If an EROEI of 10:1 resulted in de minimis economic growth, what can we use this 10:1 number to infer about how high oil prices can go today? An EROEI of 10:1 means that 10% of all energy goes to sustain the energy supply. If energy is a good proxy for general economic activity, then an economy should stagnate once 10% of its GDP goes towards producing (and by extension consuming) energy. Evidence backs this up. Many academic studies suggest an economy will fall into recession once energy takes up 10% of total GDP – an empirical result that agrees with our theory.
In 2008, energy prices were approximately 10% of GDP right before the global financial crisis. If oil represents about half of all energy consumed, this means an economy will stall when oil represent about 5% of GDP. In 2008, the US consumed 18.8 m b/d. At $120 per barrel that equated to $823 bn or 5.6% of the $14.7 tr US GDP. The economy fell into recession shortly thereafter. In 2012-14, oil consumption never exceeded 3.5% of US GDP and prices stayed between $90 and $100 per barrel with no impact on either demand or economic activity.
Today, oil represents less than 3.3% of US GDP and would have to rise to $140 per barrel before approaching the critical 5% threshold. Why do we focus only on the US? Demand is the most elastic in wealthy countries with high energy intensities and the least elastic in developing countries that need energy to fuel their ongoing development. In 2008, prices spiked as high as $145 per barrel albeit temporarily. In this cycle, we believe oil prices will at some point reach, and potentially significantly exceed the previous $145 per barrel peak before we begin to see evidence of demand destruction.
How high do prices have to go to limit demand might not be the correct question. It’s well understood that oil spikes are one of the leading causes of recessions, because energy is a tax on consumption. That suggests the speed of the price rise is at least as important as the headline rate.Click HERE to subscribe to Fuller Treacy Money Back to top