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Oil Prices 101

| May 06, 2015
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While filling your vehicle with gas, you may have noticed something strange going on. Suddenly, prices at the pump are lower than they’ve been in years. Consumers all over the country are rejoicing in that their wallet isn’t quite as empty. But they’re also wondering, “Why?”
It’s a great question. Why exactly are oil prices falling? And what does it mean for the markets? 
Read on to find out.

Oil prices 101

Contrary to popular belief, the price of oil isn’t set by any one man or entity. Oil prices are dictated by two things: the law of supply and demand, and by the expectation of future supply and demand. The former is fairly easy to understand. When the demand for oil is greater than the supply, the price rises. Conversely, when the supply of oil is greater than the demand for it, prices drop. This is partially what’s happening now. Partially.

You see, current supply and demand is not the only thing driving oil prices. As I mentioned, expected supply and demand plays a large role, too. In this case, when the expectation is that future demand will decrease, oil prices fall as a result.

Who sets these expectations? Speculators. A speculator is defined as:

“A person who trades derivatives, commodities, bonds, equities or currencies with a higher-than-average risk in return for a higher-than-average profit potential. Speculators take large risks, especially with respect to anticipating future price movements, in the hope of making quick, large gains.”1 
Basically, speculators are a special breed of investors who try to project whether the value of a commodity will rise or fall in the future, then either buy or sell that commodity accordingly. This is done mainly through “futures contracts.” A futures contract is a legal agreement giving someone the right to purchase oil at a preset price on a preset date in the future. These agreements play a large part in determining what the future price of oil will be.

In this case, speculators felt earlier in the year that the demand for oil would drop for several reasons:
The continued economic weakness around the world means less people are traveling or commuting, meaning they are spending less on gasoline. 
While oil is still the world’s primary fuel source, more people and businesses are turning to other forms of energy.
The supply of oil would remain stable or even increase.

This last point is important. Several of the various oil-exporting nations around the world could still take steps to raise prices if they wanted to. How? By cutting back on their own production. (Remember, when supply goes down, prices go up.) But none of these nations are taking the bait. The two main players are Saudi Arabia and Russia. Saudi Arabia is the most influential member of OPEC, the Organization of Petroleum Exporting Countries. Saudi Arabia has refused to cut oil production despite the fact that the world’s supply far outpaces the demand for it. Why? Because if oil prices were to rise, it would benefit several of Saudi Arabia’s main competitors, especially the United States, Russia, and Iran, who all need higher prices to turn a profit. Saudi Arabia, on the other hand, can survive on lower oil prices because of their massive cash reserves, and because extracting oil is far less costly for them. This means that lower oil prices harm their competitors while leaving them unscathed, allowing them to dominate more of the market.

Russia has also refused to cut production, despite the fact that falling prices is severely hurting their economy. (More on this in a moment.) Russia reasons that if they cut production, the countries they normally export to would increase their own production and have no need for Russian oil in the future. 
So there you have it: a few reasons why oil prices have fallen so dramatically. But what does the future hold? And what does this all mean for the markets?

How Falling Oil Prices Affect the Markets

As you already know, falling oil prices means lower prices at the gas station. But oil prices aren’t the only thing dropping.

When the price of oil falls, it takes everything dependent on oil prices with it. Take Russia, for instance. Some economists estimate that Russia loses about $2 billion in revenue every time the price of oil drops by a dollar. That’s because the sale of oil and gas makes up 70% of its export income.2 This in turn affects the value of the ruble, Russia’s currency, which is veering on the edge of collapse. A falling ruble, meanwhile, hurts bonds and mutual funds investing in emerging markets, of which Russia is one.

Closer to home, falling oil prices makes life harder for energy companies and companies closely aligned with the energy industry. The result: falling stock prices, which leads to market volatility as a whole. The United States markets got a taste of this in early December. Oil shock hit Canada even harder, thanks to the sheer number of Canadian energy companies trading on the markets. In this global economy, economic stress in one region usually leads to a tremor in another. And one person’s good fortune can be another’s bad luck.

But Here’s the Good News

With that said, I believe the overall impact of falling oil prices is a positive one. Whether you’re at the pump or paying your monthly heating bill, the numbers have to make you smile.

For the most part, spending less money on energy consumption is a good thing! It’s good for consumers and it’s good for the overall economy. After all, less money spent on gas means more spent on other goods and services, thereby pumping additional money into other sectors of the economy. This creates a kind of “rising tide that lifts all boats” effect.

The volatility I mentioned earlier has largely subsided as investors get used to the idea of cheaper oil. Since then, the markets have been surging. As of this writing, the Dow has topped 18,000 for the first time in history, and the S&P 500 is trading at an all-time high as well.3 Investors are realizing that the money they aren’t spending on gas can be put to good use. Furthermore, the United States’ overall economy is looking healthier, having grown 5% in the third quarter.4

Where Does Oil Go from Here?

It’s almost impossible to know for sure what oil prices will do in 2015. There are just too many factors in play—economic, environmental, and geopolitical. (Friendly tip: if you are ever looking for an effective sedative, just start reading crude oil forecast reports. Works like a charm.) That said, most of the estimates I’ve seen suggest prices will likely rise somewhat in 2015, but remain far below what they were in early 2014 when oil was selling for over $100 a barrel.5 That means cheaper oil for the immediate future. To celebrate, I want you to do two things for me:

Enjoy cheap(er) gas for as long as it lasts! Maybe go on that road trip you’ve always wanted to take … just don’t forget to send me pictures!
Remember that my team and I are always watching the markets—and your portfolio—carefully. If we see any major developments, we’ll certainly let you know.

Understanding the ins and outs of oil prices can be difficult even for those who do it for a living. I hope this letter made the situation a little clearer! But if you have any questions about this letter, or any other topic, please don’t hesitate to let me know. I always love hearing from you.

On behalf of all of us here at Sandy Patrick, CFP®, have a Happy New Year!

Resources:
1 “Definition of Speculator”, Investopedia.com, accessed December 19, 2014.http://www.investopedia.com/terms/s/speculator.asp#axzz1qtKjMwIt
2 Tim Bowler, “Falling oil prices: Who are the winners and losers?” BBC, December 16, 2014. http://www.bbc.com/news/business-29643612
3 Jesse Solomon, “Dow hits 18,000 for first time ever,” CNN Money, December 23, 2014. http://money.cnn.com/2014/12/23/investing/stocks-markets-dow-18000/
4 Matt Egan, “US economy grows incredible 5%,” CNN Money, December 23, 2014.
http://money.cnn.com/2014/12/23/news/economy/us-gdp-economy-5-percent-growth/ 
5 “Short-Term Energy Outlook,” U.S. Energy Information Administration, December 9, 2014.http://www.eia.gov/forecasts/steo/report/prices.cfm

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