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Jon Talton

Analysis and commentary on economic news, trends and issues, with an emphasis on Seattle and the Northwest.

December 9, 2014 at 10:40 AM

The slick slope of dropping oil prices

Oil prices have fallen almost 40 percent since June. This morning, light sweet crude futures for January were trading around $63.47 a barrel on the New York Mercantile Exchange, while Brent traded around $66.41.

The shorthand for this phenomenon is: great for (and I hate this word) consumers, bad for Putin’s Russia and other oil-producing states we either dislike or don’t pay much attention to. But let’s, um, drill deeper:

1. The oil is not particularly cheap. While the current Brent (and West Texas Intermediate) prices are the lowest since the digging-out-of-the-recession period of fall 2009, they remain relatively high by historic standards. With the exception of one spike, Brent was in the $16-$17 range for much of the 1980s and 1990s. It peaked above $58 in 2005 before making its historic run up to $138.40 in June 2008 as world demand exploded.

2. The United States is an oil-producing country, too. Even though production in the lower 48 peaked in the early 1970s, America has continued to produce large amounts of petroleum. One problem is that demand outstripped supply, so we turned to more imports. Another is that U.S. peak oil was a jagged slope down. Even so, before fracking kicked in, we were producing 5 million barrels a day in the mid-2000s. So while we’re not vulnerable like Russia, oil production remains a big part of the economy. Fracking has been a big job creator in the past six years. In other words, America has an oil industry that will be affected by lower prices. Chief among its players…

3. Unconventional drilling, such as fracking and tar sands, are dependent on high oil prices. There’s an argument over where the break-even price for extracting “tight oil” lies, and it depends on the location, but we’re getting very close. This means if the price drop continues, drillers will cut back on their work. Fracked wells play out much more quickly than conventional ones, so constant drilling and filling the earth and aquifers with nasty chemicals is necessary.

4. The frackers are deep in debt. This is a generalization but largely true. Much offshore drilling is dangerously leveraged. Defaults could begin a nasty game of dominoes. Wolf Richter offers an excellent take on the consequences of leverage and junk bonds that have played such a big role in the new oil boom. A good deal of this borrowing is connected into our old friend from the financial panic, collateralized debt obligations (CDOs).

5. Our good friends the Saudis are engaged in a price war. It doesn’t matter that is not said in public; it is the reality. Saudi Arabia is willing to suffer lost revenue now to drive competitors to ruin, especially the American and Canadian unconventional producers. If their buddies in OPEC go down with the tanker, so be it.

6. Lurking behind the price drop are some scary fundamentals. Europe, Japan and China are all in varying degrees of economic distress. The biggest reason for the price drop is not fracking but a drop in demand. Deflation is a risk, disinflation a reality. While the United States is doing better, it shouldn’t expect to avoid the downside of a global slowdown, or cascading economic woes in oil-dependent countries. Add in the big unknown from point No. 5 and the risks rise. No wonder investors are running to the dollar. As for American consumers, cheaper gasoline doesn’t help if their wages remain low.

7. If the worst-case scenario outlined above doesn’t happen, this drop is likely temporary. This is one reason why businesses aren’t rushing to pass along the savings. If world demand rises again, so will oil prices.

8. The real worst-case scenario remains climate change. Low prices that keep oil in the ground in a low-demand environment are a good thing for our children and grandchildren. Burning fossil fuels is the big enchilada of human-caused climate change and all its social, geopolitical, environmental and economic costs. Some real statesmanship would enact a carbon tax now that would kick in and step up as oil prices rise again. Oh, and take away all those subsidies to the fossil fuel industry. If we don’t accurately price the real costs of burning fossil fuels, we shall assuredly pay later. Actually, we’re paying now.


 

Today’s Econ Haiku:

Will we let Bertha

Demolish Pioneer Square?

Do cut-and-cover


 

 

Comments | More in Energy | Topics: debt, fracking, Oil prices

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