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?”
An excerpt:
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.
READER COMMENTS
nobody.really
Mar 11 2020 at 11:40am
Who wins and who loses from a drop in oil prices?
Geopolitics: Yes, since the US is a net exporter of petroleum, I expect the price decline to hurt US GDP. But given the “resource curse,” many petroleum exporters are oppressive regimes. It doesn’t break my heart to think that Russia, Venezuela, and Middle Eastern monarchies will take a hit here.
US consumers: I expect they should mostly benefit.
US producers: I expect they should mostly suffer.
Crony capitalists: I expect they are/side with the producers.
The climate: As Henderson (and Sumner, and Klein) admonish us, do not reason from a price change. Prices dropped initially because of reduced DEMAND. All else being equal, I would expect reduced demand to correlate with reduced consumption, which I would expect to reduce carbon emissions. Yay climate. But all else is not equal; producers are now threatening to increase output, further reducing price—and presumably increasing consumption. Boo climate.
But low oil prices promoted a Canadian firm to cancel plans to build a new tar sands extraction plant. Tar sand seems to be about the least efficient source of oil around, since developers must first expend energy to “steam” the oil out of the ground. So if the world beings consuming more Saudi oil as a substitute for tar sands oil, that seems like a net gain for the climate. Yay climate.
Trump: He’s grumpy. You might think he’d want to side with consumers during an election year, but he’s not having it. The Energy Dept. issued a statement objecting to “state actors … manipulating” oil markets—as if that hadn’t been the case since the 1970s. Maybe the Administration is suddenly concerned about consequences for the environment? (*Snort*)
Mark Brady
Mar 11 2020 at 8:25pm
“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.”
Two thoughts.
I understand what David means, but I suggest that we avoid statements like “the drop in prices is bad for the U.S. economy as a whole,” and “it’s only slightly bad because the United States is barely a net exporter.” It turns on measures of consumer and producer surplus that take no account of how individuals’ marginal utility of money differs among those individuals. (I’m not suggesting that we could take account of that except in a rough-and-ready fashion.)
And it reinforces the way in which so many people (from Donald Trump to shop-floor workers) all too often look at economics–in terms of national aggregates. I suggest that advocates of the free market should defend its outcomes in terms of humanity’s gains, not with reference to the gains accruing to the residents of a particular country. In any event, if commentators focus initially on the gain/loss to the residents of the country in which they are located (perhaps because so much of the public discussion is in those terms), it is incumbent on them to analyze the global story before they finish. It is therefore encouraging that David wrote that, “But we should be clear that the drop in oil prices due to OPEC’s loss of pricing power is a gain to the world,” before he concluded “and close to a wash for the United States.”
David Henderson
Mar 12 2020 at 11:48am
You wrote:
All true. And I did even better by your standards, a point you didn’t mention. Not only did I analyze the global story before I finished, but also I told the global bottom line at the end of the second paragraph of the article.
Phil H
Mar 11 2020 at 9:52pm
Hang on. There are a number of things here that don’t make sense.
“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.”
Logically, this cannot be true. Monopoly power is defined as the power to set prices irrespective of supply and demand. So if it exists, then there must be lots of other reasons: the whims of the monopolists, for example.
(“Demand decreases” also covers a multitude of sins. It includes decreased economic activity and technology shock. They’re such different kinds of real-world events that I think it’s much more helpful to separate them out. But it it is true that both would “decrease demand”.)
“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”
Wha..? Whence the random mercantilism? Why is it good to be an exporter? There is no inherent value in exporting oil at high prices. If prices fall, a certain fraction of assets will transfer to other, higher-profit industries. I know those roughnecks are just itching to retrain as Silicon Valley bros.
Jon Murphy
Mar 11 2020 at 10:50pm
No. A monopolist can set prices but it is not irrespective of supply and demand. The demand curve still represents the upper-bound of prices the monopolist can charge. His profit-maximizing point is still where MC=MR, and P where that level of Q is.
Jon Murphy
Mar 11 2020 at 10:59pm
No. The monopolist may not be able to lower prices if it is a natural monopoly (ie, the demand curve does not justify lowering prices because the price consumers would be willing to pay are lower than the average costs).
But, if this is not the case and the monopolist can just lower prices “on a whim,” then that would suggest a loss in monopoly power as new firms can enter the market and compete away that extranormal profit.
Jon Murphy
Mar 12 2020 at 9:15am
This isn’t mercantilism. It’s just economics. One exports in order to import. If the price of your exports fall, then you can import less. Given that the US is, on net, an oil exporter, the decline in oil prices means the ability for the US to consume falls. Mercantilism is concern for exports for the sake of exports; that is not what is going on here. Here it is a concern for the ability to consume (mercantilists often get confused on this point).
Think of it like this: you “export” your labor so that you can “import” other goods. If the price of your labor (ie your wage) falls, then you are indeed made worse off because you cannot “import” as much.
Thaomas
Mar 11 2020 at 9:53pm
The externality from the combustion of petroleum makes the analysis tricky. In the short run the additional production will get turned into CO2 in the atmosphere, so bad for humanity. But the lower prices may make future exploration and production more risky and reduce production/raise the price in the long run, so the price drop may be beneficial to humanity after all. That may be Saudi Arabia’s strategy, anyway
Jon Murphy
Mar 12 2020 at 12:18pm
It depends on whether or not the current about of carbon emissions are optimal or not. We cannot tell that simply from the given information.
Thaomas
Mar 12 2020 at 1:37pm
Granted that the effects of rising CO2 levels in the atmosphere are a physical scientific question, but I have not seen an economic costing out of the net effects that shows they are not harmful, have you? And firms do not face any financial incentive not to emit CO2, Therefore there is a prima facie case that the higher levels of CO2 in the atmosphere is harmful relative to a lower levels.
Jon Murphy
Mar 12 2020 at 2:12pm
Ah, but that is the incorrect conclusion to draw; simply because there is no explicit carbon tax and that the size of the externality can be measured, that does not imply there is a prima facie case that higher levels of CO2 are harmful compared to lower levels. See John Nye’s 2008 paper The Pigou Problem.
Fred_in_PA
Mar 12 2020 at 7:02pm
I’m going to reveal my ignorance, but . . .
You say, “And firms do not face any financial incentive not to emit CO2 . . . .”
It seems to me there is an obvious disincentive: If I’m going to emit twice the CO2, I’m going to have to burn twice as much fuel. Which presumably doubles my fuel bill.
Greater efficiency — getting more out for less in — would seem to be its own incentive.
David Henderson
Mar 12 2020 at 7:14pm
Not naive at all, Fred, and very well put.
Indeed the long-run response to the dramatic increase in the price of oil that happened in 1973 was to reduce the amount of energy per $ of real GDP. We are still in that long run adjustment with certain energy uses: think buildings, which typically last over 50 years. Even with these low oil prices, the inflation adjusted price of oil today is well above the price in early 1973.
Jon Murphy
Mar 13 2020 at 2:52pm
And, on top of your point, Fred, and Prof. Henderson’s addition, there are all kinds of implicit taxes on carbon emissions, like the gas tax, subsidies to public transit and green energy, road tolls, the Jones Act, etc etc etc., all of which adjust the level of carbon emissions in the atmosphere.
In John Nye’s article that I cite above, Nye points out that the standard argument for carbon taxes assumes no other taxes anywhere in the economy that affects carbon. Then, and only then, can the measurement of the externality indicate the level of taxation necessary to correct the market failure. But if there are implicit taxes and side bargains that go on, merely measuring the externality tells us nothing about the proper size of a tax.
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