“If we never experience the chill of a dark winter, it is very unlikely that we will ever cherish the warmth of a bright summer’s day.” — Anthon St. Maarten, author of “Divine Living”
Question: Would you explain why oil prices are falling and how this affects the economy?
Answer: Oil prices have tumbled dramatically since last summer, and this will surely influence the economy and consumer behavior. Like other materials, the price of oil depends on the principles of supply and demand. An added dimension is that oil prices are closely tied to various geopolitical forces. It is quite apparent that Saudi Arabia is using its oil-pricing power as a strategic geopolitical weapon.
The question now: “How low do oil prices need to fall to balance the global oil market?” Because of the complicated relationships between cash flow, spending, drilling activity and, of course, politics, there is no simple answer. The first step is to determine true demand and who will provide the supply. Survival of the fittest for those producers who are able to continue operation at lower price levels will be a key factor, just as it was with real estate a few years ago. That decline also played out across various economic sectors. Today, we’ll discuss why the demand for oil has dropped and what the economic ramifications of price decreases may be going forward.
Demand and Price Drop
The Organization of Petroleum Exporting Countries (OPEC) met on Thanksgiving Day and decided to keep oil production levels at a status quo rather than decreasing in response to lessened demand. This led to a substantial drop in the price of liquid gold as “The Beverly Hillbilly’s” called the precious commodity. For each dollar that oil drops per barrel, the Russians feel it in their pocketbook to the tune of roughly $2 billion dollars. Ouch! Geopolitical tensions between Russia, Ukraine and the Middle East have not gone away, and this could potentially generate turmoil in global financial markets.
Ying and Yang: Two Sides to the Equation
Prices go up or down in response to consumer demand. At certain price points, consumers will adjust behavior and reduce consumption. On the other side of the equation, sellers are profit seekers and hope to sell their products at the highest possible prices. When OPEC and other producers have too much product on hand, oil prices will fall, presumably enticing consumers to purchase more at lower price. So, why did demand and prices fall for this precious commodity in the first place? Here are a few reasons:
- Concern that financial slowdowns in China, Europe (Germany) and North America will reduce economic activity, consumption and oil demand.
- The East Siberia-Pacific Ocean (ESPO) pipeline exports from Russian to Asia, this creates competition and price pressure for traditional Mid-East imports to that region.
- Saudi Arabia is discounting prices to maintain market share and punish other oil producing countries. (It’s a form of international arm-wrestling.)
- United States oil boom and “shale gale” resulting in oil output growth.
Simply stated, more production and less use translates into more sellers than buyers. Yet, there are reasons why oil prices will eventually rebound.
First, it is a myth that a slowing Chinese economy reduces the amount of oil they’re buying. China actually is using this low price environment to fill its strategic petroleum reserve tanks. They are in fact, on a buying spree, which indicates that they may see current low oil prices as being temporary.
Lower prices result in production slowdowns. Less output results in lower levels of supply. This supply slump will soon result in higher prices as demand will increase during winter. Predictions this year are for a harsh winter in Canada and the Northern United States. This will make it more difficult to extract oil and reduces output from the Marcellus shale’s in Pennsylvania to the Bakken formation in North Dakota. Demand increases due to colder temperatures will push prices up.
Lower oil and gas prices mean more money in our pockets. This is tantamount to a tax cut. Extra money translates into increased consumer confidence and spending that first finds its way to retail and restaurants just in time for the holiday season. Cash will flow in all directions leading to greater overall economic activity. Airlines, trucking and transportation providers realize increased revenues and profits as fuel costs decline.
It may seem counterintuitive, yet lower oil prices translate into increased demand which pushes oil prices higher and so it goes. The full impact of lower oil prices depends on how long oil prices stay at lower levels. As in other areas of life, all things are connected. Stay focused and invest accordingly.
Views expressed are the current opinion of the author, but not necessarily those of Raymond James & Associates. The author’s opinions are subject to change without notice. Information contained in this report was received from sources believed to be reliable, but accuracy is not guaranteed. Past performance is not indicative of future results.
Investments in the energy sector are not suitable for all investors. Further information regarding these investments is available from your financial advisor. International investing involves additional risks such as currency fluctuations, differing financial accounting standards, and possible political and economic instability. These risks are greater in emerging markets. Investing always involves risk and you may incur a profit or loss. No investment strategy can guarantee success.
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This article provided by Darcie Guerin, CFP®, Associate Vice President, Investments & Branch Manager of Raymond James & Associates, Inc. Member New York Stock Exchange/SIPC 606 Bald Eagle Dr. Suite 401, Marco Island, FL 34145. She may be reached at 239-389-1041, email email@example.com Website: www.raymondjames.com/InvestmentInsights