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The Implications of Falling Oil Prices For the U.S. Economy

falling oil prices
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Thanks to the Shale Oil boom, the US is now the world’s largest producer of oil.  At the same time, the country is the biggest consumer of energy.

Brent crude oil prices had stayed high at around $110 per barrel for three years since 2011 and reached a high of $115 in June 2014.  Thereafter, it started declining sharply to an annual average price of $99 in 2014.  Brent is now hovering around $50, and WTI oil is at $48, down 55% from June 2014.  The graph’s southward movement continues.  Are falling oil prices is good news for the US?

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Cheap oil is both good and bad news for the U.S.  As per IMF’s analysis, it is net positive to US economy; every drop of $10 in price adds 0.1% to the US GDP.

Less expensive oil is a positive for oil consumers.  The crude price drop has led to a fall in gasoline prices significantly.  The AAA national average price of retail gasoline on January 12 was $2.14 a gallon, the lowest level in four years and a $1.18 drop from $3.32 in last year January.  It brings more than a 33% savings on fuel to U.S. consumers.  Gasoline prices at the pump follows the price of crude oil.  As there is generally a time lag in variations of the crude price and gasoline, the price at pump may fall further to $2 a gallon.  Individuals consumers save more by paying less to drive their cars and heat their homes.  An analysis reveals that every 1 dollar drop in gasoline and heating oil creates a surplus of $150 billion for U.S. consumers increasing their purchasing power. This, in turn, boosts the economy.

The other beneficiary of low oil prices is the transportation industry as fuel forms a fat part of its operating costs. In the same way, petrochemical and energy intensive industries will gain leading to higher profit margins.

But oil companies and the Shale industry suffer. While the production from existing wells will not decline in short term, continued low prices would harm the growth of the oil industry in the medium and long term. Though the average production cost of big oil companies such as Exxon Mobil, Chevron and ConocoPhillips is around $40 and is still lower than the current oil price, it will hurt oil producers and oilfield service providers. Lower prices would decrease their top and bottom lines. Oil companies such as Conoco Phillips and Chevron have already started budget cuts for exploration and development activities. In turn, it would reduce demand for oilfield services providers. Moreover, the flow from existing wells will also have natural decline. It makes it difficult to maintain production.

The biggest challenges will be for small companies producing shale oil. During the last five years, many new entrepreneurs were attracted by the boom in the shale industry and high oil prices. They borrowed heavily to drill wells anticipated high earnings. As per Deutsche Bank, oil companies have raised $500 billion through bonds since 2010. But many small oil fields have become uneconomical with 55% decline in oil price. Goldman Sachs and Credit Suisse report that the breakeven oil price for several shale fields is in the range of $45-$85 and so may not attract fresh investments. Existing small companies may face cash flow problems. The highly leveraged companies with high debt might even default in keeping their commitment on bonds. The yields on some oil bonds have already jumped to above 15% against the coupon rates of 9.25%.

Author Bio Photo kanchanThe author, Kanchan Kumar, is an MBA in Finance and MS in Statistics and has served as Executive Director and Advisor with several multinational companies, Financial Institutions and Universities.  He writes on Global Economy, Market and Personal Finance.

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