The market in American crude oil prices closed at $83 per barrel on Oct. 16, having recovered from prices below $80 per barrel earlier in the day. The stock market exhibited nervousness as price volatility reared its ugly head. Businessmen and governments shifted uneasily with fears of deflation, reduced profits or the inability of oil sales to match revenue expectations. The only people who can celebrate are the hoi polloi, the Federal Reserve and the Obama administration. The celebration for the Fed and the executive branch will be short-lived, but we common folk should be really happy for quite some time.
There are several tendrils to this story, but the most important one is that sustained low prices in oil translate into a direct stimulus to the economy and a guarantee that the growth cycle for the U.S. economy will not end any time soon. It is estimated that for every one cent decline in gasoline prices (sustained over one year), $1.4 billion is added to the economy. If gasoline prices decline 50 cents, that number jumps to over $67 billion. Crude oil prices have dropped by nearly 30 percent since June. If that price drop is sustained over the course of the next year, prices at the pump will in all likelihood drop by over $1 per gallon of gas. That would mean $130 billion of money in the hands of mostly ordinary folk to spend on other things. Other things could include places like Target, Walgreens, Home Depot or elsewhere. When a dollar reenters the economy in that way, it has a ripple effect. That dollar works its way through the economy to have an ultimate impact of $2.50 because the store buys more inventory, hires more people, pays better wages and each of those actions stimulate similar ones so the money ripples like the water on a pond when you toss a stone.
None of that may sound like much in a $16.8 trillion economy, but adding the benefits of the price decline with the ripple effect means that over $320 billion could be added to the economy and that is almost 2 percent. The U.S. GDP growth for 2014 is expected to be 2.6 percent and was recorded at 1.9 percent last year.
In so many words, most Americans, who have not seen real wages increase over the past 30 years, will get a boost to their budgets by a reduction in their cost of living. The Federal Reserve will be happy in one sense, because the stimulus to the economy is a substitute for a fiscal stimulus from government spending. It takes the pressure off the commissioners to keep pumping money into a banking system swimming in money. While the Fed does worry about deflation, on balance lower gas prices are a plus. Democrats may even benefit in the upcoming elections, because consumers love lower oil prices and that love is carried with them into the voting booth.
But there are other tendrils and this is where the story really gets interesting. Crude oil prices have fallen through a combination of slowing demand and increasing production. The slowdown in demand is a result from slow growth or no growth in Europe; a flattening of demand in China, where its growth expectations are getting ratcheted down; and a fall off in demand from developing countries where oil, which is paid for in U.S. dollars, has become more expensive as the dollar has appreciated in value.
The increased production is the fun part. Countries like Iran require crude oil prices to be $140 per barrel to meet its revenue needs, since 60 percent of government revenues are from oil sales. Russia requires $100, as does Saudi Arabia. It will come as no surprise that oil policy has been politicized and the recent increases in production in the U.S. and Libya have added to the problem of managing supply and therefore managing world oil prices.
Most everyone is familiar with the cartel OPEC (Organization of Petroleum Exporting Countries). Historically, Saudi Arabia has been the spigot that sets the daily production limits for its participants and provides roughly 30 percent of OPEC's daily 33 million barrels of daily oil per production. So, the Saudis know that cutting back the 9.5 million barrels per day that it produces would help support higher prices. But that would limit its "take" and subsidize the Iranians and Russians on the one hand and the high-cost producers like the United States on the other. So why not let the production stay high, let prices fall and squeeze the other players who are more vulnerable?
The Saudis have done this before, more than once. While failing to gain production-level discipline within its member ranks in 1985, the Saudis flooded the market with oil and drove prices down to historic lows. The Saudis have always viewed themselves as a partner of the world's economic powers, knowing that their one valuable resource was only valuable if there was global economic growth. It is certainly conceivable that the Saudis recognize slower growth might benefit from lower prices, at least in the short term. Even if this is not the true motivation, it makes a great cover story and it certainly doesn't hurt them to have over $750 billion in foreign exchange reserves to cover any shortfalls in the budget.
Where this issue really gets sticky is for the ordinary citizen in this country. The facts are that the oil industry is a powerful force in domestic politics and relatively high production costs for its new found fracking and secondary recovery methods require a price of $75 per barrel or more for them to be profitable. The Saudi cost base is estimated at $25 per barrel. There is no question but these American companies are getting nervous and that means we can expect a raft of advertisements alerting us to the fact that the oil and gas industry employs 9.2 million people, that we are headed toward energy independence and need to keep increasing production, that we need the Keystone XL pipeline and producers should be allowed to export their product to world markets.
However, if you consider that oil companies have recorded record profits over recent years, that they are the biggest moneymaking businesses in the history of business, that there is no meaningful congressional action that will take place to curb their tax breaks or increase their taxes and that they contributed over $70 million to candidates in the 2012 election cycle — 90 percent of which went to Republican candidates — the very least the average consumer can do to protect his or her own interest is to shop around for best gas and heating oil prices and pressure whatever is left of an independent legislature to keep the industry competitive.
Russell is managing director of Cove Hill Advisory Services.