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Oil Crash

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The price of oil is crashing – and with good reason. Supply is surging, while demand is weak. Moreover, within just a few decades, new technologies, including solar and probably hydrogen fuel cells, will make oil completely obsolete. Anyone born after the middle of this century will probably never know the smell of gasoline.

The price of oil fell by $10 a barrel last week. It’s now down 40% since June. This oil price plunge will have a significant impact on the global economy, so it is important to consider both its causes and its potential consequences.

There are three main causes. First and foremost is shale oil. Thanks to the shale oil revolution, the United States is now producing almost 9 million barrels per day, the most in 30 years. By the end of next year, US production will be approaching 10 million barrels per day. So, even with most Iranian oil off the market due to sanctions, and with Iraqi oil production at somewhere near a quarter of what it could have been had there been peace in that country during the last decade, global output is increasing sharply. According to the International Energy Agency (IEA), global supply was 93.8 million barrels per day (mb/d) in September this year, up 2.8 mb/d from one year earlier.

The second reason is that global demand for oil is weak. Demand from China is growing much more slowly than had been anticipated due to the economic slowdown there. US demand for oil is actually declining – in large part due to government regulations requiring improved fuel efficiency standards for cars. Furthermore, global economic growth is weak and there has been a very sharp slowdown in the growth in global trade. The IEA estimates global oil demand will be 92.4 mb/d this year and 93.6 mb/d in 2015.

In addition to supply and demand factors, I believe there may also be a third reason for this oil price crash: the desire of the United States to punish Russia for supporting pro-Russian separatists in the Ukraine. Russia is one of the world’s largest oil producers. Russian government finances depend heavily on oil sales. Therefore, the drop in oil prices is a severe blow to Russia. I believe it is well within the power of the United States government to push down the price of oil by selling oil futures short. The lack of transparency or oversight within the $700 trillion Over-The-Counter derivatives market would permit the US government to do this without being noticed. Since this tool is available to US policymakers (and perhaps this is just the kind of situation that explains why the government has not imposed transparency on this market), no one should be surprised that they would employ it.

Now, what about the consequences? Ultimately, the consequences will depend on two things: how far the price of oil falls and how long it remains low. Since we don’t know the answers to those questions, let’s focus on the consequences if the oil price stabilizes where it is now, at $68 per barrel for Brent.

Consumers will be better off. Lower gasoline prices will be like a tax cut for the middle class, who will be able to spend more on other goods.

The US trade deficit will become smaller as the cost of oil imports falls (although this will be partially offset since Americans are likely to use their savings from a lower gasoline bill to buy more consumer goods made overseas). A lower trade deficit will boost GDP.

Lower oil prices will mean more downward pressure on consumer prices and a greater risk of deflation. The fear of deflation is likely to cause the Fed and the Bank of England to delay their plans to increase interest rates, while it may force the European Central Bank and the Bank of Japan to accelerate their asset purchases.

In most countries, government bond yields have already fallen in response to the increasing disinflationary/deflationary pressures that will result from lower oil prices. Government bond yields in a number of European countries fell to record lows last week.

The finances of the oil exporting countries will suffer. The currencies of Russia, Norway, Venezuela and Nigeria have already fallen significantly, reflecting the deterioration in those countries’ economic prospects.

Lower oil prices are likely to put some high cost producers out of business. Canadian oil sands look particularly vulnerable. Some of the marginal shale oil producers in the US may also go to the wall. As bankruptcies occur, defaults on energy junk bonds are likely to rise significantly. At this stage, I don’t believe that the losses in the junk bond market will be significant enough to cause a new financial sector crisis. Nor do I believe that so many wells will shut down in the United States that US oil production will begin to fall. Production costs have been falling rapidly and are likely to continue falling. Oil prices will have to fall considerably further before most of the new shale oil production becomes unprofitable. Of course, the possibility that oil will fall much further can’t be ruled out. It was $20 per barrel not all that long ago.

Finally, the reduction in the US trade deficit will mean a reduction in capital inflows into the US. (Capital inflows are the mirror image of the Current Account Deficit, since every country’s balance of payments must balance.) The reduction in capital inflows will reduce the upward pressure on US asset prices that has come from this source in the past.

This has been an exciting few weeks in the oil markets and the drama could increase during the weeks ahead. But just imagine the extraordinary upheavals that will occur (in the markets and in geopolitics) when the realization eventually sets in that new technologies will make oil practically worthless sometime before the middle of this century. That realization still appears to be some time off, however. Between now and then, we are likely to see a number of other big swings in the price of oil, both up and down.

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Original publish date: December 01, 2014

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