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Cheap Oil for Change

WASHINGTON, DC – The recent decline in oil prices is likely to have a major, largely positive impact on the global economy – even greater than most observers seem to recognize. Indeed, if governments take advantage of lower oil prices today to implement critical energy-policy reforms, the benefits may improve structural features of their economies tomorrow.

A key reason why the price decline’s impact has so far been underestimated is that nobody knows how long it will last. And, indeed, past price movements provide little guidance in this regard. When prices plunged in 2008, they shot back up almost faster than experts could say “new normal”; after the 1986-1987 drop, prices remained low for a decade and a half.

This time, the price trajectory is likely to be determined by a new player in the energy game: shale oil. The marginal cost of shale-oil production (the expense of continuing to pump an existing well) varies from $55 to $70 per barrel. Add a $5 profit margin, and the oil-supply curve now has a long, near-horizontal segment in the range of about $60-75 per barrel. Regardless of demand, this will be the natural nesting range for the price of oil – call it the “shale shelf” – and will likely remain in place for a protracted period.

This provides some insight into OPEC’s decision last November not to curtail supply. Saudi Arabia correctly reasoned that cutting output would not boost prices, but simply concede space for new players to step in and grab market share.