are hitting an economic growth ceiling caused by limited cheap oil

  1. Jan Steinman says:


    Or, in the bottom half of income, people face increased cost of commuting, increased food prices, and variable-rate mortgages that increase their monthly housing payment. Guess which one goes first? Thus, the energetic reasons behind the infamous “sub prime” housing crash.

  2. Doug W. says:

    Such a clear assessment of our situation. I continue to be amazed by main stream commentary and analysis that can go through a whole discussion without every mentioning the underlying energy realities.

  3. wiseindian says:

    Spot on Gail, perhaps a cartoon or picture would capture it perfectly.

  4. wiseindian says:

    I found an apt image for this situation

    You can replace the box with oil price and the man with economic growth

  5. Back in May this year I wondered if we had in fact seen the highest price for oil we’d ever see:

    “Wouldn’t it be a kick in the pants if everyone were wrong and the world economy pooped out at $125/bbl? And wouldn’t it be even crazier if instead of the oil price stair-stepping up with each cycle, the economy just kept getting less resilient… and each go ’round the high price was actually lower than the last time?

    And so instead of higher prices enabling greater efforts at extraction and encouraging alternatives, we wound up going in the other direction and simply couldn’t afford the cost of deploying 10,000 fallout generating plants or hundreds of square miles of thermal solar ovens or even the development cost of deep water or kerogen cooking or any other “unconventional” oil source for that matter…”

    Nothing is quite that cut and dried and it was obvious to anyone looking without blinders (or a dog in the fight) that the economy was headed back down. Still, my guess at $125 is about where Brent and the OPEC Basket – and Louisiana Light for that matter – all topped out.

    I scared myself.

    • It seems like at the beginning of the year, someone asked me for my estimate of where the price of oil would top out, and I said $120. I don’t think Brent of WTI was mentioned.

      I guess we won’t know for sure for a while, but it is looking more and more like we really can’t get the price to oil price to bounce as high as it did in 2008.

      • Texasjune says:

        Maybe we shouldn’t use that as a goal. A more relevant comparison might be the tie between employment and the price of oil. I am a profit advocate, for both the producers and the consumers. Corporate profits appear to climb as unemployment falls. How can that be sold to the average consumer? Employment supports the basic needs of people – number one being the availability of food. Since energy is absolutely necessary to maintain a modern society, it plays a significant cost to society – until which time it overrides all other budgets to sustain life itself. In other words, oil is important – it is not everything. If the pursuit and stature of it destroys its own market population – those that have it, might find it unpalatable.

  6. step back says:


    While we are all on board with the “Finite World” concept, there is way too much attention paid here to oil, oil, and only oil.

    The “financial” world is a construct built on promises and the honor of a gentleman’s word (it being his bond, as they say).

    But as we know from other adages, promises are made to be broken.

    And at the end of the day, a man’s word is just noise and spit flung into the wind.

    Our financial houses of card are built on two contradictory premises:

    1) If you build it (the next iGizmo), “they” will come, and
    2) If you fire “them”, you will cut costs and increase profitability.

    “Them” and “they” are of course the middle class. But if you fire them for the sake of improving efficiencies, increasing productivity, and cutting costs; then “they” no longer exist (there is no longer a middle left to the hollowed out shell of the middle class). And then premise number one fails (“they will come”) because there is no “they” left behind to come stampeding into our field of American Dreamhood. It was bound to collapse irrespective of the peaking of oil production. It was already inherent in premises one and two. Peak Oil simply adds gasoline to the original flames of destiny.

    • I agree we would hit limits, with our without peaking. In fact, I don’t think I ever mention “peak oil”. It is the fact that oil supply is not keeping up with demand. If it weren’t oil that was the problem, it would be fresh water, or pollution, or impacts of carbon dioxide, or maybe just the impacts of overpopulation.

      It is really the fact that we have set up an economic system that depends on growth that is the problem. Once the growth stops, it badly messes up our system. Theoretically, we could figure out something else. What, and how quickly, is a big question.

      • Texasjune says:

        Gail, you have stated one of the most clear and true facts I have heard in a long time. It would be a valuable starting post for you to consider. I would appreciate being able to comment on that specific subject. Thank you.

