SPECIAL REPORT
THE PRICE OF OIL
December 16 2014
The number one topic in financial markets these days is the price of oil (or lack thereof).
Why is the price of oil crashing? What does that mean for the market?
Price change is always a reflection of the dynamics of supply and demand. A rise in price is caused by an increase in demand or a decrease in supply. A fall in price is caused by a decrease in demand or an increase in supply.
This crash seems to have been a kind of perfect storm. The past few years of rising oil prices had encouraged businesses to extract oil through more neglected and expensive methods such as hydraulic fracturing (fracking), and from more expensive areas that until then had not been economically feasible. (Fracking had been neglected until prices rose enough to encourage technological innovation in areas that would expand oil production. This is a perfect example of a free market economy overcoming a shortage. Previously rising oil prices were because of a lack of supply relative to the demand, and so the rising prices incentivized more supply.)
On top of this structural development, weakening global economic activity slowed demand for oil, which created more supply and less demand; hence falling oil prices.
Now the question is, are falling oil prices good or bad?
Most of us remember hearing, while oil prices were rising, that it was bad for the economy, as people spent more money filling up at gas stations, and less money on retail, vacations etc. Now that oil prices are falling we hear it’s still bad. You just can’t win!
The truth is, as with everything in life, it’s both good and bad. Lower oil prices feel good at the gas pump and will encourage more spending by Joe Consumer, and it lowers transportation costs, which would mean lower prices in stores. But it would also mean that many companies such as small oil exploration firms (whose businesses are not diversified and whose business models are predicated on high oil prices) will be out of luck, at least for the near future. Plus, many of those fracking companies borrowed money to finance their businesses, and counted on $100 per barrel oil to pay for their loans.
There are also entire countries that are hurting because of the fall in prices – not just the obvious Iran and Saudi Arabia, but Russia, Nigeria, and Venezuela as well.
Will oil prices return to previous levels?
From the explanation above of the reason for falling oil prices, it would follow that a cycle should ensue due to the collapse in the price of crude: production slows, more expensive production methods are abandoned and, hopefully, global demand slowly rebounds. This would suggest that oil prices will almost certainly rise at some point in the future. In other words, supply and demand dynamics should work its magic in the reverse direction. (Side note: OPEC failed to slash production, seemingly a foolish move. However, that decision, made by Saudi Arabia, may be a political one, to punish its enemy Iran. Or just a business one, to push its rivals out of the market by operating at a loss, something Saudi Arabia can do with its huge cash reserves. And, according to some analysts, the main rivals it is trying to shut down are the fracking companies, who have turned the U.S. into the world’s largest oil producer, displacing Saudi Arabia.)
This is not a necessary scenario. Although lower prices do cause supply and demand to shift accordingly, and the price of oil will probably rise, at least a bit, from where it is now, the return to the previous price regime is only certain where nothing else changes.
For example, if the previously high prices caused an engineering breakthrough in tight oil extraction that now makes it much cheaper to produce oil than earlier, that could mean that a lower price for oil is the new reality. Or possibly the expensive infrastructure has already been installed, and fracking can continue even with lower oil prices. Or perhaps consumers are now used to using less gas than they were accustomed to, due to the higher prices, creating a lower level of demand. Or maybe oil companies will adjust their business structure to deal with cheaper oil, lowering their operating costs and profit margins, which would enable them to continue supplying oil at the same rate, keeping prices low.
The point is, it’s complicated, and no one really knows anything for certain.
Michael Dym
