The price of oil has fallen more than 25 percent in the past five months, to less than US$80 a barrel. If the price remains at this level, it will have important implications — some good, some bad — for many nations. If it falls further, as seems likely, the geopolitical consequences on some oil-producing nations could be dramatic.
The price of oil at any time depends on market participants’ expectations about future supply and demand. The role of expectations makes the oil market very different from most others. For example, in the market for fresh vegetables, prices must balance the supply and demand for the current harvest. By contrast, oil producers and others in the industry can keep supply off the market if they think that its price will rise later, or they can put extra supply on the market if they think that the price will fall.
Oil companies around the world keep supply off the market by reducing the amount of oil that they take out of the ground. Oil producers can also restrict supply by holding oil inventory in tankers at sea or in other storage facilities. Conversely, producers can put more oil on the market by increasing production or by running down their inventories.
The market expectations reflected in current prices reflect lower future demand and increased future supply. Lower demand reflects both the current weakness of economic activity, particularly in Europe and China, and, more important, the longer-term changes in technology, which are expected to increase cars’ fuel efficiency and induce the use of solar power and other non-oil energy sources.
The increase in the future potential supply of oil reflects new output produced by fracking, the development of Canada’s tar sands and Mexico’s recent decision to allow foreign oil companies to develop its energy sources.
These changes in demand and supply suggest that the future price of oil will be lower than industry participants expected until just a few months ago. Some of the recent changes in expected future demand and supply could have been anticipated earlier. However, there is no way to know when attitudes and expectations will change. The historic volatility of oil prices reflects these psychological shifts as well as changes in objective reality.
Current oil prices are also linked to anticipated future interest rates. More specifically, oil producers have an investment choice: They can increase production now, selling the additional oil at today’s price and investing the proceeds at the existing long-term interest rate, or they can leave the oil in the ground as an investment.
A low interest rate encourages producers to leave oil in the ground. When the current abnormally low interest rates on long-term bonds rise over the next few years, it will become more attractive for producers to increase the supply of oil and invest the resulting income at the higher rate. Unless expectations about the fundamentals of future supply and demand change, the rise in the interest rates will cause oil prices to fall further.
The low price of oil is good news for the US economy, because it implies higher real incomes for US consumers. Within the US, the lower price is transferring real income from oil producers to households, which raises short-term demand, because households spend a higher proportion of their incomes than oil firms do. For the same reason, the lower price also gives a boost to aggregate demand in Europe, Asia and other oil-importing regions.
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