Oil free market is bad news for U.S. | Economy |Axisoflogic.com

The OPEC meeting over Thanksgiving week failed to result in any oil production cuts, immediately sending prices down by $5 per barrel. Its 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. 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 during 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 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. 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. 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 80s and the 90s, 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 below $70. The oil price may spike downward 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 Gross Domestic Product (GDP) of about 0.5%. Capital Economics is slightly less ebullient about the prospects for the U.S. because of its substantial oil production. But as quoted by the American Enterprise Institute’s (AEI) James Pethokoukis, it believes that each $10 drop in the price of oil 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 U.S., 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 U.S. It 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 don't produce anything; their trips to the mall only increase 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 revenue from unconventional oil production has associated production costs much closer to the current price level. And the great majority of the revenues are ploughed back into capital spending to search for and develop 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 U.S. in particular its analysis look too 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. 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 increases above $80 indeed depress consumer spending, while they don't increase U.S. oil production much, as the country's oil producers are already investing to expand output. Above $100 a barrel, there is no question that further rises in price depress U.S. consumption while adding to surpluses in some of the oil producers, thus depressing global GDP overall. Thus the increase to $147 a barrel in 2008 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 toward the production of oil or 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 U.S. because of its relative cost advantage in energy. That has allowed manufacturers whose processes are intensive in energy and not especially 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 encouraged the migration of U.S. jobs to emerging markets, so will the reduction or even elimination of the country’s energy-cost advantage bring a second wave of outsourcing to other countries of both capital investment and generally well-paid jobs. This is an effect entirely ignored by the simple first-order Keynesian models. But if oil prices remain below $70 a barrel there will be further unpleasant surprises for the U.S. workforce, which has 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 society, which reduces the amount of capital available for each worker, That in turn 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 level of importance.

The adverse effect of lower oil prices will be worsened by regulation, which by attempting to steer the U.S. economy toward energy sources that are now impossibly more expensive, has put itself on the path to vast malinvestment and waste. Ironically, if energy prices stay low, the Keystone XL pipeline may prove in the end to be 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 yet another positive sign for the beleaguered U.S. economy. The cheerleaders are wrong.

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