This oil price shock is different! U.S. shale oil is completely flat, and the largest supply buffer has disappeared

By Zhao Ying

Source: Wall Street CN

UBS has warned that the current oil price shock is far more disruptive than that of 2011-2014. Shale oil, once an economic "shock absorber", has largely lost its effectiveness—its investment flexibility has shrunk drastically, and a supply-side expansion of the past is no longer replicable. More troublingly, the year-on-year rise in oil prices is now approaching 100%. Coupled with a weak labor market, tighter household liquidity and persistent high inflationary pressures, these multiple headwinds have left the U.S. economy with almost no buffer, and the net impact may be severely underestimated.

The fundamental difference between the current oil price shock and the 2011-2014 high oil price cycle lies in the fact that the shale oil industry's responsiveness to price signals has weakened substantially, and what was once the most important supply-side buffer mechanism for the U.S. economy has effectively ceased to exist.

According to Zhuifeng Trading Desk, UBS economist Arend Kapteyn noted in a March 19 report that although the average Brent crude price stood at around $110 per barrel between 2011 and 2014 (equivalent to approximately $145 in current prices, about 23% higher than the current spot price), U.S. GDP growth still remained above 2% at that time. The key reason, however, was the robust hedge provided by the booming shale oil industry. This buffer has now largely vanished, making the net impact of the current oil price rally on the U.S. economy far more difficult to offset.

The report emphasizes that the destructiveness of the current oil price shock is also reflected in the speed of the price surge—if the current oil price level persists, the year-on-year increase will approach 100%, far exceeding the peak annual rise of no more than 55% seen in 2011-2014. At the same time, the U.S. labor market is weaker today, household liquidity is tighter, and inflationary pressures are more acute. The combination of these adverse factors has made the erosion of consumer income far harder to counteract.

### Shale Oil: Once the U.S. Economy’s "Shock Absorber"

In the early 2010s, the U.S. shale oil revolution was in full swing, and its supporting role for the economy could not be ignored. According to the UBS report, the U.S. mining sector (consisting mainly of the oil and gas industry) accounted for about 14% of total industrial production in early 2010. By 2012-2013, the sector contributed more than half of the total growth in U.S. industrial production, and even nearly all of the incremental industrial output in some periods.

It was this strong supply-side expansion that provided robust support for the U.S. economy amid high oil prices—the loss of consumer purchasing power caused by elevated oil prices was offset to a certain extent by the growth in employment, capital expenditure and industrial output driven by the shale oil investment boom.

### Investment Flexibility of Shale Oil Has Plunged

After the oil price crash of 2015-2016, U.S. mining output rebounded from a low base, but the investment intensity and drilling density of the shale oil industry have never recovered to pre-2014 levels. The UBS report points out that oil production still responds marginally to prices—through an increase in the number of well completions, higher capacity utilization and improved production efficiency—but overall investment flexibility has declined markedly.

In other words, if the market views the current oil prices as a temporary phenomenon, the U.S. will be unable to see any supply-side expansion driven by shale oil similar to that of 2011-2014, and thus cannot offset the erosion of consumers' real income caused by rising oil prices.

### Multiple Headwinds Combine to Make the Current Shock Harder to Absorb

The UBS report lists several key differences between the current macro environment and the previous high oil price cycle. First, the U.S. labor market is weaker now than in 2011-2014; second, household sector liquidity is tighter, leaving limited buffer room to withstand external shocks; third, the inflation shock is more severe, and the transmission effect of the rapid rise in oil prices on overall prices is stronger.

These factors together mean that, in the absence of a hedge from shale oil supply-side expansion, the net drag effect of the current oil price rally on U.S. economic growth may far exceed the market's judgment simply drawn by analogizing the historical experience of 2011-2014.

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