Why have oil prices declined so dramatically? An Interview With Sam Young

Why have oil prices declined so dramatically? An Interview With Sam Young

In this column, Sam Young, Economist in HUD's Denver Field Office, talks about the decline in oil prices and its effect on housing.

The Bakken area of Williston, North Dakota contains a large supply of recoverable oil and natural gas. Photo courtesy of the U.S. Geological Survey.

In 2014, the United States surpassed Saudi Arabia to become the world’s largest energy producer. This increase in domestic production is largely due to the increased use of hydraulic fracturing and horizontal drilling techniques. Typically, producers react to supply-side dynamics and adjust production. However, the Organization of the Petroleum Exporting Countries (OPEC) announced at its November 2014 meeting that it would maintain its current level of production of 30 million barrels per day. The markets reacted to this announcement, and oil prices have since declined.

On the other hand, demand for oil has also declined. Between July and December 2014, the International Energy Agency revised down projected global oil demand by 800,000 barrels per day. Global growth in oil demand is expected to remain much weaker during 2015 than it was between 2003 and 2008, when oil prices increased substantially. The decline in demand also contributed to the oversupply of oil, pushing down prices.

Finally, a strengthening U.S. dollar tends to negatively impact oil prices. In the second half of 2014, the dollar appreciated 10 percent against major currencies, which erodes the purchasing power of foreign currencies. A 10 percent appreciation in the value of the U.S. dollar can cause an estimated decline of 3 to 10 percent in the price of oil.

From a consumer standpoint, the decline in oil prices is welcome. We all spend less at the pump and have more disposable income to spend elsewhere. There are numerous estimates of how that additional spending power may affect gross domestic product (GDP), but the impact is positive. However, some of that gain in consumer purchasing power is offset by declining capital expenditures by oil producers. The decline in oil producers’ revenue has had a cascading effect in the United States, particularly in the oil-impacted regions of the country.

There are four primary, cascading effects. First, capital expenditures for new exploration and drilling have declined. Drilling a new well is relatively expensive, and funding that expense with lower revenues can be difficult. In fact, an energy survey by the Federal Reserve Bank of Kansas City found that half of all energy firms expected to cut capital spending by at least 20 percent during 2015, and most anticipate layoffs. Another 25 percent expect to cut spending between 10 and 20 percent.

This reduced capital spending leads to the second effect: rig counts have declined. According to data from Baker Hughes, the number of U.S. rigs peaked at 1,930 in November 2014 and declined 13 percent to 1,675 in 2 months. Rigs located in Texas fell by 139, accounting for more than half of the national decline. Rig counts declined by 21 in North Dakota.

At this point, it is important to differentiate between production and drilling. Existing wells will continue to produce oil, and oil production in the United States remains strong. The production life cycle of shale wells is much shorter than that of conventionally drilled wells). The production level of a shale well declines by an average of 80 percent after 2 years, whereas a conventional well may not decline to that level of production for 10 years. As a result, the decline in oil rigs and slowdown in drilling of new wells is likely to eventually lead to lower production.

Finally, oil rigs are a major source of employment. Oil exploration and drilling is a labor-intensive process, and employment in these sectors has increased dramatically in oil-impacted areas. For example, in North Dakota, employment in the Minot-Williston area increased by more than 15 percent annually from 2011 through 2013, largely tied to increases in oil production. Some oil companies are now scaling back and laying off workers as drilling declines and companies conserve their cash flow. In fact, the world’s largest oil-field service company, Schlumberger Ltd., recently announced that it had laid off 9,000 workers, reducing the company’s global head count by 7 percent. It is important to note that declining rig counts and drilling activity affect not only those directly employed by oil producers but also any support activities tied to energy development. For instance, as development slows, the need for transportation and oilfield support services and maintenance may decline. Laid-off energy workers and others affected may choose to work in a different sector or move to look for new opportunities, which may have short-term effects on local communities and housing markets.

As you may be aware, the dramatic influx of energy workers to oil development areas put pressure on local infrastructure and housing markets. In some areas, rental vacancy rates declined to less than 1 percent. In addition, a recent Apartment Guide survey found that the most expensive rents in the United States were in the Bakken area of Williston, North Dakota, topping rents in the urban centers of Los Angeles, New York, and San Francisco. A 700-square-foot, one-bedroom apartment in Williston can rent for more than $2,000 per month. Heavy demands were placed on roads, public utilities, and other local infrastructure because they were not originally designed to accommodate heavy usage caused by strong population growth. It is unclear at this point, but some of this pressure may ease in the short term as energy markets adjust to the current environment of lower oil prices. We will be monitoring this situation closely.

The North Dakota state legislature recently revised down the tax revenue forecast for the next 2 years by $4 billion because of lower oil prices. Although this forecast may be revised, state legislators are currently operating on the assumption that crude oil prices will remain in the $45 to $65 per barrel range through their biennial planning period.

Texas is also adapting. The Federal Reserve Bank of Dallas is predicting that Texas severance taxes from oil and gas will decline. In addition, the Dallas Fed predicts that a sustained oil price decline of 50 percent will lead to a loss of 140,000 jobs in Texas. Although the Dallas Fed still expects economic growth of 2 to 2.5 percent in Texas during 2015 because of the state’s diverse economy, low oil prices and a strong dollar will hinder stronger growth.

That is the billion-dollar question. I would love to offer solid predictions about future oil price movements and their effects on the United States, but I cannot. However, we can track some trends that may be helpful.

The next scheduled OPEC meeting is in June, and the committee members may decide to adjust production levels at that meeting. If so, markets will likely adjust and oil prices will rise.

In addition, declining rig counts could affect domestic production levels relatively quickly. Baker Hughes predicts that the average rig count in the United States will decline by 15 percent in the first quarter of 2015, from the previous quarter. Prices may rise once the slowdown in drilling affects production. The long-term effect of this would be to make domestic production more profitable again, and producers with a strong cash position may be able to react quickly and boost drilling and production again.

Continued economic weakness in other countries will likely mute demand in the near term. The European Central Bank has committed to buying 60 billion euros of sovereign debt monthly through September 2016 in an effort to boost growth in the eurozone. Third-quarter Chinese GDP growth was 7.3 percent, the slowest growth since the first quarter of 2009. The International Monetary Fund recently revised down its annual global GDP growth forecast to 3.5 percent in 2015 and 3.7 percent in 2016. These events will likely maintain downward pressure on prices.

All of these predictions, however, are based on the current state of technology. It is entirely possible that technological advances in hydraulic fracturing and horizontal drilling could lower the cost of domestic drilling in the United States, which would mean that domestic producers could lower costs and better absorb lower global oil prices.

Within HUD’s Office of Policy Development and Research, a task force is monitoring the effects of oil and gas development on housing markets, and we have been publishing work since 2012. Our first look at these markets was published in the second quarter 2012 edition of U.S. Housing Market Conditions. In December 2012 we presented at a panel discussion in Washington, DC, where we discussed the boomtown effects of new oil and gas exploration; a video of this discussion is available on YouTube. Finally, our most recent working paper discussed the impact of oil and gas exploration on affordable housing and can be found on the HUD USER website. We were fortunate enough to be able to present those findings at a SUNY Conversations in the Disciplines conference in 2014. All of these efforts offer background information on energy development and housing markets and provide the foundation for our ongoing work in these areas.