The OPEC meeting at Thanksgiving failed to agree on any oil production cuts, sending oil prices down an immediate $5 per barrel. Their action made it clear that, for the first time since 1972, there is no cartel able to control the oil market. At first sight, that looks like excellent news for America’s consumers, just in time for their Christmas shopping binge. However on closer consideration, it locks the U.S. into being the world’s high-cost producer of a major commodity. The bonanza from fracking may be about to go into reverse.
The fall in the oil price is caused by a fundamental shift in the market, whereby the price is now being driven by supply, whereas previously it was driven by demand. This has happened before: the oil price fell from $27 a barrel at the beginning of 1986 to $10 at the year’s end, where it remained until around 2000, with only a short blip for the Gulf War. The transition from a market driven by demand to one driven by supply typically causes a large price shift, because of the long lead time of oil investment and thus stickiness in the market. In 2011, when oil prices soared above $100 a barrel, there was considerable speculation that they would soon reach $200. Since then, the U.S. fracking revolution has both brought new supply on stream, making the U.S. a bigger producer than Saudi Arabia, and increased the potential resources for future production worldwide. At $100 a barrel, Canadian (and potentially Venezuelan) tar sands and shale deposits in Poland, Argentina and many other countries were potentially profitable, and investment would have poured into those sectors.
Just as in 1986, after several years of high prices, new sources of oil supply caused the price to collapse, so in 2014, after several years of high prices, supply and potential supply caught up with demand, and the price dropped back to the level at which marginal supplies became unprofitable.
In the late 1980s and the 1990s, marginal supplies were profitable at $10 a barrel. Today that figure is more like $70. There is a certain amount of further efficiencies that can be gained from experience, so the initial estimates of $80 a barrel at which fracking and oil shale made sense were probably a little high. But it seems very unlikely that substantial new supplies will continue to be developed at below $70. The oil price may spike downwards for a while, but the $65-70 level looks like a long-term floor.
Keynesian economists are overjoyed by the oil price drop. Capital Economics, a well-known London-based economic forecaster, has drawn substantial notice worldwide with its forecast that each $10 fall in the oil price causes a surge in global GDP of about 0.5%. Capital Economics is slightly less ebullient about the prospects for the United States, because of its substantial oil production, but as quoted by my good friend, AEI’s James Pethokoukis, it believes that each $10 drop in the oil price causes an increase in real U.S. GDP of $38 billion, or about 0.2% of GDP.
Capital Economics’ experts rely on the well-worn Keynesian argument that a fall in oil prices transfers wealth from oil producers, who tend to save it – think Saudi Arabia or Norway –, to consumers, who at least in the United States, spend about 96-98 cents of every dollar they can get their mitts on. That’s why traditionally, a fall in oil prices has been thought to be very good for the United States, which produced only about 60% of the oil it consumed but had avid consumers ready to spend, spend, spend and push up economic activity if only oil prices fell from $4 to $2 a gallon.
This analysis is now wrong in a number of ways. First it uses the mistaken Keynesian focus on consumption, and ignores production. Consumers, in their function as consumers, don’t produce anything; their trips to the mall result only in increases in the country’s already excessive debt level. Today, when a high percentage of consumer goods and an even higher percentage of “impulse buys” are produced internationally, consumer joie de vivre-fueled spending sprees do nothing for the productive side of the U.S. economy.
Second, it assumes that all oil producers are all like the traditional Saudi Arabia, which had nothing to spend the money on. Today’s Saudi Arabia has a government spending budget of more than a third of GDP, only barely balanced and bloated by various expensive welfare programs intended to tamp down potential jihadist unrest. Thus the Saudi government’s propensity to consume from its oil revenues is as high as that of any witless U.S. consumer. In any case, most of the revenues from unconventional oil production have associated production costs much closer to the current price level, and the great majority of the revenues are ploughed back into capital spending, searching for and developing new albeit mostly expensive sources of oil.
