Why are gasoline (and oil) prices so low — and where are they headed?Posted by
Why are gasoline prices so low? And why do they continue to drop? The recent drop in oil prices has truly been extra-ordinary.
Gasoline prices are down almost as spectacularly, and the price of
diesel is down is well. If we look at the graph, it doesn’t look at all
like anything we have seen before. What is happening, and where is this
I am becoming more and more convinced that the drop in gasoline
prices has a huge amount to do with all of our credit problems (which
in turn are related to limits on the oil supply). These credit problems
are causing more and more defaults on debt and more and more
bankruptcies. These defaults and bankruptcies have a double impact on
oil prices–partly from reduced demand, and partly from distressed
sellers disposing of futures contracts at low prices, because they are
easy assets to sell.
We often hear that "soon" oil prices will hit a bottom, and start
shooting back up again. I am less and less certain that this will be
the case. Instead, I am concerned that we may on a relentless path to a
point far below the point where energy companies can expect to have any
chance of making money. We may be on a path toward more and more
bankruptcies and defaults of all types–energy companies, owners of
commercial real estate, homeowners, financial institutions, auto
makers, airlines, and many more. If this is the case, there will be a
huge strain on governments, and some may find it necessary to default
on their debt.
In order to ultimately get past this crisis, it may be necessary for
governments to establish new currencies in which debt is severely
limited, and at the same time unwind the debt in the existing currency.
I expect that a huge amount of derivatives of all types will need to
disappear as well, so that financial assets start bearing a close
relationship to physical resources.
Supply and Demand
Most of us who have taken any economics courses have some idea of the expected workings of supply and demand.
Figure 2 – Graph from Wikipedia. Caption says The
price P of a product is determined by a balance between production at
each price (supply S) and the desires of those with purchasing power at
each price (demand D), along with a consequent increase in price and
quantity Q sold of the product.
The theory is that in a competitive market, price will act to even
our supply and demand imbalances. If supply is too great, price will
drop, and more users will find themselves able to purchase the products
and use them at the lower price, bringing supply and demand back into
Is oil priced too high, or is credit too unavailable?
I think what we have happening now is a mixture of (1) supply and
demand of the physical product, and (2) credit issues, both of which
are focusing on commodity prices of all types–oil, natural gas, coal,
copper, corn, and many others. With respect to supply and demand of the
physical product, when the US was busy building huge numbers of houses
to keep the economy going, and workers around the world were buying
many new cars, there was a great deal of demand for these commodities.
Once we started building fewer houses and cars, less oil was needed for
manufacture and transportation. This type of physical supply and demand is what we expect to underlay a curve of the type shown in Figure 2.
The second problem is debt, and it doesn’t work as nearly as
rationally. Debt, and the repayment of debt, works as long as there is
a growing economy, because with the growth, there are funds for a
reasonable percentage of debtors to pay back their debts with interest.
When a government senses that the economy is not growing as fast as it
would like, it can encourage more and more debt, to try to keep the
economy going. It seems to me that since 2001, we have had a
considerable amount of government encouraged debt, to try to get the
economy to expand faster than its natural rate.
It is not entirely clear what the impact of the growth of credit on
real GDP is. One estimate might be that an additional dollar of debt
adds an additional dollar of real GDP. One could debate whether this
relationship is correct, but clearly there is some impact. Using total
debt amount estimates from economagic.com, this is a rough calculation of real GDP, without the inclusion of debt:
Based on the calculation shown in Figure 3, and graphed in Figure 4,
there has been no real growth since 2000. Instead, we have been seeing
more and more debt-based pseudo-growth.
Without real expansion, debt will eventually start to unwind–there
start to be too many defaults. The debt probably would have started to
unwind on its own, because of the slowed growth rate, even apart from
the oil price increases. The increases in oil and food prices between
2005 and mid 2008 helped prick this debt bubble, but the underlying
debt set the stage. The underlying issue that slowed the growth rate
was limitations on resources. These resources are not becoming more
abundant, so it seems to me that it will be virtually impossible to get
the real growth to increase again to the point where it again makes
sense to have very much debt. I would argue that it probably never made
sense to have the level of debt that we have had in the past few years.
So what does this have to do with the supply and demand curve? Oil
prices can be expected to keep dropping, as long as there is more and
more credit imploding, resulting in fewer people being able to buy
products made with oil. Given the huge amount of debt outstanding, and
the lack of growth to make this debt "repayable", more and more
defaults seem likely.
We can ask ourselves, "At what price of oil (or of gasoline) will
credit stop imploding?" since the answer to that question will tell us
when the price of oil can be expected to start rising again. I believe
the answer is, "Whenever governments can figure out a way to get the
economy to start growing fast enough so that debt (and its repayment
with interest) ‘works’ again." I would argue that governments will
never be able to make this happen. We have reached a point where
resources (oil and other finite resources) are in such limited supply
that the best we might be able to hope for is a level economy for a
while. More likely, we are going to see decline. Because of the lack of
growth, we are at a point that we need to unwind the debt we have, and
learn to live without the vast majority of it.
What does this mean going forward?
To me, Figure 1 is truly scary. If the price of oil and other
commodities continues to drop, we are likely to see more and more
energy companies going bankrupt. Some of these may be large–we have
heard rumors about the financial problems of Glencore,
a large privately owned international trading company. The economies of
Texas and Louisiana are likely to take major hits, as will Russia and
some Middle Eastern countries. Even with the low energy prices, many of
the problems the US has are likely to continue (too few houses and cars
being built to "pump up" the economy, declining prices on homes and
commercial property, and many workers laid off).
