The fall in oil prices to their lowest point since 2010 makes clear that a new era for world oil is at hand – one defined by the continuing surge in U.S. production. This is a big contrast with the era – now over – that began a decade ago, when the most important factor was the dramatic increase in the oil demand of rapidly growing China.
This growth in U.S. tight oil — a light crude that is trapped in dense, hard-to-reach rock — has come on fast. It only really got going around 2008, launched by advances in horizontal drilling and hydraulic fracturing, or fracking — the same technology that created the shale gas boom. The results have outstripped expectations, with U.S. crude oil output jumping 80 percent in just six years. That increase — almost 4 million barrels per day — is greater than the output of each OPEC member, save Saudi Arabia. And the effects are clear. This year, the growth in global supplies — the bulk from the United States and Canada — will far outstrip the growth in world demand. So it makes sense that prices have dropped over the last several weeks. At first glance, it seems that the decline from more than $100 a barrel to $80 a barrel would be a good thing for the U.S. economy. It is like a tax cut, putting more spending power into the hands of consumers, but without the messiness of political wrangling. But how good is it actually?
There are two reasons to put that question forward – one having to do with what is happening outside the United States and the other, inside.
The drop in oil prices is not only the result of the build-up of supply. There is another reason. It also signals that the world economy, including China, is weaker than had been anticipated just a couple of months ago. The lower prospects for the world economy were captured in the sobering phrase from IMF Managing Director Christine Lagarde – “the new mediocre” – during this month’s IMF/World Bank meeting in Washington. This “new mediocre” will use less oil than a stronger economy. And a weaker global economy is hardly a positive for the U.S. economy.
The other reason involves what is unfolding inside the United States. The vitality of this domestic oil and gas revolution has been one of the biggest sources of strength in the U.S. economy since the economic downturn began in 2008. The development of tight oil and shale gas supports well over than 2 million jobs and could hit 3.3 million by 2020. The supply chains that support this activity run across all the states. New York may ban hydraulic fracturing, but it is still a beneficiary because about 50,000 jobs in everything from manufacturing to finance have been generated in New York because of oil and gas activity in other states.
When 60 percent of U.S. oil was imported, as was the case in 2005, the impact of a price drop would have been absorbed largely by oil exporting countries. But now, with imports under 30 percent, the impact of the price drop will have a bigger impact on the U.S. economy. Oil companies’ cash flows will be tighter, and they will have less money to invest in oil production. There will be some reduction in drilling on less promising prospects. But not as much as might initially be expected. The reason is the cost structure. It is true that some of the new tight oil is too expensive to produce with prices falling into the high $80s. However, the bulk of this oil appears to be economical at $75 or less, especially as companies continue to improve the efficiency of their operations. This means that production will actually continue to increase, though probably not as rapidly as it has.
If oil prices do fall further, to a level that presents a wholesale threat to investment and activity in the oil and gas sector, that would be a significant negative for the entire economy and would be a drag on the recovery. But, as things are now, the gains from lower prices outweigh the losses to the economy. The drop from $112 per barrel last June to $80 a barrel now means that Americans would save more than a $160 billion on gasoline and other crude oil products each year. That adds up to some significant extra money that ends up in the pockets of American motorists. And that is money that they will spend all across the U.S. economy.