Crashing Oil Prices Won't Kill The US Economy

Oil is the big story in the markets right now.

The price of crude has been falling since July, with a steep drop off in the last month, as a result of Saudi Arabia starting what’s essentially a game of chicken with US producers.

In recent years, the US has become an increasingly influential player in global energy as elevated oil prices have paid for the expensive fracking of America’s shale basins. The worry is that falling prices will cause the shale boom to hit a wall.

Here’s an excerpt from Izabella Kaminska’s excellent Q&A primer in the FT about what’s going on in the oil market:

If the US is producing more, who is producing less?

Well that’s the thing. Until now it wasn’t hard for the market to absorb all that extra oil because there were plenty of disruptions in places such as Libya and Iraq. The problem lies with changing expectations about tomorrow’s demand in a world suddenly awash with oil, but burning less.

But if demand in the future falls, won’t someone eventually have to slow production?

Absolutely. Otherwise a collapse in prices will put every producer off and risk leaving everyone without fuel. The problem is, whoever cuts first loses the revenue to someone else. It is a game of “chicken”.

So we’ve finally reached a point of global surplus, after many years of supply trying to catch up to demand. This has fundamentally changed the geopolitical landscape when it comes to oil, according to a recent note from Goldman Sachs’s Jeff Currie. The note brings forward Currie’s bearish outlook on oil prices through 2015, for three reasons:

We have greater confidence in the scale and sustainability of US shale oil production. This implies that the global cost curve has shifted lower and that cost deflation is sustainable.

We forecast that accelerating non-OPEC production growth outside North America will outpace demand growth, leaving the global oil market oversupplied.

We believe that OPEC will no longer act as the first-mover swing producer and that US shale oil output will be called upon to fill this role.

The question is, what does that mean for the American economy?

Another Goldman note looks at that. On the one hand, falling crude prices mean falling gas prices, which means a boost to consumer spending in other parts of the economy. On the other, shale production in the US will likely fall, reducing exports and reducing business spending in that area of the economy.

Goldman thinks that the two are probably going to roughly cancel each other out, predicting that GDP will decline just 0.1% as a result of this turn of events. In 2013, capital investment by the oil and gas industry was $US167 billion. That’s 11% of business fixed investment and 1% of GDP, according to Goldman. The note says that at the height of shale investment, in 2010 and 2011, this sector added as much as 0.2% to annualized real GDP growth. But it has since “declined to an unremarkable pace.”

Even with falling prices, investment in the oil sector in the US isn’t necessarily going to fall off a cliff. From Goldman’s Alec Phillips:

It is important to note that a good deal of capital investment in the energy sector is used to maintain rather than increase production, since the production from existing wells is constantly declining, so even if US production were expected to remain flat over the coming year–we still expect it to grow substantially–significant investment would still be necessary.

This slowdown is also not expected to have a ton of impact on employment in the industry. In fact, since production is still expected to rise despite falling prices, “oil and gas-related employment looks likely to continue to grow.”

Notably, the Wood Mackenzie estimates that the price below which the US starts to see supply disruptions is around $US70 per barrel for for WTI crude (and about $US80 per barrel for Brent crude).

Prices as of this morning are hovering near $US79 and $US85 per barrel, respectively.

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