This morning I ran a Google search using the sentence, “People feel that the drop in gas prices is temporary.” I ran this search for a reason which I will explain shortly. But first, I should mention something about the results of the search.
I admit that there is considerable uncertainty as to what I expected to find from this Google quest. But what I did find was quite a surprise to me.
The first hit, at the very top of the Google search results, was an article entitled “3 Reasons Why Lower Gas Prices Are Not A Good Thing.” I was intrigued. I read the article. While seemingly logical, the writer would have received an “F” in any economics class. His chief error was to mistake minor secondary effects with dominant primary consequences of an action.
As I scrolled down the rest of the first page, several other articles caught my attention which I read. I was left thinking that the “information age” in which we find ourselves is actually the “disinformation age” in which we can find ample support to protect and sanctify our prejudices, superstitions, and foolish fables. Okay, enough philosophy.
I chose that particular Google inquiry because I have read in the economic press that the recent drop in oil prices has not proven to be as stimulative to the world economy as one would have expected. Apparently, consumers and producers have been saving the windfall resulting from the drop in gas and heating oil prices, instead of spending it.
As I looked back over the past six months of popular media sites, I found numerous articles that bolstered a belief that the drop in the cost of oil would be a temporary treat, something to be savored for a moment or two.
This surprised me as one who not only assumed the oil drop to be a permanent sea change in the oil market, but who also assumed that everyone else felt the same way.
In point of theory, the oil market contains elements of the dual equilibria which we have examined of late. As we noted last week in the case of the Greek government debt market, two equilibria arise based on the behavior of the buyers of bonds.
When the Greek bonds are guaranteed, bond investors paradoxically push interest rates down to a point where the guarantee is inessential. In the absence of a guarantee, bond buyers drop their bids back to a point in which Greece will surely be insolvent.
In the case of oil, the dual equilibria arise from the behavior of oil suppliers. In a typical and traditional market, as the price of a good decreases, producers or suppliers of that good will choose to supply less. Therefore, quantity supplied is an upward sloping function with respect to price.
However, when one is trading oil, one is trading with the gods. And the oil gods are inscrutable, indistinguishable from the prince of darkness. The economic laws of the oil market can be quite different. How so?
Several countries rely on oil to meet their budgetary needs. Venezuela, Russia, Saudi Arabia, and Nigeria, to name a few, all depend heavily on the proceeds from the sale of oil to pay for public sector services. These countries need a certain quantity of money derived from the sale of oil to make ends meet.
When the price of oil declines for some reason or another, these countries find that they actually need to pump more oil to gain the same level of revenue. And what happens when they pour more oil on a falling oil market? Prices trend even lower, requiring yet more oil production ad infinitum.
In short, the oil market has a certain instability caused by a downward sloping supply curve within a certain region of oil prices.
Of course, there is a point at which oil producers refuse to pump further and the price normalizes. But the general observation of a dual equilibrium caused by an anomalous supply effect has been well documented for some time.
But what does this tell us about the temporary or permanent nature of the drop in gas and oil prices? Are we safe in spending the windfall gain from the lower price at the pump?
To answer these questions we must first ask why the price of oil embarked on its downward trajectory in the first place. What event caused the OPEC members to step up production? The answer is well known: U.S. shale oil production, aka tight oil fracking.
As recently as 2009, U.S. oil production averaged around 5 million barrels per day. This year, U.S. output has been close to 10 million barrels per day, nearly double the level half a dozen years ago.
To put this number in perspective, Saudi Arabia produces about 9.6 million barrels per day. All of OPEC produces roughly 31 million barrels per day. The doubling of U.S. oil production has altered the entire landscape of the carbon-based energy world.
The question is, is the current condition of lower oil prices something we can expect to remain or flee away? Of course, all things are possible. But the most likely outcome is that the U.S. shale revolution has made a permanent shift in the supply and pricing of oil.
Here are the relevant factors. Saudi Arabia produces the cheapest oil on the planet with some wells producing at a cost of a mere $3 per barrel. The Canadian oil sands are among the most costly at $90 per barrel.
The U.S. shale output varies considerably across the spectrum with the Eagle Ford and Bakken formations yielding profitable output at around $40. At the upper end of the market lies some of the other fields, which require a $70 or $80 per barrel market price to return to shareholders a reasonable profit.
It is worth noting that tight oil producers have experienced considerable increases in efficiency over the past five years, which has continually lowered their break-even costs. This is likely to continue.
Nonetheless, as the price of oil drops, a portion of the U.S. producers must close down operations. Conversely, as oil prices rise, a new flood of shale oil comes to market. It would, therefore, appear that the U.S. fracking has effectively placed a more or less permanent cap on world oil prices.
The number one risk to this scenario could come from a shift in public policy. Should tight oil production be outlawed through legislation, for which some environmental groups have lobbied, oil prices will likely return to and surpass previous highs. In the absence of such legislation, the world order is likely to move in unpredictable ways.
Back in the 1980s when Saudi Arabia was determined to keep oil prices low, the USSR collapsed under the pressure produced by insufficient hard currency derived from Russian oil. The world order changed dramatically. What might happen from this new energy event is beyond the scope of this writer. But this much I believe: we live in the greatest era of the world.
(Marcus Hutchins is a former economist, treasury bond arbitrage trader, and hedge fund manager. He retired to Southport in 1997, where he resides with his wife, Andrea, and his youngest daughter, Abbey. He welcomes feedback at coastaleconomist@me.com.)
