President-elect Donald Trump is right: Low energy prices are good for America, both households and businesses. One of his favorite campaign slogans was “drill, baby, drill.” Trump promised that his government would open up federal lands to more oil and gas drilling and eliminate unnecessary regulations that retard production, restrain profitability growth, and restrict investment in technological innovations that increase productivity.
Trump will follow through on his pro-energy promises. But oil and gas companies are in the business of making money. That means they will only increase production if the price is right. The energy sector understands that the market determines the prices for oil and gas. When demand is high and supply is tight, prices are higher. That is economics 101. High prices bring out additional supply. Energy companies in the United States are the most efficient in the world. Productivity growth in the oil and gas sector has been phenomenal. As prices increase, the energy giants invest more in productivity-enhancing innovations.
Today, the shale oil companies of America’s southwest region, West Texas and New Mexico particularly, can drill wells thousands of feet deep and then turn the drill bits horizontally and drill for thousands of feet more. A decade ago, U.S. shale oil companies adopted the philosophy of maximizing production and neglected profitability. Production increased dramatically, but some companies experienced financial distress. The companies learned from that harsh experience. Now they exercise strict financial discipline. They focus on the bottom line.
Companies drill new wells when the probability of positive capital returns is high. They explore for new reserves when the capital rewards are obvious. The oil and gas companies of America will not produce and drill just for the sake of higher production.
That matters because, currently, prices for West Texas Intermediate oil, the U.S. benchmark, are sufficiently high for energy companies to drill new wells in the Permian Basin. This area holds billions of barrels of oil and vast quantities of natural gas. According to the Federal Reserve Bank of Dallas, in the shale oil basins, the break-even cost for new wells is about $65 a barrel. This week, WTI is trading at around $69-70 a barrel. But the global economy is well supplied with oil. Supply is substantially higher than demand.
This means that there is not enough incentive to increase production. If a significant amount of global supply is shut off because of a geopolitical crisis, then oil prices will rise, and U.S. companies will turn on the production tap. But at the moment, Big Oil will focus on maximizing profits and returning capital to shareholders.
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Trump will, however, provide certainty for the oil and gas industry. Companies are now confident in the cost outlook for the next four years. As long as the price is right, they will produce sufficient oil to ensure that gasoline prices remain low. Moreover, under the new Trump administration, prime oil and gas acreage on federal lands will be opened up for exploration and development. When that acreage comes up for bid, companies will aggressively pursue new drilling opportunities.
Over the course of the next four years, households and businesses should not expect a cornucopia of new supply and lower prices, but the country can be confident that prices will be low and supply will be ample. Under Trump, the U.S. will maximize its comparative advantage in energy. National prosperity will be maximized.
James Rogan is a former U.S. foreign service officer who later worked in finance and law for 30 years. He writes a daily note on the markets, politics, and society. He can be reached at [email protected].