How Is This Even A Question? Oil Price Drop is Great

The recent drop in oil prices has been met with a surprising amount of negativity, as if something bad is happening.  This strikes me as insane.  The world uses 90 or so million barrels of oil a day.  The recent $30+ price drop in oil thus equals a world savings of $1 trillion a year.

Sure, oil companies and their suppliers are worse off (and believe me, I care -- a lot of my portfolio was invested in such things when oil started dropping).  But the economy as a whole is clearly better off and wealthier.

To understand why, the analysis we need to undertake is an exact parallel of the broken window fallacy analysis.  Its sort of a healing window analysis.

After the oil price drop, consumers have a trillion dollars more and oil producers have a trillion dollars less.  Even right?  Actually, not.  Because consumers then spend that trillion on other things.  Those other manufacturers and producers get the trillion dollars lost to the oil industry.  Still even, right?  No.  Think of it this way:

Before the price drop

  • Oil companies have $1 trillion extra revenue
  • Other producers have no extra revenue
  • Consumers have 90 million barrels a day of oil

After the price drop

  • Oil companies have no extra revenue
  • Other producers have $1 trillion extra revenue
  • Consumers have 90 million barrels a day of oil AND $1 trillion of extra stuff (goods, service, savings, etc)

The world in the second case is wealthier.  And this is assuming all the people involved are private parties.   In fact, much of the oil revenue drop comes out of the hands of  value-destroying governments so that in fact the wealth increase in the price drop scenario is actually likely even greater than in this simplistic analysis.

Postscript:  OK, yes I am ignoring any cost of carbon pollution.  But the market is not set up to price that, and readers will know that I am skeptical that the cost is that high.  Never-the-less, this is a separate issue that if it needs to be dealt with should be dealt with as a carbon tax on fuels.  The price drop should not affect the value of that tax.  Or another way to put it, if one thinks the tax should be $30 per ton based on a $30 cost of carbon, it should be $30 per ton at $100 oil and $30 per ton at $60 oil.

  • Daniel

    Err..shouldn't your comparison be:

    Consumers have 90 million barrels a day of oil AND oil producers have $1 trillion of extra stuff (goods, service, savings, etc.)

    Vs.

    Consumers have 90 million barrels a day of oil AND $1 trillion of extra stuff (goods, service, savings, etc)

    Not seeing a net change, unless you mean specific to the US economy and taking money away from people like OPEC.

    Am I viewing your example incorrectly?

    The other big concern is creating further negative attitudes towards the US petrodollar.

  • Shane

    I learn more from you on macro economics than I ever will in a class or from a book ... Thank You :)

  • Skeptiker

    There is however one caveat to your analysis. It highly depends on where the drop in prices situated. Less demand or more supply? Less demand only shows that the recovery was based on over production, meaning that the economy is worse off than thought. More supply actually would be a good thing, because it would actually be your case. So what is it?

  • Tim

    Yep. Oil producers aren't going to stick that trillion bucks in their collective sock drawer.

  • Mike Powers

    Low oil prices are a problem because American shale gas is only worth buying when Saudi oil is expensive. If Saudi oil is cheap, then there's no reason to spend the money needed to refit your refineries to handle American shale gas, and so American shale gas production shuts down because it can't find buyers and all those producers go out of business. Then Saudi oil gets expensive again, UNEXPECTEDLY.

    http://www.telegraph.co.uk/finance/newsbysector/energy/oilandgas/11268611/OPEC-Saudi-Prince-says-Riyadh-wont-cut-oil-unless-others-follow.html

  • NL7

    Calculating the social cost of marginal carbon isn't all that different from the Drake Equation, since there are many variables and lots of them are difficult to estimate, multiplying the error. And both of them could be wildly offset by factors that we entirely discount or fail to predict, rendering the prediction crazily off base.

  • J_W_W

    During the last Presidential election they kept asking "what would you do to spur on the economy". My analysis of that question for the US would always be "dramatically reduce energy prices". Energy drives the economy. Cheap energy lets us do more.

    BTW WRT the idea of the oil companies having $1 trillion vs the consumers having $1. The real rub there is that if the oil companies have that money than that $1 belongs to the "1%" who are invested in oil companies, if the consumers have that money than that $1 that the "99%" get. Cheap energy give us exactly what the Democrats claim to want, but the irony is they fight cheap energy like its the devil.

  • WB

    Thank you. I've been thinking this for a while - every time I look at a Federal Reserve inflation index that excludes oil and food prices. How convenient to ignore perhaps the two most essential purchases that everyone has to make (apart from shelter). One slight offset to the $1T savings is the decline that will be realized in oil field drilling and supporting services but that is isolated and will be swamped by the widespread benefits everywhere else. Hope it lasts.

