EconoMonitor

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Creative Destruction in Russia and America: The Case of Energy

There was a dramatic transformation of the world energy market in 2014 as the price of crude oil was cut in half over a six month period. The price of West Texas Crude dropped from around $110 in June to $55 toward the end of December. Prices of natural gas and gasoline ($2.40 in December) experienced similar large declines. As a result, the United States and all net buyers of energy gained, and Russia and all net sellers were harmed. The price decline was a lagged response to a remarkable increase in energy  production that began at a time when many energy experts were predicting that the world was running out of fossil fuels. How could prices fall if the world had passed “peak fossil energy” production?

Increase in Energy Production 

The increase in energy production was especially large in the United States. In 2014 the US overtook Russia as the world’s largest natural gas producer, and in 2015 it is expected to surpass Saudi Arabia as the world’s largest producer of crude oil. Since 2008, the increase in US oil production has exceeded the production of every OPEC producer, except Saudi Arabia (Yergin). In December 2014 US oil production reached 9.14 million barrels per day, the largest output reported by the U.S. Energy Information Agency, since it began keeping records in 1983. (Wall Street Journal). Other factors contributed to the increase in energy production (Grennes and Strazds 2013), but US production was a major contributor to the energy surplus that eventually drove prices down.

Why did Production Increase?

What was the source of the increase in production that drove the price down? A theory popular with  the Russian government and with the Russian public is that the governments of the US and Saudi Arabia conspired to increased production and lower energy prices in order to punish Russia and produce a change of regime in Moscow. President Nicolas Maduro of Venezuela has also accepted the same theory and extended it to include Venezuela as a victim (Reuters). A similar conspiracy theory has been offered to explain why the Soviet Union disintegrated in 1989 following a large and sustained decline in oil prices in the 1980s. A problem with this theory is that the U.S. administration of Barack Obama did very little to encourage production of fossil fuels. Instead they promoted subsidies to renewable energy, and they are expected to be developing new rules that would raise the cost of producing fossil fuels (Wall Street Journal December 2014). The large increase in US oil production (74 %) and gas production (22 %) since 2008 occurred entirely on private land. Indeed, since 2008 production on public land dropped by 16% for oil and 24% for natural gas. The main regulations affecting production during the period came from state governments rather than the federal government. Some states (Texas, Pennsylvania, North Dakota) have had permissive rules, but others (New York) have banned fracking.

Federal regulations have slowed the expansion of pipelines to distribute energy, and the administration continues to delay approval of the Keystone Pipeline. Barriers to pipeline expansion resulted in local surpluses and shortages, and increased use of railroad transportation has resulted in serious safety problems.  Rail transport of oil increased from almost nothing in 2005 to 400,000 tank cars in 2013. Several derailings and explosions have occurred, including the tragic one in Lac Megantic, Quebec that killed 47 people. Rail shipments have increased by 12% in the first half of 2014. The result of restricting pipeline regulation has been to increase shipment by rail, which is both more costly and more dangerous.

Technological Innovation 

An alternative explanation for the oil glut is that technical change was initiated by profit-motivated private companies for whom a price decrease was not part of their intention. They may have had no intention to hurt producers and help consumers.  Other producers followed the innovators and adopted the new technology. The resulting competitive process is an example of Creative Destruction that produced net gains for the world economy, while simultaneously harming incumbent producers. Adam Smith’s famous description of the motives of a businessman is applicable: “.. he intends only his own gain, and he is in this, as in many other cases, led by an invisible hand to promote an end which was no part of his intention” .

Who were these businessmen who shocked the world energy market by developing a profitable way to extract oil and gas from shale?  Were they giant private corporations, such as Exxon-Mobil or Chevron or even larger state-owned enterprises, such as Aramco? On the contrary, in 1999 wildcatter George Mitchell demonstrated in the Barnett Shale near Fort Worth, Texas, that vertical fracking was a viable technology.  (Wall Street Journal).This occurred at a time when many energy experts had proclaimed that peak fossil energy production had passed. Soon another independent company, EOG, headed by Mark Papa, developed horizontal drilling for natural gas. In 2006, EOG demonstrated that shale oil production was feasible in the Bakken fields of North Dakota. Other domestic companies followed the lead of Mr. Papa, and an oil surplus emerged. The surplus was eventually eliminated by the sharp decline in oil prices in 2014. With limited pipeline capacity, the surplus was first concentrated in the Bakken area. Later the surplus oil moved south where it lowered the Cushing, Oklahoma price of West Texas Crude. At first this additional supply produced a large discount for West Texas Crude relative to Brent Crude from the North Sea. Eventually all the local oil prices fell from over $100 per barrel to around $53.27 per barrel by the end of 2014.

