This Is Why the Oil-Price Crash Will Maul the US Economy

The plunge in the price of oil that began in July acts like a tax cut, it is said, and will boost spending by consumers and businesses, and thus goose the US economy. Among the voices propagating this view is the UBS macro strategy team. It found that each $10-per-barrel drop in the price of oil would goose US GDP by 0.1%. If the average price in 2015 stays where it is today – down nearly $50 per barrel since June – you can expect a boost to GDP of 0.5%, which would be big for the otherwise crummy US recovery.

I don’t know what these good folks have been smoking, but I want some of it too.

The idea is this: if consumers and businesses spend less on gasoline, heating oil, diesel, jet fuel, and other energy-related products, they would feel like they just got a tax cut and would spend this money thus saved on other things. And somehow this would increase overall spending, and thus GDP.

Alas, the money spent on energy products is already included in GDP either under consumer spending or business spending. Any cut in prices will actually lower GDP by that amount. Now the hope is that consumers and businesses will spend all of this saved money on other things.

In this scenario, people living from paycheck-to-paycheck would spend these savings on food, or blow it on another dress, a pair of shoes, or electronic gadgets. High-income people who earn a lot more than they spend and might not even notice they saved $50 last month, would however increase their spending on other things by that amount. And rich folks, who saved $100,000 on fuel for their corporate jet last month, and who have no idea they saved that much, would also somehow take that money and buy another Hermes necklace for their mistress or something….

The assumption is that all this money saved from lower energy costs gets spent on other things by every economic entity, that no one saves any of this money, or god-forbid uses it to pay down credit cards or student loans – which would actually lower GDP. All this saved money must be spent on something else. That’s the assumption. And even that best-case scenario would just shift spending patterns from energy to other items, rather than increase spending. It would have zero impact on GDP.

Alas, many of the items consumers would buy, such as clothing, shoes, electronic gadgets, or Hermes necklaces, are imported and involve the US economy only via transportation and the sales channels. And these imported items would replace mostly American-made oil-based products.

Turns out, the American shale revolution, the very thing that caused the global oil glut and triggered the rout in oil prices, is pushing US oil imports to the margin. The Energy Information Administration points out in its December “Short-Term Energy Outlook”:

The share of total US liquid fuels consumption met by net imports fell from 60% in 2005 to an average of 33% in 2013. EIA expects the net import share to decline to 21% in 2015, which would be the lowest level since 1969.

So next year, it expects that 79% of US consumption of liquid fuels, such as gasoline, diesel, heating oil, jet fuel, etc., will be met by US production.

These products are American-made, involving American resources, well-paid American workers in the oil patch, American engineers, IT people, and researchers. The American oil and gas industry, for better or worse, and whatever the environmental consequences may be, invented fracking and developed the equipment necessary to do it. The industry is constantly spending money on perfecting methods and equipment. America is on the forefront in these technologies and the only major producing country to use them.

The economic impact from this boom goes far beyond the oil patch. Many items used in this industry, from frack sand to steel pipes to the most sophisticated equipment, are made in the US, often by well-paid workers. Materials and equipment get shipped across the country by US railroads. Pipelines get built. Crude gets transported via pipelines or oil trains to US refineries where it is refined into gasoline, diesel, heating oil, jet fuel, and other products, to be transported once again and sold to consumers and businesses or industrial users around the country. These industries have created an immense number of well-paid jobs. There is hardly any foreign involvement in this. Most of the money spent by the US oil and gas industry and its suppliers flows into US GDP.

Replacing part of this activity with imported clothes or shoes or necklaces or electronic gadgets would boost US economic growth? I mean, come on.

This machinery was built with debt, much of it junk debt. It requires a high price of oil to continue functioning. A $50-per-barrel drop, if maintained on average in 2015, which is entirely possible, would send much of the junk debt into default. It would strangle the flow of new money into the industry, a process that has already begun. If the money stops flowing, drilling projects will be cut. Many outfits would topple because they could no longer service their enormous debts. Much of this debt would blow up. Equity would be transferred from existing stockholders to creditors. Oil bust mayhem would spread in this all-American industry that has played such an outsized role in the otherwise crummy US recovery.

