Understanding the Low Prices of Oil and Gasoline

Oil prices have fallen from over $147 per barrel (42 gallons) in July of 2008 to $64 during this Friday’s trading. I was in Houston at the end of the week and drove by some gas stations that were selling unleaded regular for under $2.26 per gallon. This price looked shocking to me as I have become accustomed to the price of motor gasoline costing at least $3.50 per gallon and even $4 plus per gallon like it was this summer. So the question becomes, what is causing these low gasoline prices?

There are dozens of factors that cause the price of motor gasoline to fluctuate, as we are aware. Let’s look at the most important factors in conjunction with the current news to see if we can figure out what is causing the low price of oil.

Long Term Factors:

  • Oil Supply
  • If new reserves of oil are found, and can be brought online at a rate faster than existing oil fields are being depleted, the supply of oil will increase and the price will fall. If new oil supplies are not found or new extraction technologies fail to offset the aging of the fields, oil production will fall and prices will increase.

    There hasn’t been much in the news about oil supplies in the last few years. There have been no new large supplies of oil brought online in recent months. There have been no new discoveries that will substantially increase supply in the next six years. There have been no substantial new innovations in production/extraction technologies. Government reports show oil supplies looking very flat since the summer of 2005.

  • Intensity of Oil Usage and Technology
  • If technology is invented that makes oil less useful or desirable at its current market prices, oil demand will drop as the other inventions take its place. If technology is invented that makes oil more useful to the economy, oil prices will rise.

    There have been no substantial changes to the oil technologies that are powering our economy. No new engine designs or significant agricultural breakthroughs have been reported. Even positive news on oil efficient technologies has been scarce. Boeing has been promising 787s that are supposed to save 20% fuel, but not one has been delivered.

Intermediate Factors:

  • Annual Cycles of Demand
  • Each year, the demand for oil changes as the year progresses. Demand for finished products is highest in the summer during driving season and demand for crude is usually highest while the heating oil inventories are being built up and there is still pre-winter driving demand.

    Currently we are at the low point of demand. Driving season is over and heating season has not really started.

  • Amount of Economic Activity
  • Oil demand is a direct result of economic activity. As long as there is no new technology to supplant oil for many necessary parts of our economy, oil will be required in direct proportion to the economic activity. Think of a small business. If delivering $100 worth of pizza requires $10 of gasoline, delivering $90 of pizza will only require $9 of gasoline. If business picks up to $110 worth of pizza, about $11 of gas will be required to deliver it.

    Consider some recent news:

    “Feds to slash interest rates as recession looms”
    “Chrysler to cut 25% of salaried workers”
    “NorthWest Airlines loses 317 Million dollars, announced schedule cuts”
    “Trading in Austrian Airlines halted”
    “Airlines see load factors drop despite capacity cuts”
    “Southwest loses $120,000,000 first loss in 17 years, will cut unpopular flights”
    “Gainey Trucking can’t pay owner”
    “Canadian truckers face losses from diesel fuel shortage”
    “UPS faces precipitous declines on overnight shipping”

Short Range Factors:

  • Speculation
  • Speculation tends to increase the volatility or the size of the price cycles; it also therefore increases the height of the highs and the depth of the lows. The reason for this is simple. If a speculator sees that each day for a year the price of gasoline is $3.00, there is no way for him or her to make any money from buying or selling it. He would just end up buying it, sitting on it, and selling it again at the same price, making no money and wasting his time. The speculator makes his money when the price deviations increase. If the price is dropping, he sells what he has and increases the market supply, causing the price to go down further. If the price is going up, he buys more to sell at a later time. Deferred selling shrinks the available market supply and raises prices.

    Consider this quote from www.marketwatch.com in an article about how OPEC is on its own as investors flee from oil speculation:

    “This time, however, OPEC is on its own. With speculators fleeing, the cartel is going to have to build a floor under oil prices through disciplined production cuts. This isn’t a group known for discipline, however. And given the wheezing global economy, OPEC has only an outside chance of pushing prices back up to $100 a barrel even if they manage to significantly slash output.”

    From this and similar articles, it is clear that investors are selling oil positions due to both the oversupply and subsequent price drop, as well as the fact that they need money to cover losses in other areas of the falling market. This causes the price of oil to drop even further, but can only continue until investors sell off all of their positions. After this, the price of oil will begin to rise even if speculators do not buy again.

