Just in time for Christmas,
there’s a surprise present for consumers: plummeting oil prices. They
have fallen forty per cent since July—gasoline now costs well below
three dollars a gallon—saving Americans hundreds of millions of dollars a
day. This has been a mini-stimulus for the economy, and one that was
almost completely unexpected. Before the summer, prices had been high
for years. Despite a lot of geopolitical turmoil and macroeconomic
anxiety, the oil market had been remarkably stable, and it seemed
possible that, as one study put it, “hundred-dollar oil is here to
stay.” But in a matter of months all that changed.
So
what happened? At the most basic level, it’s a simple supply-and-demand
story. Europe’s continued troubles and a slowdown in the Chinese
economy muted the demand for oil. Meanwhile, the U.S. shale-oil boom and
a rebound of drilling in Libya boosted supply. “Libya’s ramping up of
production caught people genuinely off guard,” Steven Kopits, the
managing director of Princeton Energy Advisors, told me. “That’s the
kind of thing that’s hard to predict unless you have really good
intelligence assets on the ground.” The result was that the market was
producing many more barrels of oil a day than were consumed. As oil was
dumped on the market, prices inevitably fell.
In
the oil market, though, nothing is simple. The real story of the past
few months isn’t that oil prices have fallen; it’s that they’ve fallen
so far so fast, and that they may still have a long way to go before
hitting bottom. That suggests that the stability of the past few years
has yielded to a new era of volatility, in which small changes in supply
and demand will lead to big price swings.
Such
volatility is exactly what the history of oil prices would lead us to
expect. Commodities are more volatile than other assets—the price of
copper fluctuates a lot more than that of a television set—and oil has
historically been more volatile than most other commodities; a 2007
study found that in the U.S. it was more volatile than ninety-five per
cent of other products. The biggest reason for this volatility is that
short-term supply and demand for oil are what economists call
“price-inelastic,” which means that they don’t respond much when the
price of oil changes. People don’t immediately start driving less when
gasoline prices spike—they just pay more for gasoline. On the supply
side, drilling projects take a long time to start up or to shut down, so
higher prices don’t immediately translate into more supply, or lower
prices into less. This means that the way prices typically return to
normal—through increasing supply or diminishing demand—doesn’t really
happen in the oil market. So a two- or three-per-cent change in supply,
which is about how much the shale boom and the Libyan rebound added to
global daily production, can spark a huge move in price.
In
recent years, hedge funds and commodity-index funds have put hundreds
of billions into the oil market, and studies suggest that this flood of
investment may have increased the market’s volatility. By its nature,
oil trading is beset by uncertainty. It’s not just the precarious
geopolitics of where most of the world’s oil reserves are. There’s also
the fact that predicting future demand requires forecasting the
performance of the entire world economy.
You might think that the existence of OPEC would guarantee stability. But OPEC is weaker than it once was, thanks to the emergence of big non-OPEC oil producers, like the U.S. Besides, enforcing stability at a time of falling prices is easier said than done. OPEC’s
members face a classic collective-action problem. They’d be better off
ultimately if they all agreed to curb production—Saudi Arabia, in
particular, would have to cut back—but individually they have a greater
incentive to continue pumping. And the Saudis know from history that
cutbacks don’t always work. In the early nineteen-eighties, they slashed
output in an attempt to prop up energy prices. “They cut production and
cut production and cut production, and all it did, more or less, was
wreck their economy for the next twenty years,” Kopits said. “This time
around, they’re drawing a line in the sand and saying We’re going to
keep pumping, and everyone else is going to have to adjust around us.”
The shale-oil boom has added to uncertainty, too. OPEC
has no control over what U.S. producers do. And even though shale-oil
producers often face higher production costs than traditional drillers
do (which should make them quick to cut production when prices fall),
many also have debt payments to make and fixed costs to meet if they
don’t want to go out of business. So they’re likely to keep pumping,
since that keeps revenue coming in until (they hope) the price recovers.
But continuing to pump, of course, makes it harder for prices to
stabilize.
It
would be a mistake for oil producers to expect a return to the high,
stable prices of recent years. By the same token, American consumers
shouldn’t get too used to cheap gas, since in the long run low oil
prices erode the conditions that brought them about. Producers are
already starting to adjust: ConocoPhillips just announced that it’s
cutting its drilling budget. And, because cheap oil gives everyone an
economic boost, eventually it leads to higher demand. We’re awash in oil
right now. Soon enough, we may be wondering where it all went.
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