Investors and Laymen alike have taken note of the steep decline in oil prices.
Lately, you might have noticed a change in the price at the pump. Even my friends who are not inclined toward economics-but who still secretly read this blog- observed this and were curious. What is going on? Since June 2014, the price of a barrel of oil has plummeted, for a consecutive 120+ days. What once sold for a high of $115 has dipped below the unprecedented $50 threshold. The driving force behind this trend is both simple and yet extremely complex. The dynamic nature of the energy sector, and in particular the especially volatile oil segment, means that there are sure to be short and long run effects on a local, national, and global scale.
The graph here demonstrates what happens when the quantity supplied increases. The supply curve shifts to the right, which causes the price (as shown on the y axis) to decrease.
The driving force behind the changes is simple: supply and demand. The United States normally imports its oil from the Middle East. Through the use of hydrofracking, it has been drilling more oil locally. The increase in the overall global supply, to be shared by fewer countries, means that the price of petroleum will decrease. This remains true as long as demand does not increase at a faster rate than supply increases. Indeed, the downward trend occurred during the summer months for countries that consume large amounts for heat during the winter. Due to the stagnant demand, the low prices persisted.
As quantity supplied decreases, prices increase.
Implementing a lesson from a basic economics course could have easily averted the unrelenting drop in price. By decreasing the quantity supplied, the price would consequently rise. On the graph, we see this by shifting the supply curve to the left.
If the solution is so simple, how come prices continue to plummet? When analyzing situations like this in the classroom setting, we look at simplified models “ceteris paribus,” Latin for “holding all other factors constant.” Denuded of extraneous details, these models can be used to test theories time and time again in a plethora of environments.
Most people connote a cartel with drugs, murder, and guns. In fact, a cartel is an economic term. It is a type of oligopoly- a market setting with a few sellers- in which there is an explicit agreement among the members to fix prices. Violence often ensues because cartels want to ensure that no one reneges on their side of the agreement- and that they know the ramifications if they do.
Real life is always more complicated, though, as is the case with the oil market. There are many external factors at play that cannot be ignored when determining the price of petroleum. OPEC, the Organization of the Petroleum Exporting Countries, epitomizes the significant role of geopolitics. It is comprised of 12 members-the countries that are the largest oil exporters globally. Its role is to “ensure the stabilization of the oil market.” With the rest of the world as its customers, members of OPEC have a tremendous amount of clout, which they frequently exploit. Namely, as a cartel, they can raise prices on a whim. Moreover, there is always political drama and tension because other countries are fearful of inciting their ire. Thus, federal policies such as foreign aid are influenced by the sentiments of these suppliers.
This is the OPEC logo. Countries belonging to OPEC are always in the news because there is such a heavy dependence on the resource they provide.
When the oil price began to decrease, OPEC congregated in order to decide on an appropriate course of action. The most prominent member of OPEC is Saudi Arabia, which decided not to slash production. Many analysts were taken aback by a move that would surely hurt OPEC’s revenue stream. Is it not in their best interest to have high oil prices? The Middle Eastern country’s motive was geopolitical in nature; it did not want to compromise its dominant market share. It has a staggering 40% of the entire OPEC reserves. In a region marked by tremendous instability, Saudi Arabia was willing to sacrifice some of its GDP for the sake of maintaining its presence in the global market economy. Moreover, it would not feel nearly as great a sting as other OPEC countries, many of whom depended on the cash inflow.
Analysts predicted that, with consumers spending less on gas, they would spend more elsewhere. The increased pocket change would translate as an injection into the American economy. Projections estimated that the trend of the downward price of oil would have a positive impact, both immediate and long run, on the economy.
The results shown on this graph may be shocking if you face the massive crowds on Black Friday. People are more conservative in their spending than in previous years, even with factors that should spending, such as near zero interest rates and low oil prices.
And yet, following the spending season (Black Friday through Christmas), data proved that growth was anemic, especially when compared to that of previous years, when gas prices were high. What happened? When prices decrease, people have not one, but two choices as to what to do with the extra money. They can spend it, as economists assumed they would do. Or, as is the case here, they can save it. Scarred by the Great Recession, spenders now exhibit a more cautious outlook. Even with the low rates being offered, people are choosing to invest more. While this will benefit the economy in the long run, in the short run, it will stifle potential growth.
As you can see, gas plays an important role in the economy. What will gas prices be in a month from now? Only time will tell!