  • Weather
  • The weather can affect both the supply and the demand of oil. Unusual weather events can be things like extreme cold snaps in the Northeast Unites States, resulting in the demand for heating oil to increase substantially. Conversely, very mild winters cause decreased heating oil demand. On the supply side, weather can decrease supply by preventing the transportation of oil from the point of production to the consumer or refiner.

    Searching the news about the weather, it looks as though the weather has been very friendly to the price of oil. There have been no weather-related reasons for declines in supply or evidence that demand has strayed from the seasonal norms in the last few months.

  • Accidents and/or Malicious Destruction
  • Accidents or malicious destruction of petroleum equipment that is necessary for petroleum production can cause oil supplies to drop and prices to increase.

    There has been no substantial accidental or malicious damage to the petroleum infrastructure in the last few months.

Conclusion:
The current low price of oil is caused primarily by what economists call “demand destruction.” That is, as economic activity winds down, the demand for oil drops and the market verges on a glut in supply. The price will stay low and most likely go lower as long as the following continues:

The weather stays good.
There are no accidents or attacks on the petroleum infrastructure.
The speculators continue to sell.
The economy continues to decline.

The last one is the most important because the health of our currently configured industrial economy is directly related to how much oil is being consumed–much like your car requires fuel in proportion to how much work it does. Let’s hope that we can get the economy going well enough again to bring on some unprecedented high prices. If not, we will be dealing with more economic disaster and unemployment.

Daniel J Swanson
dswanson@danswanson.com

3 thoughts on “Understanding the Low Prices of Oil and Gasoline

  1. thedoomletter

    Interesting post. I am in the process of writing up something similar to post some time next week. I was wondering what you thought of a theory I have about the price of oil in relation to peak oil.

    As oil was on its way up, there was a lot of talk on finance oriented sites about a “peak oil premium” being applied to the price of oil. I never really believed this, because most investors did not believe peak oil was a factor.

    All summer I was calling the price a result of supply and demand fundamentals. Spare capacity seemed tight globally, and demand seemed insatiable. Now, I am not sure if that was true or not because demand has not fallen off that significantly and the price has plummeted.

    In no part of my understanding of peak oil did I see $40/barrel oil and falling. This seems like more evidence that peak oil was not widely believed by traders and that the price spike had nothing to do with peak oil and everything to do with speculation.

    Do I need to eat crow? Or not totally? Hopefully you will see this.

    You all are good writers, I am glad I found you, hopefully you keep this going.


    Mike

    Reply
  2. Dan Swanson

    Mike,

    Thanks for the thoughtful comment.

    I believe that there are many reasons that the price will become increasingly unstable.

    Many of the investors just saw that supply was very low, and there was little relief in sight. It also took a very high price to destroy enough demand to prevent a shortage. There were spot shortages of avgas, motor gasoline, and diesel fuel this summer. They just were not widely reported.

    Once any system is delicately balanced whether it is a teeter totter blowing in the breeze, a balloon that is neutrally buoyant, or oil supply and demand being matched things become very unstable. Extremely small inputs can cause wild swings.

    In the past the Texas Railroad Commission, and then OPEC had surplus capacity on tap to smooth out the swings. Now there is none, and we swing in the breeze.

    The vast majority of the price increase was fundamentals. No doubt about it. But it also helps the traders that the system became very unstable like a balloon in the breeze. Speculators cannot create the scarcity that it takes to get the main price run up. Only real shortness can do that. The speculators can increase the size of the spikes though. People are now ignoring how much the speculators have lost.

    I sometimes use the analogy of a car with a cruise control. We used to have a car with a large engine (extra oil production), and a cruise control (TRC or OPEC). When we were going down hill the cruise control backed off the throttle, when we went up a hill, they added throttle. This created a nice smooth speed (oil price). Now we have a car that takes 30 hp to cruise down the road, and a 30hp engine that is running wide open (at least for now). The speed will vary widely depending on hills, weather, wind, etc.

    You do not have to eat crow. Peak Oil has never guaranteed high oil prices. In fact the worst case scenario is low oil prices. The best case is continuously and slowly increasing, so that we can adjust. The worst case is a government and a financial system that is so broken that it collapses when the economy cannot “grow.” This is what we are seeing now.

    Dan

    Reply

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