Introduction
Over the last one year, the global oil price has declined rapidly by approximately 50 percent. The drop in the oil prices may have largely been as a result reduced global growth prospects. Analysts argue that the rise of the U.S dollar in relation to other currencies played a significant role in the oil prices decline (Energy Information Administration, 2014). The decrease in the global oil prices has led to a significant impact on the U.S economy. In essence, the price drop has reduced the cost of living while increasing the real consumers’ incomes. The real income gain has resulted in higher spending. Similarly, firms that use oils in their production process have highly benefited from the low input prices. The resulting decline in the marginal costs by the firms translates into reduced prices in the production of goods and services. With all other factors unchanged, the decline in the oil prices will boost the U.S economy (Brown et al., 2014).
Demand and Supply Factors
Fundamentally, the major factor behind the decline in the prices is a shift in the supply. World production of oil from the OPEC countries such as Iraq, Libya, and Saudi Arabia rose higher than expected. The supply from the non-OPEC developments also increased significantly, including the supply increase following the expansion of U.S. shale output. According to a report by the International Monetary Fund, the increase in the supply accounted for about 50 percent of the oil prices fall (Taghizadeh & Yoshino, 2014). On the demand aspect, the demand of oil and the growth outlook also reduced, particularly in Europe and Asia. This growing imbalance in the oil demand and supply characterized by an increase in the financial flows into the oil production processes eventually contributed to the declining prices.
The impact of the decline in prices on the growth of the U.S economy depends on various factors, including the magnitude and nature of the oil price decline as well as the size of the decrease in price faced by the oil users. Depending on the nature of the decline in oil price, two aspects play a critical role. Primarily, the underlying booster of the decrease in price; the decline may be contributed by factors that are not related to the current economic conditions such as a change in supply due to improved technology or a shock in demand for oil. The level of persistence of decline in oil price is another aspect. This implies that the economic growth depends on whether the oil prices are either temporary or permanent. If temporary, the gain in real income will be saved. If permanent, the level of spending and oil markets will have to be adjusted to the expected decline in prices.
Owing to the current demand and supply curve, it is difficult to quantify the exact factors contributing to the decline in oil prices. Nevertheless, changes in the supply factors resulting from the increase in oil production by the U. S shale oil, and the OPEC policy shift with the idea not to cut the supply have played a significant role. Empirical estimates show that demand factors may have contributed to about 20 to 30 percent to the decline (Taghizadeh & Yoshino, 2013).
The Responsiveness in the Oil Demanded to Change in Price
The response to the demand for oil to a shift in price elasticity (elasticity of demand) can be analyzed using the concepts of demand and supply elasticity. In essence, the elasticity levels assess the response of the levels of production and consumption oil resulting from price changes (Nicol, 2003). The demand and price elasticity vary widely. In particular, elasticity tends to rise significantly in relation to time as consumers make several adjustments in their levels of demand and spending.
An economic theory depicts that over an extended period, the oil demanded should have a high level of elasticity to price change. The previous data highly supports the prediction pattern recorded in the early 1980s, which shows a perfect behavior of the theory. Similar to the theory, the oil price shock in the early 1980s showed a high level of stagnation in demand for over ten years (Nicol, 2003). Surprisingly, the U.S economy expanded significantly in the 1980s despite reduced levels of growth in demand. Improved efficiency may have contributed this phenomenon in energy consumption. The data shows that in response to a decrease in prices, there was a relatively small increase in demand for oil while its supply continued to rise.
It is good to note that understanding this concept of demand elasticity can have a crucial implication in the outlook of the oil market in future. If the prices of oil continue to decrease at a faster rate, the projection of demand in future is likely to be high (Cooper, 2013). Despite this assumption, oil production is likely to rise in the U.S shale oil. On the same note, the level of demand and the U.S supply imbalance will significantly be less. Thus, though the prices may be lower, the less significant is the elasticity effect. This may imply that the demand is likely to increase at a higher rate while the supply levels will expand at a lower rate in response to the decline in the oil price.
Figure 1: Oil Supply, Demand, Price Elasticity by Euan Mearns (2014).
Production and Cost of Supplying Oil
Overall, the macroeconomic impact of declining oil prices is highly manifested in the cost of producing and supplying the oil. Since the natural gas prices in the U.S does not seem to be closely related to the cost of the crude oil, the effects of the decline in oil prices mostly have an impact on the oil producers. Apart from reduced income, the oil producers with a total cost of production rising above $ 60 to 70 per barrel are likely to decrease their production gradually (Energy Information Administration, 2014). The high cost of production will affect producers in major companies, especially those operating in oil shale areas that have been newly developed in Texas and North Dakota.
