Do Low Oil Prices Have A Net Gain Or A Net Loss Effect On The U.S. Economy?

by: Lior Cohen

Despite the recent rally in oil prices, they have remained low compared to 2018.

I examine whether low oil prices have a net gain or net loss effect on the U.S. economy now that U.S. oil production has risen to record levels.

The short answer - it's a wash, but this hasn't always been the case and could change if oil prices were to fall further and stay low for long.

The question as to how low oil prices affect the U.S. economy has become more critical amid the expansion of U.S. oil production in the last couple of years. Currently, the U.S. produces more than 11.5 million barrels per day and is the world leading oil producer followed by Russia and Saudi Arabia – whereas the two latter countries are trying to curb their production in the hopes of stabilizing the price of oil.

On the one hand, higher oil prices can boost oil companies’ profits, hire more workers and encourage them to invest more. On the other hand, rising oil prices also translate to higher gasoline prices that could crowd out consumption - an adverse wealth effect. Up until a couple of weeks ago, oil prices have reached their lowest levels in years. And even after their recent rally, WTI is still trading around $50 – in comparison, the annual average price of WTI in 2018 was $66.

To consider the two opposing forces’ impact on the U.S. economy, I have made a (very simple) back of the envelope calculation to figure whether low oil prices in 2019 would result in a net gain or net loss to the U.S. economy. For now, let’s assume the price of oil were to remain at an average annual of $55 – or 17% lower than the annual average in 2018.

For the section in the economy that gains from higher oil prices, let’s consider the value added in the oil and gas industry, which, as of 2018, is estimated at around $210 billion (this figure accounts for the entire industry - including gas - so could be an overestimation). The elasticity between changes in value added (VA) in the oil industry and changes in gasoline prices is 1.4 (this figure was calculated using a regression analysis between gasoline prices and VA of oil in the past recent years). Thus, for an average price of oil of $55 in 2019 and assuming the elasticity of prices between gasoline and oil is 0.55, the fall in gasoline prices could result in a drop of 13% or $27 billion in 2019 in VA in the oil industry to a total of $182 billion.

Conversely, the estimated gasoline expenses in the U.S. were $316 billion in 2018. Assuming the elasticity is 0.92 (again, based on simple regression analysis), the results yield savings of roughly $30 billion to consumers and companies. So, the summing up the two figures from the two calculations results in a very modest net gain of roughly $3 billion to the economy (in the form of savings to households).

Based on this calculation, I have also extended this analysis all the back to 2011.

Source: U.S. Bureau of Economic Analysis, Bureau of Economic Analysis, and Author’s calculations

Notice that back in 2011 when oil prices spiked above $100, they had a net negative effect on the economy – as oil production was only 5.6 million bbl/d – less than half than it is now. However, back in 2015 as oil prices plummeted, they had a net adverse effect on the economy as production picked up to 9.4 million bbl/d. The drop in VA in 2015 may have also been the result of the sharp fall in investment. According to the IEA, since 2016, however, investment has been slowly picking up, albeit it has yet to reach the record levels of 2014.

This calculation isn’t complete, and the ripple effect of lower oil prices on the economy could be even higher, especially as it affects long-term investments (via its multiplier). Moreover, the savings in lower gasoline prices don’t always translate to an equal amount of gain in the economy in the immediate term; because some of the gains are saved and not spent (in other words, this calculation is static - only considers the apparent and immediate effects - and not dynamic as it doesn't consider the ripple effects on the economy).

This simple calculation aims to show that unless oil prices were to drop precipitously and remain there, which is likely to have a much more prolonged adverse impact on investment in the oil industry, the currently low oil prices aren’t likely to have a severe net adverse effect on the U.S. economy.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.