U.S.

Implications of Plummeting Oil Prices

December 5th, 2014 | By Nick Sargen

Highlights

  • Two prominent energy experts – Daniel Yergin of IHS and Edward L. Morse of Citi have issued reports contending the oil market is now being dominated by a much greater than anticipated surge in U.S. production since 2008. It has caught other oil producers by surprise, and the failure of OPEC to cut production at last week's meeting sent prices for WTI plummeting below $70 a barrel – a decline of nearly 40% since mid-year.
  • Investors currently are assessing who the winners and losers are. Yergin contends the main losers are Venezuela, Iran, and Russia, and he foresees a slowdown in new energy investments around the world. U.S. companies also will look hard at their plans, but Yergin claims new U.S. production is more resilient than anticipated and should continue to increase in 2015.
  • It remains to be seen where oil prices will shake out, but the latest developments are positive for the U.S. on two fronts: (i) the price decline is equivalent to a tax cut for U.S. consumers of about $160 billion, or nearly 1% of GDP, which should propel real GDP growth in 2015 to 3%; and (ii) according to Citi, the U.S. oil import gap will be eliminated before the end of this decade, which bodes well for U.S. trade and the dollar.

Forces Propelling the Price Declines

During the course of 2014 there has been a sea-change in perceptions about the oil market. In the first part of the year, many observers were concerned that oil prices could spike in response to geopolitical developments in Libya, South Sudan, and Iran, as well as Russia and Ukraine. When oil prices subsequently declined around midyear, market participants initially linked the moves to soft demand resulting from slower global economic growth. More recently, however, it is apparent the catalyst for recent price declines is growing production from the United States.

In a WSJ commentary titled "The Global Shakeout from Plunging Oil" (November 30), Daniel Yergin, rendered the following opinion: "The demand for oil – by China and other emerging economies – is no longer the dominant factor. Instead, the surge in U.S. oil production, bolstered by additional new supply from Canada, is decisive. This surge is on a scale that most oil exporters had not anticipated." Specifically, he notes that since 2008, U.S. oil production has increased 80% to nine million bpd. Yergin goes on to observe that new U.S. production is more resilient than had been anticipated. Specifically, a recent analysis from his firm, IHS, based on individual well data finds that "80% of new tight-oil production in 2015 would be economic between $50 and $69 a barrel."

This view about the growing importance of the U.S. as an oil producer is embellished in a recent report issued by Edward L. Morse and team from Citi entitled "Energy 2020: Out of America," (November 2014). The report begins with the following message:

"When it comes to crude oil and hydrocarbons, the U.S. is bursting at the seams. The situation is unlikely to stop even if prevailing prices for oil fall significantly – Citi anticipates that even if West Texas Intermediate (WTI) prices fell below $75 for a while, production growth would continue at relatively high levels for years to come."

One of the principal findings of Citi's report is the U.S. is on the way to becoming a net exporter of crude oil and petroleum products combined before the end of the decade. It notes that since mid-2006 the U.S. has reduced its net oil imports by 8.7 mbd, which is more than the total production of all countries in the world other than the U.S., Russia, and Saudi Arabia. The report also notes that since 2010, the U.S. moved from being the largest gross and net product importer (gasoline, diesel, jet fuel, and LPGs) to the largest gross exporter and the second largest net importer next to Russia. The report also contains a discussion of growing pressures to export crude oil that the U.S. government is facing and concludes with the following observation:

"All of these details matter because they are shaping the emergence of North America as an energy superpower that is poised to usher in disruptive changes to global oil markets, trade, and investment. How this process unfolds is sure to create new winners and losers even as it remakes the global energy landscape."


Who are the Big Losers?

In his WSJ commentary, Daniel Yergin contends OPEC's decision last week reflects the conviction of the Persian Gulf countries with large financial reserves that cutting reserves would mean losing market share to Iran and what they see as an Iran-dominated Iraq. Instead, they are content to allow the oil market to stabilize itself. While U.S. companies are looking hard at their investment plans in the wake of the recent price declines, Yergin believes it will take time for these decisions to affect supply, and he foresees further increases in U.S. oil production in 2015. He believes the biggest impact of lower oil prices on future investments will be outside North America and most likely in Africa, Asia, and Latin America.

According to Yergin, the OPEC members in the most trouble are Venezuela and Iran, which clamored for production cuts. Both economies are struggling now, and have bloated government budget deficits and small foreign exchange reserves.

The other major loser is Russia, the world's largest oil producer and not a member of OPEC, which is now preparing for lower, even "catastrophic" oil prices. While oil provides over 40% of revenues for the Russian budget, the country has built up foreign exchange reserves of several hundred billion dollars. For the time being, the authorities have allowed the ruble to plummet against the dollar, but there is growing concern the country could be headed for a crisis similar to that in 1998.


The Big Winner – The USA

Since oil prices began falling in midyear, my view has been the U.S., as a net oil importer, was a winner from these developments, because they were equivalent to a tax cut for U.S. consumers. Prior to the OPEC meeting, economists at Goldman Sachs estimated the decline in gasoline prices was roughly equivalent to a $75 billion tax cut, and the favorable impact on GDP growth was estimated to be 0.3% to 0.4%. More recent estimates that incorporate an additional price decline of 10% following the OPEC announcement show an even larger impact – up to 0.8% of GDP. It should be noted these calculations derive the benefits to consumers from lower oil prices and net out the losses domestic producers incur, so they calculate the net benefit to the economy as a whole.

The recent oil developments also have implications for the U.S. economy over the long- term. John Makin, a resident scholar at AEI, published a report yesterday entitled "Happy holidays from the Saudis and shale oil" in which he concludes that sustained cheaper oil could lift potential growth in the U.S. back to 3% if accompanied by payroll and income tax cuts of about $300 billion. He urges the new Republican Congress to maintain pressure for lower tax rates even if the economy posts 3% growth next year: "They should push harder for the tax rate cuts that could provide the basis for a sustained liftoff of the U.S. economy that has been sought since the 2008 Financial Crisis."

After reading Citi's report, I find myself even more optimistic about long-term prospects for the U.S., because for the first time in more than four decades the United States is on the path to being energy self-sufficient. The benefits from attaining this status should not be underestimated: Citi estimates it should bring the current account roughly into balance by the end of this decade, assuming everything else is the same, which bodes well for the dollar. At the same time, it should leave the U.S. less exposed to adverse geopolitical developments. I find all of this truly remarkable considering that just a few years ago many were fearful that "peak oil" would render the U.S. vulnerable to significantly higher oil prices.


Investment Implications

In the wake of all that has happened, equity analysts are busy now trying to figure out which firms and industries are the winners and losers from lower oil prices. From a macro perspective, however, the assessment is much easier: Lower oil prices on balance should bolster growth in the U.S. and other oil importing countries, while keeping headline inflation rates unusually low. In this environment, there is little urgency for the Fed to be compelled to raise interest rates, and it could very well hold off doing so until 2016.