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Ignore producers: the cost of energy benefits consumers

My Times column on the faling oil price:


So ingrained is the bad-news bias of the intelligentsia that the plummeting price of oil has mostly been discussed in terms of its negative effect on the budgets of oil producers, both countries and companies. We are allowed to rejoice only to the extent that we think it is a good thing that the Venezuelan, Russian and Iranian regimes are most at risk, which they are.

Yet by far the greater benefit of the oil price fall comes from the impact on consumers. Making this essential resource cheaper allows everybody, whatever their nationality, to spend less money on dull things like heat, transport, metal and plastic, which leaves them more money for things like movies, holidays and pets, which gives other people new jobs, which raises everybody’s living standards.

The oil price peaked at almost $150 a barrel in 2008, just before the financial crisis. That is probably no coincidence. Although the crisis was fuelled by a credit bubble, rocketing oil prices helped  trigger the bust. All over the world, but especially in America, people were saddling themselves with longer and longer commutes to find houses they could almost afford, a phenomenon known among American mortgage brokers as “drive till you qualify”. The doubling of fuel prices in the US between 2005 and 2008 killed that strategy and began the collapse of the housing market.

The price of Brent crude oil has fallen from about $115 a barrel in June to about $85 today. That will make a tank of petrol cheaper (though not by as much as it should, because of taxes) but it will also make everything from chairs to chips to chiropody cheaper too, because the cost of energy is incorporated into the cost of every good and service we buy. The impact of this cost deflation will dwarf any effect of, say, a fall in the price of BP shares in your pension plan.

It is true that part of the reason oil prices are falling is that world economic growth is slowing. But economists reckon that every 10 dollars off the price of a barrel of crude oil transfers 0.5 per cent of world GDP from countries that export oil to countries that import it — and the latter tend to spend the money more quickly, accelerating the velocity of money and encouraging investment and innovation.

The industrial revolution itself was built around abundant cheap energy, mainly in the form of coal, which enabled mechanisation, which vastly amplified the productivity of the average worker and therefore his income. Today a typical British family of four uses as much energy as if it had 400 slaves in the back room pedalling eight-hour shifts on exercise bicycles. It would use even more if it also fed those slaves!

The falling oil price is largely the Americans’ fault. By reinventing the extraction process for first gas, then oil, with horizontal drilling and hydraulic fracturing, engineers have almost doubled the country’s output of oil in six years. That ingenuity was made possible by the high price of oil, which promised fabulous riches to those who could get oil out of shale, but it is no longer dependent on the high price of oil. It is often said that the cure for high oil prices is high oil prices and so it has proved.

The International Energy Agency (IEA) says that most shale oil production remains profitable at  $80 a barrel. One North Dakota oilman tells me that his rate of return on fracked wells drops to 10 per cent only when oil prices reach $55, and that’s without taking into account the falling price of fuel for his vehicles. Every month American oil production rises by 100,000 barrels a day at the moment and that is not going to change for a year or so whatever happens to the price of oil. The number of rigs drilling for oil will start to drop off if the oil price falls further, but only slowly. Of course, unlike the nationalised decisions of Opec, oil production in America is the sum of the investment decisions of hundreds of independent companies.

The IEA reckons that only about 3 per cent of world production needs a break-even price above $80. Much of that is in China, Indonesia, Malaysia, Nigeria and Russia, where costs are high largely because of big government taxes and royalties. It is governments, in other words, that are most likely to take the  spring out of the consumer’s step, with Opec’s impending decision on whether to constrain production being the best hope of the spoilsports.

Talking of spoilsports, here in Britain the opposition has managed to deprive people of the benefits of lower energy prices. Ed Miliband’s promise that he would freeze the price of energy from 2015 came just before world energy prices began to fall smartly. The energy utilities, reluctant to have their prices frozen when they are low, have therefore done their utmost to avoid dropping their prices in case Mr Miliband becomes prime minister.

As Paul Massara, head of  npower, told the regulator Ofgem in August: “We are acutely aware that if the Labour party were to implement their proposed price freeze, we will be living with the consequences of our standard rate tariff price for a very long time and beyond the level of risk that we could manage in the wholesale market.”

Not that the Liberal Democrat part of the coalition government has covered itself in glory on energy costs either. In 2010 Chris Huhne’s Department of Energy and Climate Change assumed that gas prices would double by 2020, leading renewable energy subsidies to wither away. Instead gas prices have fallen. In a normal market that would mean lower electricity prices, but in DECC’s wonderland, we have to pay the difference between gas prices and the costs of wind. In other words, this country’s official energy policy insulates consumers and manufacturers to some extent from the benefits of falling costs. That way lies uncompetitiveness.

But is cheap fossil fuel not bad news for the climate? A new paper in Nature magazine argues that when the gas boom sparked by fracking goes global, prices will fall fast, economic growth will accelerate and so we will end up using more energy and producing more emissions than before, even if we give up coal. It forgets to mention that if we get that much richer, we will also abolish much more poverty, disease and misery, and have the investment funds to invent new, cheap and low-carbon forms of energy too.

By Matt Ridley | Tagged:  rational-optimist  the-times