Oil prices are in a serious free-fall. US drivers are spending less than $2.50 per gallon at the pump for the first time in more than five years. According to the AAA, “the average price at the pump has fallen nearly 25 percent since the start of the year.” Why is the price of oil falling?
To understand why oil prices are falling, we have to go back to the late-2000s. As the global economy began to recover from economic crisis, the price of oil spiked due to increased demand – especially in China. Between 2011 and 2014, oil remained relatively stable at around $100 per barrel.
As oil prices increased, it suddenly became profitable for energy companies to extract oil from difficult-to-drill places. In the United States, for example, energy companies began to use techniques like fracking to extract oil from shale formations. That led to a boom in “tight oil” production. In 2008, US oil production hovered around 5 million barrels per day. In the period week Dec. 5, production had increased to 9.12 million barrels per day. Canada and Russia experienced similar increases.
Typically, such a dramatic increase in oil production would trigger a decline in the price of oil. But that didn’t happen. Why not? Because at the same time the US saw a fracking boom, geopolitical conflicts flared in key oil regions around the globe. Iraq descended into chaos. Libya was engulfed in a civil war. Sanctions were levied against Iran, pinching that country’s exports. In all, even as oil production increased in the US, Canada, Russia, and others, conflicts around the globe took more than 3 million barrels per day off the market.
Over the summer, however, conditions began changing dramatically. Many of the geopolitical conflicts in key oil regions eased, and oil flooded the market. In Libya, for example, oil production increased from 200,000 barrels per day in June to 900,000 barrels per day at the end of September. Even more significantly, oil demand in Asia and Europe has been weakening.
The combination of rising supply and weaker demand has caused oil prices to drop from their June peak of $115 per barrel down to its current low of $59 (for Brent crude oil) and $54.11 (for US crude). The Organization of Petroleum Exporting Countries’ (OPEC) announcement that it would not cut production will cause this trend to continue. Prices have slipped about 20 percent since OPEC decided against curbing production at a Nov. 27 meeting, and the group has pumped more than its output target of 30 million barrels per day for the last six months.
The relationship between oil prices and gasoline prices isn’t perfectly symmetrical. When oil prices spike, gasoline prices spike quickly. But when oil prices drop, retailers are slower to pass on savings to consumers. In 2010, a Federal Trade Commission (FTC) study found that gas prices rise four times faster than they fall after the wholesale price changes. The recent collapse in the price of oil, however, has amounted to huge savings for US drivers, not unlike a big tax cut. Economists at Goldman Sachs estimate that US households have already saved about $75 billion over the past six months.
But while precipitous drop in oil prices may be good for consumers and businesses, it may portend the end of the US fracking industry, much of which is funded with borrowed money. Morgan Stanley estimates the average breakeven oil price for these US plays to be about $76 to $77 per barrel. Goldman Sachs puts that number at closer to $75. More alarmingly, it could lead to civil unrest in financially stressed nations that rely heavily on oil revenue (e.g. Nigeria and Venezuela). In Venezuela, for example, oil makes up roughly 95% of the country’s export revenue, and the country needs the average price of oil to sit at about $85 to pay for imports and keep up with its debt, making default more likely than not in the next two years.
Eventually, however, energy companies are going to be forced to pare production. The reduced supply of oil will create, once again, expensive oil. This scenario is inevitable. Even as prices fall, oil costs continue to rise. “The current fall in price does nothing to offset the squeeze on the total economy from rising costs,” Jennifer Grantham writes. “It merely transfers massive amounts of income from one subgroup (oil producers) to another (oil consumers), in a largely zero-sum game.”
According to Grantham, “[t]he only longer-term price relief and net benefit to the economy will come when either we reverse recent history and start to find more oil more cheaply, which will be like waiting for pigs to fly, or when cheaper sources of energy displace oil.”