        • step back says:

          Gail & June,
          We should divide up the word “growth” into at least two kinds:
          1) Growth of “real” wealth (that which contributes to well-being of all); and
          2) Growth of “imaginary” wealth (that which is on paper only).

          And if you have caught on to my way of grokking the situation, you would add “growth” of bads and disservices as it applies to the well-being of all our citizens.
          Then again, that begs the question as to who are all “our” citizens and which people are left out of that equation. I suspect that based on political ideologies, some would say that certain people are not to be included in the calculation (i.e. the middle and under class people).

        • I can write more on this issue–thanks for mentioning the idea.

          I gave a presentation a couple times this week, and people have asked me to write it up, so I will probably do that first, though.

      • Bicycle Dave says:

        Hi Gail,

        If it weren’t oil that was the problem, it would be fresh water, or pollution, or impacts of carbon dioxide, or maybe just the impacts of overpopulation…..Theoretically, we could figure out something else. What, and how quickly, is a big question.

        Yes. And, we’ve been down this path before – it seems pretty obvious that humans have the capability of reversing these negative trends but simply have a collective intellectual impediment to actually using that capability. There are numerous ways we could avoid the worst consequences of our planetary behaviour and, most likely, emerge with a much better quality of life for humans and the rest of Earth. I suppose our evolutionary process makes it very unlikely that we can become sufficiently enlightened to avoid some very nasty events in the coming decades.

        I’m coming to the conclusion that the most important value of discussions like this is to simply gain some insight into what are the most likely scenarios that will unfold in the coming years and to attempt crafting some coping mechanism with friends and family. I’m hoping there is some value to being able to read the tea leaves as they unfold.

    • stravinsky7 says:

      Actually, seeing as how Gail came here from TOD, she thinks wayyy outside the barrel.

      The harsh reality is right now the oil depletion program is kicking full swing, right now.

      Spot on points on the economics of the “they” and “them” class. But whAT AM I SUPPOSED TO DO ABOUT IT? economics is not changeable through anything but politics. and there’s already way too much capital in capital hill.

      I could take all my energy there, and accomplish, literally, nothing. so i follow oil, and consider preparing my family for what’s to come.

    • weaseldog says:

      These things are not a problem so long as the energy pie keeps getting bigger and bigger.

      These promises get broken when the energy pie doesn’t grow to keep up.

  7. Steven Kopits says:

    From my perspective, we’re seeing the second peak oil shock and recession. Nothing more, nothing less. When crude oil consumption has exceeded 4% of GDP, the US has fallen into recession–always. This number has run at 5.5% for most of the spring, and reached 6% in April. These levels should be more than ample to crush the economy.

    The transmission time for an oil price shock into the economy is historically 30-180 days, which would imply a recession begininng during the course of the summer. And lo! here we are. There is absolutely no surprise here.

    Historically, I have been among the more sanguine about the effects of high priced oil. However, it’s hard to see the riots in Greece and Britain (and Wisconsin!), and not give credit to those who predicted dire consequences of peak oil.

    • Thanks for your thoughts. I think what makes this difference from previous recessions is how overextended the government is financially. Unlike in the past, it cannot do stimulus without making its debt level even worse than it is today. Government spending is exceeding income by something like $1.5 trillion year. Anything that makes that worse will be truly catastrophic.

      By the way, the WSJ had an interesting graphic in the paper version of the paper on page A5, under the label “Summer Staycation”. They added up prices of hamburgers and fixing and a gallon of gasoline for every summer from 2005 to 2011. The prices clearly jump in 2008 and 2011, compared to other summers. The combined price in 2011 is even worse than 2008.

  8. Texasjune says:

    Thank you, Gail. I look forward to it.

  9. Pingback: Recession: We are hitting an economic growth ceiling caused by limited cheap oil | The Great Transition |

  10. Lunar Gazer says:


    Good article, and you have a very nice site.

    I would love to see you write articles/editorials for magazines such as TIme, Newsweek, etc.

    Are you planning to author a book?

    I searched for you on Amazon and found a 2005 article on medical malpractice cost price dips.

    Please keep up your fine efforts here!

    • I keep thinking about writing editorials, but so far I haven’t really tried. I do have some information to do that (word length, contacts, etc) which may be a little out of date. It seems like it would be difficult to say anything and get published, but I suppose I should try. Thanks for the encouragement.

