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The fiscal cliff and its threat to US oil

With the election over, Obama faces what may be the toughest economic decision he will ever make. And the effects of that choice will be played out in the oil markets

For President Barack Obama, re-election was the easy part. Now comes the fiscal cliff.

The fiscal cliff is a legacy of his first term when, after a battle with Congress to raise the US' debt ceiling, the White House agreed to a raft of spending cuts that will come into force just as Bush-era tax breaks expire. At midnight on 31 December, those breaks will end and the federal government will begin chopping the first $110 billion of $1.2 trillion in legislated spending cuts over the next 10 years.

The debate with Congress last year cost the US its treasured triple-A credit rating. The outcome of this battle could be just as severe, with implications far beyond the US economy.

According to the US Congressional Budget Office (CBO), the combination of higher taxes and lower government spending could pull some $560bn from the economy and reduce GDP by about 3% in 2013. The CBO released those estimates on 8 November, two days after Obama's election victory.

While it would slash the $1 trillion budget deficit in half, the CBO predicts that 2m jobs would disappear overnight, raising the unemployment rate by a full percentage point and plunging the country back into recession. Given the weakness in Europe and China, the global economy would probably follow the US into any dip.

Nobody knows what lies on the other side of the cliff, but stripping $4.4bn of discretionary spending from consumers in the form of higher taxes will reduce retail sales, and the consumption of everything from imported goods to crude oil.

In terms of energy, it is logical to assume oil prices will fall in step with lower demand. How low could they go? US oil prices fell to a low of $33.87 a barrel following the 2008 crash. Demand fell 750,000 b/d, or 4%, to 18.77m b/d in 2009.

After recovering in 2010, the Energy Information Administration (EIA) expects US demand to fall to a post-recession low of 18.66m b/d in 2012, the lowest level since 1997. If the cliff were to result in another 4% hit, US consumption would be at its lowest since the late 1980s.

Any good news?

This is not necessarily a bad outcome. Economists estimate that every $10 drop in the price of crude adds half a percentage point to GDP, blunting the impact of a sharp recession. Low natural gas prices have saved consumers $16.5bn a year, according to HIS, a consultancy. The figure could rise to $100bn a year by 2015.

While the cost savings to consumers would cushion a major economic contraction, a big drop in oil prices would threaten higher-cost domestic production in states like Texas and North Dakota.

The US drilling boom emerged when oil traded at $150/b, and relies on high global prices to be viable. With individual wells costing more than $10m in unconventional plays like Eagle Ford, setting the clock back to 2008 would stifle growth and idle rigs.

The same holds true for deep-water exploration, which needs full-cycle run rates of about $80/b to be economic.

Those are numbers that should cast doubt on forecasts for energy independence of the kind proposed during the presidential campaign. "Global trade ensures that no one country can have energy prices below world levels without massive subsidies," points out Walter Zimmerman, an analyst at United iCap. "Energy independence does not mean price independence."

Despite its higher cost, domestic oil production is an important source of economic growth and jobs in local markets. North Dakota had the US' lowest unemployment rate before the election, at less than 3%, mostly owing to rapid development of the Bakken play. A major drop in activity would reduce the $3.4bn in revenues paid to the state's treasury since 2011.

Time to come together

So the fiscal cliff is a national problem that begs national solutions. Unlike the European debt crisis, the fiscal cliff is a housekeeping item that could - and probably will - be averted with the stroke of a pen. The consequences of inaction are simply too high.

Ballots were still being counted when bond-rating agency Fitch warned a repeat of the debt ceiling battle would result in further downgrades to the US credit rating. Even if the US steers clear of the fiscal cliff, without a plan to reduce deficits, downgrades could still be pending. It does not mean Greece-style austerity, but things could still get tough.

There is a simple enough path away from the catastrophe. According to the CBO's most recent numbers, maintaining government spending at present levels and extending the Bush-era tax cuts would immediately add 2% to its GDP forecast for 2013.

It urges the government to scrap the Budget Control Act - legislation passed in 2011 to pre-empt another debt-ceiling crisis - and adopt an "alternative fiscal scenario" to extend the status quo for at least two more years. It is a stop-gap measure. The deficit will grow by about $1.3 trillion in the same period, increasing it to 70% of GDP, its highest level since 1950.

Even the CBO admits that such a path for federal debt "could not be sustained indefinitely, so policy changes would be required at some point".

But it buys time until the real fiscal cliff looms after 2022, by when economists predict today's loose monetary policies will give way to crippling interest rates and declining GDP. By then, the CBO says, the US' debt will be unsustainable. If that is the case, then the fiscal cliff is just one scary signal of far bigger economic troubles to come in the world's largest economy.

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