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The two sides of cheaper gas

Hydrocarbon Engineering,

Charles L. Perry of the Brookings Institution explained in a recent report that, as the price of crude oil has dropped over 26% since June, prices at the pump have fallen 15% to US$ 3.17/gal. That translates to savings of approximately US$ 500 per household, similar to what consumer tax cuts or transfer payments would do to consumer purchasing power (but at no cost to taxpayers). As prices also fall for fuel intensive industries such as transportation, trucking and delivery other prices to consumers will fall as well.

However, there is a catch: the marginal cost of maintaining oil production in the US is relatively high. If oil prices were to fall far enough, fracking would become too costly and the industry would contract.

The development of fracking as a new technology for mining crude oil has made the US a major oil producer with output levels about to surpass those of Saudi Arabia. There are several benefits. More domestic production helps free the US from dependence on terrorist states, oligarchies and other non-democracies for energy needs.

Furthermore, is these new supplies didn’t exist, oil prices would have risen much higher in the face of rapidly rising oil demand from China and other large developing nations. Equally important, developing these fields and maintaining their production has been a critical source of new jobs for skilled production workers during the economic recovery and expansion. That growth process is expected to go much further.

Why are prices declining?

The demand and supply sides of the oil market have both contributed to the recent price declines. On the demand side, most of the world’s economies have continued to slump, with Europe, China and most developing nations growing slower than expected. On the supply side, Saudi Arabia – the lowest cost producer – has historically carried its production within a modest range so as to offset short term fluctuations in the global supply demand balance. This time, the Saudis and the other Gulf States have not done so.

Perry speculates that this may be because the Saudis want to discipline other low cost producers into sharing the burden of reducing output to maintain prices. They may be holding down prices to starve Iran and other political rivals of needed revenues and, as some believe, to starve Russia of revenues at the behest of the US. Or they may simply want to maintain market share rather than cut output to support prices. This last point would be consistent with a concern about how rapidly the US share is growing.

Some industry experts estimate that if prices fell below US$ 70/bbl, it could make some US production unprofitable. The recent oil price decline has not gone that far, but it has highlighted the risk that prices could fall much lower. The stock price of companies in the fracking field have been among the hardest hit in the market decline.

In short, now that US employment has become sensitive to oil production, lower prices at the pump may have costs as well as benefits. With crude prices at levels that encourage continued development of US oil fields, global demand will have to rise steadily to absorb that capacity. Indeed, there’s a sweet spot prices satisfy consumers while production incentives remain strong. However, Perry suggests that the world markets may not find that price anytime soon.

Adapted from a report by Emma McAleavey.

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