What Effect Do Low Oil Prices Have On The U.S. Economy?

One of the more interesting parts of the downturn has been what, if any, effect low oil have had on the U.S. economy. On October 01, 2014, WTI closed the day at $90.73. By January 2, 2015, oil was pricing at $52.27. From October 01, 2014 until September 28, 2016, oil reached a low of $26.05, averaged $49.09 and was down $66.91 (-%49.33).

Historically, low oil prices have had a positive effect on the U.S. economy. Such venerable names as Moody Analytics were quick to argue that low oil prices are a boon to the U.S. economy.   Here is just one such quote explaining why, historically, low oil prices are so beneficial:

Numerous crosscurrents must be considered when calculating the effect of oil price declines on the prospects of the U.S. economy. Oil price declines act as a tax cut, enabling consumers to spend a greater percentage of their incomes on nonenergy goods and services. Every 1-cent decline per gallon in gasoline prices frees up $1.1 billion in spending over the course of a year. If the $60 decline in oil prices is sustained over the course of a year, lower oil prices would free up $165 billion for nongasoline expenditures. Households would also benefit from lower heating oil and diesel prices, freeing up an additional $50 billion. Furthermore, since the U.S. is still a net oil importer, lower oil prices reduce the nation’s trade deficit…the extent to which lower oil prices help the economy to expand depends on the decline in inflation, which amplifies real spending and creates jobs, and the increase in corporate profits. Higher real spending prompts businesses to increase investment and hire more workers. Businesses also benefit from lower input costs and thus higher profit margins, especially those for which oil is a major input cost. These include transportation, agriculture and manufacturing companies. https://www.economy.com/home/products/samples/2014-01-14-Economics-of-Lower-Oil-Prices.pdf

Moody’s does go on to explain that lower oil prices hurt U.S. drillers thereby reducing CAPEX for new development and result in layoffs. However, they conclude:

On net, though, lower oil prices are an unambiguous positive for the U.S. economy. Even when accounting for the indirect jobs tied to the energy industry, two jobs will be created in nonenergy industries for every energy-linked job that is lost. Corporate profits also get a net boost, although the positives are diffused among a greater number of businesses than the negatives. Because of the preeminent effect of lower inflation in the lower oil price equation, each $10 decline in oil prices boosts U.S. real GDP growth by 0.15 to 0.2 percentage point per year. If oil prices come in as expected this year, real GDP growth would be boosted by 0.5 percentage point.

Please understand, I am certainly not picking on Moody’s here. There are very smart folks that write these opinions. And their opinions are in line with traditional economic reasoning. Before the downturn, most economists would have concurred wholeheartedly with Moody’s and stated emphatically that theoretically and historically lower oil prices are good for the U.S. economy as a whole.

And that, in part is what creates the boom/bust cycle in oil. Historically, low oil prices result in the simultaneous cut of CAPEX expenses and an increase in demand because of the economic growth caused by low oil prices. Eventually, demand then outstrips supply, and supply is slow to recover resulting in the boom before the crash. And then, inevitably, a crash.

So What Actually Happened?

A thorough analysis of all of these issues was conducted by the Brookings Institute in their awesome 53 page report is available at https://www.brookings.edu/wp-content/uploads/2016/09/5_baumeisterkilian.pdf. Let me save you some time and lots of reading to cut down to the highlights:

Despite stellar predications at the beginning of the downturn, average U.S. real economic growth has increased only slightly since 2014Q2 from 1.8% to 2.2%. (Note: under the traditional model, it should have easily been double that number).

Some Sectors did well. In particular, candy and soda (+7%), beer and liquor (+10%), and tobacco (+16%) do well, perhaps because such goods are sold at gas stations, but also food products (+7%), and apparel (+11%). Both tourism (+11%) and restaurants, hotels and motels (+8%) benefited from lower oil prices, as consumer demand rose. So did retail sales (+14%). Amazon (+38%) and Home Depot (+32%) did particularly well. Only recreation, entertainment services, and publishing did not partake in this boom.

The petroleum and natural gas sector (-28%), unsurprisingly, was hit hard. Within that sector, refining companies that use crude oil as a production input fared somewhat better. Other industries that rely on oil as a major input and hence would have been expected to profit from lower oil prices such as rubber and plastics (+4%) and logistics (+2%) did not benefit much, and chemicals (-6%) actually performed worse than the overall market, arguing against an important supply (or cost) channel of transmission. Airlines (+15%) benefited both from lower fuel costs and higher travel demand. Likewise, textiles were helped by lower input costs and higher demand (+13%). The surprising fact that auto companies performed below average (-9%) is largely explained by weak foreign sales, reflecting the recent global economic slowdown. Sectors tied to commodity markets such as agriculture (-12%) or mining (-31%) performed poorly for the same reason. Steel (-26%), fabricated metal products (-51%), machinery (-19%), and ship building and railroad equipment (-13%), all suffered from lower demand, in part from the declining oil sector and in part due to the decrease in global real economic activity.