Even on Keynesian assumptions, therefore, Capital Economics’ analysis looks misguided. There is however a further reason why for the United States in particular their analysis looks over-optimistic: at the margin, after the fracking revolution and its investment in deep-sea drilling, the U.S and its neighbor Canada are the world’s high cost oil producers.
At $80 or above, perhaps even at $70, this doesn’t matter much. Thus between $80 and $100 the Keynesian analysis of U.S. GDP’s oil dependency may have some validity (even if internationally, there appears to be little saved from oil revenues at prices below $100.) Price rises above $80 indeed depress consumer spending, while they don’t increase U.S. oil production much, since the country’s oil producers are already investing to expand output. Above $100, there is no question that further price rises depress U.S. consumption while adding to funds surpluses in some of the oil producers, thus depressing global GDP overall. Thus 2008’s oil price rise to $147 a barrel was one of the major causes of the 2008-09 recession, albeit a cause much less celebrated than the housing and financial crashes.
However once the oil price falls below $70, the economic ill-effects for the U.S. of being the world’s high-cost oil producer kick in. Investment in the oil sector becomes hopelessly unprofitable, so a wave of bankruptcies must result. In the Austrian economic analysis, the U.S. and Canadian investment in fracking, tar sands and deep-sea drilling becomes “malinvestment” that must be liquidated. You can see the effect of this in the market’s reaction late last month to the abolition of Seadrill’s (NYSE:SDRL) dividend; the stock dropped 23% in one afternoon and has fallen a further 10% since. The energy sector now represents 15% of the U.S. junk bond market, a percentage that has doubled over the last few years. While some of that borrowing has gone to invest in refineries, which benefit from lower prices and pipelines, which are close to neutral, any that has gone towards the production of oil or indeed gas is likely to be very difficult to service.
There will be an important second-order effect on the U.S. economy from the energy price downturn. In the last few years, energy-intensive manufacturers have been encouraged to invest in the United States by its relative cost advantage in energy, which allows manufacturers whose processes are intensive in energy and not especially intensive in labor to make up for the U.S. labor cost disadvantage, thus creating jobs that are relatively invulnerable to outsourcing to the Third World.
However, just as cheap money has reduced or even eliminated the U.S. advantage in the cost of capital, and so encouraged the migration of U.S. jobs to emerging markets, so the reduction or even elimination of the U.S. energy cost advantage will bring a second wave of outsourcing, of both capital investment and generally well-paid jobs to other countries. This is an effect entirely ignored by the simple first-order Keynesian models, but if oil prices remain below $70 a barrel it will result in further unpleasant surprises for the U.S. workforce, who have already suffered so badly from U.S. economic mismanagement.
Energy sector bankruptcies, many of which will result in production capacity being taken out of the market, and the accompanying outsourcing of energy-intensive manufacturing capacity, are likely to cause damage that far outweighs any benefit from increased consumption. Capital destruction through bankruptcy reduces the wealth of the society, which reduces the amount of capital available for each worker, which reduces the long-term living standards of the workers themselves (and indeed their ability to consume.) Additional consumption, much of which will be spent on imports, brings no benefit that is even close to the same importance.
The adverse effect of lower oil prices will be worsened by regulation, which by attempting to steer the U.S. economy towards energy sources that are now impossibly more expensive, has itself involved vast malinvestment and waste. Ironically, if energy prices stay low, the Keystone XL pipeline may in the end prove an unattractive investment, as the Canadian oil that would be moved by it becomes uneconomic. However to counter that spurious and random gain from the U.S regulatory morass, the billions of dollars of solar and wind farm investments that have been made will become spectacularly less economically justifiable in an era when oil and gas prices have unexpectedly dropped sharply. The cost of regulation in the energy sector alone is sufficient to explain much of the economic sluggishness of the last six years; it is depressing to know that regulation’s effect will be further worsened by the fall in oil and gas prices.
The market and its Keynesian boosters have taken the fall in oil prices as being yet another positive sign for the beleaguered U.S. economy. The cheerleaders are wrong.
-0-
(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)