The Oil Shock Has Arrived

The absolutely stunning drop in oil prices, which hit a new recent low, is really important to both track and understand.

There are two issues here, one near term and one long.

In the near term, lower oil prices will help consumers have extra money for other purposes. If they're smart, they'll pay down debts and save money. If they aren't, they'll simply redirect it to other purchases.

The other side of the coin, however, is that the energy producers will take exactly offsetting losses to their revenues which will nullify any broad economic gains. If or when you read about how the lower oil prices will be a big boost to GDP, you'll be reading almost pure spin.

The only countries that receive a pure economic gain from lower oil prices will be those without any domestic oil producers. Japan and Greece should be loving the price declines, but Greece more than Japan because the fall in the yen has almost exactly matched the fall in oil.   Oil is cheaper, but so is the yen; so it costs about the same amount of yen to get the same amount of oil.  So, not much help for the Japanese on that score. 

The shale oil producers in the US are remarkable in several ways, but quite a few producers were simply not profitable enterprises at $100 oil. A fair number of the marginal operators are going to be complete disasters — as in bankrupt — at $63 oil.

Over the long term, say 2-3 years, these lower oil prices will spell big trouble because a lot of expensive but essential oil projects are being hurriedly shelved.

If the global oil business could not seriously advance global oil output with oil over $110 a barrel, what do we think might happen now that oil is $40 lower? Obviously, reserve replacement and additional output are both going to suffer.

The basic idea here is that, in a couple of years, the world will find itself with less oil coming out of the ground than it does today. Unless….unless oil prices recover and quickly! If they don't, and deflation has indeed taken over, the global economy is surely headed for recession. And if producers cannot find it within themselves to cut production, then the world will have too much oil, keeping prices low.