      I did write the draft of a book. I’m not quite sure where that stands–I think caught in other people’s vacation schedules.

  11. Richard Elder says:

    Gail, I’ve followed your articles in The Oil Drum for several years, and your idea that high oil prices are the main causal factor in triggering economic downturns/recessions in advanced industrialized countries has been a major recurring theme. However I remain unconvinced that you have proven your hypothesis. Your data shows the events to be strongly correlated, but we all know that correlation does not equal causation. Drawing plausible connections is the first step toward developing a theory, but plausibility is insufficient to determine the extent to which high oil prices are the main causal factor or the trigger event in economic contractions.

    I’d posit that Peak Oil is no longer a hypothesis, but rather data and proof a has advanced to the point where it should be considered a scientific fact. Your task is to bring the Peak Oil/recession hypothesis to the same level of confidence.

    In order to do so you will need to prove that the process of class stratification and income inequality that has been accelerating for the past three decades in the US is not a far more significant factor. If the theoretical structure is familiar that is because it has been around since the 1840’s.

    The thumbnail hypothesis would read something like this:
    1- Upper class uses its initially disproportionate resources to buy access to governmental power.
    2- Uses political power to change taxation from highly progressive in the Eisenhower era to highly regressive under the Bush/Obama regime. Buys control of mainstream information/propaganda media.
    3- Creates real estate bubble in order to sustain rising short-term middle class incomes while real wages from employment are falling.
    4- Moves majority of industrial production overseas in search of low wage sweatshop conditions, decimating the manufacturing job market, leaving only construction for real estate speculation.
    5- Turns the middle class real estate bubble into a banker’s Ponzi scheme based upon fraud overlooked by the bought-off political class and “Justice” department. Uses it to extract much of the remaining wealth held by the middle class.
    6- Ponzi scheme collapses in 2008 as all of them do eventually.
    7- Pumps 16 trillion dollars in loans and subsidies into a worldwide zombie banking system at the behest of the billionaires positioned to harvest the rewards, leaving no funding or political will for job creation in the Keynesian mode or large scale development of future energy sources.

    Which brings us to where we are today— on a parallel path to a second Greater Depression, with no cheap energy or non-nuclear war to bail capitalism out of the hole it has dug for itself.

    Are high oil prices a second level cause of the current economic collapse as I posit? If oil prices had remained stable would the process of class stratification have not led to similar results? What can you show me in the data to prove otherwise?

    • Fossil fuel driven growth is what allowed the system you describe to develop. Oil, and the growth caused by oil, is what allows society become more than a society of subsistence farmers, with a few merchants, clergy, and a small political class. You have described a way we have managed to keep growth taking place, even as our share of the world’s energy resources stagnated. We found more low wage labor, and encouraged places such as China and India to support world growth by burning more coal–meanwhile patting ourselves on the backs for not being the ones raising CO2 emissions.

      I suppose I could write a post about how many of these things all fit together. These things aren’t possibly the cause of our current problems–they are other manifestations of the same problem that I have been describing.

      I have basically been saying the same thing for at least four years now, and what I have predicted has pretty much turned out to be true. An early post was in April 2007, called Our World Is Finite: Is this a Problem. I talk about severe recession being likely, among other things, and problems with the financial system.

      In January 2008, I pretty much forecast the things that would happen in 2008, in a post called Peak Oil and the Financial Markets: A Forecast for 2008. After what I said would happen, in fact happened, I wrote a post called Delusions of Finance.

      All of the things I say are very much related to the idea of Limits to Growth. It is very clear to me that we are running into limits, and this limits can be expected to cause problems of precisely the type we are having now. I suppose if it would make people understand things better, I could go back and explain how these other things fit in with the whole pattern. As we go forward, we can expect more and more Ponzi schemes to fall apart. It will be tempting to say that our problems are taking place because of the Social Security Ponzi scheme, or the banking Ponzi scheme, or the commercial real estate Ponzi scheme, or the stock market Ponzi scheme, but the issue is that what I am saying is fundamental. All of these things we take for granted no longer without growth. We can blame our problems on the bursting of these Ponzi schemes, but our real problems are the underlying ones, of running short of resources and too much pollution in a finite world.

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