Are Big Drops in Oil Prices Bad?
By David Henderson
The question in this title was asked by someone on Facebook Monday morning. That motivated me to write my latest Defining Ideas article, which came out a little while ago.
It’s titled, “The Drop in Oil Prices: Good or Bad?”
A most useful principle I learned in my Ph.D. economics program at UCLA, about which Professor Benjamin Klein never failed to remind his students, is “Never reason from a price change.” Scott Sumner, an economist at the Mercatus Center and one of my co-bloggers at EconLog, often points that out in his posts.
Let’s apply that lesson here. There are three (and only three) reasons that oil prices drop: (1) demand decreases, (2) supply increases, or (3) the monopoly power of oil producers falls.
On the Saudis and Russia:
Saudi Arabia is the most important OPEC producer; Russia is the most important non-OPEC producer that attends the meeting. This time, the Saudis and the Russians had a big disagreement. The Saudis wanted to slow or stop the price erosion that had happened due to the drop in demand by cutting output: that of OPEC members and that of other countries that attend OPEC meetings but are not members. The Russians wanted the output cut too but didn’t want to be the ones doing the cutting. As CNBC’s Brian Sullivan put it on Friday, they wanted to have their cake and eat it too. In that respect, the Russians are like the non-Saudi members of OPEC: all of them want the Saudis to cut output. Although the violin I will play for the Saudis’ predicament is very tiny, it is true that they have traditionally been the “swing producer:” the country that sucks it up and reduces output to maintain the price while many other members of the cartel cheat like crazy. At times, the Saudis have produced as little as 4 million barrels a day to support the price; at other times, they have said the hell with it and have produced as much as 10 million barrels per day.
And my bottom line answer to the question asked:
But something important has happened in the last decade: fracking. As I noted in my most recent Defining Ideas article, fracking substantially increased the U.S. supply of oil and natural gas. In December 2019, the United States became, for the first time since 1949, a net exporter of oil. So the drop in prices is bad for the U.S. economy as a whole: the loss to the producers will exceed the gain to consumers. But it’s only slightly bad because the United States is barely a net exporter.
For the world economy as a whole, then, the drop in oil prices due to demonopolization is a net plus. That should be no more surprising than the fact that the increase in competition in the retail sector is a net plus.