Over the past couple of months, it seems that my engagement in small talk has been revolving around cheap gas prices. In fact, it seems that I cannot escape the discussion, be it at work, running errands, watching the news, etc. (I realize by writing this post, I am contributing to my problem.) No doubt your experience has been the same. Perhaps you have heard comments like this:
“Can you believe gas is under $2 a gallon again?”
“I filled up my SUV for $25 last week!”
“I’ve been thinking about buying a new SUV myself.”
“My family is planning a cross country road trip this spring break in our new SUV we just purchased.”
Such conversations have typically ended on a comment like, “I wonder how long it will last.” In light of such comments, I wanted to take a moment to re-hash how we got here, some possible expectations going forward, and actions we as consumers and investors can take. (If you are not interested in analysis, skip to the last heading for the short version!)
Oil Supply and Demand
Let’s begin with June of 2014, when oil prices last peaked at over $110 a barrel here in the US. Since then, prices have been down as much as 60%, and the price of gas has followed suit. What is the reason for this dramatic drop?
In simple terms, the price of oil is very sensitive to changes in supply and demand. If you recall from your incredibly interesting and engaging economics professor’s lectures, an increase in supply of ‘product x’ will decrease the price, and a decrease in demand of ‘product x’ will also decrease the price. This relationship between supply and demand is especially dramatic with oil; small changes in supply and demand can have great impacts on price.
An increase in US oil production, a surprise announcement from OPEC in November that they would not cut their production, and an apparent global slowdown in demand have all contributed to the precipitous fall of oil and gas prices since last summer. It seems, then, that the real driver behind the recent fall is a price war. In other words, businesses are vying for dominance in a smaller global market and attempting to push competitors out of the business. Simple enough right?
So… What’s Next?
It can be quite difficult to forecast, in the near term, where commodity prices are headed. As a result, a slew of opinions have surfaced stating that oil is headed as low as $20 a barrel, and others just as adamantly declaring it’s going back up to $100 a barrel. This article is not an attempt to add my voice to the chorus, but what is one to believe at this current juncture?
Let’s consider a few current assumptions:
According to a November report from Citi’s Ed Morse*, around half of the worldwide drilling projects are losing money at the time of this writing. At the very least, margins are quite tight for many drilling projects. Furthermore, any continued drop in price is likely to push more companies towards operating losses and thus cutting production.
Oil consumption has been on the rise for a long time. The last 30 years have seen increases in consumption coming largely from the developing world (think China, India, Brazil, Russia, etc). Any disruption in demand from developing countries caused by political and economic issues will likely be short-term. The growth in demand from these regions will no doubt pick up again. Even if demand were to begin to taper, the world is unlikely to cure its dependence on fossil fuels overnight.
On the other hand, oil prices have been historically quite volatile, with dramatic swings in price that are seemingly unrelated to actual events. Basically, extremes in either direction are often followed by an extreme move the opposite direction. Expect more volatility going forward.
With the unpredictability of oil prices in mind, it seems reasonable to say that even if we see some extra drop in the near future, it is likely to snap back quite quickly. In other words, this is a roller coaster. Surprises will abound. Am I being sufficiently obscure?
Actions We Can Take As Consumers and Investors
The point is this: while it feels uncustomarily good to fill up at the gas station right now, do not be lulled into a false sense of security. The prudent and wise will assume cost savings at the pump to be a short-term bonus, and will use the opportunity to strengthen personal savings and budgets. Others will no doubt get stung when the trend eventually reverses or normalizes, as they take the opportunity to add to their monthly obligations. Come out of this glut stronger than when you entered it.
As an investor, consider putting some money to work in the energy sector. Markets tend to overreact to these little events, leaving plenty of opportunities for those able to keep their wits about them. Make sure to do your due diligence and also consult with your investment advisor when making decisions on this.
Enough said for now on this topic. Enjoy your next visit to your local gas pump!
*Udland, Myles. (2014, November 28). Here Are the Breakeven Oil Prices For Every Drilling Project In the World. Retrieved from http://www.businessinsider.com/citi-breakeven-oil-production-prices-2014-11