Will The Oil Boom End With A Bang Or A Whimper?

by: Dana Blankenhorn

Oil is being priced to disaster right now. Yet the economy keeps moving forward. What might happen if the price were to fall?

That depends on how it falls.

If it falls slowly, with a whimper, then adjustments will be easy to make. Economic growth will accelerate and that could slow the fall. It could really be "all good" in that it would be unlikely to fall below production costs, on either fossil fuel or alternative energy, and a slow fall would moderate demand increases.

A slow fall would provide a boost to both the U.S. economy and the developing world, especially big energy importers like India and China. It would be of less benefit to countries like Brazil, which is increasing its own production, but unlikely to hurt too much.

The biggest loser would be Canada, whose tar sands are expensive to turn into oil, and whose ancillary costs (pollution) are still not being factored into the price. Major oil exporters, in both the Gulf and the Gulf of Mexico, would also suffer somewhat.

But what if the price fell suddenly? What if the oil boom ended with a bang? Given the nature of our oil auction market this is the more likely scenario.

The fall of the Iran's present government, an outbreak of peace, or even rapid introduction of new supplies from Libya or Kenya could quickly cut prices on the futures markets by as much as 25% - markets often overshoot news.

A sudden wash of $75/barrel oil might sound like good news, but it would raise the risk of instability in Gulf oil states that are dependent on high prices to maintain social peace, and could knock the underpinnings on U.S. drillers and exploration companies.

We're already getting a taste of what that might look like in the U.S. natural gas sector, where prices have fallen 60% since 2009. Drilling has slowed, and drillers like Chesapeake (NYSE:CHK) are taking it on the chin. Those drillers could get another hit from an oil price collapse, as could majors that have been driving the drilling boom, including ExxonMobil (NYSE:XOM).

But that's not all. Lower prices will create pressure to shut-in high-priced plays like the Canadian tar sands, and put enormous pressure on alternative energy companies - solar, wind, geothermal, algae and ethanol.

An un-managed fall in the price of oil could actually prove bearish for the economy as a whole, setting off a round of deflation, reducing the premium American manufacturers now have for efficiency, and putting China's economy back into hyper-drive at our expense.

While most analysts are looking at a bullish case for oil, of prices remaining stable or even increasing dramatically, I'm reminded of a talk I heard over 30 years ago, when the Houston oil boom was at its height and I was writing for the Houston Business Journal. An economist measured the impact of stable prices, higher prices and falling prices on the local economy, and found in all three cases a recession could be ahead.

That economist was ignored, and the result - in Houston at least - was a depression after an oil price crash that was actually worse than the one we have just gone through.

Managing falls in oil prices as well as increases will be key to sustaining the recovery.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Additional disclosure: This is sort of a think piece, but an important one. I've slugged it economy, but it could be slugged as commodities or market outlook. Let me know if you want a host of links, because I can get them for you quickly.