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What cheap oil means, and where do prices go from here?

Andy Serwer
Editor in Chief

At first blush $40 dollar-a-barrel oil sounds like a beautiful thing. It means cheap gas for your SUV and lower energy bills. Plus, businesses benefit so it’s a good thing for the overall economy, right? That’s all true as far as it goes, but dig a bit deeper and you see the calculus is a little trickier. What does cheap oil really mean for the economy? How did we get cheap oil to begin with, and where are prices going? I’ll get into all of that in a second, but here’s a headline: I think you can make the case that oil will stay cheap for some time, which could have a number of wide-ranging and long-lasting consequences.

Let’s take the unassailable good news first: The price of benchmark West Texas Intermediate crude oil recently dipped below $39 a barrel, which is down from $140 in 2008. That’s an incredible 72% drop. And, yes, lower oil prices have pushed down gas prices. At $2.60 a gallon, gas is now about a dollar below where it was last year at this time. And it could continue to fall. Some analysts are looking for prices to drop below $2, maybe even down toward $1.60 a gallon, the low during the Great Recession in early 2009. When President Obama predicted in his State of the Union Address in January that “the typical family this year should save $750 at the pump,” he was probably right. Multiply that by the nation’s 115 million households and you get a total savings of over $86 billion. That’s huge.

Lower gas prices help poor people in particular; households with incomes of less than $50,000 spent 21% of their income on energy in 2012, according to analysts at Bank of America Merrill Lynch, while households earning more than $50,000 spent 9%. Additionally, Americans who live in chillier regions like New England and the Midwest could save another $750 or so on energy bills.

And of course businesses make out as well. Automakers sell more cars and especially higher-margin trucks when gas is cheap. Over the past four years, as gas prices have dropped, total vehicle sales have climbed from 12 million a month to nearly 18 million. Trucking companies and railroads benefit tremendously from lower fuel costs. So, too, do fertilizer makers or any business that has to heat a factory or that has to pay a fuel bill. So overall, $40 oil is a huge positive for the economy.

On the other hand...

And yet there is a downside. First thing to consider is U.S. employment in the oil and gas business. Numbers are a bit difficult to pin down, but it appears that some 500,000 Americans work in the oil and gas business in the U.S. That number has been dropping since late last year, which will especially hurt the big five oil producing states: Texas, North Dakota, California, Alaska and Oklahoma. Bottom line: While these states in particular will suffer some from declining employment in this industry, Fortress America can absorb the hit, and furthermore, lower energy prices will more than make up for it.

Another problem with cheap oil, though, is that it will likely derail efforts to develop alternative sustainable energy sources like solar, wind and hydro. These businesses suddenly become uneconomical when the price of oil drops precipitously.

But the biggest problem with cheap oil may well be the destabilizing effect that it can have on oil-dependent nations around the world. Yes, some may cheer the pain Saudi Arabia and other OPEC nations will feel, but they should be careful of what they wish for as a raft of difficulties looms here. There are 19 countries that produce over a million barrels of oil a day, and it’s a diverse group, including, of course, the U.S., Saudi Arabia and Kuwait, but also the likes of Brazil, Norway and Angola, and Canada. Each country will have to adjust to less income and lower employment in oil-related businesses. The nation’s that stand to lose the most, though, are Russia, Saudi Arabia, Iran and Iraq—in order, the biggest oil exporters in the world. Coincidently or not, these countries pose huge potential risks to the rest of the world if their economies crater and they become unstable, or I should say in most cases here, more unstable. So in a way, low oil prices almost becomes more of a political problem than an economic one.

As for where oil prices go from here, of course no one can predict with certainty, but I would venture a guess that oil won’t be soaring back up to $100 a barrel any time soon. And it’s not because I think economic growth will necessarily be weak. It’s simply because the world is awash in oil right now. To understand why, you have to go back to the work of an obscure Shell geologist named M. King Hubbert, who in the 1950s conceived of what became known as the Hubbert Curve, or the Peak Oil Theory, which postulated that production would peak in the coming decades as the planet ran out of oil. And as production slowed over the past few decades, it seemed that Hubbert might be right. His work developed a strong following, which contributed to the major run-up in oil prices over the last decade when oil rose from $20 to that $140 peak.

But a funny thing happened on the way to peak oil production: it didn’t. In fact, Hubbert’s work served as a challenge to the oil business. Oil companies increased exploration and discovered vast new fields, particularly off shore in places like Brazil and Indonesia. New technology and techniques were brought into the business to extract shale gas in the United States and other countries, which vastly increased supplies. Meanwhile, while demand for oil has climbed, it hasn’t increased as fast as many anticipated as cars, factories and buildings become more efficient. And now demand from China may be slowing. So while Hubbert predicted that U.S. oil production would peak in the 1970s at about 9.5 million barrels a day and then fall to around two million barrels a day today heading to zero, it actually peaked at 10 million and fell to five, but has now climbed back up to nine million barrels a day.

All that could spell a long-lasting era of low prices. Which means American consumers and businesses mostly win, though there will be tough times for some people who work in either traditional energy or new sustainable energy businesses. The big worry is how low oil prices will impact certain global economies, and what that means for the rest of us.