Commodity Trade Mantra

Falling Crude Oil Prices and the Fallout

Falling Crude Oil Prices and the Fallout

Falling Crude Oil Prices and the Fallout

The “Wells Fargo Economics Group” opines in its daily email:

Crude oil prices have not been this low since the nascent stages of the recovery in 2010. From recent cycle highs set in June, crude oil prices are down roughly $40/barrel or more than 35 percent. That is true whether you are talking about West Texas Intermediate or Brent prices. For the economy, lower energy prices come with trade-offs. The positive effect of a decline in prices for consumers is well-known. It is also generally accepted that cheap oil is positive news for energy-intensive manufacturers.

However, the part of the economy that does not benefit is investment in capital equipment for the extraction and transport of crude and its derivative products.

And boy, is spending on capital, labor, and land for oil extraction a big deal right now. If the demand for those factors declines meaningfully, it will mean significant trouble for many industries and communities. And unfortunately for us, oil extraction is the latest industry on which investors and the US government are relying to “drive” the next expansion, much as they did with housing prior to 2008.

Oil Booms Come and Go 

Some of those who remember the oil-extraction industry in the 1970s and 1980s may remember the rise of the oil shale industry (not to be confused with shale oil) in western states and especially in western Colorado. Thanks to very high prices, oil shale was then just beginning to become a viable industry. Indeed, the real price of oil in the very early 80s was only matched in 2008, and the oil industry began to throw large amounts of money at oil shale development. Boom towns, such as those around the Colony Shale oil project in western Colorado, sprang up amidst triumphalist predictions of huge future metropolises in the region growing up around billions of barrels of oil flowing to the patriotic song of “energy independence!”

Then, in May 1982 came “Black Sunday” when Exxon packed up the whole operation, and the economy of the entire region crashed. in the 1970s, it was assumed that high oil prices would continue forever, but by the early 80s, increases in oil supply, combined with the economic turbulence of the early 1980s destroyed the economic viability of the oil shale industry, which relies on very costly methods to extract the oil from the shale.

real

Are Things Different This Time?

“But, McMaken,” many will object, “the modern shale oil industry is very different from the the oil shale  industry of old. The new technology is more economical and and can better weather such a situation.” This is no doubt true, since when viewed in comparison to old oil shale methods, the shale oil industry certainly is relatively economical, and is also based on more promising technology. But it is still no accident that the industry began to really take off in a period of historically high oil prices, and that in the big scheme of things, the industry remains reliant on very expensive exploration and extraction methods. It makes sense in an economy where the price of oil is over 80 dollars per barrel. Does it make sense when the price is down to 65 dollars per barrel? How about 60 dollars per barrel?

As Wells Fargo pointed out, the price of crude is down 35 percent from June’s high. This is not the sort of thing that should be ignored. Indeed, as Mark Thornton has pointed out,

Higher oil prices can be a indicator of Fed-fueled bubbles which leads to higher oil prices as entrepreneurs compete for resources to carry out their plans. Lower oil prices can be indicator that the economy is going into a correction or recession and that entrepreneurs are contracting their operations.

Thornton points to the last three recessions where this relationship holds. This was also certainly true in the early 80s as well when the price of oil peaked at $35 (more than $100 in modern dollars) in 1980 and began to fall after. Sure enough, the recessions of 1981 and 1982 were not far behind. The oil prices continued down and with it, many operations within the energy sector.

oil

And yet, as I pointed out here, so much of US economic growth depends on the oil extraction business right now. The states driving GDP growth in the US are oil states, such as Texas, Colorado, and North Dakota. This is not a coincidence. And if the price of oil falls significantly and these oil fields cut back operations (I’m not assuming a worst case scenario like Black Sunday) then what of those states’ economies?

The media has certainly taken note of this. What Zero Hedge refers to (in typical breathless Zero Hedge fashion) as the “imploding energy sector” displays some interesting dynamics, to say the least,  including the fallout that may be coming for those who are invested in the sector. According to another article on ZH: “Everyone believes that the oil-price decline is temporary. It is assumed that once oil prices plummet, the process is much more likely to be self-stabilizing than destabilizing” This was assumed in 1980 also, but that assumption was perhaps only finally dead years later when the price collapsed yet again in the oil glut of 1986.

But everything’s different now, we’re told. And yet, markets appear to be acting as we might expect, and as we’ve seen them do before. “Shale oil in a bind” writes the Economist. “New U.S. oil and gas well November permits tumble nearly 40 percent” Reuters writes, following up with:

The pullback was a “very quick response” to U.S. crude oil prices, which settled on Tuesday at $66.88 CLc1, said Allen Gilmer, chief executive officer of Drilling Info. New permits, which indicate what drilling rigs will be doing 60-90 days in the future, showed steep declines for the first time this year across the top three U.S. onshore fields: the Permian Basin and Eagle Ford in Texas and North Dakota’s Bakken shale.

The Permian Basin in West Texas and New Mexico showed a 38 percent decline in new oil and gas well permits last month, while the Eagle Ford and Bakken permit counts fell 28 percent and 29 percent, respectively, the data showed.

That slide came in the same month U.S. crude oil futures fell 17 percent to $66.17 on Nov. 28 from $80.54 on Oct. 31. Prices are down about 40 percent since June.

Will Western American states continue to boom without $90/barrel oil prices? What will American GDP look like without this latest bubble industry to fuel job creation, tax revenue, and investment? It’s impossible to say right now, although the price of oil in relation to the last four recessions does provide some fuel for speculation.

 
Courtesy: Ryan McMaken via Mises.org

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