The Two Sides of Cheaper Gas

Lower gas prices are one of the feel-good stories in today’s economy. As the price of crude oil has dropped over 26% since June, prices at the pump have fallen 15% to $3.17 per gallon nationwide.

That translates to an annualized savings of about $500 per household similar to what consumer tax cuts or transfer payments would do to consumer purchasing power (but at no costs to taxpayers). As prices also fall for fuel-intensive industries such as transportation, trucking and delivery other prices to consumers will fall as well.

All good? A decade ago, the story of gains from lower oil prices would have ended right there. But over the past 5 years, the development of fracking as a new technology for mining crude oil has made the U.S. a major oil producer with output levels about to surpass those of Saudi Arabia. There are several benefits. More domestic production helps free the U.S. from dependence on terrorist states, oligarchies and other non-democracies for our energy needs.

Furthermore, if these new supplies didn’t exist, oil prices would have risen much higher in the face of rapidly rising oil demand from China and other large developing nations. Equally important, developing these fields and maintaining their production hasbeen a critical source of new jobs for skilled production workersduring the economic recovery and expansion. That growth process is expected to go much further.

But there is one catch: the marginal cost of maintaining oil production in a fracking field is relatively high. If oil prices were to fall far enough, fracking would become too costly and the industry would contract. We’re not seeing a serious risk of that today but this could change.

The demand and supply sides of the oil market have both contributed to the recent price declines. On the demand side, most of the world’s economies have continued to slump, with Europe, China and most developing nations growing slower than expected. On the supply side, Saudi Arabia – the lowest-cost producer – has historically varied its production within a modest range so as to offset short-term fluctuations in the global supply-demand balance. This time, the Saudis and the other Gulf states have not done so, and we can only speculate why.

The Saudis may want to discipline other low-cost producers into sharing the burden of reducing output to maintain prices. They may be holding down prices to starve Iran and other political rivals of needed revenues and, as some believe, to starve Russia of revenues at the behest of the U.S. Or they may simply want to maintain their share of the market rather than cut output to support prices. This last point would be consistent with a concern about how rapidly the U.S. share is growing.

Some industry experts estimate that if prices fell below $70 a barrel, it could make some U.S. production unprofitable. The recent oil price decline has not gone that far, but it has highlighted the risk that prices could fall much lower. The stock price of companies in the fracking field have been among the hardest hit in the market decline.

In short, now that U.S. employment has become sensitive to oil production, lower prices at the pump may have costs as well as benefits. With crude prices at levels that encourage continued development of U.S. oil fields, global demand will have to rise steadily to absorb that capacity. Indeed, there’s a sweet spot where prices satisfy consumers while production incentives remain strong. But the world markets may not find that price anytime soon.