Monday, December 1, 2014

Cheaper oil is great news

Markets love to worry about new developments, and the recent plunge in crude oil prices is a case in point. With the exception of oil producers and related industries, a big drop in oil prices is great news for everyone. 

Think of oil prices as a tax on GDP, since it takes energy to run an economy. If you tax something less, you should expect to see more of it. Cheaper energy prices should be a boon to the majority of economies around the world since we should see stronger growth. Who cares if a plunge in oil prices leads to deflation? Central banks should not be concerned (controlling oil prices is NOT part of their mandate), and consumers should be rejoicing. Spending less money on energy leaves more money to spend on something else.

The chart above shows inflation-adjusted oil prices. One thing should stand out: every recession since  the early 1970s has been accompanied by a significant rise in the real cost of oil. Recoveries have generally been accompanied by a lower real cost of oil. This business cycle is no different than the rest in that sense. Cheaper oil doesn't threaten a recession, it bolsters the case for continued growth.

If gold prices of $1200/oz. are reasonable, then the chart above says that oil prices around $65/barrel are also reasonable. The ratio of gold to oil prices today is right around its long-term average; oil is neither expensive nor cheap. There's nothing scary going on here. Oil prices are coming back into line with other prices. 

For most of the past several years, oil prices have been very expensive, both in nominal and in real terms. Now they are more reasonable. This is good, it's not something to worry about. Expensive oil fueled the development of new fracking technologies, and that in turn led to a significant expansion of oil supply. Oil supply now exceeds oil demand, so prices have declined, and we are likely to see less intensive efforts to expand oil production going forward. This is as it should be. Prices work to equilibrate supply and demand. 


Joseph Constable said...

I am a free market person. I think the US should subsidize US oil producers.

The oil market is not a free market. It is cartel controlled. The members of OPEC are not our friends and most are anathema to out way of life.

Saudi Arabia wants to bankrupt US oil producers? I say let us bankrupt that disgusting, totalitarian, islamocrazy country.

This is war by other means.

Ausgarry said...

I don't think the decline in the oil price is equivalent to a tax cut, its more complex - it is an income cut for those involved in its production exactly equal to the expenditure saving of consumers so the overall effect on (global) demand should be neutral.

William said...

And there are huge currency implications, balance of payments problems and potential national debt defaults. When Saudi Arabia drove down the price of oil to $10 per gallon, Russia ended up defaulting on its debt.

With the US dollar rising and the foreign debt of developing countries to some extend valued in dollars, there are potentially major problems for poorly manged raw material exporting countries beginning with Venezuela, Argentina, Libya, Algeria, Iran, Iraq, Brazil, etc.

terex said...

Good news yes. But after such a long period of high commodity prices and low interest rates I can't help wonder how much credit that is at risk, but this just another brick in the wall of worry?

Frozen in the North said...

Well to be honest, the issue here are the unintended consequences. There's no doubt that Russia is suffering -- but what about the junk bond market (right here at home!). About 15% of all issuers are oil&gas related. They cannot be enjoying this time.

THe other more important issue is why prices are collapsing; it would seem economic slow down is the main culprit...that's never something over which to rejoyce.