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Wednesday, January 7, 2015

Cheap oil isn't always a good thing

The price of crude oil is at a cyclical low, equivalent to 1974's price on a constant-dollar basis. It was only the summer of 2008 when the price was three times higher.

Why has the price fallen? The simple answer: supply and demand. High prices in the past encouraged new capacity to come online, and there is now an oil glut. Meanwhile, American consumers have been buying more fuel-efficient cars while consumers in most other western nations are stuck in economic doldrums. That's burning the candle at both ends.

I observe that the current situation significantly disadvantages Russia, whose Ruble has dropped in value by 55%. Have oil producers and their western customers conspired to put the screws to Vladimir Putin? I am not prone to cry "Conspiracy!", but I don't believe anyone in the West is feeling sorry for Putin at present. Of course, no one in the West wants to destabilize Russia entirely, either. Other victims of low prices are Iran and Venezuela, two nations that have hardly won friends in recent years.

Who benefits from cheap oil? Consumers, for one. This map shows that the effect on retail gasoline prices is most dramatic in states that don't tax gasoline heavily. (Thank heavens for South Carolina.) Airlines, railroads, trucking operations, the American military, and manufacturers of plastics and organic chemicals that use oil for feedstocks also benefit directly. Ultimately many of those benefits reach the American consumer indirectly, although it takes a while.

Who is hurt by cheap oil? To begin with, producers of oil whose cost of production is high. I've read that the Saudis produce oil at a cost of $10, so they won't be hurt significantly; besides, they've already extracted their trillions of dollars from us and they have invested it smartly. But oil exploration and new production will be curtailed if these prices persist, and you'll see significant pain in Texas and Alberta — not just the oil sector but the real estate and banking sectors, too. Already the Canadian dollar has fallen to a five-year low.

Deflation can be a bad thing. Very few Americans remember the deflation of the Great Depression, although we had a taste of it in 2009-2010 when the residential real estate bubble finally popped. The European economy, aside from Great Britain, has been so anemic that reductions in oil prices could easily put them into a deflationary posture. Likewise for Japan.

American exporters will suffer too. Many other currencies have fallen relative to the American dollar, notably the Euro (now at a nine-year low). American products thereby become more expensive overseas and fall in volume. On the other hand, many imported goods become less expensive for American consumers.

But what worries me the most is that cheap oil will undercut concerns about global warming. One barrel of oil produces the same amount of carbon dioxide, regardless of its market price. And remember the graph that I showed you in the opening paragraph: the price of oil can be quite dynamic. What it will be in 2020 is anyone's guess.