If you are puzzled by the debate over the future of oil and, like most of us, have no access

to primary data to form an independent opinion based on physical facts, there is still help
available to see through the fog of information and disinformation. Consider the
following:

Conservative estimates published by U.S. Government sources indicate that the world is
fast approaching the point where half of its oil endowment will be gone; consumption
outpaces new discoveries of conventionally accessible reserves by a wide margin; loud
and clear market signals for increased supplies during the past decade remained
unanswered; and the current flow of capital into expanding production to levels
commensurate with the planet’s economic ambitions is wholly inadequate.

These four seemingly unrelated observations in toto lead to the conclusion that the
maximum rate of global oil output cannot be far. If we could complete the graph of
historical production with 20 more annual entries, and calculated a 10-year moving
average for the century of 1930-2030, a smooth, Hubbert-like curve rising, peaking, and
descending without recourse would appear on the screen.

Contrast the apparent, cost-dictated difficulties a sustained increase of oil production

faces with forecasts of further growth in the world’s already precarious dependence on
this paleo-biological substance, and the picture becomes even clearer: The peak is not a
knife edge-like turning point. It is a time zone, a temporal force field. Its effects are felt
long before and after it shows up as a statistic. We are already living cheek by jowl with
its consequences, but the perplexingly contradictory expert opinion on reserves, tainted
with brazen claims of superabundance, and resistance against parting with routine
economic and political motivations prevent their recognition.

While it is generally acknowledged that the world economy needs to reconfigure its
energy base so as to rely primarily on renewable sources, it is rarely admitted that the
requisite process of transition cannot be smooth. Putting it as succinctly as possible, here
is the reason why.

There is conflict between economic growth objectives and the structural

transformation of the energy base.

Our techno-economic civilization’s dependence on fossil sources is so overwhelming that

the expansion of the renewable energy sector is inconceivable without heavy reliance on
them. An economist might say that the coefficient of renewable-energy supply elasticity
for fossil-fuel demand is a positive number (hopefully less than 1.0).

Even if a solar panel and cell manufacturing plant is able to produce the energy it needs,
its total material (metals and minerals), off-plant energy demands involved in
warehousing, marketing, transportation (personnel and goods), and administration are
built into the economy’s input-output grid. Renewable energy generation is entangled in
the flow of inputs into the sectors and the transaction of outputs among them. A drastic
change in the scheme implies an epochal development in technology as well as in the

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ways value added is generated and distributed; that is, income and employment, living
standards and socioeconomic institutions are maintained.

John Donne’s “No man is an island . . .” applies to every heroic effort aimed at carving
out a local sanctuary of “green energy.”

Fumbling on the margin of transition is possible without transforming the economic

structure; which, given the past threescore years’ advances in trade liberalization, has
acquired a distinctly transnational character. However, prohibitive obstacles would
emerge before the scale and tempo of the process could reach its tipping point.

Transition’s unsolved problems

A tradeoff exists between using resources (including energy and material inputs of fossil
origin) to feed the growth of material production (industry and agriculture) and to support
the economy’s structural transformation.

Hearing this, conventional economics comes out swinging with the old one-two:
Economic growth is not confined to such a zero-sum game (resources constantly expand);
and the desired transformation has always been envisaged as gradual. Then the knock-out
blow: Knowledge, efficiency, and organization have reduced the human economy’s
dependence on natural resources.

To show how ineffectual and off target this entire argumentation is, let us begin with the
intended “knock-out.” It is true that material resources and energy carriers together
account for less than ten percent of the GDP in developed economies, but so does the
weight of blood supply in the average human body. Restricting that small percentage in
either case spells calamity. Vulgar (un-ecological) economics has turned the economy-
natural resource relationship on its head and tries to keep it that way.

The “old one-two” also misses the target for reasons that are at once physical and
systemic.

The scale of a primarily renewable-energy-based world economy may be smaller than the
one already in existence; a circumstance that long-term official growth targets, certainly
justified by the abject poverty of at least one billion people and the legitimate aspiration
of billions of others to raise their levels of living to developed country standards,
completely ignore.

