Tuesday, December 9, 2014

Low Oil Prices? I don't think so.

Oil prices are low. Groovy! Hold on they tell me. Low oil prices are bad. What? Tell my new gas guzzling Santa Fe that lower gas prices are bad. Tell my wallet. What is going on here? We cried and moaned every time we went to the gas station for years and now that gas prices have dropped a few cents, we are supposed to see a crisis in the making? This is economics gone wild

Where to start? Basic economics. Suppose people want fewer Thingies. This leads to a lower price for Thingies. Firms supply fewer Thingies to the market. That sounds pretty intuitive. People want less so firms supply less. It happens all the time. So when global demand for oil started to fall and this caused the price of oil to decrease, it makes sense that oil firms produce less. What is the problem? The problem is that some folks are worried that the price will fall so far and get so low that most firms would lose money selling oil and the supply would dry up.

Now you see the rub. But come on guys – what are we assuming here about oil firms? Basically the worry warts are saying that firms are passive entities who bark at the ring of a bell.

First, is it not possible that oil firms could work harder at cutting costs to remain competitive at lower prices?

Second, is it not possible that firms could innovate or find better ways to make money with oil? Notice that when prices are high and rising there is very little incentive for oil firms to cut costs and innovate. But when they are falling, the stakes are much higher and there is plenty of incentive for protecting profits.

Third, is it not possible that firms who got rich when oil prices were super high might have invested or saved some of that money for a rainy day?

Finally, is it possible that oil prices are not yet really so low that we have to worry?

It is this last question that I want to address here. Are oil prices really so low? So I found some data on crude oil prices. You can get data back through 1776. Ha ha. No you can’t. But you can get them back to before I was born! I found monthly data on crude prices and I mostly wanted to focus on when they got interesting – after the early 1970s.

Before 1973 crude went for about $3 a barrel.

After two oil crises we found oil near $40 by 1980. You have to admit that is quite an increase. My allowance didn’t go up nearly that much.

At that time a strange bunch of fellows who were part of a group called the Club of Rome predicted that oil prices would soon reach $100 per barrel. Unfortunately their timing was quite wrong as oil prices fell below $40 very soon and basically fluctuated for the next 24 years! Yes, it took until 2004 before oil prices reached the magic $40. $100 per barrel sounded pretty stupid.

One reason for telling the above story is that we have mental giants who like to extrapolate the latest changes into the forever future. What goes up must go up! That same logic prevails with some people today. Oil prices went down so they must keep going down. Maybe they would go to -$100 if only prices could be negative.
The Club of Rome must have started singing JD drinking songs because they finally got their wish in 2008 when oil prices climbed to about $133 per barrel. I wish all of my forecasts would turn out correctly 38 years later!

Okay, Larry get to the point. As I am typing a barrel of crude oil costs about $66. Is that a low price we should worry about? Well, it is low compared to the $133 of 2008. But then it is quite high compared to the $39 per barrel of February of 2009. Are you getting seasick yet? Yes, oil prices oscillate like crazy. But even more telling is the fact that $66 per barrel is HIGHER than virtually every month since 1946 except for a little burst in 2006 and another one from about 2010 to sometime in 2014. 

If oil companies could make money on oil during all those months when it was priced at $66 or less, then I am guessing they will be okay now and they will continue producing oil. While $40 dollars a barrel might be a little tougher on them, I am guessing they could survive prices less than $66.

Some of you sharp cookies might worry that I haven’t accounted for the general level of prices. After all, $66 dollars today buys a lot less than it would have bought some years ago. So I deflated the CPI energy Index with the CPI. Guess what? Even if you account for general inflation, energy prices today are higher – not lower – higher than in most months since the 1970s. That is, a dollar earned from energy buys more than it did in the past. For example, in 2002 a dollar of energy could buy only about 60 cents of consumer goods and services. In September of 2014 a dollar of energy could buy a whole dollars-worth of consumer goods and services.

So whether you deflate or not, oil prices are not low at $66 per barrel. If anything they are high. I am not about to begin weeping JD tears for these energy companies. Most of them will do fine, especially the ones that aggressively invest, manage costs, and innovate.   While supply of oil might decline because of good economic reasons, it is hard to imagine a future energy crunch like we had in the 1970s. In the meantime, enjoy pulling up to the pump and paying  $2.something for a gallon of gas. 


