In recent weeks, many analysts have expressed considerable surprise as oil prices have hit $80 per barrel and prices at American gas pumps have fallen. This “surprise” seems to have crept up on us, but evidence of shifting market demand and energy production has been available for some time. Over the past three years, high oil prices have generated increased interest in oil and gas in remote locations such the Arctic and East Africa. In addition, breakthroughs in oil and gas technology have also driven the development of unconventional oil and gas resources in regions of the world that were previously considered too high-cost, too high-risk or too far away from established markets for profitable energy production. Further, as a result of climate change melting Arctic ice, new oil fields and delivery routes have opened up, while technological advancements in resource extraction are opening vast new regions for resource exploration in countries like Mozambique and Tanzania, which lack even the most the most basic infrastructure and need high energy prices to justify their development.

Despite possible environmental and infrastructure challenges, a number of countries and regions are motivated to pursue increased resource development and extraction for a variety of non-energy related reasons. For example, the political leadership of Greenland views the development of energy and mineral resources as an opportunity to gain independence from Denmark. For its part, Canada sees the development of its northern territories as a way to bolster its claims to national sovereignty over its “internal waters,” a view contested by both Washington and Moscow. In the case of Russia, development of the Yamal Peninsula and its offshore Arctic waters has been a major priority for President Vladimir Putin, who believes the policy will catapult Russia into the vanguard of future global oil and gas producers and, as a result, will make Russia a market player in the Far East as well as Europe.

Unfortunately, while these emerging energy producers are coming on line, the market for energy has been shrinking—at least for the near-term. Since June 2014 (when oil was at $115 per barrel), oil prices have been in a free fall, with demand dropping across Europe, Japan, India, China, Brazil and much of the emerging world market. The drop in demand is the result of a number of factors, including:

• Slowing global economic growth;
• Rising global oil production (especially in North America);
• Unexpected resumption of oil production in Libya, Nigeria, South Sudan and Iraq;
• Increasing energy efficiency, a response to three years of oil prices in excess of $110 per barrel, which, in turn, had an impact and continues to impact long-term global demand;
• A decision by Saudi Arabia in August 2014 to cut oil production by 400 thousand barrels per day, an attempt to defend its market share in the face of falling global oil prices;
• Record oil output from Russia;
• Surging natural gas liquids and hydrocarbon gas liquids production outside the OPEC quota system;
• Natural gas eating away oil’s market share as a refining fuel and as a feedstock in petrochemicals;
• The decision by Japan to restart some of its nuclear reactors, reducing forward demand for fuel oil in the power sector;
• Dumping of oil onto the marketplace by hedge fund managers who had gone long on oil prices (by some estimates as much as two million barrels per day) in anticipation of further price rises – the hedge funds had no alternative but to liquidate their positions when the market turned against them.

In August, Saudi Arabia tried and failed to stop the slide in oil prices. Now supported by the United Arab Emirates and Kuwait, the Saudis have decided to send a message to the world market that it will do whatever is necessary to maintain its market share, even accepting a near-term loss in revenue over the next two years. The Saudi goal is to slow or halt unconventional oil production, which is undermining their market share and profits. The short-term decline in oil prices also serves Saudi Arabia’s agenda by hurting their adversaries (Iran and Iraq) and squeezing Russia’s ability to fund the Assad regime in Syria.

However, the Saudis and their allies may be overlooking the complex economics of unconventional oil production in North America. For example, while drilling new wells in some unconventional basins may not be profitable at $80 per barrel, many existing wells have largely been amortized by current tax policies making them economic at prices in some basins such as the Permian at prices as low as $40 to $50 per barrel. The most important factor is that the production profile of many unconventional wells is very different. For example in the Bakkan wells flow very strongly but then crash often initially only recovering four percent of the oil in place while the Permian wells tend to plateau but ultimate recovery is much higher.

While various pundits have opined on this question, the truth of the matter is that no analyst really knows the full range of production costs across the unconventional crude oil production continuum since this information is highly proprietary. Nonetheless, with oil prices for West Texas Intermediate (WTI) at $81 per barrel and Brent at $83 per barrel and with Wall Street in turmoil and Europe poised on the brink of a new recession, the specter of a major price decline similar to that of 2008 cannot be ruled out. While prices could overshoot on the downside, I believe that prices will fall to $60 to $70 per barrel, before stabilizing at a level still far above the $38 per barrel we saw in 2008.

