In a normal economic times falling energy costs would be considered unadulterated good news. The facts are simple. No one buys a barrel of oil to display above the mantle. No one derives happiness from a lump of coal. Energy is simply a means to do or get the things that we want. We use it to stay warm, to move from Point A to Point B, to transport our goods, to cook our food, and to power our homes, factories, theaters, offices, and stadiums. If we could do all these things without energy, we would happily never drill a well or build a windmill. The lower the cost of energy, the cheaper and more abundant all the things we want become.
This is not economics, it is basic common sense. But these are not normal economic times, and the mathematics, at least for the United States, have become more complicated.
Most economists agree that the bright spot for the U.S. over the past few years has been the surge in energy production, which some have even called the “American Energy Revolution”. The stunning improvements in drilling and recovery technologies has led to a dramatic 45% increase in U.S. energy production since 2007, according to the International Energy Agency (IEA). And while some suggest that the change was motivated by our lingering frustration over foreign energy dependence, it really comes down to dollars and cents. The dramatic increase in the price of oil over the last seven or eight years, completely changed the investment dynamics of the domestic industry and made profitable many types of formerly unappealing drilling sites, thereby increasing job creation in the industry. What's more, the jobs created by the boom were generally high paying and full time, thereby bucking the broader employment trend of low paying part time work.
The big question that most investors and drillers should have been asking, but never really did, was why oil rocketed up from $20 a barrel in 2001 to more than $150 barrel in 2007, before stabilizing at around $100 a barrel for much of the past five years. Was oil five times more needed in 2012 than it was in 2002? See my commentary last week on this subject.
Despite the analysts' recent discovery of a largely mythical supply/demand imbalance, the numbers do not explain the rapid and dramatic decrease in price. Yes, supply is up, but so is demand. And these trends have been ongoing for quite some time, so why the sudden sell off now? Instead, I believe that oil prices over the last decade has been driven by the same monetary dynamics that pushed up the prices of other commodities, like gold, or of financial assets, such as stocks, bonds, and real estate. I believe that oil headed higher because the Fed was printing money, and everyone thought that the Fed would keep printing. But now we have reached a point where the majority of analysts believe that the era of easy money is coming to an end. And while I do not believe that we are about to turn that monetary page, my view is decidedly in the minority. Could it be a coincidence that oil started falling when the mass of analysts came to believe the Fed would finally tighten?
If I am wrong and the Fed actually begins a sustained increase in rates starting in 2015, oil prices may very well stay low for a long time. But apart from the fact that our broad economy can't tolerate higher interest rates, an extended drop in oil prices may create conditions that further force the Fed's hand to reverse course.
If prices stay low for very long, many of the domestic drilling projects that have been undertaken over the past few years could become unprofitable, and plans for further investment into the sector would be shelved. Evidence suggests that this is already happening. Reuters recently reported a drop of almost 40 percent in new well permits issued across the United States in November (this was before the major oil price drops seen in December).
