It is true that the U.S. economy has not recovered completely from the financial crisis of 2008, but the domestic economy is not doing too shabbily either. Even so, since the beginning of 2016, we have been seeing wild gyrations in the stock market accompanied by steep declines in the values of the three key indices: the Dow, the Nasdaq, and the S&P 500. Why? The single biggest factor contributing to the recent string of stock market losses is the declining price of oil. To comprehend what is really going on, let us take a crash course in oil economics 101.
The price of any market-traded good such as oil is determined jointly by the forces of supply and demand. Let us focus on supply first. Until very recently, the United States produced very little oil and we relied significantly on oil imports from nations like Saudi Arabia. However, the shale oil boom has now made the United States a noteworthy producer of oil. So, even though we are still a net importer of oil, our oil production—when added to the oil produced by the world’s other major producers—has substantially increased the global supply. On top of this, when we figure in the fact that as a result of the nuclear accord with Iran, that nation will soon supply large quantities of its own oil, we begin to see why the world is awash in oil.
In such a situation, a rational response by a major supplier such as Saudi Arabia would be to pump less and thereby reduce the amount of oil available in the world market. But the Saudis have three interrelated goals that together mean that they will not pump less. First, they want to thwart their bitter rival Iran and hence appear prepared to bear the pain associated with declining oil prices. Second, they are adamant that they do not want to give up their share of the world oil market. Third, they would like to drive out higher-cost oil producers—such as U.S. fracking firms—from the industry.
Moving on to the demand for world oil, consumption has been relatively flat and there is definitely some question about the strength of oil demand in both the (mostly rich) OECD nations and in key Asian countries such as China. For instance, the Economist reports that OECD oil stocks in October 2015 stood at 267 days of net imports, which is almost 50 percent higher than what it was just five years ago. So, putting the forces of supply and demand together, we have strong supply being met with weak or flat demand; that is what’s causing the low price of oil.
Even though we are still a net importer of oil, as economist Jared Bernstein points out, the U.S. shale oil boom means that a lot more jobs, families, and towns are now engaged in energy extraction. The low price of oil has not only hurt those families but, more generally, it has also significantly reduced the energy industry’s share of capital spending from about 10 percent in 2012 and 2013 to 5 percent now. In addition, the dramatically lower price of oil and the declining fortunes of the energy sector have rippled through financial markets and resulted in both significant losses in share prices and in higher volatility.
Let us now focus on U.S. consumers. Before the United States became a noteworthy player in the world oil market, when oil prices declined, a dollar gained by consumers was a dollar lost by foreign producers, but that is no longer the case. As noted by Binyamin Appelbaum of the New York Times, a dollar gained by consumers now means that the negative effect of the dollar lost is partly felt by domestic oil and gas producers and hence this partially offsets the otherwise positive impact of low oil prices on the U.S. economy. This last feature has also contributed in part to the 10 percent downward correction that we have seen in the S&P 500 stock index.
To conclude, the International Energy Agency recently noted that the oil market could “drown in oversupply.” In other words, there is little reason to believe that there will be a reversal any time soon in the direction of oil prices. Therefore, we may just need to hunker down and accept short-term instability in both the energy sector and in financial markets.
Amitrajeet A. Batabyal is the Arthur J. Gosnell professor of economics at Rochester Institute of Technology. These views are his own.
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