Assuming this price scenario, an implosion of the junk-bond bubble and the fracking boom will damage the US economy overall and devastate some local economies where drilling has become the main economic activity. And despite what the hype mongers on Wall Street are propagating in order to pump up stock valuations to ever crazier levels, markets are already in the process of sorting this out.

Wall Street made a killing on the junk-bond bubble and the fracking and offshore drilling booms. But now the tide has turned. Read…   Oil Bust Contagion Hits Wall Street, Banks Sit on Losses

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  18 comments for “This Is Why the Oil-Price Crash Will Maul the US Economy

  1. Vespa P200E
    Dec 15, 2014 at 1:35 pm

    Wolf,

    Good call on fracking implosion which may lead to junk bond implosion.

    Guess be careful on what you wish for low gas price as last bastion of hiring frenzy and good paying “manufacturing” job along with highly leveraged frackers may usher in the fracture to junk bond market not used to the word “default” and perhaps domino effect on the rest of the bond market (not to mention spider web of derivatives and counterparty risks unwinding).

    Could the bond market rout be the tipping point of equity market with most players all in for 2015 with smugness of invincible market?

  2. Dec 15, 2014 at 10:12 pm

    “The idea is this: if consumers and businesses spend less on gasoline, heating oil, diesel, jet fuel, and other energy-related products, they would feel like they just got a tax cut and would spend this money thus saved on other things. And somehow this would increase overall spending, and thus GDP.”

    Conventional wisdom is exactly backwards, what must be understood is that price is a consequence, never a cause. Nobody lowered the price of fuel in order to ‘raise heck’ in North Dakota or elsewhere.

    Fuel prices are low because customers (non-drillers) are spending less on gasoline, heating oil, diesel, jet fuel and other energy products. Not only are customers spending less in the US but more critically in European countries and the mysterious East.

    They are spending less b/c they cannot borrow, they are bankrupt. Our current price plunge has the Bank of Japan’s fingerprints all over it: monetary easing does not create new money (central banks are collateral constrained), it shifts funds from customers toward big business (drillers in Japan’s case) and the banks. The shift eliminates customer purchasing power which leads lower fuel prices. Instead of the hoped for inflation there is accelerating deflation: more easing more broke customers more deflation.

    Easing also shifts RISK even as interest rates are repressed. Risk that is not priced by interest rates must be compensated for somehow. Instead of rates rising, the currency is depreciated. Since all the world’s currencies cannot be depreciated at once the outcome is a (highly deflationary) strong dollar amplified by panic flight toward dollar’s relative safety. Any benefit from low fuel prices is overcome by currency volatility. In some countries such as Russia or Japan there is the small but increasing possibility of hyperinflation as citizens seek to obtain non-native currencies (hyperinflation is a form of currency arbitrage.)

    Once customers fail the drillers follow (are also worthless as bank collateral). Less driller output adversely affects customers who cannot support even very low prices.

    Instead of pricing the cost of extraction (plus returns) what is taking place now is the pricing of returns on consumption. Since only the smallest part of current fuel use (waste) is remunerative, (about 7% for commercial endeavors) the supportable price is likely to be very low indeed, perhaps $8 – 10/barrel or less. Of course, at that price the economy will have come to a screeching halt. I call this process ‘energy deflation’ and it is a) similar to Irving Fisher’s ‘Debt Deflation’ because it is self-reinforcing, and b) cannot be controlled or stopped by monetary/fiscal means once it has taken hold.

  3. VegasBob
    Dec 16, 2014 at 12:55 am

    I spoke to a friend in Houston tonight. He’s a manager at a luxury retailer, and says business has fallen off a cliff over the past few months.

    So either the oil price collapse is materially affecting the idle rich in Houston, or the entire economy is getting ready to fall off a cliff.

