Shock Waves.

The implications and possible effects of the drop in oil prices are complex and hard to predict.[1]

One effect of falling oil prices is to hammer oil producing countries at odds with the US (Russia, Venezuela, Iran). The fall in oil prices is putting far more pressure on Russia than are the international sanctions imposed over the unpleasantness in Ukraine. Both the Saudis and the Americans are quietly amused by the difficulties being encountered by the Iranians and the Russkies.

At least over the short-term (but likely over the longer-term) the fall in oil prices will reduce the revenues earned by the established oil producers. The effects could ripple through Middle Eastern politics. Saudi Arabia buys off domestic discontent with a high standard of living paid for by oil sales. Less revenue could translate into more discontent. When the United States scaled back aid to Egypt after the overthrow of the Morsi government, Saudi Arabia stepped in with generous assistance. Egypt plowed ahead with its suppression of the Muslim Brotherhood and other dissidents in open defiance of the United States. How long and how generously will Saudi Arabia be able to continue to support Egypt and other conservative regimes if the money stream starts to fall? Other Muslim states—like Algeria—are in something like the same boat in their dependence on oil revenues to fend-off unrest.

What does this suggest about climate politics in the United States? Will falling gasoline prices lead to more driving in bigger vehicles—with more emissions? Will the deflation of predictions about having passed “peak oil” reduce the pressure for the development of alternative energy sources?

What are the implications for the business-government relationship going forward? Eduardo Porter argues that government support for the development of the technology behind “fracking” endorses smart industrial policy. He suggests that this can offer a model for the development of new technologies to limit climate change. In particular, he endorses raising the gas tax during the period of low oil prices. The revenues “could be leveraged into a boon in tax revenues that the government could use to pick some of the winners that will help solve the [environmental] problems.”

The problem with “industrial policy” is that it’s just like other forms of politics. Established interest groups have a stronger position than do rising interest groups. The winners “picked” by the government are likely to be big campaign donors or the pet causes of political leaders. When government picks winners, we get farm subsidies and Solyndra. Porter’s own account of the development of fracking technology emphasizes the importance of research into new technologies paid for by the government, not that government picked winners. One thing that goes unmentioned by Porter is that government labs and subsidies were spread over a wide area. They didn’t focus on one technology or energy source. Continued investment in research certainly sounds like a good idea. So does an increase in the gas tax. Within that framework, however, would it be better to let the market pick the winners?

Why was this a surprise? Between 2008 and 2015 American domestic production of oil doubled. The European economy has been stagnant for a bunch of years. “Fracking” has been a loudly contested issue in American domestic politics for years. These are the key factors in the price decline. Yet markets, media, environmentalists, and politicians all seem equally surprised. Did no one see the rise in production/fall in prices coming? It’s a sort of Pearl Harbor in reverse.

[1] Eduardo Porter, “Behind Drop in Oil Prices, A Federal Role,” NYT, 21 January 2015.

Seismic Shift.

It’s probably hard for most people to accept this, but economic growth raised incomes all around the world by 28 percent between 2005 and 2013. All that growth required a rise in oil production of 19 percent. That rise in oil production never happened. In large part, it never happened because Saudi Arabia and other major producers never increased their production.[1] They preferred a stable target price of $100 a barrel. Instead, oil prices held steady. By June 2014, West Texas crude was selling for $107 a barrel. Revenues flowed in to oil-producers. But, as the Germans said about the Greeks, “they’ve had their fun.” Nemesis was at hand.[2]

It has been a long time coming. In October 1973 the Organization of Petroleum Exporting Countries (OPEC) launched the first “oil shock” against the industrial democracies. The target countries responded in a variety of ways. Some of the responses were ludicrous, but some had important long-run consequences. In the United States, Congress approved construction of a pipeline from Alaska’s Prudhoe Bay, tried to foster nuclear power generation, first imposed fuel-economy standards on car manufacturers, and created the Energy Research and Development Administration. All these were efforts to prepare a long-term strategy.

Eduardo Porter has argued that federal support for research and development paid big dividends.   In particular, Porter touts the role of government “industrial policy” in the developments that led to the recent shale revolution. The government helped pay for the development of “directionally deviated drilling,” the antecedent to the horizontal drilling that is used in “fracking.” The government pioneered large-scale hydraulic fracturing. The government subsidized the “polycrystalline diamond compact bits” that do the drilling. Micro-seismic imaging, originally developed in government labs to trace coal mine collapses, found application in identifying fracturing sites. The Reagan administration ended obstructive price regulations that had hindered investment.

The shale revolution took decades to develop. Recovering natural gas from shale formed the initial target. When natural gas produced by “fracking” entered energy markets in large quantities a few years ago, natural gas prices started dropping. The drillers’ effort shifted to releasing oil. By 2013 it began to pay off. That year American producers generated 3.5 million barrels of oil derived from shale. From June 2014 to January 2015 the price of oil fell from over $100 a barrel to $45 a barrel.

Why didn’t OPEC cut its own production to push the price back up? Probably because they could not cut back enough to off-set the rise in American production. Cutting production would just cede market-share to the Americans. They are hoping that prices will bounce back up in the future. A revival of world economic growth will increase the demand for energy. This will off-set the expansion of American production to a degree. Shale oil is expensive to produce in comparison to “regular” oil. The current low price will cause many American producers to shut down their operations until prices rise to a profitable level. However, no one now expects oil prices to rebound to anywhere near $100 a barrel. A ceiling of $70 a barrel is more likely.

Falling oil prices have dragged down prices for gasoline, diesel, heating oil, and natural gas. Consumers all around the world are enjoying the equivalent of a tax cut, which in the US amounts to $1,000 a year. That is a valuable prop to growth when strong growth tarries.

[1] Excluding a brief fun-up to counter the 2008 economic collapse.

[2] Eduardo Porter, “Behind Drop in Oil Prices, A Federal Role,” NYT, 21 January 2015.