Thursday, September 18, 2014

Lower oil prices no longer help the US economy

The US currently consumes around 19 million barrels of oil per day (5% of the world's population consuming 21% of global oil supply. Global supply is roughly 91.5 million barrels per day).

A drop in prices of $1 per barrel equates to a $7 billion boost in non-oil US consumer spending when annualized. This is money which US consumers do not have to spend on oil and instead can spend on new mobile phones and other goods.

However, the US is also increasingly a larger oil producer. Since 2009 there has been an upward trend in US oil supply which had until then been declining steadily since 1973. This has been due to new high cost US tight oil (fracking) supply. With this increase in US oil production there has been a reduction in US oil imports which is expected to continue until around 2020 (see chart below). Whether this US trend can continue beyond 2020 is subject to a high degree of uncertainty at this time.

Netting the spending boost from US consumers against the revenue reduction to US oil producers, each $1 drop in oil prices currently provides only a net $2 billion annual boost to the US economy.

This is a small number given the overall scale of the US economy. For example, Apple Inc's revenue is running at $175 billion per year. So while lower oil prices in the 1990s and 2000s were almost always beneficial to the US economy, today they are neutral.

There are three caveats:

*1. Neutral until below $75: The recent increase in US oil supply is due to high prices. Marginal production from high cost tight oil (fracking) requires $75 per barrel (basis WTI crude). As a corollary to this, if prices were to decline below $75 per barrel, production from high cost tight oil (fracking) could decline and prices lower than $75 may, over the short term (1-3 years), hurt the US economy. In summary, lower oil prices are neutral to the US, so long as prices stay above $75 per barrel. Prices below $75 may be negative to the US economy.

*2. The big sign effect - consumer price psychology: A further caveat is the sentiment effect. Almost everyone in the US is aware of the price of oil due to large government mandated signs at refueling stations. If oil prices move below $3 per gallon at the pump (see chart below) then there may be an boost in consumer spending on non-oil goods due to pricing psychology which overwhelms the decline in revenue for oil companies.

*3. Shocks are unpredictable - speed of the price move: Consumers react to the speed of price movements in addition to the magnitude of the move. Oil prices halving or doubling in 6 months generates a much different and more unpredictable reaction than oil prices gradually doubling or halving over 5 or 10 years.

[Summary: Lower oil prices in the 1990s and 2000s were almost always beneficial to the US economy, today they are neutral. Oil prices below $75 may be negative to the US economy.]

[For the sake of brevity and simplicity I am not including economic multiplier effects in the above.]
Follow @CommodityMD