The lessons from cheap oil

By: Frank Yunker

Date: 2014-12-18

There are several lessons to be taken from the current decline in gas prices. To begin with, people (and thus corporations) react to incentives. High oil and prices have led to the debate about shale oil and fracking.

Remember that the cost of production is not the same for everyone, so some corporations (according to Wikipedia) can produce shale oil at $25 a barrel and some for $95 a barrel. Obviously, as the price rises above $100 for a sustained period of time, corporations who produce even at $95 a barrel are eager to enter the market. Students often make the mistake of assuming everybody can produce at the same price and therefore should be able to sell at the same price. But not every shale fracking experience is equal. Costs to extract the oil can vary widely. The start-up costs are expensive, so the incentive to get into the market is there only when the long term expectations are for high oil prices.

So, private drillers on private land anticipated the prices would remain high a long time. OPEC seemed to have a strong grip on price and a few solar panels and windmills in America were not enough to offset the growing world demand from places like India or China.
In 2012, the Presidential campaign argued about the price of oil and gas. The Romney campaign stated - accurately - that the number of new leases on Federal land fell sharply during the first 4 years of the Obama administration. Production on Federal lands also decreased, though it had been steadily decreasing since the middle of the Bush administration. Newt Gingrich also made the claim that if he became the nominee of the Republican party and he subsequently won the election, his policies would bring gas prices below $2.50 per gallon.

Quoting President Obama from a March 15, 2012 speech, "They tell the same story. They head down to the gas-- gas station. They make sure a few cameras are following them. And then they start acting like, we've got a magic wand and we will give you cheap gas forever if you just elect us."

So, Obama did not believe gas prices would ever get below $2.50 a gallon, yet two and a half years later here we are. Oil is less that $60 per barrel, down from a high of $110 from a few years ago. What does this prove beyond that some politicians do and other politicians do not understand the basic principles of economics?

The market works. People (and thus corporations) enter and exit the market all the time. If the trend continues long term, Americans will feel better with a bit more cash left over at the end of the week. Russia will enter a tailspin - interest rates on the ruble jumped from 10% to 17% just last week. Venezuela will find socialism unffordable as oil revenues collapse. The economic train-wreck will ugly.

And then what? If prices remain low, the shale oil discussion will disappear. Governor Cuomo will finally render his verdict on fracking in New York State to a sparse audience with little or no impact. Oil pricing this low makes shale fracking and extraction uneconomical. Suppliers will be getting out of the market. And if suppliers leave the market, guess what?

It all starts over again.