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Cheap Oil: Why Is It Bad News?

By Shlomo Maital

 cheap oil

 

   All too often, economic analysis seems to many like a good news/bad news joke. No economic news is ever completely happy, is it?   Take for instance oil prices. The price of oil has fallen below $30, and with Iran about to add millions of barrels to the excess supply every day, it looks like the price of oil will remain low for some time.  

   So this is good news, right? Cheaper gasoline, more discretionary income to spend, cheaper energy prices, and indirectly, cheaper goods and services… all good news. Because, when the past oil shocks (1973/4, 1978/9) zapped oil prices way up, the result was recession. So the opposite should cause…boom?   Right?

   If so, then why have global financial markets reacted very negatively to the oil price fall. Why is the rule of thumb – a 10 % fall in oil prices boosts GDP growth by 0.1 to 0.5 points – not longer true?   Why have global stocks fallen sharply?

   Note that the cause of the current oil glut is clear – Saudi Arabia. Its Minister of Oil (acting under the aegis of King Salman, young and highly pro-active) chose to take on Saudi’s enemies, Iran and to some degree Russia, by engaging in an oil price war and bashing prices down. Saudi Arabia can do this, because it is by far the world’s low cost oil producer. It can still make money when oil is $30, unlike Russia, Iran and most other nations. And $30 oil can kill a lot of American oil production, through fracking, and reduce competition in the long run.  Saudi Arabia though is suffering too, and the Oil Minister may yet lose his job.

   Collapsing oil prices seem to be taken by the world as bad news, not good, because: * they will increase instability in an already unstable world, in countries like Venezuela and the Gulf States; * oil producers are slashing their spending and investment, especially Russia, as oil revenues collapse; * many investment projects involving energy exploration are now on hold; * emerging market corporate debt of an added $650 billion was in oil and commodity industries; that debt is now much more risky; * Higher risk aversion to energy firms has spread to other parts of the market and other industries as well. * real interest rates are at near zero and there is no room to slash them lower.

     There are some winners. E.g., India, China, South Korea. But, notes The Economist, with the world still trying to dig itself out of the 2008 financial crisis hole, “the world could yet be laid low by an oil monster on the prowl.”

The most distressing aspect of the fall in global equities, due to cheap oil, is that it signals who really matters in the world. Big Oil, big capital, tycoons, the 0.01 per cent…THEY matter and they are the ones who are hurting. The rest of us 99.99?  Well, we benefit from lower oil prices… but since we are not players in global money, we don’t really count. 

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How the U.S. Govt. Helped Smash the Oil Cartel

By Shlomo Maital

oil

With the price of oil below $50, and likely to remain low for quite some time, with $100 oil unlikely to return,  it is interesting to discover why.  The main reason?  America is now the world’s biggest oil producer, topping Saudi Arabia, because of fracking and frantic drilling – and the Saudis choose not to fall on their swords and slash their production.  

    But WHY has America been able to produce so much oil?  The answer is in Eduardo Porter’s piece in today’s Global New York Times (“Behind drop in oil prices, the hand of Washington”).  It is:   U.S. government policy and funding, dating back to Nixon, Reagan and the elder Bush.     “Facing years of a broad energy shortage, in the shadow of an embargo by Arab oil producers [in 1973], Nixon..and Congress laid the foundation of an industrial policy that over …four decades developed the technologies needed to unleash American shale oil and natural gas onto world markets”.    Porter cites a scholar who notes, “public investments in technology innovation [e.g. energy] can bring a huge benefit for both the economy and the environment”.

    Congress approved the Prudhoe pipeline from Alaska just weeks after the Arab embargo.   The 1974 Energy Act, creating the Dept. of Energy, kick-started a period of heavy government investment in R&D to recover gas from shale. This agency provided the funds to develop ‘horizontal drilling’ and polycrystalline diamond compact bits to cut through the shale, and performed the first big proof of concept hydraulic fracking, while Energy Dept. labs created a multi-well fracking site.  The inventor of shale fracking, George Mitchell, got a lot of help from the government.  And, the Reagan Administration, earlier, abolished price regulation, to remove a major barrier to unconventional development of gas deposits. 

    Of course, bold entrepreneurs who took risks and invested in fracking deserve credit.  But as in many new technologies, the hand of government, in regulation and investment, was highly visible. 

     A key point is that even if rock-bottom oil prices drive oil shale producers out of business for now,  the ability to quickly revive oil shale output will put a ceiling on oil prices that is far below the record $111 peak.    Saudi Arabia can produce oil at a marginal cost of $5 to $8 a barrel, enabling it to smash prices lower.  But America’s ability to produce virtually infinite amounts of fracked shale oil at a marginal cost of around $58 will help keep crude oil prices reasonable in the near future. 

     Let’s keep in mind, however, that persisting low oil prices will bankrupt countries like Russia, Iran, Venezuela, and others.  This may not be good news.  Russia is already looking for creative ways to make trouble for America, in Yemen and in Iran,  out of spite for America’s lead in imposing sanctions on Russia.  The world will remain unstable, despite low oil prices and in part because of them.

 

Blog entries written by Prof. Shlomo Maital

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