As the substitution of renewable for nonrenewable (primarily fossil) energy continues,

nature exerts resistance at some point; the scale limit begins to bind. Either economic
growth or transition must halt. Both alternatives lead to severe disequilibrium. The first
because increased pauperization and the apparent irreducibility of income differentials
would endanger social peace. Also, since an economic order built on competition among
private firms cannot exist without expansion, the free enterprise system would flounder.

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The second alternative is equally untenable because the depletion of nonrenewable
resources, proceeding along a rising marginal cost curve or, equivalently, along a
descending Energy Return on Energy Invested (EROI) schedule, increases production
costs across the entire spectrum of activities. Supply curves shift upwards.

The problem that substitution tries avoid -- running out of affordable nonrenewable
resources -- becomes more acute as time passes.

The prevalent incentive system, which is naturally aligned with traditional consumer
capitalism, rejects a large-scale substitution of nonrenewable resources. It does not jibe
with its endless long-term growth perspective and it reflexively repels the requisite
transformation in the short run.

This is the mechanism through which the system’s complex defense network
unconsciously immunizes “poisonous greening:” When energy prices are low, energy
carriers flow into expanding the production of consumer goods. But when as a result of
the system’s inability to maintain the abundance of cheap energy, the exchange value of
carriers begins to increase faster than the general price level, aggregate demand receives a
shock. The resultant threat of recession closes the door on private incentives. The
economy’s currently unchangeable dependence on oil seals it.

The obvious requirement for substituting away from oil is that its price should exceed the
price of the substitute by a significant margin. However, given the importance of oil in
every single cell of the body economic, the price of solar and wind energy, for example,
would tend to rise with the barrel.

The incentive that worked (and still works) in substituting consumer and manmade
capital goods for one another will not lead to a sustainable energy base.

The currently experienced will-o’-the-wisp reprieve from the oil constraint only
reinforces this ever more obvious conclusion. Goldilockean, “not too low and not too
high” oil prices neither spur the private sector to green the world’s energy base nor is it
more than a strictly temporary phenomenon. It is tied to persistent unemployment in the
United States, the world’s largest consumer and importer of crude. Once demand begins
to press against supply as a result of “India and China,” the price of oil will go up to
disruptive levels once again with or without resumption of U.S. growth.

The micro-foundations of the mixed economy are such that the elasticity of substitution
between nonrenewable and renewable energy sources is too low in the desired direction.
Even when the price of oil rises above its renewable-source substitutes -- sluggishly for
the reasons cited; the global input ratio, “quantity of nonexhaustible substitutes for oil
consumed per a given period divided by the quantity of oil consumed during the same
period” will not increase to an extent that would be needed to accomplish transition to a
significantly more sustainable world economy.

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To summarize, the physical constraint facing the global economy invalidates the
“expansion of resources” argument, and the one that claims that transition will be
accomplished with gradual smoothness falters on the system’s micro-level resistance.
There is trouble also with the macro-foundations.

Public authority in the mixed economy is insufficient to clear the logjam.

A petit tour of recent macrohistory in support of this proposition follows.

The Great Depression turned the United States of the 1930s into an experimental
laboratory in which democratic institutions and traditions allowed society to seek a new
equilibrium between labor and capital and develop modalities appropriate for guiding the
growth of mass production and consumption. The resultant “mixed economy” (solidified
legally, ideologically, and psychologically by the Employment Act of 1946) was cloned
with incredible speed and matter-of-fact naturalness by the rest of the industrialized
world immediately after the war.

Based on the principle of multilateralism, the United Nations, with its panoply of
chartered organizations, provided the framework of international cooperation. Since
supranational institutions remained subordinate to nation states; i.e., they cannot be
regarded as a “World Government,” the current global system may best be described as
mixed economy/weak multilateralism. (Until the end of the Cold War, it seemed that there
were two competing global systems vying for domination. In retrospect, this view is
incorrect. During its peak years, the Soviet Bloc represented less than five percent of
world trade and, to avoid ruinous isolation á la Kim Jong-il’s North Korea, countries
under communist control had to conduct their international relations within the industrial-
democracy-dominated UN framework.)

