Anybody who drives a car knows the price of oil has dropped dramatically over the past six months. According to AAA, the national average price for a gallon of regular was $2.12 on Jan. 13, down 18 percent from $2.58 in just a month and down 36 percent from $3.31 a year ago. I smile every time I fill my Yukon.
Since the start of 2010, the price of a barrel of U.S. benchmark light sweet crude oil traded in a fairly tight band between $80 and $110, averaging $92 for the five years ending Dec. 31, 2014. Crude oil reached its 2014 high of $107.26 on June 20 before plummeting to $53.27 at year-end, down 50 percent to a five-year low.
At a basic, Economics 101 level, an imbalance has developed between supply and demand. According to Strategas Research Partners, U.S. production has almost doubled, from 4.7 million barrels per day in 2008 to 9.0 million barrels per day, due in large part to the shale oil boom. This helps explain why U.S. oil imports from OPEC are down 42 percent over the same period. On the demand side of the equation, while the U.S. economy has been strengthening, Europe and Asia have been slowing.
The New Yorker’s final edition of 2014 featured “How Low Can Oil Go?” which offered a clear explanation of how this supply/demand imbalance has translated into crashing prices. Over the short term, supply and demand for oil are “price-inelastic,” which means they don’t respond to changes in prices as quickly as other goods.
For instance, if prices increase, consumers don’t immediately drive less. Similarly, if prices decrease, consumers don’t automatically drive more. Wealthy producing countries like Saudi Arabia want to maintain market share, so they don’t cut production. Countries on shakier economic footing—like Russia, Venezuela and Iran—desperately need revenue, so they can’t cut production. Similarly, many producing companies have significant debt obligations to meet if they want to stay in business, so they have to keep pumping, regardless of price.
With supply and demand essentially fixed over the short term, small changes in either (or both, in this case) can lead to relatively large changes in price. In addition, commodity-based hedge and index funds have attracted billions from investors who probably believed oil was more likely to rise to $150 than fall to $50. So, it’s very possible some of these funds are being forced to liquidate positions into a falling market (sound familiar?).
I have no idea where the price of oil will settle, but if oil averages its 2014 year-end level in 2015, Strategas estimates U.S. consumers would save $192 billion, representing quite a tax cut. With consumer spending accounting for almost 70 percent of the U.S economy, this is a clear positive. On the downside, the energy sector represents 8 percent of the market value of the S&P 500 (12.3 percent of the S&P 500’s earnings) and its capital expenditures 1 percent of U.S. nominal GDP.
There is an old adage in the oil business: “The cure for high oil prices is high oil prices.” Over the long term, supply and demand will adjust and the corollary is also likely to be true: “The cure for low oil prices is low oil prices.” Enjoy them while they last!•
Kim is the chief operating officer and chief compliance officer for Kirr Marbach & Co. LLC, an investment adviser based in Columbus, Indiana. He can be reached at (812) 376-9444 or email@example.com.