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Why are oil prices falling?
Howard Richman, 12/10/2014

When prices fall, there are two possibilities: (1) increased supply or (2) reduced demand. If oil prices are falling because of increased oil supply, that can be very good for the U.S. economy. On the other hand, if oil prices are falling due to weakening world aggregate demand, then the price collapse could be a signal that the world economy is about to collapse. Thus, it is important to determine why oil prices are falling.

One way to determine whether supply is rising or demand falling is to look at quantity sold. If quantity is rising, then supply is rising. If quantity is falling, then demand is falling. I found some statistics that might cast some light on whether world oil consumption was rising or falling on the U.S. Energy Information Administration's (EIA) website. According to their short term energy outlook, total world consumption of oil is rising from 90.48 million barrels per day in 2013 to 91.44 in 2014. Thus, unless the EIA has missed a fourth quarter collapse in oil consumption, it appears that world oil consumption is rising.

I see no signs of a fourth quarter collapse in world aggregate demand. In fact, according to the Bureau of Economic Analysis, U.S. exports of goods and services in October increased to $197.5 billion in October, $2.3 billion more than September exports. If world aggregate demand were collapsing, then U.S. exports would likely be falling. So, we can rule out collapsing fourth quarter world demand for oil. 

OIL-PRICE.NET has a good summary (Oil Price Drops on Oversupply) of geo-political reasons why oil price supply is increasing at the moment. Here are some of the ones that they list:

  1. Hydraulic Fracturing in the United States. "In 2005, the US had to import 60 per cent of its supplies from abroad.... By 2014, however, the USA only needs to import 30 per cent of its oil consumption."
  2. Insurgency in Iraq not Affecting Oil Supply. "IS controls the central region of Iraq and eastern parts of Syria. All of Iraq's oil is in the Shia-populated southern Basra region of Iraq and the Kurdish region in the north of Iraq."
  3. End of Iranian Oil Embargo. "The end of the US-led embargo on Iran automatically presaged a glut in oil supply.... Iran's extreme need for cash meant that it would inevitably pump out as much oil as physically possible".
  4. Lybyan Oil is Back. "Libya suffered a lot of damage to its oil infrastructure during the overthrow of Gadaffi three years ago. However, all that damage has been repaired and now Libya is back in business. Like Iran, Libya is desperate for cash and will sell as much oil as it can no matter how low the oil price goes."
  5. Japan Nuclear Generators are Back. "Japan closed down all its nuclear power plants and reopened its mothballed oil-, gas- and coal-fired power stations. This factor placed enormous pressure on the world's fuel supplies keeping prices for all three power sources buoyant. However, this demand suddenly evaporated in July 2014 when Japan reopened all its nuclear power plants."
  6. Saudi Arabia needs Sales "Saudis ... need to maintain production to lavishly pacify their islamists."

Point 6 is unfair to Saudi Arabia. They are fighting the islamists in Iraq and are lavishly supporting countries, including Egypt, that are providing a bulwark against the islamists. 

So, we can conclude that oil prices are falling because of increased world oil supply. What does this imply for the U.S. Economy? The most likely effect will be very positive. Oil is a resource that goes into transportation and many other products. When oil prices fall, business costs of production and transportation fall. Other things being equal, this will be very good for the American economy.

Will there still be problems? The answer is "yes." The fall in oil prices will result in a slew of bankruptcies. Many oil producers will likely go bankrupt. Some of the countries that rely on oil revenue may default on their sovereign debt. U.S. banks could be caught with lots of bad loans. There could be a financial crisis.

Moreover, it is not clear that the U.S. economy will benefit very much from lower oil prices. The dollar is going up in exchange rate relative to U.S. trading partners. Foreign governments, including Japan's government, are playing the currency manipulation game with abandon in order to give their producers an advantage over U.S. producers.

Investment in oil production has been contributing to U.S. economic growth lately. Falling oil prices will greatly reduce that investment. In a normal world of balanced trade, that loss of oil investment would be offset by investment in new U.S. factories to meet the increased U.S. and world consumer demand. Unfortunately, we do not live in a normal world. We live in a world in which America gives away its industries to mercantilist trading partners. 

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Comment by Howard Richman, 12/16/2014:

I might be wrong. There may indeed be a global oil consumption slowdown: EIA just revised down its forecast for global world oil consumption next year. From http://www.hellenicshippingnews.com/crude-oil-continues-downward-spiral/: "The US EIA too has revised down its forecast for global consumption by 200,000 barrels per day next year. According to the EIA’s estimates, global oil consumption will climb by only 880,000 bpd next year. Previously it had assumed an increase of 1.12m bpd."




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