The amount of debt we have outstanding is extremely high. The debt
shown in Figure 3 is not really all of the obligations of the US public
and US government, since it excludes things like Social Security and
Medicare liabilities. According to one web site,
the amount of debt Americans have outstanding is $53 trillion, plus
unfunded governmental promises (including Social Security and Medicare)
of $64 trillion, and plus trillions of dollars of related to
derivatives. Not counting the derivatives, this amounts to $386,091 per
person. I don’t know whether these numbers are precisely correct, but
it is clear that with limited resources and a declining economy, there
is no way that amounts similar to these amounts are going to be paid in
I am sure that the Bush and Obama administrations and other administrations
around the world will try to fix the problems, but I fear many may not
be successful. If they somehow are successful, the current oil price
collapse may lead to a rebound, but it is likely that we will still
have to face the need to unwind our debt later, even if we somehow make
it past our current crisis.
I don’t know whether it is necessary to go through a full economic
collapse and restarting process, to get past all of this debt. I find
it hard to imagine that governmental leaders will sit down, look at the
situation rationally, and start thinking about how to unwind the debt.
But eventually, and I fear, sooner rather than later, we will need to
get rid of most of this debt, and start over again with a monetary
system that is more closely tied to resources and discourages debt. It
is possible that forward-looking leaders could even start the new
monetary system before the old one is phase out. The new monetary
system might, for example, start out as more of a rationing system for
food and energy products, and eventually be expanded to cover other
products as well.
I am afraid I don’t have all of the answers. My problem is that when
I see a trend line based on oil prices pointing almost straight down,
and I can’t see a good reason for prices to suddenly start rising, I
start worrying that the consequences of the current price collapse
could be far worse than any of us on The OIl Drum have been talking
These are a few of my recent posts that are related:
Near the end of the book, "The Creature from Jekyll Island" is the following sentences: "The monetary and political scientists who created the Federal Reserve System never intended to repay the national debt. It has been their ticket to profit and power." (Page 577)
I wish I could remember what I was listening to on the internet when oil was at around $130 a barrel. A guy who claimed to have a source inside the “inner circle” claimed that “they” were going to take the price of oil down to under $50 a barrel in order to destroy the dollar. I don’t recall just how those two events were related, but whoever he was, his credibility has jumped up a notch since the first part of his prediction has already come to pass. It might have been on an Alex Jones program so I took the information with a grain of salt, but I wish I could remember the correlation between low oil prices and dollar destruction.
I’ve been asking myself this same question.
I’m not quite sure I undestand your explaination of how debt plays into it.
I figure some loss in demand, stronger dollar, and perhaps some extra oil in pipeline pumped during high prices explains some of it, but it’s dropped to what, less than a 1/3rd of it’s peak?!
What scares me is:
1. Noone really seems to know – how could we not understand the pricing of a basic commodity like oil?
2. The huge swing may be due to speculation of one sort or another.
Number 2 is really bad. I would think worldwide oil use would be reasonably constant with some variation for seasons. Also, to some extent, OPEC controls supply and price. Given these I would think the price should not vary that widely. Something else is going on, and if it’s due to speculation (and by that I mean futures contracts, hedge funds, etc) we are in serious serious trouble.
One graph that I really found interesting was from your last link:
When supplies are very tight because of peak oil, both the supply
curve and the demand curve are nearly vertical. A small change in
demand (or supply) can result in a huge difference in price.
Many years ago, whale oil was used for lamps until it became
depleted. Historical graphs show that its price was very volatile, once
production passed its peak value. The price of petroleum is likely to
be very volatile post-peak also.
Maybe it’s a result of peak oil, but it’s still odd how volatile it became so quickly.
start worrying that the consequences of the current price collapse
could be far worse than any of us on The OIl Drum have been talking
Let me see if I got this right. It’s bad when oil prices go up and it’s bad when they go down?
Noone really seems to know – how could we not understand the pricing of a basic commodity like oil?
People are not predictable. It’s the normal state of markets.
What’s the price of gas doing in other countries around the world?
[quote]My problem is that when I see a trend line based on oil prices pointing almost straight down, and I can’t see a good reason for prices to suddenly start rising, I start worrying that the consequences of the current price collapse could be far worse than any of us on The OIl Drum have been talking about. [/quote]
The way I see it, if Oil prices go down, then it will stimulate the economy because of cheaper cost of energy usually allows cheaper production of goods, transportation, and standard of living. So, that’s good.
If Oil prices go up, then if you bought the oil indexes, futures, or stocks at rock bottom, you and people who took the risk will make tons of money. So, that’s good too.
So, why worry? 🙂
I would think worldwide oil use would be reasonably constant with some variation for seasons. Also, to some extent, OPEC controls supply and price. Given these I would think the price should not vary that widely. Something else is going on, and if it’s due to speculation (and by that I mean futures contracts, hedge funds, etc) we are in serious serious trouble.
I don’t know much about economics, but I do think that oil makes the world’s ‘engines’ go around, and if these engines slow down then less oil is needed. I would think that any slowdown in demand/production would have an effect on oil use – especially when considering all the oil that’s used in each stage of turning raw resources into marketable products or services.
Taiwan is dropping fast. About half of what it was 3 months ago.
I can’t help but wonder if this is controlled somehow. I mean, who’s going to make all the money once the market recovers, assuming a high probability, that it will. With all of those predictions (listed on the "Daily Digest"), how could they not see that oil would be affected and thus serverly handicapping OPEC? I can’t believe I’ll never have the answers to these questions!!!
Thanks for the links. I think the person I was thinking of was Lindsey Williams.