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The decline in oil prices to less than $50 per barrel should not be a surprise. The surprise is how long oil prices stayed above $100 per barrel when supply and demand fundamentals could no longer support such a price. Given the supply outlook, oil prices will likely remain below $50 per barrel for some time, boosting world output by approximately 0.7 percent—according to simulations using the International Monetary Fund's (IMF) world economy model—though I suspect it could be even more. Low oil prices also provide an opportunity for governments around the world to phase out harmful energy subsidies that amount to over $600 billion per year (IMF). While the winners are spread widely and thinly, the losers are concentrated. There will be some visible dislocation to the economies of major oil exporters, to stock markets heavily weighted to oil and oil service companies, and to those that sell what the oil barons spend their $1 trillion of oil export revenues on, such as homes in London's Kensington district, European luxury goods, and US financial assets.
Lower oil prices are good news today for the world economy because they reflect an increase in supply and conservation, not a drop in economic demand. Some fret that Chinese growth slowed in 2014 to its slowest rate in 24 years—7.4 percent. But this statistic is more meaningless than it appears. After almost 24 years of 10 percent annual growth rates, the additional GDP created from an economy growing at 7.4 percent a year is seven times greater than that of the same economy growing at 10 percent 24 years ago. Even a slowing China imported 7 million barrels of oil per day in 2014, more than the United States and 30 times more than it imported 24 years ago when the pace of Chinese growth first quickened (Energy Information Administration [EIA]).
There are demand factors weighing down on oil prices, but these are structural, not born of the economic cycle. Although the US economy was 10 percent larger in 2013 than in 2005, consumption of motor gasoline, diesel, jet fuel, and other refined oil products was down 12 percent. Economists often say that the best solution to high oil prices is high oil prices, meaning that expensive oil is a strong incentive to conserve it and to develop alternatives. But there were a raft of other incentives too. In the United States, the Energy Policy Act and the Energy Independence and Security Act were just two of many new laws and initiatives across the world between 2004 and 2014 intended to promote energy conservation. Fuel economy standards for vehicles were raised, ethanol blending targets increased, and much more. Lower oil prices will relax the pressure to find further efficiencies, but past gains are seldom reversed.
Those surprised by the drop in oil prices believed two things: The shale revolution would be stifled by environmental concerns, and the Middle East was imploding politically. Often these beliefs served other causes, but whatever the motive of their proponents, reality turned out differently. The quadrupling of oil prices between 2002 and 2012 financed improvements in drilling technology that paved the way for the shale revolution. In 2005, fewer than 150 oil wells were drilled into the Bakken formation beneath North Dakota, Montana, and Saskatchewan. Last year the total number of oil wells exceeded 2,000, with production surging from 2,500 barrels of oil per day in 2005 to approximately 1 million at the end of 2014 (North Dakota Geological Survey). Today, shale represents 5 percent of total oil consumption (EIA).
Even with technological improvements, shale only makes commercial sense when oil prices are north of $30 per barrel, and in some places north of $75 (EIA). What kept oil prices high and US shale production in business was concern that tensions in the Middle East would crimp production or create uncertainty in supply. In the first half of 2014, news outlets were filled with stories of Libya disintegrating and ISIS running amok in the oil fields of Iraq and Syria. These concerns prompted financial investors to build up long positions in Brent and West Texas Intermediate oil futures contracts, equivalent to 650 million barrels of oil (KempEnergy).
In the wonderful vision of hindsight, this storyline was blown on June 22, 2014, when two supertankers loaded 1.3 million barrels of crude at the port of Tobruk in eastern Libya. Libya's production, which had dropped from 1.8 million barrels per day to just 250,000 by May 2014, rebounded to 900,000 by August. ISIS won more free airtime than oil wells, and production in Iraq and Syria has not fallen substantially. As oil prices slipped, investors began bailing out of their positions, accelerating price declines. Open interest suggests that 60 percent of the net long position in oil futures had disappeared by September.
Financial markets overestimated the challenges to oil supply. Their capitulation made the slump in oil prices abrupt. Today, financial markets are underestimating the structural nature of reduced demand and increased supply. The strength of the world economy will likely surprise on the upside. Political pressures may mount, but policymakers should hold their nerve and not be frightened into rash decisions. They should let part of the dividend from lower oil prices boost private consumption and investment and use part of it to dismantle energy subsidies.
