One thing that is especially prevalent so far this year is the relationship between oil prices and stocks. What has been occurring is that on most days oil prices and the stock market are moving in the same direction. That is when oil prices are declining, we are also seeing a fall in stock prices.
On the surface one would normally expect to see lower oil prices being good for the economy and stock prices. When the price of gasoline falls, it is similar to a tax cut, in that consumers have more money to spend on other goods and services.
If you look back to the 1970’s and 80’s a major contributor to two recessions was a significant increase in oil prices. Therefore, it would appear to be somewhat surprising that the stock market would be doing poorly when oil prices retreat.
There are a few reasons to explain this surprising occurrence. Our economy has become much more energy efficient since the 1970’s and 1980’s. Therefore, a change in energy prices has less of an impact on consumer spending. In addition, while we are still a net oil importer, oil production in our country has increased significantly, so we derive less benefit from falling oil prices.
The previous explanations show why we might not get too much benefit from lower oil prices, however that doesn’t show why the reverse in occurring. Essentially what the stock market moves are indicating, is that the major fall in oil prices is a sign of instability in the world economy. Higher degrees of uncertainty is a negative for stock prices, because it implies risk is increasing.
Oil prices are essentially determined by changes in supply and demand. In theory an increase in supply that is brought about by technological improvements is a good thing. The development of fracking in our country brought about a major increase in supply. Some may have environmental concerns about fracking, but that is a separate issue. In addition OPEC supply has increased both from Saudi Arabia and now Iran with the removal of sanctions.
While oil supply has increased, which helps to lower prices, global demand is increasing less than expected. This is due primarily to a slowdown in China, but a number of other countries throughout the world are experiencing economic difficulties. This slowdown in demand is the main factor that has the stock market concerned.
Given this recent relationship between oil prices and the stock market, there is a strong likelihood that oil prices and the stock market will reach their bottom at a similar time. Last week at the low point for stocks, oil prices were in the $26 per barrel range. As I am writing this column on Friday the 22nd, stock prices have recovered somewhat and oil prices are above $30 per barrel.
If someone looks at a long term chart of oil prices you can see that they have been quite volatile over time, as most commodities are. In 1998 oil prices briefly dropped to around $10 per barrel, and peaked at over $140 per barrel in 2008. It is highly unlikely that we would expect to see either extreme any time soon.
What might be useful to do is look at a range of where oil prices might settle down at. Applying basic economics might offer a useful perspective. In a competitive environment price equals marginal cost. For an economist the definition of marginal cost includes the highest cost of production to meet final demand, and that cost includes a reasonable return on investment.
The highest costs of worldwide production tend to be in our our country where some estimates are around $60 per barrel. With improvements in technology those costs could fall to the $40 per barrel range. In any case current prices are well below marginal cost, which implies that few new projects will be undertaken. Of course ongoing production will continue, as long as variable costs exceed current prices.
Prices can certainly go over marginal cost in the future, especially if there is a major supply reduction. OPEC may restrict supply again in the future, though countries have an incentive to cheat on supply restrictions, and they normally don’t work in the long run. If lower cost sources of alternative energy are developed, then that would allow for oil prices to permanently stay down.
While some readers may not be too concerned about the stock market, anyone who drives has an interest in the price of gas. There are approximately 42 gallons in a barrel of oil, so when oil prices change $10 per barrel that should impact gasoline prices by about $.25. Gasoline prices nationally have fallen in line with the decline in oil prices. However, in California because of refinery outages and environmental standards gasoline prices are about $1 a gallon higher than the national average.
Oil prices will eventually increase again because they are lower than the cost of new production. It is too early to say, if oil prices reached their bottom last week, but in any case are not likely to fall much further. In the near term a recovery in oil prices will be good for the stock market, if that implies more stability in the world. Longer term higher oil prices would not be a positive, if it is caused by a supply disruption.