The Bear's Lair: Oil free market is bad news for U.S.

For the record, I don't think anybody knows what the effect of the "free market" in oil is going to be, but I do think it is safe to say it will be very disruptive, good for some people, bad for others, and forcing us all to adapt.

However, once the oil price falls below $70, the economic ill-effects for the U.S. of being the world's high-cost oil producer kick in. Investment in the oil sector becomes hopelessly unprofitable, so a wave of bankruptcies must result. In the Austrian economic analysis, the U.S. and Canadian investment in fracking, tar sands and deep-sea drilling becomes "malinvestment" that must be liquidated. You can see the effect of this in the market's reaction late last month to the abolition of Seadrill's (NYSE:SDRL) dividend. The stock dropped 23% in one afternoon and has fallen a further 10% since. The energy sector now represents 15% of the U.S. junk bond market, a percentage that has doubled over the last few years. While some of that borrowing has gone to invest in refineries, which benefit from lower prices, and pipelines, which are close to neutral, any that has gone toward the production of oil or gas is likely to be very difficult to service.

There will be an important second-order effect on the U.S. economy from the energy price downturn. In the last few years, energy-intensive manufacturers have been encouraged to invest in the U.S. because of its relative cost advantage in energy. That has allowed manufacturers whose processes are intensive in energy and not especially in labor to make up for the U.S. labor-cost disadvantage, thus creating jobs that are relatively invulnerable to outsourcing to the Third World.

However, just as cheap money has reduced or even eliminated the U.S. advantage in the cost of capital, and encouraged the migration of U.S. jobs to emerging markets, so will the reduction or even elimination of the country’s energy-cost advantage bring a second wave of outsourcing to other countries of both capital investment and generally well-paid jobs. This is an effect entirely ignored by the simple first-order Keynesian models. But if oil prices remain below $70 a barrel there will be further unpleasant surprises for the U.S. workforce, which has already suffered so badly from U.S. economic mismanagement.

Energy-sector bankruptcies—many of which will result in production capacity being taken out of the market—and the accompanying outsourcing of energy-intensive manufacturing capacity are likely to cause damage that far outweighs any benefit from increased consumption. Capital destruction through bankruptcy reduces the wealth of society, which reduces the amount of capital available for each worker, That in turn reduces the long-term living standards of the workers themselves (and indeed their ability to consume). Additional consumption, much of which will be spent on imports, brings no benefit that is even close to the same level of importance.

http://www.prudentbear.com/2014/12/the-bears-lair-oil-free-market-is-bad.html#.VIjuPih8vzI