The precipitous drop in oil prices could not have come at a worse time for U.S. oil producers, who have been advocating for the United States to lift the long-time ban on crude oil exports (in place since 1975).  According to the Brookings Energy Security Initiative’s research on the issue, if the ban were to be lifted immediately, the United States could be exporting 1.7 million to 2.5 million barrels per day (mmbd) by 2015. With the market in such a weak position and demand falling, adding as much as 2.5 mmbd to the world market would significantly drive down both crude oil and petroleum product prices (gasoline and home heating fuel). While beneficial to consumers in the near term, the effect on crude prices will only add to the current market turmoil and a further downward spiral in crude prices. Furthermore, with many unconventional oil wells also producing natural gas, to the extent that oil prices fall below $60 per barrel, some natural gas production could also be affected.

Keep in mind, however, that the further crude prices fall in the near term, the faster they may rebound, as low prices become the engine that leads to a resumption of demand and world economic growth. The fall in oil prices will have various effects on different countries, though the magnitude is often overstated. For example, any further fall in oil prices could have serious deleterious effects on the Russian economy. As a major oil export economy (with oil accounting for 14.5 percent of Russia’s gross domestic product), Russia’s budget for 2014 is predicated on an average price of $97 per barrel. Therefore a price slide to $80 per barrel or below would pose a major economic setback for that country. The fact that prices have averaged at $110 per barrel for the year-to-date however allows Russia some cushion in the event of a short term price drop – as do Russia’s large financial reserves. However, any prolonged drop in oil prices will pose serious challenges to the Russian economy.

Countries that produce at a high cost with large populations, subsidized consumer prices and various political constraints, such as Iran (sanctions), Indonesia (falling energy exports), Iraq (political turmoil), Nigeria (political instability and falling exports) and Venezuela (a collapsed economy in need of high export prices) will be thrown into turmoil. Fearful of low prices, Venezuela recently attempted and failed to call an emergency meeting of OPEC to discuss the situation. Given the already fragile nature of many of these regimes, the prospect of serious social upheaval cannot be ruled out. On the other hand, large oil importing countries such as China, India, Brazil, Japan and South Korea stand to benefit from falling oil prices.

It is against this backdrop that OPEC will meet in late November. The oil price slide and efforts to reverse it will be priority one on the ministers’ agenda. While the Saudis may be willing to cut production if all the other OPEC members also agree to substantial cuts, the prospects for an agreement are slim to none, given their individual internal political realities and revenue needs.

As a long-term observer of the oil market, I have seen this game played out in various manifestations over the last 40 years. We are clearly in for a wild ride; buckle your seat belts. 

Drive through any number of outer-ring suburbs in America, and you’ll see boarded-up and vacant strip malls, surrounded by vast seas of empty parking spaces. These forlorn monuments to the real estate crash are not going to come back to life, even when the economy recovers. And that’s because the demand for the housing that once supported commercial activity in many exurbs isn’t coming back, either.

By now, nearly five years after the housing crash, most Americans understand that a mortgage meltdown was the catalyst for the Great Recession, facilitated by underregulation of finance and reckless risk-taking. Less understood is the divergence between center cities and inner-ring suburbs on one hand, and the suburban fringe on the other.

It was predominantly the collapse of the car-dependent suburban fringe that caused the mortgage collapse.

In the late 1990s, high-end outer suburbs contained most of the expensive housing in the United States, as measured by price per square foot, according to data I analyzed from the Zillow real estate database. Today, the most expensive housing is in the high-density, pedestrian-friendly neighborhoods of the center city and inner suburbs. Some of the most expensive neighborhoods in their metropolitan areas are Capitol Hill in Seattle; Virginia Highland in Atlanta; German Village in Columbus, Ohio, and Logan Circle in Washington. Considered slums as recently as 30 years ago, they have been transformed by gentrification.

Simply put, there has been a profound structural shift — a reversal of what took place in the 1950s, when drivable suburbs boomed and flourished as center cities emptied and withered.