  • Harry

    You nailed it, Coyote. I really liked the knee-jerk dip in stock prices today; it may have confounded Macros' models. Nearly all the traders use the same models, or they would be fired by the bankers, who think they are investment advisors, a fatal conceit.

    Lower oil prices are like manna from heaven, unless you are invested in electric luxury automobiles. Expect some vigorous resistance. I look forward to a lower heating bill.

  • LoneSnark

    I agree, lower oil prices are undeniably a good thing (barring the risk of too low and a catastrophic collapse of the industry). However, your explanation is mostly wrong. Oil producers do not sit on the dollars they earn, they spend them. True, being governments mean they will spend the money badly, so taking the money out of their hands is a nearly dollar for dollar improvement all by itself. However, even factoring that out, say all the world's oil came from private owners in Texas, it is still good that the good investors from Texas lose their income as well.

    It is rather misleading to think of this in terms of dollars, as the dollars really don't matter. Remember, every dollar I pay the oil company they themselves should spend. The number of times a year a dollar gets spent is not an input we can calculate with, but a result determined by individuals operating within the constraints of reality. It is reasonable to think that oil companies are more likely to spend/invest money that individuals would have otherwise left in their pocket as direct savings.

    Therefore, following the money is a useless analysis. We should follow the incentives, which is what prices are. A lot of human effort was being wasted economizing on oil, and lots of other potential human endeavors went unfulfilled due to the disincentive of high oil prices. High oil prices cause lots of productive activity to be abandoned. Otherwise profitable businesses shutdown or reduce production. Travel is curtailed. Think of the highly productive factory worker opting to take a lower paying job just so he can utilize mass transit getting there. Both international trade is lower and domestic trade is lower, with resultant loss of economies of scale as producers get smaller and loss of scales of markets as producers face less competition from each other.

    Of course, this presumes oil prices were high relative to the costs of production. If oil really costs the high price to produce, then all the effort expended and abandoned activity economizing on oil's use was worth it to secure production at the oil price we needed.

  • Aheho

    You are forgetting the sage advice of Scott Sumner: Never reason from a price change.

    A fall in the price of oil can be good or it can be bad. It depends on what is driving the change: supply side factors or demand side factors.

    The supply side factors are the shale/fracking revolution in the United States and the ramping up of oil output from Libya. Both good things.
    The demand side factors is the prospect of a slowing of the global economy (Europe and China), This is a bad thing.

    On balance, I agree with you that it's a good thing, particularly for Americans, however context matters. The price drop alone isn't enough evidence to tell whether this is a good or bad development.

  • Mercury

    Well, it follows that deflation in general (at least for necessities) maybe isn't quite as universally BAD as we've been led to believe either.

  • Zachriel

    Coyote Blog: OK, yes I am ignoring any cost of carbon pollution. But the market is not set up to price that, and readers will know that I am skeptical that the cost is that high. Never-the-less, this is a separate issue that if it needs to be dealt with should be dealt with as a carbon tax on fuels. The price drop should not affect the value of that tax.

    The problem is that lower prices encourages consumption and discourages the search for alternatives. As there is no carbon tax in most places, there is a downside of lowering prices in terms of carbon pollution.

    If there were a significant carbon tax, then increased supplies could be used to leverage the revamping of the economy. But that's not what is happening. Rather, it is being spent now at a cost to the future, some of which cost can't be recovered.

  • J Calvert

    Well, I work for a small oil company. So I consider this a horrible development....

  • skhpcola

    CO2 isn't a pollutant, therefore taxing it in any fashion is a farce. Leftists and retards talk about taxing carbon. Sentient humans know that this agitprop is BS.

  • What the...

    But - politicians. Never one to miss an opportunity to increase the take from the public this is like blood in the water to them. Since fuel prices are lower an increase in gas taxes would not cause as big a blowback now, especially if it doesn't increase prices back to pre-oil-price-fall-off-cliff levels.

    http://www.cnbc.com/id/102241157

    http://www.marketwatch.com/story/heres-why-us-states-are-mulling-a-tax-on-gas-as-oil-prices-crater-2014-12-11

    Never mind that miles driven is a better tool since ecars and hybrids aren't paying their share of road infrastructure use using a gas tax system (if you believe that gas taxes are directed to road infrastructure), or that rising fleet fuel economy lowers the amount collected (see tobacco tax).

    I know, I know ... libertarians desire less government and leaving money in the hands of the public. Problem is most of the American public can't think for themselves and is happy to be "governed" so that isn't happening anytime soon. Well happy enough not to revolt on those doing the governing anyway.

  • Nehemiah

    Not to worry, the states up north are talking about raising their gas tax rates so that those consumer savings get shifted into the government coffers. You cannot let mere citizens decide how to spend the fuel savings.

