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By Jeff Danner Jeff has worked in both the chemical and biotech industries and is the veteran of thousands of science debates at cocktail parties and holiday dinners across the nation. In his Common Science blog, Jeff aims to make technological and scientific concepts accessible to all.

Gas Prices and the Dow Jones

By Jeff Danner Posted July 4, 2011 at 2:53 am

As I continue this series on petroleum it can be difficult at times to determine the best order in which to cover which topics. If you have been following along so far you should have a good feel for the following:
  • All petroleum started as carbon dioxide in the air which was captured by plants through photosynthesis
  • The plants, primarily algae and bacteria, turned the carbon dioxide into simple sugars (glucose) which is the primary basis of both the energy stored in fossil fuels and the basic building block for all life on earth
  • As algae and bacteria fell to the bottom of bodies of water it was buried, heated, and over the course of 300 million years, turned into petroleum
  • We have been extracting petroleum enthusiastically for about 100 years, during which time we have extracted about half of the world’s petroleum, the easy to extract half
  • Petroleum accounts for most of the energy use in the modern world, particularly energy for transportation
  • Petroleum is basically the raw material for everything we use in day-to-day life here in Chapelboro (subject of a future blog).
 
So if petroleum provides the primary source of both energy and raw material for modern life, it’s not a difficult leap to understand the following:
  • As economic activity in the world picks up consumption of petroleum increases
  • As consumption of petroleum increases the rate of extraction of approaches the capacity of the world’s oil wells to supply it
  • This results in shortages of petroleum which disrupts economic growth and result in price spikes of petroleum-based products such as gasoline
  • This results in global economic slumps which then temporarily slow the extraction of petroleum
  • Then the economy recovers and the cycle repeats
As long as there is plenty of easy-to-extract oil still in the ground, with each economic cycle more oil wells are drilled so more capacity is created which can forestall the next cycle, at least for a little while. The problem is that the peak year for oil discovery in the world was 1965, 1965! With less and less oil to find it becomes more difficult and expensive to extract. The economic models for this situation suggest that the economic boom-and-bust cycles should start to occur with shorter intervals. 
 
So let’s consider the economic dynamics of the last 6 years by looking at the data in the two graphs below.
 

 

First consider graph number 1 showing the Dow Jones Industrial (DJI) average and the monthly average of worldwide petroleum extraction from January of 2005 until last month. For this graph I am utilizing the DJI as a reasonable proxy for the health of the world economy (I recognize that this assumption is open to criticism). From January of 2005 until October of 2007 the DJI grew from just over 10,000 to nearly 14,000 indicating a strong global economic climate. Throughout this period world oil extraction is increasing and starts to approach an all time high of 88 million barrels a day.   At this point global oil extraction can’t keep up with demand which causes shortages, economic growth falters, and the DJI plummets all the way to 7,000 in February of 2009. 
 
For the moment let’s move to graph number 2 showing the same DJI data and the average price of gasoline in the US. The peak in the DJI occurs in October of 2007 and falls. We can see from graph number 1 that oil extraction falls with a decline in world economic activity which, in turn, reduces the supply of gasoline a sure prelude to higher prices. During the summer driving seasons of 2008 the average price of a gallon of gas in the US climbed to over $4.00 per gallon. At this point continued recession and high gas prices reduced the demand for gasoline, creating a temporary excess, and prices fell quickly having a brief respite below $2.00 per gallon.
 
Now consider the trends in both graphs 1 and 2 from February 2009 until now. The DJI is recovering along with economic activity and is at 12,540 as I type this and world oil production has returned to the 88 million barrel per day range which is near to the global capacity. My expectation is that the cycle from 2007-2008 is about to repeat. Petroleum shortages will  crop up again in the September-October time frame, resulting in another round of worldwide economic disruption, followed, after a lag of some months, with a spike in gasoline prices, this time reaching at least $4.50-5.00 per gallon (likely next June or July).
 
During this period of time a lot of silly things will be said, and dutifully reported, particularly since these events will coincide with the upcoming 2012 presidential election cycle. Here is what you should expect:
  • Suggestions will be made that we can drill out way out of this problem. This is absurd. Remember world peak oil discovery was 1965 at which time the world’s population was 3.3 billion versus the nearly 7 billion people on earth today.
  • There will be a lot of articles about “oil speculators”. These articles will be true in the sense that traders will be making money on short-term fluctuations in supply and even manipulations of prices. While this behavior is troublesome and reporting on it can make for some passably interesting copy, the real story, and driver on prices, is basic supply and demand in the face of declining petroleum reserves.
  • There will be appeals to convert to more renewable energy sources and to build more nuclear plants. While I am a strong supporter of alternative energy sources and, to an extent, construction of more nuclear plants, I will be frustrated that the articles will not address a key point… electricity does not make a good transportation fuel like gasoline or diesel. There will never be a global fleet of electric cars due to lack of raw materials for batteries (subject of a future blog).
 
You will read a few articles reviewing the supply-demand balance and the reduced time between economic cycles somewhere on page 7 of your paper in small print with dull titles. But right here on the home page of chapelboro.com you are reading the real story which will dominate the news and the political activity during the lives of your children and grandchildren.   Almost everything in modern society, cars, clothes, food, and medicine is dependent on this wondrous black liquid we pump from under the ground. The scarcity of which will change everything. In the next blog in this series I will cover how everything comes from oil, everything.
 
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