Oil price drop offers short-term gains but long-term pains

Oil prices have dropped to levels not seen in years. It’s not all good news. Reuters

The recent drop in crude oil and gasoline prices in the United States is a nice stocking stuffer for consumers this holiday season, but it could turn into a lump of coal.

A global oil glut has caused the spot price of benchmark crude to fall from US$133 a barrel in 2011 to a five-year low of US$63 a barrel this week. That has cut the average weekly price of regular gasoline from US$3.91 a gallon to about US$2.66 over the same period.

A surge in US oil supplies, coupled with weak global demand, is the main reason behind the decline. Horizontal drilling and fracking have lifted US oil production to 7.4 million barrels per day, a 49% increase since 2008. Last year, the US became the largest producer of oil, followed by Saudi Arabia and Russia.

The good and the bad

First, the good news. A study by Joseph LaVorgna and Brett Ryan, two economists at Deutsche Bank, suggests that when gasoline prices fall by one penny, Americans spend $1 billion less per year on energy. And Tom Kloza, the chief oil analyst at Gasbuddy.com, estimates that the recent decline in gas prices has saved a typical American family about US$50 a month since last June when a gallon averaged around US$3.60.

Now the bad news. Part of what’s causing prices to fall is decreased demand for fuel because of a slowing global economy, which, if it continues, could stifle the US’s economic recovery.

Catching the world’s cold

Slow or negative growth rates in some of the biggest oil-importing economies from Europe to China is curbing demand for crude. China imports 61% of its oil, while India imports 75%. Both of these countries are experiencing less growth than expected.

Meanwhile, Japan, which imports almost all of its oil, is entering its fourth recession in six years, and Europe is close to experiencing its third recession since the global financial crisis that began in 2007. This global slowdown may adversely affect the still fragile recovery that the US has experienced since the Great Recession ended in 2009.

The American economy relies less on exports to fuel growth than its European and Asian trading partners, and in the short run the US may be able to withstand the global pressures. But if global growth continues to slow, US firms will find fewer buyers for their products overseas, resulting in layoffs in an already weak labor market.

Bad for the environment and domestic production

A period of sustained lower prices of crude oil would in turn increase US dependence on fossil fuels and raise the associated environmental costs. The incentive to invest in alternative energy sources would be reduced as they become less competitive. And the discussion, development and implementation of a long-run energy strategy for America would continue to be postponed.

It might also trigger a reversal of the surge in US oil production that led to the glut in the first place, while the fall in petroleum-related revenue will hurt the energy industry. A decline in profits will lead to lower stock prices and a drop in employment.

OPEC’s recent decision not to cut oil production and bolster the price of crude has been interpreted as a signal that members are waiting for a stable oil market. However, there may also be a Machiavellian reason for allowing the continued price decline. As crude oil prices fall, potential investment projects of US energy firms – particularly involving horizontal drilling and fracking – will become less attractive, resulting in less exploration and production.

In the past, these production techniques were expected to be unprofitable if crude oil prices fell below US$85 per barrel. In the long run, this would reduce the supply of crude and prices would rise – though some studies suggest these methods could be profitable even if prices fall as low as US$50 a barrel.

So, in the short run, lower gas prices have increased consumers’ purchasing power, leaving them little to fear if they are visited by the Ghost of Christmas Present. But in the long run, if the global economic slowdown that caused the lower gas prices results in growth and hurts an already weak labor market, we may be faced with a visit by the Ghost of Christmas Future.

Found this article useful? A tax-deductible gift of $30/month helps deliver knowledge-based, ethical journalism.