Unintended Consequences

Innovations by the independent oilmen had unintended consequences. Mitchell and Papa appear to have been motivated by self-interest, and they were well-rewarded for their work. Mitchell has been described as a billionaire. There is no reason to believe that they intended to help users of oil or to harm the Russian government or the friendly oil exporting countries of Canada, Mexico, United Kingdom, and Norway. Neither did they intend to help landowners and state governments in North Dakota, Pennsylvania, and Texas where laws and regulations are friendly toward fracking. These were unintended side effects, and there were others. Producers of wind and solar energy were harmed. Americans are already buying more pick-up trucks and SUVs, and sales of electric vehicles are down. Another unintended side effect is the decrease in greenhouse gas emissions in the US, as cheaper natural gas displaced coal in the production of electricity. (A full discussion of energy and the environment is a separate subject).

As with many technological innovations, the fundamental ideas were well-known for some time, but the application was new. In Papa’s company, there was no research department. Instead they proceeded to drill by trial and error. Major producers were surprised by the innovation.

The low prices of energy have had major negative effects on the Russian economy. Russia has fallen into recession. The ruble has depreciated sharply, and the inflation rate has increased. Capital is flowing out of the country, and credit rating agencies are considering lowering Russian bonds to junk status. The Russian stock market was the worst performer of all countries included in the MSCI global index in 2014. The rate of return was – 42%. No doubt Russia has been harmed by recent developments in world energy markets. However, the harm to Russia was not caused by a conspiracy. Neither was the gain to all users of energy. They were both caused by the invisible hand of competition.

Conclusion 

Technical change produced a surplus of oil that benefited innovators and users and harmed traditional producers. The innovation was an example of creative destruction that provided great benefits to many people, but it also had a destructive effect on traditional producers and their governments. In spite of its destructive effect on Russian oil producers, the innovators did not conspire to harm Russians or anyone else. They were profit-motivated businessmen whose actions had many unintended consequences. The U.S. government did not promote greater production of fossil fuels. The invisible hand is still with us, and it is not easily manipulable by the authorities in Washington, Riyadh, or Moscow.

References:

Financial Times. 2014. “Russian Equities Worst Performer in 2014”. December 31.

Grennes, Thomas, and Andris Strazds. 2013. “The New World of Energy in the New World”.EconoMonitor. August 21.

Reuters.  2014. “Maduro Blames Plunging Oil Prices on U.S. War vs. Russia, Venezuela”. December 29.

Wall Street Journal. http://www.wsj.com/articles/joseph-rago-the-oilman-to-thank-at-your-next-fill-up-1417822381

Yergin, Daniel. 2014. “The Global Shakeout from Plunging Oil”. Wall Street Journal. December 1.

 

 

8 Responses to “Creative Destruction in Russia and America: The Case of Energy”

__Tom__January 7th, 2015 at 8:24 pm

Agreed. Obama's fuel efficiency drive helped some. Also, on the way down relatively little of the price cut has been passed on to consumers in countries that fix fuel prices or whose currencies have collapsed. Those countries had been the main demand drivers.

ThomasGrennesJanuary 7th, 2015 at 11:00 pm

What countries did you have in mind that fix fuel prices? EU members have traditionally had much high gasoline prices as a result of higher gasoline taxes. In the past EU gasoline prices have been market determined.

__Tom__January 7th, 2015 at 11:22 pm

Many Asian, African and Latin American countries. No, no European that I'm aware of. Google the headline below for a recent article about east Asia.

Asian Consumers See Little Trickle-Down From Cheaper Oil

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