Tuesday, January 13, 2015

Low Gas Prices- Not All Good



Everyone loves low priced gas. With the amount we drive today, the cost of gas can add up very quickly. This is why when gas prices started plummeting the past few months, many celebrated. Even though, in the short run, this is a nice break from the prices we are used to; these low prices is not something to be excited about.


Before talking about why such low gas prices are not favorable in the long run, we must first understand how this happened. Put simply, the supply of oil in the global market right now is extremely high, thus causing the price per barrel of oil to plummet. Since Jan 2014, the price per barrel has fallen to about $50 a barrel, or 48.45%.[1] How did this happen? There are a few reasons behind this. OPEC, or Organization of Petroleum Exporting Countries, controls a good amount of the world’s oil production. OPEC is a cartel of oil producing countries, mostly based in the Middle East and Africa. When OPEC meets, the member countries decide how much oil they will produce for that year. This essentially helps them control prices, since they are controlling the supply. Things are different this year, however.

OPEC recently failed to agree on how much oil each country should produce. Whether this is intentional or not is unclear, but what has happened is that the global market is getting flooded with barrels of oil, causing the price to plummet. Also, another action taken by President Obama has caused even more supply in the oil market. The President essentially lifted restrictions on fracking, which is “…the procedure of creating fractures in rocks and rock formations by injecting fluid into cracks to force them further open. The larger fissures allow more oil and gas to flow out of the formation and into the wellbore, from where it can be extracted.”[2] With these restrictions lifted, oil production in the United States skyrocketed. One would assume that with traditional market forces, supply should naturally slow down, and prices would eventually return to normal. CME Group, however, stated in a report about Energy Prices that this view has a few risks.
  •  “First, when powerful asset allocation shifts are involved, there is always a strong likelihood that markets can overshoot some hypothetical supply-demand valuation that fails to take into account the behavior of investors.
  • Second, oil production tends not to respond to short-term price movements. A considerable proportion of oil production costs are in the capital investment phase, and these costs are often incorrectly (from an economics perspective) partly included in the perceived marginal cost of producing the next barrel of oil. In fact, production dynamics are much more complex, actual marginal costs are much lower than they might appear, and short-term production cuts are very unlikely.
  • Third, and in the other direction, while the current situation in the Middle East (and Russia) has produced a relatively benign or grudging consensus that Middle East oil production will stay high despite the tensions in the region, one should not ignore the low probability, but high impact potential, of surprise oil supply shocks.”[3]
With these three views in mind, it is unlikely that the oil supply is going to just suddenly slow down. It is still in companies’ best interest to continue drilling, rather than stop drilling. The consumption of oil is also important to note. In the following graphs from the same report from CME, we see that oil consumption is going down, and oil production is rising. These all make for a large decrease in the price of oil.

Former Wells Fargo Chairman and CEO Richard Kovacevich claims that “The refusal by OPEC to cut production in the face of prices plunging to 5½-year lows shows the cartel is looking to put a lid on the U.S. fracking boom.”[5] The true intentions behind every party’s actions are unclear. The fact of the matter is most people seem to be enjoying low oil prices. However, in the long run, this low of oil prices is unsustainable.

With oil falling so fast, many oil producing companies, and even countries, are in the red. Russia, for example, is in the midst of an extremely dangerous economic crisis. Since oil is such a large export for Russia, the low prices have drastically reduced its income. This, along with US sanctions, has caused a disaster in Russia. The Russian economic crisis, however, is deeper than just oil prices, so I will touch more on that next week.

In the United States, low oil prices have caused a variety of actions to be set into motion. Even though lifting the regulations on fracking has caused a surge in oil production, many US oil companies are losing great amounts of money. “The meltdown in oil prices has wiped out more than $200 billion in market valuation among the 10 largest oil and natural gas companies in the S&P 500.”[6] Now I understand that many will disregard this, as large oil corporations losing money isn’t exactly sad news to them. However, this affects the workers on the drills and the wells. These companies have already started “…hitting the brakes on spending and laying off workers.”[7] To put exact numbers on this trend, “More than 1,000 employees at Civeo (CVEO), a provider of housing for oil workers, have lost their jobs in recent months.”[8] This is just one company, others are quickly following suit and laying off workers to cut costs.

The oil companies aren’t the only ones getting hurt by these prices, however. Consider car companies, and their initiatives to make more fuel efficient cars. While gas prices were high, hybrids and other fuel efficient cars were in high demand. Every year we saw cars getting more miles per gallon than the year before. However, with low gas prices, the demand for these cars has fallen. It has fallen so much, that some car factories that produce such vehicles are temporarily closed. In Detroit, the President was scheduled to visit an auto plant in Detroit to celebrate the resurgence of the auto sector, however “The White House confirmed Monday that President Barack Obama will visit Ford Motor Co.’s Michigan Assembly plant on Wednesday — a factory that is closed this week because of lagging demand for its small gasoline-powered and hybrid cars[9] On the other side of the spectrum, however, SUVs and fuel- inefficient cars are in high demand. “Cheap gas prices helped make that happen, as sales of trucks, SUVs and luxury vehicles rose rapidly. Jeep's sales, for instance, were up 40 percent on increased consumer demand for crossover SUVs.”[10] This reversal in automobile demand is backward progress for automobile efficiency. Even though oil is needed, it is in our best interest to continue to innovate and continue advancing in new types of energy.

As seen from the evidence provided, Obama’s move to open up fracking was not the only thing that drove gas prices down. The enormous amount of supply coming from all over the world and the dropping level of demand have caused this oil price drop. As you can see, there is more than meets the eye when it comes to low gas prices.

Check out some of the sources I used for more information on this topic. All contain even more information on the topic that, for the sake of length, I couldn’t include in this post. Feel free to leave a comment if you agree or disagree with what I said, I will be sure to read and reply to all of them.









[1] http://money.cnn.com/data/commodities/?iid=EL
[2] www.investopedia.com/terms/f/fracking.asp
[3] http://www.cmegroup.com/education/featured-reports/a-look-at-what-is-happening-below-the-surface-in-energy.html
[4] http://www.cmegroup.com/education/featured-reports/a-look-at-what-is-happening-below-the-surface-in-energy.html
[5] http://www.cnbc.com/id/102313386#.
[6] http://money.cnn.com/2015/01/07/investing/big-oil-price-energy-stocks/index.html?iid=Lead
[7] http://money.cnn.com/2015/01/07/investing/big-oil-price-energy-stocks/index.html?iid=Lead
[8] http://money.cnn.com/2014/12/30/news/economy/oil-job-cuts-civeo-stock/index.html?iid=SF_INV_River
[9] http://www.detroitnews.com/story/business/autos/ford/2015/01/05/president-obama-ford/21292663/
[10] http://www.npr.org/2015/01/05/375201451/car-sales-surged-in-december-capping-a-good-year-for-the-industry

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