Crude Unglued

The big news in the financial world for the past few months has been the dramatic drop in oil prices. Since June oil has lost nearly 50% of its value and is now at a price not seen in over five years during the depths of the recession. Although the signs have been around for a while, the sudden and protracted decline has taken everyone by surprise. We’re now seeing all sorts of explanations, justifications, and ruminations about what it all means.

Aside from homeowners in the Northeast who heat their homes with heating oil, the big impact on most of us is the lower gas prices to fill up our cars. If you’re like me, unless there is some big news about it, we really don’t notice fluctuations at the gas pump. However, when prices drop this much, it’s hard not to notice something is up. And in this case, that something is we have more money left over when we pull out. For most of us it’s certainly a good time of the year to have that kind of pleasant surprise.

A lot of people, unfortunately, don’t see it that way. Some of them think that lower prices aren’t such a good thing. I guess some people can’t get into the holiday spirit.

The esteemed liquidity expert and chronicler of the debt crisis John Mauldin has just dispatched a report on the oil price’s effects on overall growth. There’s a lot of information here, muddied somewhat by the gratuitous inclusion of the tinfoil hat brigade at Zero Hedge, who’ve never met an economic event they didn’t think was going to cause the collapse of Western Civilization. Here’s the important takeaway:

Employment associated with energy production is going to fall over the course of next year. It’s not all bad news, though. Employment that benefits from lower energy prices is likely to remain stable or even rise. Think chemical companies that use natural gas as an input as an example.
I am, however, at a loss to think of what could replace the jobs and GDP growth that the energy complex has recently created. Certainly, reduced production is going to impact capital expenditures. This all leads one to begin thinking about a much softer economy in the US in 2015.

Thankfully, Mr. Mauldin dismissed the more ridiculous assertions going around that the drop in oil is a replay of the subprime credit crisis, but that does still leave us with a picture of the energy industry facing serious problems. The emergence of fracking has been an absolute boon for those communities sitting on shale oil and gas fields. One would expect their fortunes to be reversed when the price of oil drops.

One immediate area that is starting to see some signs of life since oil dropped is employment of young workers. Now, kids in retail and entry level jobs may not restore confidence in those who see collapse of mighty industries around the bend. On the other hand, all the consternation lately about the rise of the machines, technological unemployment, and the lack of relevant job skills has a lot to do with companies unwilling or unable to invest in training unskilled and entry level workers because it’s simply not affordable. Kids getting jobs again is definitely a step in the right direction to correcting the mismatch. Except in overly regulated states, that is.

Unlike every other state in the United States, California increased its minimum wage on 1 July 2014, just as the employment situation was about to improve across the entire country thanks to falling oil and fuel prices. No other state has likewise implemented an increase in their minimum wages during this period.
By arbitrarily increasing their minimum wage from $8.00 to $9.00 per hour in July 2014, California’s politicians effectively jerked away the prospect of finding employment from its job-seeking teen population at a time when it would have its best chance at doing so in years, while also damaging their prospects for increased future earnings. All by making it too costly for the state’s employers to employ them profitably.

Which tells us the real danger to growth isn’t the natural movements of markets but the unnatural manipulation from government.

As for where the rest of the growth is going to come from to offset the decline in energy sectors, if the oil industry existed in a vacuum then there would be something to worry about. However, the fact is they sell to other industries and to consumers who will have more money to spend. Period. It’s not just petrochemical industries either. Car companies and heavy equipment industries and airlines and shipping companies and on and on and on.
Why some people choose to ignore these benefits and obvious upside is somewhat baffling. Luckily I’m here to let them know: absent some other unforeseen shock, lower prices will definitely and absolutely create more jobs then it will destroy. End of story.

But what about the energy industry? Surly lower prices will bankrupt it, end the American energy renaissance, and enslave us all to Arab Petro-Sheiks forever, right? It turns out that immense capital intensive projects like oil drilling take a long time and aren’t as responsive to price fluctuations. North American production is still expected to grow in 2015, mostly because there’s no alternative. The easy oil coming from Saudi Arabia that everyone believed was close to or at the peak is still probably running out. Sticking a straw into the ground and slurping up oil was great while it lasted, but it really is increasingly a thing of the past. That’s not a bad thing as new technologies naturally spring up to replace it and introduce innovations that bring the price down where it probably should be in the first place.

Likewise, high prices encourage the discovery of new technologies that allow explorers to find and recover previously untapped reserves of oil. And high oil prices encourage the development of alternative sources of renewable energy, allowing us to shift away from the use of hydrocarbons altogether. In the graph, we can clearly see how these incentive effects worked to bring oil prices back down in the 1800s and the 1980s. Most likely, these same incentive effects will work to push oil prices lower in the years ahead.

For years there was manipulation and a geopolitical premium on the price of oil. Now prices are dropping because the market is actually working correctly again. Let’s welcome it and allow it to continue.

13 thoughts on “Crude Unglued”

  1. I would think it a good thing if the feds bought up a lot of the cheap Saudi crude and put it in the strategic reserve but, of course, that would be against Obama’s religion.

  2. One thing that needs to be emphasized: there are big differences between the oil market and the natural gas market. Oil is basically a world market since the transportation costs are quite reasonable compared with the cost of the product; gas, the other way around. Fracking is applicable to both; sometimes the same project generates both, sometimes it is mainly an oil project or mainly a gas project.

