Oil Prices: Is That the Sky Falling?
No, it’s the price of oil. On Tuesday, December 16, the WTI spot price closed just below $55 per barrel, its lowest level since May 2009. Prices of petroleum products like gasoline and diesel are following the price of crude oil in its downward march. The price of oil has trended downward since June and in late November fell sharply immediately after OPEC announced that “member countries” (read Saudi Arabia) would not cut production.
The fall in the price of oil follows a three-year period of relative stability. Its decline was not all that surprising given that U.S. oil production continues to grow (it totaled approximately 9 million barrels per day [mm b/d] in November, up 3.9 mm b/d since the beginning of 2008). On top of this, the amount of oil production removed from the market because of unplanned supply disruptions has declined in recent months. The increase in U.S. oil production has more than offset oil lost from unplanned disruptions. Finally, world oil consumption is growing more slowly than previously forecast due largely to slower economic growth in Asia and the Eurozone.
One might think that the fall in the price of gasoline in the U.S.—it’s down an average of $1.14 per gallon since the beginning of May—might spur consumption and that increased consumption would put upward pressure on the price of gasoline. Gasoline consumption, however, is very “price-inelastic” (especially in the short-term), meaning that a large change in price has a very small effect on consumption. This line of reasoning extends to total petroleum consumption and thus there is little reason to think that the lower price of oil will have much of an impact on total petroleum consumption. Economic growth has a much stronger impact on consumption and it is the slowdown in global growth that has contributed to the fall in the price of oil.
U.S. manufacturers are affected in different ways by the fall in the price of oil. If prices remain below $65 to $70 per barrel, we will likely see a reduction in oil development activity. In turn, this will reduce the demand for manufactured products used in oil development. On the positive side, manufacturers benefit from reduced shipping and transportation costs. Those that use petroleum in their production processes also benefit from lower prices. Finally, most manufacturers and the overall economy benefit from what is similar to a significant tax cut. U.S. gasoline consumption in 2014 will equal about 136 billion gallons. At this level of consumption, gasoline consumers (residential, commercial, and industrial) will spend $141.6 billion less on gasoline than they otherwise would have if the price of gasoline remains $1.14 per gallon lower than its May price for an entire year. This is equivalent to approximately $1,230 per household.
Of course, the $64,000 question is where do we go from here? Few have had success in forecasting oil prices very far into the future and history has shown that price trends can change abruptly. In July 1986, the refiner acquisition cost of imported oil was 59% lower than its level one year earlier. It rose gradually after that but the price remained below its previous peak for more than 15 years. Some analysts believe the price of oil will remain in the range of $55 to $65 per barrel through 2015 and after that increase very moderately. My own view is that the price of oil will not remain at its current level ($55 as this is written) for very long, but that it will remain below $70 through 2015.
What happens to the price of oil depends on three main factors: 1) the extent to which the upswing in U.S. oil production in recent years is cut back due to the lower price; 2) global economic growth, especially in Asia; and 3) the oil production decisions by OPEC (dependent on oil revenues to fund their governments).
The Energy Information Administration (EIA) estimates that OPEC members (excluding Iran) will see their revenues fall from $970 billion in 2013 to $446 billion in 2015. If production continues to increase in the U.S. and if world oil consumption grows slowly, OPEC will find it difficult to engineer a significant increase in the price of oil over the next few years. However, anyone who follows the oil market knows that one should be prepared for surprises.