Insights & Advice

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Out of the Tank and into the Bank

Oil prices are dropping and those declines are starting to show up at the gas station. For American consumers, this is as good as a tax cut.

In some parts of the country prices at the pump have fallen below $3/gallon. Nationwide gas prices hovered at $3.61 this week. That’s not cheap, but it is a heck of a lot better than paying $4/gallon or more.

Back in February, I warned readers that gas prices were going higher. At that time oil was flirting with $102/BBL. It ultimately reached $110/bbl. before falling to as low as $84/bbl. this week. The driver behind this decline is global oil consumption, which fell to 88.5 million barrels a day by the end of April from 90.4 million in late December and is still falling.

Two factors have impacted energy prices. A slowing global economy has reduced demand for oil at the same time that supplies have been rising over the last 12 months. In addition, the “fear factor” in energy prices has been alleviated somewhat. Have you noticed that Iran has disappeared from the headlines recently?

 For months the tension between that Middle Eastern state and the rest of the world fueled fears of a major oil disruption. Investors applied a risk factor of almost $25/bbl. on that possibility. Today, with tensions easing, energy prices have come down to what I consider a sustainable level. For some time I have argued that the proper price of oil should be about $85/bbl. At that price, I believe that oil prices accurately reflect supply and demand and longer-term global economic growth.

But that does not mean prices won’t fall further. Commodities prices of all kinds rarely remain stable and often over or under shoot target levels. Economic growth prospects are being ratcheted down in Europe, where a recession is underway. In Asia, China is the main consumer of oil and its economy is slowing as well. In North America we are also experiencing a decline in economic growth.

OPEC, according to its economic forecast, expects global oil demand to continue to slow to 87.47 million barrels per day this quarter before firming a little in the third and fourth quarter. Part of that future demand will come from Japan, which has shut down most of its nuclear reactors as a result of the Fukushima accident. As a result, we could potentially see oil prices trend a bit lower to around $75/bbl. before stabilizing at my $85/bbl. level.

That’s good news for consumers. Every one cent decline in the price of gasoline generates about $1.2 billion in extra spending. Consumers are nervous, however. The soft patch we are experiencing in the economy has been accompanied by a slowing of job growth. Consumers, I suspect, may decide to save rather than spend this windfall gain at the pump. They are painfully aware that short-time gyrations in oil and gas prices are not something that you can count on and can reverse at any given time.

Posted in A Few Dollars More, Macroeconomics