July 18, 2016

Weak GDP Keeps Oil Prices Down

The decline in oil prices has been anywhere from tough to catastrophic for states relying on severance taxes for their budgets. Alaska has taken a brutal beating and is on the brink of bankruptcy. North Dakota has experienced one of the largest contractions in GDP any state has seen in recent memory, shrinking the tax base as well.

Wyoming is having a slightly different experience, with a lighter dependency on oil than Alaska but a coal production that at its peak made Wyoming the world's second largest coal producer. The combination of gradually tighter regulations on coal, a global drop in energy demand thanks to recessions in Europe, China and Japan, and on top of that depressed oil prices has been a death-by-a-thousand blows experience for the Cowboy State.

In all the states where severance-tax revenue has declined substantially there are political wishing wells where legislators go to find a glimmer of hope that the good old severance-tax days are going to come back. Some of them think that the recent rebound in oil prices is only the beginning. 

Some media stories seem to reinforce that hope. For example, according to CNN Money:

U.S. oil production is down seven straight months and recently dropped below the 9 million barrel mark for the first time in nearly two years. It's further evidence of how the supply glut and relentless pumping from Saudi Arabia,Iran and other OPEC nations have forced American shale companies to hit the brakes. But OPEC has hardly dealt the U.S. oil boom a death blow. Production is still twice what it was in 2008 and there are early signs of a rebound thanks to the rally in oil prices. Goldman Sachs recently predicted American production will continue declining this year, but then resume growing in 2017 and beyond. "Reacceleration of U.S. oil production may be gradual initially, but the world will still need U.S. shale longer-term," Goldman analysts wrote in a report this week. In other words, don't expect U.S. production to fall off a cliff.
Unfortunately, from a macroeconomic viewpoint there is very little reason to believe in a sustained rise, or even a maintained level, of oil prices. The most obvious reason is the business-cycle trend in the U.S. economy, pointing to weaker economic activity rather than stronger (which would be needed to sustain, let alone increase oil prices further). Here is the inflation-adjusted annual growth in U.S. GDP, measured quarterly, over the past 30 years: 

Figure 1
Source: NIPA, Bureau of Economic Analysis

Since the economy recovered from the Great Recession it has not had one year with growth at three percent or more. On the contrary, GDP has parked itself on a long-term path around two-percent growth; counting Obama's second term through the first quarter of 2016, he has presided over an average of 2.1 percent GDP expansion.

This level is troubling, to say the least. An economy that stays at or below two percent growth for a sustained period of time will in reality not grow at all. All that happens is that the same standard of living is reproduced and the two-percent extra GDP annually is consumed by quality advancements of the same-standard life. For example, when a family buys a new car they buy the same model as before, only new instead of the used one they trade in; if they increased their standard of living they would trade up to a bigger model.

Children grow up to at best enjoy the same standard of living their parents achieved.

In an economy that essentially spends its growth just reproducing the same standard of living there will be no sustained rise in demand for natural resources. With the expansion of supply and new oil fields competing with old ones across the country, it is from a macroeconomic viewpoint much more likely that oil prices will stabilize or decline $5-$10 in the next year or two, than that there will be any sustained rise in prices.

Furthermore, it is likely that the economy will slide into a recession during the second half of 2016. When that happens, it will increase downward pressure on oil prices. A recession is probable based on, among other variables, GFCF, or gross fixed capital formation (or "business investments" as it is known to the public).

Looking at the last 30 years of GFCF it is easy to see where investments are heading today:

Figure 2

Source: NIPA, Bureau of Economic Analysis

In addition to a repetition of investment trends from the early 1990s, the late 1990s right before the Millennium Recession and the late 2000s leading up to the Great Recession, there are recession indicators in the GFCF details. For example, investments by businesses in structures - production facilities, warehouses, stores - are declining and have been doing so for four of the past five quarters (through first quarter 2016). In real numbers the decline from fourth quarter of 2014 to Q1 2016 is not dramatic at 5.5 percent; however, the trend stands out, with the percentage decline increasing per quarter.

The plain-English message in these numbers is that businesses overall are sitting on idle production capacity. From retail mall space to assembly lines for motor vehicles, American businesses are increasingly stuck with over-capacity. This is partly but not primarily due to substantial investments in structures a few years ago; more importantly, though, this is the result of reduced sales that precipitate a general recession.

With a recession comes weakened demand for oil. However, as mentioned earlier, even if the economy sustains around two percent per year in real GDP growth the oil market will largely be stagnant.

And so will prices.

I wish I could bring better news to oil-dependent states. Unfortunately, facts speak louder than rhetoric, and the facts overwhelmingly support long-term stagnation or decline in oil prices. 

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