Multilateral institutions -- especially the WTO/GATT, the IMF, and The World
Bank -- are the guardians of the world order’s “mixed economy” character.

Only pariah regimes remain outside these agencies, but once inside, they are
contractually obligated to abide by the fundamental principle of the mixed economy:
Laissez fair, with government’s role restricted to using mainly indirect tools of
governance; i.e., fiscal and monetary measures.

The system tolerates state-led industrial policies within limits, particularly when it comes
to developing countries. But the pressure against the idea and practice of government
support extended to specific economic sectors or industries is relentless. Using its
virtually apostolic authority, neoclassical academe has come close to turning the claim
that government interference does more harm than good into an edict. It has injected into
public policy analysis mathematical models that treat tax and tariff reductions as
automatically growth-spurring, job-creating achievements of enlightened societies.

The substantial public role in Asia’s economic progress over the past decades has been
smeared and rubbed to innocuousness through definitions and by imparting more clout to

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econometric work in support than in opposition to the principle that “privatization and
liberalization” is the quickest, surest, and least-expensive way to high living standards.

Time relentlessly tests the appropriateness of economic organization for its ability to
fulfill social objectives.

No matter how successful the system of mixed economy/weak multilateralism has been in
increasing and spreading prosperity over half a century, it is no exception. If it becomes
widely recognized that it cannot harmonize the planet’s activities with its physical
limitations, it will have to go too. This may indeed be the case.

The curve depicting the marginal social cost of oil production faces an abrupt acclivity,
the introduction of substitutes is mired in demanding oil as a complement, and the entire
process seems helpless without enlarging the role of the state beyond the mixed
economy’s legal-institutional parameters.

This new reality, which differs so profoundly from what postwar generations came to
regard as permanent, does not announce itself clearly. But nor is it hidden beyond any
hope of grasping it. A little unorthodox eyeballing suffices to show that, given the role
that oil now plays in global welfare, the system is out of whack; the stasis built around it
has been punctuated. Specifically, one of the mixed economy’s canonical principles, the
independence of the market rate of interest from any given industry, no longer applies.

Checking out from “Hotelling”

The “Hotelling Rule,” dating to 1931, retains a considerable influence on the way
economists think about nonrenewable resources. It has been stated in many different
ways, but the bottom line is simple enough: The market rate of interest (i), characterizing
general economic conditions, plays a key role in deciding how fast to draw down
reserves.

If owners of a scarce resource expect return on investments they could make in the rest of
the economy to exceed the appreciation of their reserves, increasing extraction makes
good sense. The appreciation of reserves is measured by dividing next year’s expected
“rent” (profits to be obtained exclusively as a result of possessing the scarce resource) --
denoted as λ (t + 1) -- by this year’s “rent,” λ (t ). When λ (t + 1) / λ (t) is smaller than
overall return in the economy -- (i +1) -- there will be more of the scarce resource on the
market since (1 + i) > λ (t + 1) / λ (t) makes it rational for the owners to step up the
liquidation of reserves and invest the proceeds elsewhere in the economy.

When the inequality sign points in the opposite direction, i.e., interest rates are relatively
low, the incentive goes into reverse: Scale back and wait until the opportunity cost of
sitting on the reserves -- (1 + i) -- rises.

The “Hotelling Rule” proposes that competition among the owners of nonrenewable
resources will tend to equate the opportunity cost of production now and production later

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via the market rate of interest. That is, the condition (1 + i) = λ (t + 1) / λ (t) will pave the
optimal path to emptying reservoirs.

To appreciate this theory, it is important to note that economists like to equate high real
(inflation adjusted) interest rates with prosperous times. Productive capacity and
purchasing power are growing. The world produces and earns more; capital continues to
flow into new machinery, equipment, buildings, infrastructure, and intangible productive
assets. Growth calculus even equates a summary, symbolic rate of real interest with the
“steady state” tempo of global expansion, determined by the combined increase of
population and productivity.

Beautiful minds conceived all this, but after the insatiable Leviathan has gone through a
trillion barrels of oil and, in close relationship with this devastating throughput, an
unsalvageable international monetary-credit system begot astronomic quantities of
worthless payment obligations, winds blow differently.

