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What's wrong with the sharp drop in oil prices?

There is no such thing as a free lunch. When it comes to economic changes, that says it all, and the recent sharp drop in oil prices clearly fits that reality. But sometimes, the cost of the meal is worth the indigestion it might cause.

There is no such thing as a free lunch. When it comes to economic changes, that says it all, and the recent sharp drop in oil prices clearly fits that reality. But sometimes, the cost of the meal is worth the indigestion it might cause.

While some parts of the economy may suffer from falling energy costs, for most of us, it's nothing but the joy of a good meal.

I used to joke that oil prices go in two directions: Up slowly and up quickly. Not anymore. The oil market is in near free-fall. Over the last year, petroleum costs are down more than 25 percent, and 35 percent from the summer peak. Meanwhile, gasoline prices have declined by 50 cents from last December and by $1 - or more than 28 percent - from the spring high.

So, why are prices dropping like a rock? Even in the energy market, supply and demand matter, and right now, supply is king. Fracking has led to a surge in U.S. energy production. Oil output has increased about 80 percent in five years, reducing our dependence on foreign oil to a 45-year low.

At the same time, the Organization of Petroleum Exporting Countries has maintained its production levels while non-OPEC nations are increasing theirs. Meanwhile, slowing European and Chinese economies are restraining demand. And when supply exceeds demand, prices fall.

For the first time in four years, gasoline prices are below $3 per gallon, and that means big bucks for consumers. If prices remain at current levels, an average driver could save more than $500 a year, adding about $70 billion to household spending power.

Importantly, the price decline is coming at exactly the right time: the holiday shopping season. Since most of the gasoline cost savings are going to people who can really use the money, they will probably spend it. That might add 0.5 to 1 percentage point to Gross Domestic Product growth, which is no small change.

But it is not just consumers who benefit. Any firm that uses petroleum-based products is helped as its costs go down. Companies in the delivery and trucking businesses, manufacturing, and airline industries should love the falling prices. Don't expect many price cuts, but higher earnings could increase competition.

Given all who benefit, what could possibly be wrong with falling oil prices? Think of it this way: When we pump gasoline, we fill up the coffers of energy companies, not just our gas tanks. Lower prices mean lower revenue and usually lower earnings for energy companies.

But the biggest impact might be on oil-drillers. In the U.S., the cost to produce a barrel of oil from fracking varies, but is somewhere in the $50-to-$70 range. If prices drop below that break-even point, losses occur, creating the risk that production would be cut back. That could also lead to a reduction in investment in future capacity and a decline in energy-sector employment.

That said, the negative impacts might not be significant. Energy companies now recognize that high and rising prices are not a God-given right. Thus, they will work even harder to increase productivity, innovate by improving technology, and lower costs.

Additionally, energy projects require long lead-times to go from planning to production. Short-term energy-price fluctuations generally don't create immediate capital-spending changes. The current construction projects should continue, and unless prices really collapse, production, investment, and employment reductions are likely to be limited and only in very high-cost areas.

Once the industry adjusts to the new cost environment - or prices rise again - those cutbacks would likely be unwound.

While the negative impacts on the U.S. economy should be modest, internationally, they could be large. Oil-producing nations depend heavily on oil revenue for their budgets. Countries such as Russia, Iran, Venezuela, Ecuador, and even some of the Middle Eastern nations could find themselves in dire financial and economic straits, including recessions, if oil remains near current levels.

On the other hand, consumers around the world will benefit in the same way as U.S. households. Europe and Japan, whose economies are barely growing, could see significant boosts to growth from reduced consumer energy costs that translate into additional consumer spending.

The energy sector may suffer some agita from the price decline, and there may be some short-term effects on investments, earnings, production, and even employment. But there are winners and losers every time there is an economic change, so the energy sector should simply take its Nexium and move on.

Most important, consumers' wallets will be a little fatter. The "energy price-drop lunch" might not be free, but its costs are clearly affordable.