    Also, lower oil prices have a big effect on the economics of shipping. A lot of container ships have been running way below their design cruise speeds in order to save fuel; I expect now some of them will be speeding up and offering better schedules. Domestically, the economic benefits of rail vs trucking for long hauls are eroded somewhat by lower fuel costs, though the ratios are already so high that I’m not sure how much difference it will make.

  3. The people who are bemoaning a fall in oil prices are the same people who would have bemoaned a rise in oil prices, with the sole difference that they’d have been right about the latter.

  4. This is an excessively long riff on what it all means.

    Natural Gas and Petroleum are, at some theoretical level, substitutes. They are not perfect substitutes because you need some capital investment (at least tanks, hoses, and burners) to be able to switch between the two. You can run many forms of transportation equipment on either. I don’t think it takes much modification for a diesel engine to be able to use either.

    Gas is sold by the unit of One Million BTUs. A barrel of oil (there are lots of different grades of oil) contains about 6 million BTUs. When the price difference between oil and gas is more than a factor of six, there is an arbitrage opportunity. Although, you need to account for things like the fact that gas in the US has an excellent pipeline network between wells and customers, but that in Europe and Asia a lot has to move as LNG which is more expensive.

    During the run up to the Panic of 2008, both oil and gas prices spiked. Oil hit 140* in the summer of 2008, and gas got up close to 14*. Yes, there was a split between the prices, a factor of 10, some of that was related to the transportation issues mentioned above. At the denouement of the panic in the fall of 2008 and the winter of 2009, the prices of both crashed. In early 2009 oil was under 50 and gas was headed for 3.

    However, what happened after the panic ended is the conundrum. Oil recovered in 2009 to 80, and in 2011, helped by the continuing chaos in the Middle East, oil went above 100. But gas stayed under 5 and settled into a trading range around 4.

    The popular explanations were that oil would remain high because new demand in Asia (esp. China) would outstrip supplies. Indeed there was a lot internet noise about the idea of “peak oil”, that the world’s supply of oil was finite and that production had peaked, and could only go down. That meme was spread by a site hight, which shut down in September 2013.

    The popular explanation for gas prices was that fracking had created a surplus of product in the US.

    I asked any number of people if they could reconcile the reasoning for 100 dollar oil and 4 dollar gas, a price gap in excess of 4 times the energy gap. I didn’t get any good answers. If I had the guts, and the capital (both of which I lack) I would have set up a trade, long on gas and short on oil. Moreover, I am conscious of the aphorism that markets can remain irrational longer than traders can remain solvent.

    What does all this mean. Of course I have no idea. In the immortal words of a Hollywood insider, “Nobody knows anything.” However, I think it is at least as likely that oil will land under 30 as that gas will go up.

    Good policy would be to encourage domestic oil production and to encourage the production and export of LNG. That would cause the prices of oil and gas to converge at an economic level. But, expect no intelligent policy until 2017 at the earliest.

    *The quoted prices are for Brent crude in the North Sea and for gas at Henry Hub in Louisiana. Midwestern oil prices are quoted at Cushing, Oklahoma and have been somewhat below Brent, because of transportation issues.

  5. Natural gas burns cleaner than oil, producing about a third less carbon dioxide. This may have been seen as more favorable against the Climate Catastrofarians in the Obama Administration and the EPA who wanted to cap admissions. Now that all the bureaucratic alarmism has been ostensibly arrested (at least for now), it makes some sense that the spread between oil and gas would narrow.

    I’ve read stories about how the Saudis are trying to bankrupt frackers, the Russians, Iran, and/or ISIS. I’m not sure what is true, but I do know with each passing week, the reported break even point for shale plays keeps dropping. I’m beginning to wonder if anyone really knows what it is for sure. Illinois was to begin fracking next spring, and news reports say they’re still planning on going through with it. Drillers who had endured years of regulatory hurdles are probably glad to now be competing with OPEC instead of Illinois Bureaucrats.

  6. I’m still waiting for the boom in nuclear power that the enviers would seem to want. The KGB did a very good job back in the 70s.

  7. “Gurray: $4 natural gas didn’t stop fracking. Why would $50 oil?”

    Yes, exactly. Fracking and the politico-economic environment that has emerged around it are driving price changes, not the other way around and not OPEC.

    “I’m still waiting for the boom in nuclear power that the enviers would seem to want. The KGB did a very good job back in the 70s.”

    There were recent news reports that the Russians were secretly bankrolling anti-fracking groups in Europe.

    When I look at some of the opposition around here I have to wonder if they’re somehow on the payroll also.

  8. “When I look at some of the opposition around here I have to wonder if they’re somehow on the payroll also.”

    It hides in plain sight. Like when Qatar paid Al Gore $500 million for his utterly worthless cable network, which they shut down immediate.

    I think that it is very safe to assume that most environmentalist organization are being bankrolled out of the Middle East.

  9. >>I think that it is very safe to assume that most environmentalist organization are being bankrolled out of the Middle East.

    I would agree with that. And maybe the Russians.

  10. Don’t forget that Gore in 1993 (as VP) was part of the Clinton Administration that shut down the Integral Fast Reactor project, an on-site pyro processing fuel cycle demonstration that addressed the issues of long lived waste streams. It was also “walk away” passively safe; the less-than-atmospheric pressure sodium coolant loops would naturally shut down the fission reaction if temperatures got too high. They actually simulated a loss of cooling accident with all active response systems disabled and the reactor just shut itself down and cooled itself off to a stable temperature.

    I wish someone would put Gore on the spot and ask him why the risk to the planet from carbon energy isn’t high enough to bring back those sorts of nuclear power technologies.

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