Monday, June 24, 2013

Why Cheap Gasoline Could Be Bad For America's Economic Comeback

Oil prices have fallen in the past week, with benchmark Brent crude down more than 5% to less than $100 a barrel on Monday morning.


West Texas Intermediate is now trading at $93. With the market plunging and China on the cusp of a liquidity crisis, oil looks likely to continue its swoon. Is it too soon to see relief at the gasoline pump on the horizon? And would that even be a good thing?

The average price of a gallon of gasoline in the United States is $3.566. Wouldn’t it be nice if we could go back to the days of $2.50? If you drive around 15,000 miles a year a $1 drop in the price of gas would save you about $600.

What would be the savings to the nation if we spread that buck-a-gallon savings across the 350 million gallons of gasoline we burn every day? It comes to more than $125 billion a year. And that’s only the direct fuel costs.

Cheaper fuel means cheaper transportation for everything you want and need, adding billions more in savings. So how much would oil have to fall to get us $2.50 gas? Looking at recent history, when we’ve had $2.50 gasoline oil was roughly $60 a barrel — a level last seen in 2009. So we should all be hoping for $60 oil then, right? Maybe.

But maybe not. America is, of course, in the midst of an unprecedented oil boom. Thanks to advances in drilling and fracking, oil companies have figured out how to develop massive reserves in fields like the Bakken and Eagle Ford.

Since 2008 U.S. oil output is up 43%, including a massive 1 million barrel per day gain in 2012. This year, for the first time in decades, the U.S. relies less on imported oil than on domestic supplies.

According to IHS IHS +0.77%- CERA, the boom in unconventional oil and gas supports 1.7 million jobs, generates some $70 billion in federal, state and local taxes, and adds roughly $250 billion a year to the U.S. gross domestic product.

And all those numbers are set to grow in the years to come. But only if oil prices stay high. It’s high prices that incentivized drillers to develop the Eagle Ford and Bakken — the two biggest contributors to oil growth.

The average costs of getting a barrel of oil out of those fields is between $60 and $65 a barrel, according to Morgan Stanley MS -2.05%. That includes the costs of surveying, drilling, fracking, processing, transporting, taxes and royalties (but excludes costs of land acquisition). At current prices companies will go right on drilling.

But if for any reason oil were to drop to $60, activity would quickly dry up. And considering that the average unconventional oil well declines in volume by more than 50% in its first year, it wouldn’t take long for domestic supplies to slump — and for jobs to slump with it. So then we should be hoping for a continuation of $100 oil? Maybe?

Michael Levi doesn’t think so. He’s a fellow at the Council on Foreign Relations and author of the recently published book “The Power Surge: Energy, Opportunity, and the Battle For America’s Future.“

I sat down with him in Houston last week to discuss the state of the energy world, and asked him whether higher or lower oil prices would be better for America.

“One of the arguments I make in the book in some detail is that if we cut our consumption and prices fell and we had less domestic production, then that would still be a net positive for us,” says Levi. “The way I think about high oil output in response to high oil prices is by an analogy with white blood cell counts in response to illness.

When you get sick you want your white blood cell count to go up because your body is fighting that illness and making that illness less consequential for you. But you don’t want to get sick just so that you can produce more white blood cells. I think roughly the same way when it comes to high oil prices and greater U.S. oil production.

We would be better off with lower oil prices and lower oil production.” It’s an interesting analogy, the implication being that innovative drilling techniques are a kind of domestic immune response to high oil prices.

But it’s not a view shared by Carl Tricoli, the president of energy-focused private equity group Denham Capital. We discussed the issue among many others in a wide-ranging conversation last week. Tricoli believes that domestic energy independence is a very worthwhile goal.

Not necessarily via greater oil and gas output, but through an optimized mix of fossil fuels, nuclear and renewables.

Of course, more domestic oil is a vital ingredient in that mix. “I like energy independence. If you’re looking at it from a macro basis, what is the impact on the economy of paying a little bit more for your fuel versus the enormous cost of arming myself and protecting myself in order to make sure I’m protecting the fuel imports I need?” says Tricoli, adding that the more energy security America enjoys, the less we need to spend stationing soldiers and sailors in the Middle East.

“ Which means that the money I’m spending on domestic fuel is going into the economy and promoting the economy” rather than sending U.S. wealth into the coffers of OPEC nations. Tricoli is biased, of course.

He and his investors have a big stake in domestic oil and gas production. Besides, because oil is a global commodity, as long at the U.S. has to rely on a meaningful amount of imports, we’ll need to protect shipping lanes or be exposed to price volatility even on domestic barrels.