The shift is durable and lasting because of a major demographic event: the convergence of the two largest generations in American history, the baby boomers (born between 1946 and 1964) and the millennials (born between 1979 and 1996), which today represent half of the total population.

Many boomers are now empty nesters and approaching retirement. Generally this means that they will downsize their housing in the near future. Boomers want to live in a walkable urban downtown, a suburban town center or a small town, according to a recent survey by the National Association of Realtors.

The millennials are just now beginning to emerge from the nest — at least those who can afford to live on their own. This coming-of-age cohort also favors urban downtowns and suburban town centers — for lifestyle reasons and the convenience of not having to own cars.

Over all, only 12 percent of future homebuyers want the drivable suburban-fringe houses that are in such oversupply, according to the Realtors survey. This lack of demand all but guarantees continued price declines. Boomers selling their fringe housing will only add to the glut. Nothing the federal government can do will reverse this.

Many drivable-fringe house prices are now below replacement value, meaning the land under the house has no value and the sticks and bricks are worth less than they would cost to replace. This means there is no financial incentive to maintain the house; the next dollar invested will not be recouped upon resale. Many of these houses will be converted to rentals, which are rarely as well maintained as owner-occupied housing. Add the fact that the houses were built with cheap materials and methods to begin with, and you see why many fringe suburbs are turning into slums, with abandoned housing and rising crime.

The good news is that there is great pent-up demand for walkable, centrally located neighborhoods in cities like Portland, Denver, Philadelphia and Chattanooga, Tenn. The transformation of suburbia can be seen in places like Arlington County, Va., Bellevue, Wash., and Pasadena, Calif., where strip malls have been bulldozed and replaced by higher-density mixed-use developments with good transit connections.

Reinvesting in America’s built environment — which makes up a third of the country’s assets — and reviving the construction trades are vital for lifting our economic growth rate. (Disclosure: I am the president of Locus, a coalition of real estate developers and investors and a project of Smart Growth America, which supports walkable neighborhoods and transit-oriented development.)

Some critics will say that investment in the built environment risks repeating the mistake that caused the recession in the first place. That reasoning is as faulty as saying that technology should have been neglected after the dot-com bust, which precipitated the 2001 recession.

The cities and inner-ring suburbs that will be the foundation of the recovery require significant investment at a time of government retrenchment. Bus and light-rail systems, bike lanes and pedestrian improvements — what traffic engineers dismissively call “alternative transportation” — are vital. So is the repair of infrastructure like roads and bridges. Places as diverse as Los Angeles, Phoenix, Salt Lake City, Dallas, Charlotte, Denver and Washington have recently voted to pay for “alternative transportation,” mindful of the dividends to be reaped. As Congress works to reauthorize highway and transit legislation, it must give metropolitan areas greater flexibility for financing transportation, rather than mandating that the vast bulk of the money can be used only for roads.

For too long, we over-invested in the wrong places. Those retail centers and subdivisions will never be worth what they cost to build. We have to stop throwing good money after bad. It is time to instead build what the market wants: mixed-income, walkable cities and suburbs that will support the knowledge economy, promote environmental sustainability and create jobs.

Event Information

A conversation with Senator John McCain

On May 19, the Center for 21st Century Security and Intelligence at Brookings (21CSI) hosted Senator John McCain (R-Ariz.) to address major reforms to the organization of the Department of Defense, the defense acquisition system, and the military health system included in the National Defense Authorization Act for Fiscal Year 2017, which is planned for consideration by the Senate as soon as next week.

Given his role as chairman of the Senate Armed Services Committee, McCain also addressed ongoing budget challenges for the Department of Defense and the military and his views on what needs to be done. Michael O’Hanlon, senior fellow and co-director of 21CSI, moderated the discussion.

Join the conversation on Twitter using #FY17NDAA

Video

• Introduction by Martin Indyk, and remarks by Sen. John McCain
• Discussion between Sen. John McCain and Michael O'Hanlon

Audio

• New demands on the military and the 2017 National Defense Authorization Act

Transcript

• Uncorrected Transcript (.pdf)

Event Materials

• 20160519_mccain_defense_transcript