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December 15, 2014

Why Plunging Oil Prices Could Crash The U.S. Economy

By Wolf Richter at Wolf Street

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.

Courtesy Wolf Richter at WolfStreet.com (EconMatters archive HERE)

The views and opinions expressed herein are the author's own, and do not necessarily reflect those of EconMatters.

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