This holiday season has brought what seems like a glorious present: cheap gasoline. Fuel at $2 a gallon or so frees up cash for families to spend on gifts or paying down debts. But by the time this gift is fully unwrapped, it will likely leave people covered with greasy economic residue that will be hard to remove. With oil falling from more than $90 a barrel to under $60, the effects go far beyond how much a tank of gas costs. Because Russia relies heavily on oil exports, its economy is already faltering, and we can expect social unrest, perhaps sparking Vladimir Putin to new military aggression to distract people from their plight. Airfares should fall but likely will not because the three major carriers can maximize profits by avoiding competition. Shares of heavily leveraged fracking companies may burn up like so much flared natural gas, wiping out some investors. The Keystone XL pipeline may be delayed or even killed, preventing a pipeline of American cash that Canadians counted on to buoy their economy. The Chinese are hiring tanker ships, quadrupling rental rates, as they convert some of their trillions of American dollars into oil, which will earn a higher return than the minuscule interest now paid on the U.S. government bonds China holds. Most significant, cheap oil is disrupting the transition to renewable energy, which promises to slow global climate change and save many millions of lives. Our accounting rules ignore much of the damage from relying on oil and natural gas. Corporate profit and loss statements do not record how the slowly heating atmosphere affects crops, sea levels and weather patterns or how diesel fuel particles spewing out of tailpipes affects people’s asthma. But they should: Cheap oil comes at a price that shows up not on your credit card statement but on the universal ledger where all costs must be recorded and paid.

Why the fall-off

The decline in oil prices illustrates how the most basic economic principle, equilibrium, plays out on a global scale. Oil prices were stable for many years, until about 2002 when, as the accompanying graphic shows, oil prices began to rise even after adjusting for inflation, as China, India and other countries expanded their middle classes.



Crude oil prices, 1986-2014







Source: Federal Reserve Bank of St. Louis.

Data is not seasonally adjusted and indexed for 2014 dollars.

That spike in oil prices was the result of oil traders manipulating the price even though supply and demand remained fairly constant. Today, though, supply has grown while demand is easing, driving prices down. Prices, like water, tend to flow until they find their own level, where they stabilize. If you can make a huge profit from any activity, others will join in to capture some of that profit, bringing down the overall profit rate until it makes no sense to invest more. People with cash then invest in some other activity that will earn a higher return. It is not quite that simple, of course, even in nature, where physics rules. Water that appears flat is not always so. A combination of winds and differences in air pressure can make the water level in Toledo, Ohio, on the west end of Lake Erie, several feet higher than in Buffalo, New York, at the east end. With oil, the pricing pressures come not from nature but from humans. Government rules that affect the production, transportation, refining, trading and use of oil in turn affect prices.

A domino effect

We can see how equilibrium plays out in the energy landscape, which is much more complex than a simple drop in prices at the pump. Today’s increased supply of oil is the result, in part, of human ingenuity that has allowed us to extract ever more carbon fuels from the ground. The earth contains vast troves of stored sunlight, some of it in liquid form near the surface (as in the Middle East) and some of it buried deep (as in the shales of North America). Peak oil — the idea that we had already extracted so much that production would rapidly decline until we ran dry — was based on what we thought was recoverable from the ground. But new technology allows us to extract even deeply buried hydrocarbons. But that technology is costly — and with oil prices dropping, the fracking industry is already feeling the effects. Fracking pioneer Harold Hamm has seen his $18 billion paper fortune halved in the last few months, and his debt-laden firm, Continental Resources, is raising cash while slashing its investment in new production next year by about half. Nationwide, drilling rigs are disappearing fast.

The real price of cheap oil may be in turmoil, bloodshed and faster climate change.

Cheap oil will only defer fracking, though, not stop it. The stored energy is not going anywhere — in some parts of the U.S., fuels lie in as many as nine layers of shale — and will be tapped when prices justify going after it. In the long term, what’s more worrying is that lower oil prices discourage alternatives that use current, rather than stored, solar energy. Wind turbines, photovoltaic cells and more exotic technologies such as electric generators powered by waves and rivers are economically feasible only when they cost the same as or less than oil and natural gas, at least the way we account for costs. Taxpayer subsidies, which already benefit fossil fuel companies, will continue to be necessary to make renewable energy viable until oil prices rise again.

Political and human costs