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Oil & The U.S. Economy

|Includes: SPDR S&P 500 Trust ETF (SPY), XOP

With the price of gasoline at the pump falling some investors are confused about how that could be bad for the U.S. economy. The topic of lower prices or more broadly, deflation, is complex. As much as monetary policy makers consider deflation to the equivalent of kryptonite to Superman, the fact of the matter is many prices have continuously fallen and industry still thrives (think televisions). Intuitively it is reasonable to believe less money spent on energy costs by consumers would lead to spending in other areas. However, you have to take into account the impact lower oil prices might have on the energy industry as a whole.

The energy sector in the U.S. represents approximately 8% of the U.S. economy and the shale and fracking exploration booms have increased employment and capital expenditures in the industry. Some economists attribute the boom in the energy industry as a major contributor to the U.S. economic recovery since the 2008 recession; it may be playing a more important economic role than many realize.

The price of oil must maintain a minimum level to justify the costs of drilling. Back in 2008 it was estimated that the equilibrium for oil exploration in the U.S. was around $70 a barrel. It is believe to be higher today due to the more challenging drilling techniques being deployed (horizontal fracking).

If oil falls below the equilibrium cost to drill explorers shut down production and cancel capital expenditures, both of which are happening as the price of oil falls.

While lower prices at the pump are welcome by consumers, the weak consumer spending in December suggests any savings at the pump are not necessarily being spent.

The more perplexing challenge is trying to determine if the decline in oil is based on increases in supply or decreases in demand. Generally speaking you don't want to see a decrease in demand. That would suggest a slowing economy. In the U.S demand is somewhat flat as a function of better MPG, migration to cities, and telecommuting. Normally energy use would be increasing during an economic growth cycle but technology and structural changes are at play. Globally we would expect countries like China and India to see a big increase demand based on their large population and modernizing economies. However, other explorers are now using the same techniques pioneered in the U.S. to increase oil extraction globally so supply issues are certainly at play. Over the longer-term low-cost energy should be a plus for the global economy.

In terms of economic growth for the balance of this decade it will be important for the price of oil to find equilibrium and ideally that equilibrium will allow the energy industry in the U.S. to continue expanding exploration and the capital expenditures and jobs that come with it.

Disclosure: The author has no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.