Oil Prices, Recession-Depression, and Investment

The following is a guest essay by Kevin Kane. Kevin is the author of the Energy Fanatic Blog.

Oil Prices, Recession-Depression, and Investment

Low Oil Prices Foster Future Oil Price Peaks

By Kevin Kane

As the global economy stalls, some economists including Paul Krugman argue that unless governments take action now, we risk slipping into a period of recession, or possibly even depression. If the world economy does double dip, ceteris paribus, oil prices will decrease following weak consumer demand. Should this double dip turn into a recession, or even worse, a depression, its long term impacts on oil supply additions and renewable energy innovation will be considerably negative.

Low oil prices are in general bad for consumers over the long run, particularly in a globalizing economy that has proven itself capable of expanding faster than the oil industry can bring on new additions to daily oil production capacity. We could sum this phenomenon up with the statement, “Low oil prices today are bad for consumers tomorrow.” This is true because,

(1)  A near-perfect linear relationship exists between oil prices and supply-addition investment—new supplies are added only when companies invest in discovering and developing wells with income gained from the sale of produced oil. Thus, higher oil prices today help to create lower prices tomorrow (See the Figure below that utilizes FRS Data); and,

(2)  Low oil prices result in governments and energy companies cutting energy R&D investment, which slows technological breakthroughs, diversification from oil, and the climb over the learning curve for costly substitutes.

Low Oil Prices Foster Future Oil Price Peaks

If we enter a recession and economic output declines, oil prices will follow along with investments in supply-additions and energy R&D. When prices increase again, our ability to offset these price movements with new supplies or substitutes will be limited—such a scenario portends a repeat of exactly what happened from the mid-1980s to August 2008.

Although the relationship between oil prices and future supplies proves to be straight forward, we need to apply something more technical other than a scatter plot to identify the causal relationship between oil price changes and investments in energy R&D

The Oil Price and R&D Connection: From Renewable to Nuclear Power

Oil prices directly influence changes in investment for government R&D in fossil fuel technology, nuclear power, batteries and energy storage, renewable energy, and efficiency technology. This is an empirical and causal reality extrapolated from multiple panel regression analysis in my thesis titled “Oil Cross-Price Elasticity of Energy R&D Demand: A 12-Country Panel Analysis.” This thesis shows that despite all the rhetoric, policy papers, institutions, and promises, government investment in energy R&D reflects shot-term erratic political behavior rather than keen and calculating long-term energy security strategies.

Even more alarming, statistical results in aforementioned thesis suggest that we are not learning from the past. With the exception of a few cases of sustained disinvestment, governments generally continue to change energy R&D investment with oil price fluctuations despite over-investment and under-investment experiences in the 1980s and 1990s, respectively.

If economic globalization continues as it has in the past, governments need to make a change by benchmarking their energy R&D investment levels on energy security goals rather than short-term market movements, perhaps by creating a more stable measure than oil price—changes in primary consumption demand serves as one example.

Whether we would like to substitute fossil fuels or use innovation to increase the supply of oil, whatever the timeline, a recession or depression scenario will slow this process, if not bring it to a halt. Unless governments break the pattern of benchmarking energy R&D investment levels to oil prices changes, history portends that a double-dip will have terrible implications for future energy security and the environment.