    Wile E. Coyote, anyone?

    • Michael Gorback
      Dec 16, 2014 at 4:14 pm

      I live in Houston and haven’t seen anything different but I don’t shop at the Galleria. You hear all sorts of speculation here. Some say real estate will fall 10-12%. Others say that would be good because we’re on the verge of a housing bubble. Others say there’s not enough housing supply as it is.

      Houston is on both ends of the energy sector. It’s home to E&P companies but there are also a lot of refineries that will benefit from low oil prices. The economy is also a lot more diverse than it used to be.

      It’s also fragmented and you can have feast in one part of town and famine elsewhere. Closing the Space Shuttle hit the southeast hard while the north was booming with new companies coming in.

      In 2008-9 there was no question that the area had been hit. There were lots of “For Sale” signs in yards and there were increased numbers of empty storefronts in the malls. I haven’t seen that.

  4. PL
    Dec 16, 2014 at 2:04 am

    I keep hearing about how shale has caused an oil glut.

    But when I look at the stats I see no glut —- I see production barely increasing at all

    12-1st half 89.68128717
    12-2nd half 89.83083083
    13-1st half 89.61196729
    13-2nd half 90.69364283
    14-1st half 91.10622417

    What I do see is Japan in a slow motion collapse — China slowing — the EU sinking — the US on life support.

    There may be a glut — but it is NOT a production related glut — it is a glut caused by a reduction in DEMAND.

    Which is of course caused by tanking global growth.

    • mick
      Dec 16, 2014 at 3:17 pm

      Well said.

    • Dec 17, 2014 at 10:42 pm

      PL, I don’t know where you got these number, but you’re wrong about there not being a BIG increase in crude oil production. There has been a 15%+ increase annually for the last three years.

      Per the US Energy Information Administration, total crude oil production in the US, in million bbl/day, with annual percentage increase:
      2010 – 5.48
      2011 – 5.65 +3%
      2012 – 6.50 + 15%
      2013 – 7.44 + 15%
      2014 – 8.60 +16%

      Currently, in Dec 2014, the US is producing over 9 million bbl/day. So from 2011 (average) to Dec. 2014, production (in million bbl/day) soared over 60%. That’s a massive increase!

      Here is the production data: http://www.eia.gov/forecasts/steo/tables/?tableNumber=3#

      It’s a glut, and it IS caused mostly by soaring production in the US. Global demand is still GROWING, but at a slower rate than global production, hence the surplus, or “glut.”

      • Pl
        Dec 18, 2014 at 12:47 am

        Those are Reuters numbers.

        Global production is most definitely nearly flat over the past year as demonstrated here https://oilprice.com/images/tinymce/James%2011/AE3430.jpg

        What has happened in the past 6 months that could be causing the price of oil to slide?

        I would have thought it was obvious – global growth is worsening.

        • Dec 18, 2014 at 7:24 am

          PL, thanks for clarifying that these are global production numbers. The difference in production between the 1st half of 2012 and the 1st half in 2014, based on these numbers, is about 1.5 million bbl/day, and growing.

          Demand is still growing but too slowly to use up this extra supply (economic growth is tepid at best, as you point out, and many efforts are undertaken everywhere to use less oil through increased efficiency, switch to other fuels such as bio fuels, use of mass transit, etc.). So crummy global growth comes at a time of increased supply.

  5. PL
    Dec 16, 2014 at 2:22 am

    If people put the money they save on energy costs and put it into a bank account the money will get loaned out many times over (fractional banking) so it will actually have a much greater impact on GDP than if the person were to immediately spend the savings.

    Also surely far more jobs are created when people have more money in their pockets to spend that if they were to continue paying higher energy prices — which primarily creates shale related jobs?

    When people have more spare cash they go to restaurants, they take on larger loans for cars and homes and other consumer goods — they go on vacation paying for hotels and air tickets.