  • Nehemiah

    As skhpcola said, CO2 is not a pollutant. You know, of course, that ever time you exhale you are releasing carbon dioxide into the atmosphere.

  • Zachriel

    Animal respiration is roughly carbon-neutral.

  • Zachriel

    Tragedy of the commons

  • Zachriel

    The vast majority of climate scientists recognize that anthropogenic greenhouse gases will likely have deleterious effects on the Earth's climate.

  • skhpcola

    "The vast majority of 'climate scientists'" are full of shit. CO2 lags increases in average atmospheric temeratures by hundreds of years and is in no way causal. Water vapor is the most potent GHG and humanity scarcely can affect the concentration of that. "Climate change" is a farce, pushed by wannabe totalitarians and believed by retards and leftists...but I repeat myself.

  • Zachriel

    skhpcola: "The vast majority of 'climate scientists'" are full of shit.

    Yeah, those "scientists" doing "research" to make "discoveries".

    skhpcola: CO2 lags increases in average atmospheric temeratures by hundreds of years and is in no way causal.

    That is incorrect. The basic greenhouse effect due to CO2 has been known for over a century. Historically, atmospheric CO2 has acted as both cause and effect.

    skhpcola: Water vapor is the most potent GHG and humanity scarcely can affect the concentration of that.

    In fact, anthropogenic CO2 emissions cause warming, which increases atmospheric water vapor, a positive feedback.

  • skhpcola

    We think that you are ignorant of the facts and we know that you are full of shit, also. Nothing that you just drooled is true...even about the "climate" "scientists" doing "research" to make "discoveries." They--and you--are just leftist trolls trying to make the world a more primitive and poorer place. You proglodytes are an evil cult.

  • Tom Lindmark

    Good thoughts. Taking it one step further, initially the drop in prices represents simply a transfer of wealth. We know that the effect on the group losing wealth (oil producers) will most likely entali a cut in investment - a negative for the economy. The group gaining wealth (consumers for simplicity) may or may not spend their windfall. If they choose to save it or pay down debt then there is a potential negative overall outcome from the price decline as the decline in investment isn't offset. In the more likely scenario in which they consume a goodly portion of their increased disposable income then potentially the overall effect is positive. We simply don't know the outcome at this point in time.

  • bigmaq1980

    Yes. I think Coyote cuts the story a bit short. There is a shift that will have positive consequences for many. At the same time, the many in related to or geographically near to the centers for the oil industry will have negative effects.

    For those on the downside, beyond lower fuel costs (directly, and indirectly in the cost of goods), the only other mitigating factor is the possibility that the shift puts money in the hands of those who would generate even greater GDP (rising water floats all boats).

    It is not good news for those in Texas, North Dakota, Louisiana and other locations with significant percentage of GDP coming from oil and related industries. The hardest hit will be the towns dependent on the oil business.

    The bloom may be off on Texas...just in time for the new Governor.

  • MJ

    The problem is that lower prices encourages consumption

    Not when those lower prices are being brought about by lower consumption levels (which they currently are, at least in part).

    and discourages the search for alternatives.

    So what? Those alternatives will always be there, if and when they are ever needed / become feasible.

    If there were a significant carbon tax, then increased supplies could be used to leverage the revamping of the economy

    The purpose of a carbon tax is simply to internalize the externalities from burning carbon-based fuels, not to "revamp" the economy.

    Rather, it is being spent now at a cost to the future, some of which cost can't be recovered.

    I don't even know what this refers to, much less what it means.

  • MJ

    It is reasonable to think that oil companies are more likely to
    spend/invest money that individuals would have otherwise left in their
    pocket as direct savings.

    I don't think that's reasonable at all, especially if the phenomenon is a short-term one and the producers are not convinced that prices will stay where they are for very long. That's more of a disincentive to invest.

  • LoneSnark

    They need not invest their money in oil exploration.

  • Charles Clarke

    Yes, if Saudi oil is cheap, then we buy more of that now and shale oil is idled. Then after oil prices go up(this is assuming that renewable energy doesn't drive prices into the dirt), *we* have more oil left that can be pulled out of the ground, probably at lower cost due to technological improvements, and sold at higher prices. I'd like to be the one left with more oil. I'd like other folks to sell things to me cheaper.

  • Charles Clarke

    Yes, I would rather have individuals have the money. Especially when some of that 1% folks are in countries that aren't friendly to us.

    On the other hand, in our country, those 1% folks are probably more likely to invest in new technologies that will improve lives for us all.

    Best case would be if the 99 percenters would take their savings from dropping oil prices and invest it in companies that improve our lives, maybe even companies that make it easier to produce oil or avoid oil use.

  • Mike Powers

    There's a lot of startup cost for extraction --and there's a lot more cost to set up the supply lines that deliver raw stock to the refinery, setting up the refinery to handle that particular stock (not all crude oil is created equal), and many other costs associated with the industry.

