The Promise and Peril of Cheap Oil
Everyone likes $2 gasoline. But what if it's bad for the long-term growth of the U.S. economy — and for global stability?
The U.S. House of Representatives is expected to vote on Friday to do something that would have been unthinkable only a few years ago: lift the restrictions on exporting domestically produced crude oil that have been on the books since the 1970s. It’s a topic that is definitely heating up in Washington: During a Senate hearing Tuesday on energy security, in which I testified about the importance of ensuring that the 40-year-old Strategic Petroleum Reserve can continue to be effective in an emergency, the questioning was overwhelmed by senators asking U.S. Energy Secretary Ernest Moniz to lift the restriction. The move, which many U.S. oil producers cheer, comes at a bleak moment for them.
A combination of surging oil supply and economic weakness sent oil prices plummeting in August for the second time in the last year, hitting six-and-a-half-year lows — down nearly 40 percent from their 2015 high reached in May. Although U.S. production has held up better than expected in a low-price environment, thanks to technological improvements and cost declines, U.S. producers have still been hit hard. After seeing output rise some 4.6 million barrels per day (b/d) since 2008 to a peak of 9.6 million b/d in June, U.S. oil output has fallen to 9.1 million b/d and is projected to fall several hundred thousand b/d further next year.
Because oil production from shale wells declines so quickly after initial production, producers must keep drilling new wells to maintain or grow their output. That also means that U.S. shale oil can respond much more quickly to price changes than conventional oil wells, as producers lay down rigs. But that process still takes time, with U.S. production just starting to turn south more than a year after the price collapse began. This, along with several other important factors, has weighed heavily on oil prices. Since OPEC chose not to cut production at its November 2014 meeting, the producer group has actually increased output by more than 1 million b/d. Further pressure on oil prices is coming from historically high global inventory levels, to which will be added the expected return of Iranian barrels to the market when sanctions are lifted.
Lower oil prices are generally good for U.S. consumers and the economy. Gasoline prices are currently at the lowest level for this time of year since 2006 — more than a dollar below where they were at this point last year — and are projected to fall to $2 per gallon by the end of the year. Heating oil and propane costs for the winter are projected to be 25 percent and 18 percent lower, respectively, than last year. Those gasoline savings of nearly $100 per month per household will act like a tax cut for consumers and could stimulate the U.S. economy. (Although initial surveys suggested consumers, nervous about the economic outlook, would rather save their extra money than spend it, a recent analysis of credit card data found they, in fact, spent most of their gasoline savings.)
But cheap oil can also bring unintended consequences.
First, cheaper prices can stimulate people to drive more and encourage more overall oil use. In the long term, U.S. oil demand growth is declining, with consumption in 2025 now forecast to be 34 percent lower than was projected just a decade ago. But in the short term, driving in the United States is up 4 percent over the last 12 months, and total U.S. oil consumption is projected to rise this year from 19.1 to 19.5 million b/d. Lower pump prices also cause complacency, as people forget that prices will invariably rise again. The average fuel economy of new vehicles sold in the United States in September was down 0.6 miles per gallon from its August 2014 peak, driven by the decreased price of gasoline and consequent increased sales of pickup trucks, SUVs, and crossovers.
And globally, oil demand in 2015 is now projected to be 900,000 b/d higher than was projected before the price collapse.
Second, low prices and falling U.S. oil output risk undermining momentum toward instituting smart policy responses to the shale revolution. U.S. oil output from shale will rise again as prices recover — the last year has forced the industry to make dramatic improvements in the economics of shale production — and state and federal regulation must continue ensuring that production happens safely. Tighter margins and lower profits seem to be leading businesses to fight especially vigorously against even low-cost and smart regulations — like the Obama administration’s new effort to reduce methane emissions from oil and gas production.
Third, while the U.S. economy benefits overall from lower oil prices, it benefits less than it did in the past. While consumers on the whole are better off, oil- and gas-producing states will see net employment declines — especially Wyoming, Oklahoma, and North Dakota — according to a study by the Council on Foreign Relations (Texas is the largest oil-producing state, but its economy is more diversified.) The overall impact on the U.S. macroeconomy of an oil price rise or fall also declines as U.S. import dependence declines, as the White House Council of Economic Advisors explains, due both to the smaller terms of trade penalty and the fact that when prices rise, more of the increase in oil producer revenue stays within the United States.
Fourth, while oil prices are low today, they are likely to be more volatile in the future due to important changes in the oil market. OPEC has, for the time being, given up its role of market balancer, leaving very little buffer of spare capacity — the ability to quickly bring new oil supply into the market to compensate for production losses elsewhere. OPEC’s spare capacity today is less than 1.3 million b/d, the lowest level since 2008. Without that buffer, any disruption to global supply could have an outsized impact on price, though high inventory levels will help for a while. U.S. shale oil production can now contribute to the “swing supplier” role, as it can be ramped up and down more quickly than conventional oil. But, as we are seeing, that can take up to a year or longer. If prices fall low enough and long enough to pull U.S. shale oil off the market, and then rise high enough to prod it back, consumers may be in for greater price swings, especially without a buffer of spare capacity. Volatility can harm consumers by undermining their ability to make informed longer-term financial decisions, such as where to live or what kind of car to buy, and this uncertainty harms the economy more broadly, stymieing consumption and investment.
Fifth, lower prices create an increased risk of political and economic chaos in oil-producing countries. The World Bank estimates that a 10 percent decline in oil prices can cause economic output to contract 0.8 to 2.5 percent in some oil-exporting countries. In Saudi Arabia, oil exports account for almost 90 percent of budget revenues and 43 percent of GDP. In Iraq, the numbers are roughly 80 percent and 45 percent, respectively, while countries like Russia, Venezuela, Iran, and Nigeria are all similarly dependent on oil. Saudi Arabia has borrowed and dipped heavily into its foreign reserves, which have dropped from a peak of $737 billion last August to $655 billion one year later. Others don’t have that cushion to fall back on: Several of these countries were already facing instability before prices crashed, and the drop in oil revenue may push them over the edge. As a new study from Columbia University’s Center on Global Energy Policy explains, Venezuela may be most at risk of geopolitical and economic crises. Increased instability in producer countries can have significant ripple effects globally — from reduced revenue for the battle against the Islamic State to the stability of Caribbean and Latin American countries that have long depended on Venezuelan largesse.
Americans understandably cheer when oil and gasoline prices fall. And yes, on net, lower oil prices are indeed good news for the United States. But, with the United States reemerging as an energy superpower, it must now be wary of the risks that lower oil prices may bring.
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