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December 4, 2014

The Long and Short of Falling Energy Prices

Earlier this week, The Wall Street Journal asked the $1.36 trillion question: Lower Gas Prices: How Big A Boost for the Economy?

We will take that as a stand-in for the more general question of how much the U.S. economy stands to gain from a drop in energy prices more generally. (The "$1.36 trillion" refers to an estimate of energy spending by the U.S. population in 2012.)

It's nice to be contemplating a question that amounts to pondering just how good a good situation can get. But, as the Journal blog item suggests, the rising profile of the United States as an energy producer is making the answer to this question more complicated than usual.

The data shown in chart 1 got our attention:

141204a

As a fraction of total investment on nonresidential structures, spending on mining exploration, shafts, and wells has been running near its 50-year high over the course of the current recovery. As a fraction of total business investment in equipment and structures, the current contribution of the mining and oil sector is higher than any time since the early 1980s (and generally much higher than most periods during the last half century).

In a recent paper, economists Soren Andersen, Ryan Kellogg, and Stephen Salant explain why this matters:

We show that crude oil production from existing wells in Texas does not respond to current or expected future oil prices... In contrast, the drilling of new wells exhibits a strong price response...

In short, the investment piece really matters.

We've done our own statistical investigations, asking the following question: What is the estimated impact of energy price shocks in the second half of this year on investment, consumer spending, and gross domestic product (GDP)?

If you are interested, you can find the details of the statistical model here. But here is the bottom line: the estimated impact of energy price shocks is a very sizeable decline in investment in the mining and oil subsector relative to baseline and, more importantly, an extended period of flat to slightly negative growth in overall investment relative to baseline (see chart 2).

141204b

In our simulations, the "baseline" is the scenario without the ex-post energy price shocks occurring in the third and fourth quarters of 2014, while the "alternative" scenario incorporates the (estimated) actual energy price shocks that have occurred in the second half of this year. These shocks lead to a cumulative 8 percent drop in consumer energy prices and a 6 percent drop in producer energy prices by the fourth quarter of this year relative to baseline. By the fourth quarter of 2017, 2 percentage points of these respective energy price declines are reversed. In chart 2 above, each colored line represents the percentage point difference between the "alternative" scenario and the "baseline" scenario.

As for consumption and GDP? Like overall investment, there is a short-run drag before the longer-term boom, as chart 3 shows:

141204c

So is the recent decline in energy prices good news for the U.S. economy? Right now our answer is yes, probably—but we may have to be patient.

Note: We have updated this post since it was originally released, clarifying a sentence in the paragraph above chart 2 and providing the data for the charts. The original sentence stated: But here is the bottom line: the estimated impact of energy price shocks is a very sizeable decline in investment in the mining and oil subsector and, more importantly, an extended period of flat to slightly negative growth in overall investment (see chart 2).