    It's not like there's just a hose pipe sticking out of the ground and we turn the tap and oil comes out.

  • Charles Clarke

    True. It isn't instant and there are costs.

    But if those costs have already been spent, then basically we do just turn on the tap. We've seen that here in Colorado where pump jacks that used to only pump enough to keep the oil lease 'producing' have been more active with the higher prices. And we've had lots of new pumps, pipelines, etc go in also. Those facilities will probably still be around when prices go back up.

    And if those costs haven't been spent, there is no need to until prices go back up. New technology could even make that more efficient like horizontal drilling has.

  • Zachriel

    skhpcola: We think that you are ignorant of the facts

    Except that you are the one who just posted a fact-free comment.

    "the global temperature averaged across the world's land and ocean surfaces for October 2014 was the highest on record for the month ... The most recent 12-month period, November 2013–October 2014, broke the record (set just last month) for the all-time warmest 12-month period"
    http://www.ncdc.noaa.gov/sotc/global/2014/10

  • http://devilish-details.blogspot.com/ mesaeconoguy

    It is not your job to “revamp” the economy, especially based on fraudulent science.

  • Q46

    Carbon pollution: that's soot, carbon is.

    Carbon dioxide - without which no life on Earth - is no more pollution than water vapour or oxygen expelled from plants during photosynthesis, and Humans expel CO2 too as a byproduct of cellular respiration.

    Picky? Words have meaning and we should stick to them.

    And since carbon dioxide increase in the atmosphere are 'greening' the planet, particularly in desert areas, as observed from satellite, it is a positive externality.

    Since there is no demonstrable link between CO2 emissions and global warming outside natural variation and the numpties and their computer models have no idea how global warming affects climate taking into account all the things they clearly don't know, a bit premature to declare CO2 emission a negative externality... and in any case it is water vapour caused by retained heat that is the culprit.

    Tax water.

    Meanwhile if 90 billion barrels a day prior to price drop and 90 millions after, whatever is emitted remains constant.

    But price drop is due to lack of demand... the usual reason... so we are not actually getting the price differential more in extra goods purchased, we are just not buying, hence less oil required, hence price drop.

    This is why Governments are in spin and rinse encouraging everyone to spend, spend, spend on cheap debt to keep the taxes rolling in to squander. Precisely the policy that has caused the current economic depression, causes boom and bust cycles.

  • Zachriel

    MJ: The purpose of a carbon tax is simply to internalize the externalities from burning carbon-based fuels, not to "revamp" the economy.

    That is not correct. It's to discourage emissions and encourage use of alternatives.

    MJ: I don't even know what this refers to, much less what it means.

    The cost to revamp the energy economy is cheaper the sooner changeover begins, as well as causing less permanent damage to the climate and ecosystem.

  • Daublin

    Yes, I agree. However, we need merely observe that overall production is also increasing.

    This combination should mean that oil producers are simply more productive than they used to be. In other words, they are better at what they do. That has to be good for all of us.

  • Daublin

    To put the story in a more obvious way, imagine the extreme case where energy became free. Someone found a material, buried somewhere in the earth, that is so potent that a teaspoon of it will provide all a person's energy usage for wheir whole life.

    That would be good, wouldn't it? As such, movement toward that state should also be good, so long as there's no reason to suspect a discontinuity.

  • Zachriel

    Daublin: That would be good, wouldn't it?

    That would depend on balancing against any deleterious effects.

  • Mike Powers

    And what the Saudis are hoping is to undercut the American producers before those costs get spent, which is why low oil prices aren't necessarily a good thing.

    Or we could have a government that supports oil producers the way Russia and the OPEC states do, instead of knifing them in the back because Oil Is Sinful. But that's just crazy talk.

  • MJ

    That is not correct. It's to discourage emissions and encourage use of alternatives.

    That might be the implied or interpreted purpose for a statist, but it is most certainly not the textbook purpose for a carbon tax according to any microeconomic theory.

  • Zachriel

    MJ: That might be the implied or interpreted purpose for a statist, but it is most certainly not the textbook purpose for a carbon tax according to any microeconomic theory.

    Of course it is. People avoid taxes, so reduce emissions where they can, such as by finding other sources of energy that have lower emissions per unit of energy.

  • TruthisaPeskyThing

    A tremendous deficiency in America's understanding of oil -- when oil prices go up, very little of increased revenue goes to our oil companies; the bulk of it goes to OPEC governments. Increases in oil prices are like increases in taxes paid to foreign governments. Exxon is the largest private company, but it ranks 14th in the list of all oil companies. So as oil prices have gone down; consumers get a extra trillion dollars, and most of that trillion dollars is there because less $ goes to foreign governments.

  • Daniel

    Thanks for the enlightening reply.