Oil Prices: Good News by the Barrel

A few months ago, when the rise of ISIS (Islamic State of Iraq and Syria) pushed up oil prices, articles abounded about the danger posed to the U.S. and the global economy. Now that oil prices are falling, articles abound about the dangers to the economy of lower prices, sometimes by the same people. Can pessimism really have it both ways? The answer is “no.” While there are economic positives and negatives to just about everything, declining energy prices are on balance favorable for the economy. If they persist, they will boost growth rates. They already have helped reverse the market correction of a few weeks ago.

The Economic Effect
A recent Wall Street Journal article1 summarized the negative view of reduced oil prices. It centers on the threat to the fracking energy boom. Noting that fracking is a relatively expensive way to lift oil, this argument frets that low prices will render much existing American production unprofitable. It goes on to point out that oil and gas extractions have increased their importance to the U.S. economy in general and increased the worries, accordingly, over the ripple effect from layoffs in the country’s new oil fields on consumer spending and on housing. The concern focuses on the centers of the new boom: North Dakota, Oklahoma, and Texas. All three states are leading growth centers. North Dakota stands out.  Rich in the Bakken Shale deposits, the state’s economy grew 9.7% in real terms last year. Since the general economy is already growing much slower than normal, and certainly slower than these boom states, the loss of their superior growth, these concerned analysts contend, could shut down the recovery.2   

While the logic here is not wrong, it certainly is incomplete. For one, the fracking revolution is not so fragile as implied by these pessimists. According to the International Energy Agency, only 4% of U.S. wells require oil above $80 a barrel for profitability. Other sources suggest that most of the shale oil production can remain profitable even if oil prices were to approach $50 a barrel. The same is true of the Canadian tar sands. Though the extraction industry has grown as a share of the economy, it still only accounts for 1.7% of the total. Even if it were to disappear altogether, though hardly likely, it would not take down the whole economy. Meanwhile, the Labor Department reports that oil and gas extractions, though booming, have accounted for only some 60,000 new jobs since 2010. Though a remarkable turn from past years, that entire amount equals less than a third of the average monthly jobs gain this year, and even if new exploration were to stop altogether, again hardly likely, the industry would not give up all these jobs.3      

Still more significant in this balance of good and bad is the positive impact of cheaper fuel on the American consumer and on most American industry. The Labor Department reports that the average family dedicates some 10% of its budget to fuels of all kinds. The 25% drop in oil prices since last June, then, amounts to what effectively is a spendable income gain of 2.5% and in just a few months, effectively a $373 billion addition to households’ gross spending power. Even if families spend a small portion of this freed-up money, it cannot help but boost the economy. Beyond this consumer effect, lower oil prices also benefit shipping, warehousing, manufacturing, and all the rest of American businesses that are net energy consumers. Taken together, these effects conservatively could add in excess of one percentage point to the economy’s annual pace of growth, more if prices fall further, less, obviously, if the relief proves short lived.4               

Relief for How Long?
Barring new problems in the Middle East, there is every reason to expect low prices to persist. Increased sources of oil and gas production—from fracking in the United States, tar sands in Canada, and, broadly, from technologies that permit greater recoveries from existing conventional wells—has enabled global oil output to climb by amounts approaching some 50% since 2010, far faster than demand, especially since the world’s economies are expanding only slowly.What is more, oil finds in the South Atlantic, in Australian shale, and promise in the Russian Arctic indicate still greater supplies going forward. As a recent piece in this space, “Oil Prices: Fracking to the Rescue” (July 14), explained, a strict supply-demand consideration would set prices even lower than they are today, perhaps to $60 a barrel. 

But for all the favorable impact of new supplies, there is nonetheless still a meaningful chance of an upward price spike. The unstable Middle East remains, after all, an important source of oil. Some 35% of all the oil shipped in the world passes through the Persian Gulf. Any threat to that flow could force up oil prices, despite all the production gains made in the United States, Canada, Australia, and elsewhere. It was, after all, the threat ISIS leveled at Iraq’s oil fields that drove up prices from around $85 a barrel in late 2013 to more than $100 a barrel last spring, even with all the additional sources and production from elsewhere. No doubt prices have fallen recently because, contrary to earlier fears, Iraqi production has continued to reach markets. But the situation in Iraq is far from secure. A strong possibility of growing tension between the United States and Iran also remains. A reverse on any of these fronts could easily and quickly turn today’s favorable pricing picture on its head.6

Indeed, the pressure of low prices on producers, Russia and Iran in particular, has created a powerful incentive for producers to foment just such problems. Tehran, for example, already has accused the United States of fostering the price decline in order to destabilize Iran’s economy. Apart from that country’s adolescent sense of self-importance, the damage to Iran’s economy, from the oil price declines and the sanctions, already has had a destabilizing effect and weakened the position, according to some reports, of the so-called moderate President Hassan Rouhani. He then has ample reason to introduce an element of uncertainty into world oil markets. So does Russia, which also has been hit by sanctions as well as the oil-price drop. With oil accounting for some 80% of that country’s exports and 50% of the Kremlin’s revenues, Russia’s leadership may well calculate that it has more to gain by making trouble than it does by cooperating in Europe and elsewhere.7    

Pulling the Pieces Together
It would be foolhardy in the extreme to forecast geopolitical trouble on the basis of such pressures, however real or plausible. At the same time, these risks recommend against a smug reliance on favorable supply-demand calculations. What circumstances do allow is a threefold conclusion: 1) Contrary to some media suggestions, the fracking revolution by and large is not threatened by today’s reduced prices; 2) though straight supply-demand calculations suggest continued low prices, that prospect is less secure than many imply; and 3), for as long as prices remain low, the economy on balance should benefit and gain cumulatively the longer prices remain low. 

Nick Timiraos, “Gas at $3 Carries Rewards and Risk,” The Wall Street Journal, October 28, 2014.
See, Larry Kudlow, “Lower Oil Prices Are Unambiguously Good,” Real Clear Politics, October 18, 2014, and Chip Register, “Time to Protect the U.S. Shale Revolution,” Forbes, October 17, 2014.
Data from the Energy Information Administration, the Department of Commerce, and the Department of Labor Department.
Data from the Department of Labor and the Department of Commerce.
Data from the Energy Information Administration.
6 Ibid.
7 See, Leon Aron, “The Political Economy of Russian Oil and Gas,” American Enterprise Institute, May 29, 2013, and “Falling Oil Prices Put Pressure on Russia, Iran and Venezuela,” Washington Post, October 19, 2014.

© Lord Abbett

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