See baconbacon’s comment below and my response. I may well have blown this big time.

World Oil Market.jpg

I had been meaning to write a post about oil prices and the economy. Now this article in the New Yorker by James Surowiecki has beat me to it–and done it well.

It’s not that long and so I recommend reading it. I’ll hit one highlight and then add a couple of my own thoughts.

Investors aren’t just worried that oil is the canary in the global coal mine, though. They’re also worried that low oil prices are, in themselves, hurting the U.S. economy. For instance, as oil prices have plummeted, shale-oil drillers have sharply reduced their investments, and that has hit places like North Dakota and Oklahoma hard. These setbacks are real, but they should be seen in proportion. Even after the shale revolution, the U.S. is still very much a net consumer of oil, importing five million more barrels of oil a day than it exports. That means that the drop in oil prices has amounted to a windfall for consumers–one that Harris estimates saved them a hundred and ninety billion dollars over the past six quarters. In other words, cheap oil means Americans have an extra ten billion dollars in their pockets every month.

I have been saying something similar to students and colleagues who have asked. Given that the United States is a net importer of oil, a decrease in the price of oil helps consumers more than it hurts producers. Of course, we should never simply reason from a price decrease. We should always ask what caused the price change. It has to be due either to a drop in demand or an increase in supply (or some combination–see Figure above) or an increase in supply that exceeds an increase in demand. How do we tell? By checking the equilibrium quantity and not just the price. Up until recently, the equilibrium quantity has increased as the price has dropped. Specifically, from 2014 to 2015, total world production rose from an average of 93.3 million barrels per day (mbd) to an average of 95.6 mbd. From 2014 to 2015, total world consumption rose from an average of 92.4 mbd to an average of 93.8 mbd. (Why the difference between production and consumption? A build up of inventories.) Those data, combined with the approximately $45 drop in price from 2014 to 2105, suggest that the outward shift in supply exceeds any leftward shift in demand.

Had I been Surowiecki, I would not have written the last sentence that I quoted from him above. Why? Because he focuses on consumers and ignores producers. If his method of estimating is correct, then yes, consumers have an extra ten billion dollars per month. And producers have approximately ten billion dollars less a month. It’s not a wash because American producers produce less than the amount consumers consume: that’s what it means to say that the United States is a net importer. U.S. producers now produce about 75% of the amount consumed by Americans. So that means $7.5 billion a month less in the hands of producers. So the relevant net gain (I’m ignoring little bits of triangle producer loss and consumer gain) to the U.S. economy is more like $2.5 billion a month.

Also, like Surowiecki, I don’t think the drop in oil prices should have tanked the stock market. But I’m not as certain as he is that participants are making an error. Perhaps they are responding to other information. My gut feel is that he’s right in assuming an overreaction in the stock market. But that’s my gut feel, not more.

HT2 Jeff Hummel