Getting It Straight on Oil

As of this writing, the price of a barrel of crude oil is less than $50.  The price sunk quickly in the latter part of 2014 and nobody knows where it will find a bottom at this point.

There are a lot of misconceptions about what is happening and what it means, as so often happens with any economic subject.

There are basically four factors to consider in the pricing of oil.  There is the supply of oil.  There is the demand for oil.  There is the supply of dollars (or whatever currency you are pricing it in).  And there is the demand for dollars.

To be clear, when talking about the supply of oil or the supply of dollars, the supply expectations for the future are a big factor.  You could have no greater supply of oil today, but if there were new discoveries coming online and the oil production was expected to double next year, then the price would fall quickly just on the news.

It is the same with the dollar.  If the supply of dollars were currently steady, but people expected the Fed to start creating trillions of new dollars next year, then prices would start going up right away, all else being equal.  That is why markets move on Fed announcements, as opposed to just the Fed actions.

So what is driving the price of oil down?  In all likelihood, it is probably a combination of all of these things in something of a perfect storm.  The supply (and expected supply) of oil is going up due to the shale oil boom in the U.S.  Also, an announcement from OPEC, and Saudi Arabia in particular, that it would not cut production, helped trigger the downward price, although the price had already been moving down.

It would not be surprising if the demand for oil is down globally.  China has been slowing down a bit, not counting the stock market there.  Japan and much of Western Europe are in recession or worse.  So it makes sense that demand might be down for energy.

In terms of the dollar, the money supply has leveled off since the Fed ended its QE (money creation) program at the end of October.  This means that the money supply is expected to stay relatively flat in the near future, barring a major policy shift from the Fed.  This can also contribute to raising the demand for dollars.

Some might object to the dollar being a cause of declining oil prices because other prices are not going down.  Stocks are mostly booming (not counting the last couple of weeks) and consumer prices are not falling in most areas.  But here, it is important to understand the effects of monetary policy.  It is never uniform, which should be obvious based on recent history.

There was a tech stock boom in the late 1990s that went bust.  There was a housing boom in the 2000s that went bust.  These areas saw much of the monetary inflation rush into these sectors.  Therefore, they were also the sectors that crashed the hardest when it came time.  This is why I am very cautious about the current stock boom.

One thing that is important in all of economics is to not confuse cause and effect.  Low oil prices might be indicating a recession, but this doesn't mean it will cause a recession.  Oil prices started declining in the summer of 2008 before most people knew we were in a recession.  It is quite possible the same could be happening here.  Or it is possible that it is just the weak global demand from the many major countries in the world that are in recession.

There are some people out there who think that falling oil prices are a bad thing, but not because it is a possible warning sign of a coming recession.  They think it is bad because it is hurting the oil business in the U.S., which has some high paying jobs.  But this is bad economics.  We should celebrate falling oil prices, unless you happen to be an employee in that sector or a major investor.

If the price of oil dropped to one dollar per barrel, it would be great.  We could fill up our cars for almost nothing.  It would be bad in the short run for some investors and employees, but resources would have to be reallocated to be more efficient.  This would include some employees having to work in a different sector.

As an individual, you should take advantage of the low oil prices.  If you are like the average American, you should be saving about 50 dollars per month at the gas station.  Maybe you are saving more.  Take your savings and pay down debt or contribute to your savings/ investments.  The low prices may not last.

I am very cautious about the overall economy right now.  The Fed has tightened and I believe that much of the so-called recovery of the last 6 years has been artificial due to the loose monetary policy of the Fed.  The 10-year yield is just under 2% right now.  With oil also low, there are a lot of warning signals.  But as long as things hold up in the U.S. and oil prices stay down, take advantage of the situation and add to your savings.