    The consumer economy was built on consumption which was made possible by cheap oil for over a century.

    High priced oil destroys growth because it destroys consumption.

    It is absurd to claim that high oil prices are beneficial to GDP — they absolutely destroy GDP because the positive impact of high oil prices on shale industry jobs and industries absolutely cannot offset the disastrous impact on overall growth of expensive oil.

    Note that $60 oil is NOT cheap oil. It remains a tremendous drag on growth.

    See this research that came out as oil started to climb just after the turn of the century.

    HIGH PRICED OIL DESTROYS GROWTH

    According to the OECD Economics Department and the International Monetary Fund Research Department, a sustained $10 per barrel increase in oil prices from $25 to $35 would result in the OECD as a whole losing 0.4% of GDP in the first and second years of higher prices.

    http://www.iea.org/textbase/npsum/high_oil04sum.pdf

    This is also useful — it was put in front of investment banking clients of Prebon not long ago (and appeared in the FT) – you do NOT do that unless you are very certain of what you are saying:

    THE PERFECT STORM (see p. 59 onwards)

    The economy is a surplus energy equation, not a monetary one, and growth in output (and in the global population) since the Industrial Revolution has resulted from the harnessing of ever-greater quantities of energy. But the critical relationship between energy production and the energy cost of extraction is now deteriorating so rapidly that the economy as we have known it for more than two centuries is beginning to unravel.

    http://ftalphaville.ft.com/files/2013/01/Perfect-Storm-LR.pdf

    • Dec 17, 2014 at 11:01 pm

      PL, Gross Domestic Product (GDP) is a measure of spending. It attempts to account for the money that all economic entities (consumers, businesses, governments) spend for consumption or investment (in machinery, factories, etc., not mutual funds).

      As far as this GDP measure is concerned, it doesn’t matter where the money comes from; whether from earnings, savings, or borrowing is irrelevant.

      When you put money into savings, rather than spend it, it doesn’t enter into GDP at all. That’s why the Fed doesn’t want you to save. They want you to spend money so that it goes into the GDP calculations. Banks don’t need your money. They have more deposits than they can handle, and they can get all the money they need for free from the Fed.

      So when a consumer spends $50 a month less on gas, it’s actually a reduction of GDP of $50 a month. If the consumer spends the entire $50 thus saved on something else, GDP just stays even. There is still no benefit to GDP from lower gas prices.

      But some consumers/businesses won’t spend all the money they saved on gas, hence a reduction in GDP.

      And here is the problem pointed out in the article: by switching spending from gas (mostly American made) to smartphones and other things (often imported, and imports are subtracted from GDP) for long enough, it will reduce capex and other activities in the oil industry, and that’s a big detriment to GDP (and other aspects of the economy, such as jobs).

  6. GetReal
    Dec 16, 2014 at 11:59 am

    Some of these comments are beyond stupid. Lets just raise the price on Corn, Wheat and Soybeans to $50 a bushel, and electricity to 50 cents/kWh. All that extra spending goes straight into the GDP! Woohoo! Problem solved right? Do you think that consumers which make up 70 % of the GDP would rather spend $100 per tank of gas or $50? Do you you think they want to pay $80 or $40 for heating oil? Consumers will use the savings to purchase other things, that lead to more jobs, that lead to more taxes, that leads to more government spending, which leads to more jobs, which leads to more taxes, and on and on. All of sudden wages go up, the cost of oil goes back up, and therefore gas prices. The cycle continues. No one ever learns, and we have boom, bust, boom, bust forever. Until we as a world community figure out that excess profit eventually causes the problem, we will never break the cycle. I love profit, just not excessive profit. That’s what you get at anything above $85 a barrel.

    • PL
      Dec 18, 2014 at 1:16 am

      Exactly!

  7. Kelly Nickell
    Dec 16, 2014 at 10:30 pm

    Two things that may absorb the impact here. The first revolves around the ACA and a whole lot of new customers to the healthcare business that have a real ability to fill the gap, as people that have been putting off health decisions due to lack of ability to pay for them, begin to have that ability; lot’s of Americans in that demographic.