Levi, on the other hand, thinks that reducing activity in the U.S. oilpatch could spur innovations and investment in other parts of the economy.

Says Levi: “Split the economy into oil producers and oil consumers. What happens if you have lower prices and less domestic production? The consuming side is better off; they are paying less for their oil. The producing side is a bunch of resources: capital, labor, ingenuity, technology that can be put to other productive uses.

The productive use of oil production is to feed oil into oil consumption. And so the value is the value delivered to the consumer. If the consumer can get a better value by buying imported oil for cheaper it’s not clear to me that you add a huge amount of extra value by boosting domestic oil — it’s a bit of a Rube Goldberg machine.”

So what Levi is saying is that if all this American ingenuity weren’t going into shale plays then it would be going into inventing the next Facebook FB -2.43% or the next Apple AAPL -2.65% or reinvigorating Detroit or whatever.

So why isn’t that happening simultaneously? I ask him. Doesn’t America have enough capital and labor to do both at the same time? “There are limits,” counters Levi. “There is a limited number of scientists and engineers in the country.

There are a limited number of entrepreneurs. You can’t invest an unlimited capital in everything without interest rates going up. So there are constraints on that.”Really? Tricoli doesn’t see any real limit on capital or entrepreneurialism. “I am a firm believer in the capitalist system as an allocator of resources,” he says.

“We don’t have Apple and Microsoft MSFT +1.35% because somebody decided we should reallocate resources out of Detroit and put them in Silicon Valley.” Besides, he says, “having a secure source of energy gives the entire economy a competitive advantage that enables all this other stuff to happen.”

Levi, naturally, offers a caveat: “ There’s one complication to the story. What I’m telling you is true in the long run but not necessarily true in a depressed economy.

So having a stimulus to job creation and capital creation in a depressed economy can give you outsized benefits.” Ok. Everyone agrees that the domestic oil and gas boom was beneficial for getting the country out of the economic ditch. We needed high oil prices to accomplish that.

But now that things are starting to stabilize, maybe the American Oil Boom has outlived its usefulness? So what’s the ideal price of oil (and gasoline) for America?

I suppose it all depends on your point of view. If you’re a rabid anti-fracking, anti-oil idealist who would rather we all live in caves than burn fossil fuels, then you want to see oil prices rocketing higher (even if it means a healthy domestic oil industry and a richer OPEC) because that will incentivize changes in technology and behavior away from petroleum.

But for the rest of us, what we should want to see is oil staying in the sweet spot it’s in now — just high enough to keep the drill bits turning and frack crews busy in the shale plays, but not so high that it starts putting an unacceptable pinch on motorists.

But history says oil prices don’t stay stable for long. Unconventional U.S. oil has been the wildcard in the global oil industry for the past three years. Growing U.S. supply meant that NATO could assist in the overthrow of Libya’s Muammar Ghadafi without worrying too much about the impact that losing 1 million bpd of Libyan crude would have on world markets.

U.S. supplies have also supported the deepening of sanctions on Iran that are keeping an estimated 1.5 million bpd of oil off the market. But Libya’s oil output is roaring back. Iraq is growing fast. West Africa has enormous potential. Venezuela could boost output 1 million bpd if it ever got its act together.

Even Mexico is talking about allowing private investment into its state-run monopoly system. Saudi oil minister Ali Al-Naimi has said repeatedly that $100 a barrel is a “reasonable price” for Brent crude. But if supply growth continues apace (and if demand stumbles in the wake of China’s emerging liquidity crisis) OPEC might have to cut output to defend that $100.

Or there’s another possibility. America has proven that it has the resource base to spur miraculous production growth and has thus emerged as a true challenge to OPEC’s control of the oil market. If the cartel wants to maintain its power over oil supplies in the long run, then wouldn’t it make sense for its members to join together to open the spigots, drive down prices below U.S. marginal costs wipe out the shale oil threat?

A year of $60 oil might play havoc with the budgets of OPEC nations, but it would significantly weaken U.S. independent oil companies and make them think twice before plunging back into U.S. shale plays. This would allow OPEC to consolidate its market share.

What would be bad for the American oil companies, would of course be good for American motorists. It’s the perfect cover for OPEC: our over-production may be destroying your oil companies, but we’re doing you a favor every time you fill up your tank. If Michael Levi’s right that would be good for America, and the money we save at the pump will be free to seed some other worthy venture.

forbes.com

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