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Why are Prices at the Pump Lower?

Since July, the price per barrel of oil has fallen from about $107 to $61 this morning. The national average price per gallon of regular gasoline has declined during that time from $3.70 to about $2.70 today. The decline in oil prices has put more disposable income into consumer pocketbooks, and boosted business profit margins.

What explains the huge drop in oil prices? In fact, oil prices have been declining because of straightforward supply and demand.

On the supply side, crude oil production in the U.S. has been increasing because of shale discoveries from North Dakota to Louisiana. The U.S. is producing close to a billion more barrels of oil per year compared with four years ago.

Even though domestic oil production is up and imports are down, OPEC decisions are still felt at the gas pump. In the face of falling prices, OPEC unexpectedly decided to hold production steady, putting further downward pressure on oil prices.

The OPEC decision was likely taken to retain market share from non-OPEC countries. A reduction in OPEC oil production would be quickly replaced by production from other countries.

Further, Saudi Arabia, the most powerful member of OPEC, is pressuring its regional rivals within OPEC. Lower oil prices hurt Iran and Iraq much more than Saudi Arabia because of higher production costs from aging infrastructure.

The fear that OPEC is attempting to strangle U.S. shale oil production is unfounded. But will lower oil prices reduce U.S. shale production? Some top energy analysts see the shale break-even point as between $50 – $70 per barrel, while the CEO of ExxonMobil sees the break-even point as low as $40 per barrel.

Lower oil prices will lead to less exploration and drilling, but don’t expect supplies to dry up any time soon. The Energy Information Agency reported last week that proven oil reserves are at the highest level since 1975.

On the demand side, slowing global economic growth has decreased demand for oil. Growth in China has slowed, the Japanese economy is contracting, and European growth has slowed to a crawl. Even though U.S. economic growth has been solid, energy efficiency improvements have held demand in check.

What does this mean for the economy? If the supply and demand dynamics remain in place, consumer spending should continue to get a boost, and higher profits will translate into higher capital expenditures, propelling the U.S. economy forward.

Reserves, Production, Imports

4 Comments Post a comment
  1. Gilbert W. Chapman #

    Way back in ‘Ancient Times’ . . . during the 1970s . . . The price of oil skyrocketed, and the stock market (DJIA) went from around 1,000 to less than 600 . . .

    Now . . . Given the essence of the above excellent analysis, with the price of oil crashing, why is the DJIA down 200 points today, rather than up 400?

    ? ? ? ? ? . . . . What’s wrong with this picture . . . ? ? ? . . . Or . . . Am I just ‘crazy’ ? ? ?


    December 10, 2014
    • Luke Delorme, Research Fellow #

      You’re not crazy, Gil…the news media like to craft narratives around stock prices rising and falling, but sometimes the narratives are just that.

      Take a look at this excellent post from Joshua Brown, in which he concludes “They’re giving you an ex-post description of the beliefs of your fellow guessers who are no better at explaining day-to-day randomness than you are.”


      December 15, 2014
      • Gilbert W. Chapman #

        Thanx for the Reply, Luke . . .

        Brown certainly makes far more sense than (most of) the buffoons on MNBC do ! ! !


        December 15, 2014
  2. Interesting analysis of Saudi motivations. On what do you base your assertions?


    December 10, 2014

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