Cheap Oil: Good News or Bad News?
Good times at the gas pump equates to bad times in the economy? Usually people equate high gas and oil prices to recessions and difficult economic times. While correlations exist between the cost of oil and certain elements of the economy, the situation is far more complex and unpredictable than a direct relationship. The effect of oil prices propagates through many segments of the economy — from transportation costs for goods, to chemical feedstocks, to your fill-up at the local gas station. Thus, cheap oil can harm our economy as well as boosting it.
To truly understand the connection and the likely future effects of low oil prices, consider why they are low. Are they low because of the supply side of the oil market, the demand side, or both? Do the underlying conditions look to be short-term, long-term, or chronic?
In today's environment, economists are concerned because oil prices are being attacked on both the supply and demand sides. Thanks to classic market forces, oil prices have hit their lowest point in seven years. Brent crude dropped below $38 per barrel on Friday, while West Texas Intermediate (WTI) dropped below $36 per barrel. Let's look a little closer at the reasons for the fall and why oil prices are likely — but not guaranteed — to stay low for some time and how that is likely to affect the markets.
Plentiful Supplies, Slowing Demand
Oil production is high all across the globe, but not for the same reasons. The fracking revolution in the US allowed for large increases in production and a lesser demand for foreign oil imports. Heavily oil-dependent economies such as Russia and Venezuela must keep the oil flowing to minimize the damage to their economy. With freshly lifted sanctions, Iran will be joining the party in earnest. The OPEC nations, led by Saudi Arabia, are maintaining high production levels for strategic reasons — they hope to drive the more expensive fracking sources out of business with their cheaper-to-extract oil and regain their dominance over the global oil market.
OPEC arguably caused much of this month's tailspin in oil prices with their failure to announce any cut in production levels. In turn, the International Energy Agency (IEA) released their forecast on Friday noting that a glut of crude oil is likely to last through the majority of 2016. At the same time, the IEA forecast growth in world oil demand at 1.2 million barrels per day in 2016, compared to the 1.8 million barrel per day growth in 2015. The main growth comes from China, the US, India, and Europe — not coincidentally, the main targets in the Paris climate change conference. (More on that topic later).
Stock markets reacted appropriately to the news, with the Dow Jones Industrial falling 310 points. The S&P 500 dropped almost 40 points. The NASDAQ composite fell over 111 points. Global markets fared no better, with the FTSE 100 in London falling over 135 points to reach its lowest level in over two months.
The market is coming to terms with the fact that cheap oil is likely here to stay for quite some time, and there are no signs that global demand will increase enough to soak up the massive glut of oil within the near future. The underlying conditions for low oil prices are inching away from short term toward longer-term. Could they become chronic? That probably depends on the demand side.
Fossil Fuel Transitions
Eventually the supply side will work itself out as somebody blinks first — or more likely, goes out of business. Increased oil demand is generally correlated to economic growth, at least in our economy as currently structured. Will that continue as momentum gathers for the transition away from fossil fuels toward renewable energy sources? What would such an economy look like?
Consider the potential effect of the new climate change agreement. The target of less than 2 degrees Centigrade in average global temperature by 2050 requires not only conversion to cleaner energies, but also much less consumption. There is simply no way around that conclusion — and by much less, we mean an enormous amount.
Eduardo Porter of the New York Times points out that to meet this target, considered the tipping point of catastrophic future changes, the collective economies of the world would have to reduce the amount of carbon dioxide per dollar of GDP to six grams or less. The US currently emits approximately 360 grams per unit of economic output. Even the conference host France, a relatively efficient country with respect to carbon because of the nuclear power component, emits 150 grams per dollar of GDP.
The huge drop in consumption required would reset the entire supply/demand model that forms the basis of today's markets. Realistically, such a drop is not going to occur in the near future — but it does suggest that slower growth could become a new norm in the developed nations as a consequence. At the very least, growth will take a new form. One could argue that it already has, since technological advances have been a large component of the last few growth cycles.
In the end, those technological advances result in products made in traditional factories, and fossil fuels remain an important part of those factories — so far. It's fair to say that low oil prices are not chronic and that a traditional market cycle will kick in over the next few years. Someday in the distant future, that will not be the case.
Every sign points to both oversupply and weak demand working to keep oil prices low through 2016, and perhaps well beyond. Oil will eventually rise as supply finally starts to match demand. If you want to try to pick up bargains in oil-related stocks, be prepared to hold them for the long haul to see significant returns. Do your homework on the fundamentals of the company to make sure they have sufficient business and cash on hand to make it through these difficult times. For oil extractors, dig into their production costs. How do they compare to other sources?
One thing could change the equation radically. Global unrest that results in destruction of oil fields and infrastructure through terrorism – or merely disrupts oil distribution — could drive rapid price increases. Consequently, it pays for investors to keep up on global events.
Meanwhile, enjoy the currently low gas prices, but do so wisely. Low gas prices aren't necessarily the signal to buy that gas-sucking SUV you always wanted. They are a signal to use your savings to pay down debt, put money away for larger purchases like a down payment on a home — and then engage in reasonable spending. After all, we are a consumer-driven economy. We are the origin of demand.