    The other is the continued reduction in ROI price points that are coming from the efficiencies being realized almost daily in solar and wind, battery and capacitance technologies, and all of the science, technology, and innovation that contributes to that space, and some of the outliers such as LIDAR, chip technology, and other advancements in way of life enhancements, not to mention the national independence that comes with that on a global plain.

    I’m willing to bet that the shift from the oil patch back to technology, science, and basic innovation, with the added benefit of about forty to fifty million new customers to healthcare will happen on a broader scale than all of the best fracking has the ability to keep pace with.

    Smart money always finds a place to be.

    The oil business is not it. Broadly available healthcare and renewables, and their associated build out, is.

  8. Julian the Apostate
    Dec 17, 2014 at 7:06 am

    Kelly, while I agree with you in principle that in a normal market the ‘smart money’ would sort out the oil problem. But the market is no longer normal, and ‘smart money’ has become an oximoron. Also we are dealing with the Prime Mover. There have only been three in written history- literal horsepower, the external combustion engine (steam) and the internal combustion engine. The last changeover took a half century to fully implement.
    Your other panacea, medicine, will slow to a crawl due to government takeover. People are already hunting workarounds to that problem, which will result in sideways motion with a downtrend. I am not sanguine as to the future efficacy of either in the near term.

  9. ralph
    Dec 17, 2014 at 8:25 pm

    As usual the unseen economic problem appears.
    This is all nonsense.
    For every dollar less from a consumer, a dollar disappears from a producer. when the bubble blew in housing, consumers did not benefit. when the bubble blows in oil, consumers will not benefit. read david stockmans piece.
    There is a worldwide decline in oil demand. led by china and others- brazil in recession, europe in recession, india barely growing, china at 7% published, but probably 2%-or 0. we didnt just wake up and have a 1/2 price sale.

  10. Richard Date
    Dec 18, 2014 at 1:58 pm

    WTI below 55
    DJI up 600 points in 2 days
    oops make that 700

  11. PL
    Dec 19, 2014 at 12:19 am

    “PL, thanks for clarifying that these are global production numbers. The difference in production between the 1st half of 2012 and the 1st half in 2014, based on these numbers, is about 1.5 million bbl/day, and growing.”

    The only number that counts in the global production number.

    12-1st half 89.68128717
    12-2nd half 89.83083083
    13-1st half 89.61196729
    13-2nd half 90.69364283
    14-1st half 91.10622417

    Wolf – we have added 1.4 million barrels of oil per day since 2012. That is well under 1% per year.

    You used the word glut which implies that this is a production glut.

    There is no production glut — production is barely increasing.

    Therefore the conclusion has to be that:

    1. global growth is killing demand (I saw an article on Zero Hedge indicating that the Saudis are stating exactly that)

    OR

    2. That the US is pushing down the price of oil in an attempt to destroy Putin

    If it is one then we are in one hell of a lot of trouble because even oil $50 oil is far too expensive to restore growth and second even if we do get a slight spurt of growth out of this drop in oil prices, suppliers are starting to slash capex massively … if demand picks up there will be a bottleneck — and do we not go back to $147 or higher oil?

    The only thing that has been offsetting the drop in conventional oil is shale oil — and as we can see since 2012 we are barely keeping out heads above water.

    As we know, shale plays are short-lived, so many of these fields where are are pumping like there is no tomorrow (because there is no tomorrow when global production peaks) therefore we will peak on shale sooner than later.

    So if shale peaks — and conventional oil continues sliding (and how can that slide not accelerate when capex is being slashed) — then we must surely be near a global production peak.

    The fact that total production is virtually stagnant since 2012 leads me to believe that we are very close to total peak oil.

    Desperate and dangerous times.

    BTW – I posted a couple of replies to your oil/gdp reply to mine — I didn’t see that either of them were published.

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