  1. Larry, thanks for another insightful post and for continuing to educate us, challenging the status quo and helping us think outside the box.

    I agree that the oil prices are low-er, but they're not low. Honestly, I don't even know why they're lower? Supply & demand? I doubt, as the car sales continue to grow, people drive as much as they used to... Financial market's decreased demand and futures trading? Perhaps. It would be interesting to hear your perspective.

    Also, another interesting phenomenon, if the food prices rose 100-200% during the $133/barrel phase, you'd think that they would decrease by at least some since the oil is down by 50%. But no, the food prices continue to rise. Again, puzzled - why?

  2. Hi Inga. Thanks for your comments! With sluggish world growth reducing demand for energy and US oil and gas supply on the upswing, S&D can explain the decreases in price of oil. Unless political instability spoils the brew, some experts think this price softness could go on for a while. As for food prices I blame lazy consumers. I cannot believe how much we buy more expensive processed food. So long as people would rather buy cute little packages of watermelon and shredded lettuce instead of watermelons and heads of lettuce, we are going to pay more. I noticed the other day that snipped and packaged green beans cost about 10 times what you pay for a handful of raw beans!

    1. We have not learned that we pay, sometimes exorbitantly, for convenience. It's much easier to buy a can of French-cut green beans than cut them ourselves. It's definitely much cheaper than hiring a Frenchman to cut them for us. Also, some food prices are tied to our friend ethanol the production of which reduces the amount of corn available for fodder and for the production of many food stuffs.

  3. Larry, John here. I think some of the concern is based upon the following:

    1. Substantial increases in domestic and Canadian production have helped bring down prices along with reduced demand.
    2. Domestic production supposedly becomes unprofitable for SOME firms at about $75/barrel.
    3. If these firms go out of business then there will be less competition in the future and higher prices in the future.
    4. The Saudis are allegedly aiming to do that by keeping production up at prices below $75/barrel hoping to raise prices later. In other words, they are supposedly going to "price punish" in marketing terms.

    I'm not smart or well-informed enough to know whether all of this is completely accurate or not, but this is one version of the case I've heard made.

    Your faithful-but-not-very-astute student of macro, I remain....

    1. Hi John, I am not convinced that $75 is the magic number. I am also not convinced that the change in price has been proportional to the excess supply. As you know, markets can do over-shoot because of psychological reactions. Supply will decrease because of recent changes but I am not yet ready to believe the reduction will be a major problem from a national standpoint.

  4. Dear LSD. John mentioned something I’ve heard from the talking heads—that lower prices can hurt shale oil drillers/frackers because their cost of production/extraction is higher than conventional drilling; I recall the formers’ cost of production/extraction about $80/bbl. The conspiracy guys say Saudi is keeping prices low to put the shale oil drillers/frackers out of biz ‘cause they’re responsible for the surge in U.S. oil production. Don’t know if true. But, low oil prices certainly put the hurt on Russia and Iran, so is there another or double intent the Saudis are playing—squeeze Western shale oil drillers/frackers and Russia/Iran? Could this be a real-life video game that uses economics instead of missiles to win conflict/domination?

    1. Saudi Arabia has been playing this game a long time but it is hard to see where it has ever worked. Part of the reason is that the Saudis would much rather be getting $110 for each barrel rather than $75. There is a big market out there and they cannot supply all of it. So there are always going to be competitors. I think they did what they did to stop prices from falling even further. A drastic approach to keep short term prices higher might have backfired and made things even worse. I don't think the $80 you quote is fixed. Shaofraks (shale oil/Frackers)may be more flexible than was previously thought.

  5. Great post! I recall back in the early 60's when gasoline was at .17 cents a gallon in the "gas wars."

  6. Great post as usual. I recall the gas prices back in the "gas wars" of the early 1960's when it was .17 cents a gallon

  7. Hi Spear, you must be pretty old. :-)

    Gas and cigarettes were cheap back then. The good old days!