Other key highlights from the report (please note these are almost direct quotes in most cases and I have added emphasis for you):

• Further inspection of the annual real value added data, which provide a more detailed breakdown, suggests that oil and natural gas extraction combined, far from contracting, actually continued to grow even in 2015 at an astounding rate of 16%, even as other mining activities and overall mining support declined by 7% and 14%, respectively (note that oil and gas is included in mining for U.S. Government statistical purposes). This evidence suggests that much of the contraction in the shale oil industry occurred not in production so much, but in support services. The reason why these changes do not matter more at the aggregate level is not only that some of the changes are offsetting, but that the share of mining in GDP has remained quite small, having risen gradually from 2.2% in 2007 (before the shale oil boom) to a peak of 2.6% in 2013, before falling to 1.7% in 2015.
• When the price of oil fell, many other sectors of the economy in the oil states contracted as well. It is difficult to measure these impacts directly, but a simple thought experiment allows us to bound these broader impacts at the state level on U.S. real GDP. The BEA provides data on real GDP growth for every U.S. state. We classify these states into states with an oil share in value added in 2014 above 5% (referred to as the “oil states”) and states with a lower share… In fact, between 2014Q2 and 2015Q4, shale oil states overall slightly increased U.S. real GDP growth from 2.33% at annual rates to 2.38% rather than lowering it, as one might have expected. Only starting in 2015Q3, when growth in the oil states had dropped from 3.7% to 0.7% at annual rates, is there any evidence that these states pulled down aggregate real GDP growth. The counterfactual growth rate exceeded the actual growth rate by 0.15 percentage points. This evidence suggests that if the shale oil sector was indeed responsible for the sluggish growth of the U.S. economy, there must have been other channels of transmission at play.
• Nonresidential investment in the U.S. economy between 2014Q2 and 2016Q1 on average increased by 1.6% at annual rates, compared with 2.2% growth in real GDP. Over the same period, oil investment dropped at an annual rate of 48%. Thus, after excluding investment in the U.S. oil sector, real investment would have increased at a rate of 4.6%, about three times as fast as the actual data. Investment in structures would have grown at 10.2% (rather than declining at a rate of 2.9%), and investment in equipment would have grown at 2.7% (rather than merely 1.6%). This is not to say that the increase in nonoil investment after 2014Q2 was primarily caused by lower oil prices; indeed, additional analysis (not shown here) suggests that the bulk of this increase was not driven by unexpectedly lower oil prices. More important than the source of the increase in non-oil investment is the fact that this increase was largely offset by reduced investment in the oil sector.
• The effect of reduced oil investment on U.S. real GDP growth is less dramatic, reflecting the comparatively low share of total investment in GDP compared to the share of consumption in GDP, but is still economically significant. U.S. real GDP would have increased at an average rate of 2.6% per annum excluding the decline in investment in the oil sector and in railroad equipment. The latter component is included here given the importance of oil transport for the railroad sector, compared with 2.2% in the data. To summarize, lower oil related investment accounts for a reduction of 0.4 percentage points in U.S. real GDP growth measured at annual rates.
• Many have posited that the reason we did not see an economic boon was because consumers increased savings rather than spending the savings as they have traditionally done. The increment of 0.3 percentage points in the savings rate relative to June 2014 is much smaller than the increment of approximately 1 percentage point in the savings rate that one would have expected all else equal, if the cumulative gain in discretionary income since June 2014 had been converted entirely into savings. Thus, this theory appears not to be true.
• Thus, the fact that average U.S. real GDP growth accelerated only slightly from 1.8% at annual rates to 2.2% is not surprising. One reason why real GDP growth did not increase faster after 2014Q2 undoubtedly has been the slower growth of real exports after June 2014… It is difficult to quantify this effect without a fully specified model, but the case can be made that real GDP growth after 2014Q2 would have increased by about 0.3 percentage points to 2.5% on average, had U.S. real exports continued at an average annual rate of 3.2%

 

The bottom line is that while the U.S. economy did not truly contract as a result of low oil prices, it did not grow by near the predicted levels, thus indicating the increased importance of oil and gas, and the industries that service it, to the American economy.

So How Does This Downturn Differ From Others?

First, it is worth pointing out that oil and gas has been the fastest growing sector in the U.S. economy for about a decade – meaning that anything causing investment to stall and employment to be slashed will have a negative impact, at least in the short term.  It is theorized capital spending by oil and gas producers increased at a compound annual rate of around 16% between 2002 and 2012. Indeed, Oil and gas producers accounted for almost $1 in every $8 of new business investment in the U.S. economy in 2013, according to data published by the Census Bureau – which equates to approximately 14% of all new capital expenditures in the U.S. for that year. Compare that to a measly 2.7% increase per year for the rest of the business capital spending.

And, of course, the problem is job loss. Unlike our new consumer driven economy (think about your friendly McDonald’s personnel), oil and gas jobs are high paying. Average wages in the oil and gas extraction sector, at nearly $160,000 in 2013, were almost three-times the private sector average, according to the Bureau of Economic Analysis. Even in the support sector, average wages and salaries were more than 50 percent higher than average.

After the data has come in, it appears that high-paying oil and gas jobs are being lost in the oil and gas sector more quickly than they are being added to the other industries that might eventually replace them.. Note that this is directly opposite of the traditional predictive model that state two jobs replace every one that is lost. Oil and gas producing industries directly employ fewer than 500,000 individuals out of a total nonfarm workforce of 140 million, less than half of one percent, according to the Bureau of Labor Statistics. However, these employment numbers do not include the large oil and gas service industry we are all familiar with, or the steelworkers making OCTG (which alone employees around 7,500 workers making an average of $30 per hour, well above the average private sector wage). In other words, a decline in oil prices and production now has a substantive effect on the U.S. economy. While perhaps not enough to offset the gain, low oil prices are not nearly as beneficial as previously thought.

By: Ty Chapman

Five Star Metals, Inc.

Raising the Bar for Customer Service and Quality

Twitter: @FSM_TY

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