The Biggest Systemic Risk For The Financial System Is Limited Oil from Business Insider by Gail The Actuary(This guest post previously appeared at The Oil Drum, and is licensed under a Creative Commons Attribution-Share Alike 3.0 United States License.)

In July of this year, Lloyds of London issued a white paper on the risks of peak oil, noting that we are headed toward a global supply crunch.¹ In September, 2010, a paper was published in Energy Policy called “Global oil depletion: A review of the evidence.”² It concludes, “A peak of conventional oil production before 2030 appears likely, and there is a significant risk of a peak in oil production before 2020.” In other words, the world’s conventional oil production may start declining in not too many years.

It seems to me that if we are in fact reaching limits with respect to oil supply, this should be of considerable concern. We have a financial system that demands economic growth, for reasons that will be discussed later in this paper. At the same time, as we approach limits with respect to oil production, the ability of the world’s economy to grow becomes constrained, because in order for economic growth to occur, we will need to do more and more, with less and less oil.

The conflict of these two forces – a need for economic growth in a world that can no longer provide growing oil supply – sets the financial system up for a systemic risk of collapse. Furthermore, there is significant evidence that the financial problems of 2008 were early signs of this systemic risk affecting the financial system. If oil supply should actually begin to decline in the future, we can expect financial problems of 2008 to return and worsen.


Oil’s Connection to the Economy
Oil is used for a huge number of purposes—transportation fuel, heating fuel, fuel for extracting minerals of all types, lubricant, and raw material for asphalt for road paving, plastics, synthetic cloth, medicines, fertilizer, pesticides, and herbicides, to name a few things. A declining oil supply, or even a level supply, should be a serious concern, with the world’s rising population.

In recent years, there have been many attempts to try to find substitutes for oil, but with very limited success. Ethanol from corn has probably been the biggest success, but in 2009, its use in the US amounted to only 660,000 barrels a day³, compared to total consumption of oil products of 18.8 million barrels a day⁴, or 3.5% of the total. Raising this percentage is proving difficult for several reasons: manufacturers’ warranties only permit the use of 10% ethanol in gasoline; ethanol tends to be more expensive than gasoline without subsides; and there are relatively few stations offering E-85 gasoline.

Other so-called replacements for oil are only very partial replacements, and are still very far away from being full-scale solutions. Biofuel from algae is being investigated, but it is still very expensive, and not yet scalable. Electric cars are being developed, but they still are many years from being ready to replace our huge fleet of cars with internal combustion engines.

It should noted that the problem with oil supply is really an economic one. There is a huge amount of oil theoretically available—in the oil sands in Canada, for example, and in the oil shale in the US west, and perhaps in the Middle East. But in order for this oil to be available now, huge investments would need to have been made starting at least 10 years ago. Also, in order to justify this investment, the cost of the finished oil products would need to be very high—high relative to the energy required to extract the oil, and high relative to people’s salaries. At some point, limits are reached in the amount people can afford to pay for oil, and we may already approaching those limits.⁵

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