Notably, according to the report by EIA, the cost of oil by the U.S shale oil rose significantly up to 1.6 million barrels despite the decline in the oil prices (Suvro et al., 2015). Thus, though the reduced prices may negatively affect the costs of supply and production, the U.S shale, which contributes to about 50 % of U.S total oil production, is likely to improve its crude oil production until its peaks out at just below 5mbpd around 2020 (Suvro, et al., 2015). In one of the recent analysis, the cost of oil production continues to fall gradually despite the decrease in prices. The cost reduction is linked to a decline in the well cost as well as an increase in the oil recovery process per well. This decline in cost has been attributed to the shorter drilling and completion time. The improved technology has enhanced efficiency by increasing the rate of pad drilling and use of zipper fracs, thus resulting in a decline in the production cost.
Apparently, the improved efficiency decreases the company’s resilience to lower oil prices and also lowers the supremacy of OPEC to determine the global oil prices or even set them at higher levels. However, the decline in the oil prices has discouraged further investment into the production process, which may impact severely on the development of further U.S shale projects. Besides, a further decline in the oil prices is likely to increase the production and supply cost in the long term. In fact, the U.S shale top producers have announced a decline in production and supply due to an anticipated rise in the cost of producing and supplying the oil.
Figure 2: U.S Oil Shale Production in Response to Low Prices by Trends & Strategy (2015)
This chart shows how the domestic levels of production have changed after the advancements in shale-oil reserves. The quantity of oil produced increased rapidly in 2011.
Conclusion
The effects of the decline in the global oil prices by end of-2014 should have a significant positive effect on the U.S economy by increasing the level of economic activity, reducing the cost of living while increasing the real consumers’ incomes. Similarly, the cost of production has tremendously reduced, especially for those firms that depend on oil inputs in their production process. It is clear that supply and demand factors may have contributed to the decline in oil prices. However, the supply factors have, to a greater extent played a crucial role in decreasing the oil prices, which dropped by almost 50 percent between the mid-2014 to early 2015. Despite the reduction in oil prices, the U.S oil shale has increased its crude oil production significantly. The decline in oil prices has much effect on the elasticity of demand. Though the level of oil demand in response to the decline in prices is still low, if the prices of oil continue to decrease at a faster rate, the projection of demand in future is likely to be high. Thus, the consumption of oil will rise, but the supply levels will expand at a lower rate in response to the decline in the oil price.
References
Brown, S. A. & Mine K. Y. (2014). Energy Prices and State Economic Performance, Federal Reserve Bank of Dallas: Economic Review.
Cooper, J. (2013). Price elasticity of demand for crude oil. OPEC Review, 27(1), pp.1-8.
Energy Information Administration (EIA). (2014). Country Report. Washington, DC: US Energy Information Administration.
Mearns, E. (2014, November 24). The 2014 oil price crash explained. Retrieved April 26, 2016, from <http://oilprice.com/Energy/Crude-Oil/The-2014-Oil-Price-Crash-Explained.html>
Nicol, C. J. (2003). Elasticities of demand for gasoline in Canada and the United States. Energy Economics, 25(2), 201–214.
Suvro, S., Ho P. H., & Janice, C. (2015). Oil Prices: Where will we go from here? DBS Asian Insights, 31(1), 1-48.
Taghizadeh Hesary, F., & Yoshino, N. (2014). Monetary policies and oil price determination: An empirical analysis. OPEC Energy Review, 38(1), 1–20.
Taghizadeh, H, F., & Yoshino, N. (2013).Which Side of the Economy Is Affected More by Oil Prices: Supply or Demand? United States Association for Energy Economics (USAEE), 28(4). pp. 13-139.
Taghizadeh Hesary, F., & Yoshino, N. (2013). Which side of the economy is affected more by oil prices: Supply or demand? SSRN Electronic Journal, 28(4), 13-139
Trends & Strategy. (2015, December 29). The impact of lower oil prices on the U.S. Economy: Wells Fargo wealth management insights center. Retrieved April 26, 2016, from <http://m.wealthmanagementinsights.com/aspx/detail.aspx?pid=776>