“Peak Oil” renders “Hotelling” obsolete.

Since both theories predict a decline in the rate of oil output over the long run, they seem
to be compatible. But this is mere appearance.

The “Hotelling Rule” has practical relevance only if the low and diminishing supply of
the nonrenewable resource in question does not constrain economic growth and if strong
competition prevails among suppliers. Short of allowing oneself to remain hypnotized be
the internal consistency of neoclassic algebra -- along with sound-bites attesting to the
titanic lore of markets and man’s unlimited engineering genius -- one can see that these
conditions are absent from the contemporary economic scene.

The actual and prospective supply of oil does act as a growth constraint and the past
decade has revealed that OPEC can act more in a concerted fashion than previously
believed.

The absence of conditions required for the Hotelling Rule has shrunk the mixed
economy’s policy space. Keynes, the system’s philosophical sire, considered the rate of
interest an “independent variable” in the hands of central banks. But if the state of the
economy can worsen as a result of reduced flows of oil, central banks have no choice but
to reduce interest rates through increasing the money supply in order to stimulate
recovery. There goes the independence of “the independent variable” and the
meaningfulness of the real rate of interest as a long-term growth indicator. High real rates
are as likely to imply expansion as contraction, good news or bad news.

To repeat, the mixed economy and the global system based on it presume that firm- or
industry-level investment decisions do not alter general economic conditions. All
particular judgments about investing in real capital (machinery, equipment, etc.) are
guided by what the same amount of money would expect to yield if it were invested
elsewhere, including the financial sector. That is, economic agents depend on

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comparative (present value) calculations in which the prevailing or expected market rate
of interest is independent from their actions.

Things have become very different in our brave new, post-Hotelling, post-Keynesian
world. Decisions made in the boardrooms of OPEC forcefully affect both the global
economy’s critical resource and the market rate of interest, nominal and real.

Oil is king but, as Hemingway mused, “how happy are kings?”

Monopoly power means an ability to influence the price. But in the sunset phase of the
petroleum age this simple one-step has turned into a roundelay. The price will have an
impact on the rate of interest that will loop back to the price. In theory, major oil
producing nations could control this interwoven dance, but in practice they cannot. Even
if monopoly power can be preserved as oil depletion proceeds, the chain of causalities
along the “price-interest rate-price” circle is too uncertain both in terms of time and
effect.

Prices set too high could catalyze “post-peak-characteristic” structural transformation in

the world’s energy base, devaluing reserves. And while sovereignty over how high the
ceiling can go has been reduced, the floor is rising. The inevitable increase in the
marginal cost of production tends either to reduce the “rent” (price minus marginal cost)
or lead to the error of setting prices cripplingly high.

To recap the same dilemma in an alternative way, if the oil monopoly over-boosts the
“rent” it destroys opportunities to invest profitably in the rest of the world. If it wants to
feed global prosperity in order to maintain and expand opportunities for investing export
revenues, it would hasten the end of the bonanza, reducing the time budget available for
transiting to an economic structure no longer dependent on oil export revenues.

In this all-around dangerous Odyssey, the monopoly tries to navigate the whirlpool
between the Scylla of overcharging (and harming itself indirectly through damage caused
to the global economic environment) and the Charybdis of undercharging (suffering
direct harm through forgone revenues). The thickening fog of uncertainty may require
modifying the tactic daily, but the overall strategy has constant components. Exhaust
nature’s one-time gift as slowly as possible and forestall net oil importers’ momentum
toward greening their energy base.

Consequently, the oil monopoly must lull the rest of us into believing that the Earth, in
general, and itself, in particular, have enormous riches of untapped reserves -- much more
than claimed to be the case by independent (i.e. not oil money supported) expertise.

Such self-regarding course of action is logical and judicious from the monopoly’s
standpoint. Yet it defies imagination how widespread, unfounded expectations for
affordable long-run oil supplies will not lead to an all-engulfing catharsis, a Wagnerian
finale to our reckless materialistic disposition and correspondingly deficient economic
and social structures.

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The specter of segmented rationality haunts the world just when it needs collective vision
more than ever.