IMMEDIATE RELEASE 28 November 2014
WASHINGTON MERRY-GO-ROUND
Today’s Events in Historical Perspective
America’s Longest-Running Column, Founded 1932
It should have been the headline
By Douglas Cohn and Eleanor Clift
WASHINGTON – It should have been the headline, but, except for financial publications, it was not. Yet, it is going to impact the nation’s economy and our personal budgets more than any other single factor currently on the horizon. The Organization of Petroleum Exporting Countries (OPEC), meeting in Vienna while Americans were taking a Thanksgiving timeout, decided to leave oil production levels unchanged. This would appear to be a benign act. It wasn’t.
Thanks to post-recession depressed levels of fuel consumption coupled with increased production from Canadian oil sands and U.S. shale oil extractions, the price of a barrel of oil has fallen more than 30 percent in a matter of months. This has resulted in a glut of 1.5 million barrels a day of excess oil. Consumers rejoiced. Airline and automobile stocks soared as did the value of almost any company that manufactures or uses oil-based products – which include a wide range of items from plastics to chemicals. On the other hand, the entire oil industry took a hit.
But there is a potentially dark side to this picture. Federal Reserve Chairman Janet Yellen continues to warn that her greatest fear is deflation. So, instead of the usual talk of combatting inflation, the Fed has said it wants inflation at a minimum of two percent per year.
OPEC members as well as non-OPEC members such as Russia urged Saudi Arabia to cut production, but the Saudis said they would not go it alone. It is an interesting dynamic at play. Saudi oil extraction costs are among the lowest in the world and its population is so small that it does not have the same dependency on oil revenues most other oil-producing nations such as Russia, Venezuela, and Iran have. Also, U.S. shale oil extraction costs are among the most expensive.
Further, the Saudi riyal is pegged to the U.S. dollar, and the dollar remains the world’s strongest currency and is getting stronger. As the dollar continues to gain against the euro, ruble, and other currencies, the Saudi piggy backing benefits them because, except for oil, they are a net importer of most of their goods and services, especially from Europe. And those dollar-driven lower import costs will offset much or all of the Saudi’s decreased oil revenue.
So the Saudis have a win-win scenario. Cheaper imports will allow them to keep oil production at current lower-revenue levels, while those lower levels undermine U.S. shale oil production, which the Saudis accordingly believe will be cut back. So it would be the U.S. not Saudi Arabia, its OPEC partners, or Russia that would cut production.
The problem for the U.S. is that a decline in our burgeoning oil output would undermine an industry that is on the verge of making the nation energy independent, but the consequent rise in oil prices would then help stave off the specter of deflation. In a worst case scenario, the short-term decline in oil prices would bring on deflation at the same time that the U.S. shale oil industry is practically destroyed. And deflation would impact all sectors of the economy, especially real estate, which would see home prices decline along with the wages necessary to pay home mortgages.
The good news is that the American economy has proven to be quite resilient, and the independent Fed, ever since the chairmanship of Ben Bernanke and his successor, Janet Yellen, has proven to be the primary bulwark against financial disruption. Bernanke’s program of massive quantitative easing (having money printed to buy U.S. Treasury securities and mortgage-backed securities) was largely responsible for reversing the Great Recession, and Yellen’s Fed likewise has the incentive to aggressively employ interest rates and liquidity to help ward off deflation while lowering corporate – substitute “shale oil companies” for “corporate” – costs of borrowing.
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END WASHINGTON MERRY-GO-ROUND