The Peculiar Economics of Falling Oil Prices

The sharp fall in worldwide oil prices is a silver lining with a silver lining, even if the linings are a bit tarnished.  The price of the world’s most widely-used commodity has fallen sharply over the last five months, from a spot market price of $115 per-barrel in late June to $77 last week.  For consumers everywhere, that means major savings that will mainly go to purchase other goods and services; and those boosts in demand should spur more business investment.  So, if low prices hold for another six months, analysts figure that growth in most oil-consuming and oil-importing countries could be one-half to a full percentage-point higher than forecast, including here in the U.S. and in the EU, China and Japan.  It’s a blow to the big oil-producing and oil-exporting nations; but the global economy will come out ahead.  After all, the U.S., EU, China and Japan account for more than 65 percent of worldwide GDP, while the top ten oil exporting countries, led by Saudi Arabia and Russia, make up just over 6 percent.

The hitch for this rosy scenario is that much of the revenues that OPEC countries now won’t see would have gone into financial and direct investments in the U.S. and EU.  That means that new investments in American and European stocks and bonds could be reduced by some $300 billion per-year.  The upshot may be slightly higher interest rates and slightly lower equity prices, which would dampen the growth benefits of lower oil prices. 
The lower prices are driven mainly by supply and demand, but market expectations and some strategic maneuvering by Saudi Arabia play a role, too.  Yes, worldwide oil supplies are up with rising production from U.S. and Canadian tar sands and shale deposits, and Libya’s fields are fully back online.   Moreover, these supply effects are amplified by softness in demand for oil, coming from economic stagnation in much of Europe and Japan, China’s slower growth, and our own increasing use of natural gas.  Oil prices also are influenced, however, by the prices that buyers and sellers expect to prevail months or years from now.  Last week, when the “spot price” of crude oil was about $77 per-barrel, the price for oil to be delivered next month was almost $10 lower.  In fact, the world’s big oil traders see crude prices continuing to decline not simply into 2015, but for a long time:  The price for oil to be delivered in mid-2016 is less than $72 per-barrel and, according to these futures prices, not expected to reach even $80 per-barrel until 2023. 
Don’t count on a decade of cheap oil.  Yes, technological advances have brought down the cost of extracting oil from tar sands, shale and deep water deposits, as well as the cost of producing and transporting natural gas.  But the economics of these new energy sources work best at prices higher than those prevailing today.  A long period of low oil prices would slow the growth of supply from those sources -- and so drive oil prices back up.  The Saudis are counting on it.  They’ve refrained from cutting their own production, which could restore higher prices, in hopes that another year of low prices will slow down investments in all of those alternatives sources.
The truth is, oil prices will rise again whether the Saudis’ tactic works or not.  While the outlook for much stronger growth remains slim for Japan and much of Europe, an extended spell of lower energy prices will support higher growth here, in China, and across many of the non-oil producing countries in Asia, Latin America and Africa.   Stronger growth and energy demand will bring on line more alternative sources of energy -- so long as oil prices are high enough for the alternatives to be competitive.
This is an old story.  Oil prices fell, and as sharply as they did this year, in 1985 and 1986, in 1997 and 1998, and in the aftermath of the 2008-2009 financial upheavals.  Each time, oil prices marched up again after one, two, or at most three-to-four years.  Of course, that volatility also makes some people billionaires.  To join them, what you’ll need is patience and a hedge fund’s access to credit.  With that, all you do is go out and purchase a few billion dollars in contracts to take delivery of crude in 2018 or 2020 at today’s futures prices, and then dump the contracts when oil prices once again head north of $100 per-barrel.
This post was originally published on Dr. Shapiro's blog

Oil in the Spotlight

While oil prices have come down since their recent peak a few weeks ago, they remain in the spotlight.  This weekend, President Obama used his Saturday address to call for increasing drilling.  Coming on the heels of last week's grilling by the Senate Finance committee of the nation's top oil executives a propos of a proposal to end longstanding tax breaks for drilling, his remarks capture the frustration many people feel about rising gasoline prices.

Our anger would no doubt bemuse many overseas for US gas prices are low by global standards.  Indeed, as the attached graph shows, they are still less than those registered two years ago.  What is nonetheless frustrating about gas prices is their volatility.  Gas price shocks like hurricanes and flooding are hard to predict but when they occur,devastating.  The impact of the 1970s shocks are well understood: they launched stagflation in the US and Europe and inaugurated a huge transfer of wealth to the oil states that persists to this day.  But even the milder 2008 shock, some economists now believe, may have played a role in triggering the Great Recession.  And the story that many are using to explain the collapse, not just in oil prices but in commodity prices across the board in recent weeks, is expectations of a weak economy ahead--perhaps one deflated by high commodity prices over the last year.

As frustrating as oil shocks are, the record of efforts to address them has been more frustrating still. The 1970s oil shocks were bad but the famous lines at the pump that helped Ronald Reagan defeat Jimmy Carter were due not to the oil shocks but to price controls--a policy intervention that succeded only in creating shortages.  Worse, price controls were slapped on domestic oil but not foreign oil, and traders reaped millions by illegally recertifying shipments. 

In 1980, Congress passed a windfall profits tax on oil.  Given the huge profits by oil companies at the time, it seemed like sound economic policy  However, the tax applied only to domestically produced oil and, in retrospect, was a key step in accelerating our dependence on foreign oil.  More successful was the creation of the Strategic Petroleum Reserve and the creation of gas mileage standards. But neither of these has proved a silver bullet either.  The Reserve has yet to be tapped and the CAFE standards, while they have cut fuel use, by looking at the entire fleet are correctly criticized for allowing gas guzzlers to persist.

If controlling volatility in commodities markets has never been easy, it has become more difficult in recent years.  A series of commodity index funds launched by Merril Lynch but now owned by Goldman Sachs have become established vehicles for hedge funds and others to place large quantities of money, exacerbating movements.  Indeed one theory of the commodiites runup this past year is that it reflects global liquidity created by the QE2 program of the Fed that spent about $600 billion buying securities.   Indeed, the commodities crash last week, coincided with the end of QE2.  Yet another theory for the commodities crash is that authorities raised margin requirements on commodities traders.  The commodities "bubble" as some has described it has drawn comparisons with the financial and real estate bubbles, in particularly, in light of the IPO "at the top" scheduled this week by Glencore, the company started by Marc Rich decades ago after he fled the United States.

All of this is a way of saying that reining in oil and gasoline prices is not easy.  But given the devastation, price spikes can cause, it must still be attempted.  Perhaps the single most important thing we ought to do is reign in Opec, the organization that more than any other can alter the price of oil.  Secondly, financial regulators need to study more carefully how trading in commodity indices as an asset class can drive monetary movements with serious real world consequences.  Beyond that, we should be working over the long term to wean ourselves off scarce resourcs such as oil toward renewable resources.  That cannot happen overnight but it will be the only long term resolution to the problem of oil and gasoline price volatility.

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