Oil Prices and Their Implications

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Oil Prices and Their Implications

As a beautiful summer spread across the United States last July, beckoning travelers to do what Americans had been doing by the millions since World War Two — that is, to hit the road — oil prices were reaching $147 a barrel.  Last summer, consumers gasped as prices at the pump surged above $4 a gallon. 

One result of this was that people did not hit the road.  In a family SUV that gets 12 miles to the gallon, a 700-mile vacation trip would have cost $231.  Add to that motels, meals, entertainment, and other traditional costs, and the vacation that Americans once took for granted seemed suddenly to have receded out of reach. 

This had an entirely predictable effect.  Oil is a commodity.  Any time the price of a commodity goes up, people use less of it.  When people use less of a commodity, the sellers of that commodity begin to have trouble finding buyers. 

In this case, those who sell and stockpile oil found that they had more of it than they thought.  By the fall of 2008, the domestic demand for oil had fallen to under 19 million barrels a day, the lowest level since June 1999.

For people who remembered their history, there would be no surprise in the collapse of commodity prices.  During the second oil crisis that spanned the years from 1977 to 1985, the exact same thing happened:  People drove less, bought smaller cars, and as a result used 17 percent less oil.  Overall, America cut its use of imported oil by half.  Predictably, the price of oil collapsed because of that flagging demand. 

Once the price fell, driving seemed attractive once more.  With environmental restrictions on exploration tightening, supply inevitably fell short of demand.  So, as people flocked to the highways during the next 15 years, and people in countries like India and China began to drive cars en masse, we gradually drove the price of oil back up by demanding more and more of it. 

Beyond the simple realities of supply and demand, broader geopolitical forces drive oil prices as well.  When Nigerian militants blow up oil rigs, when Israel threatens war with Iran, and when Russia invades its neighbors, all those forces create anxiety that drives up oil prices.

But the behavior of consumers also has a very powerful influence on the price of oil.  The oil industry has historically responded to high prices by pumping more oil and investing more in new exploration and drilling.  Conversely, it has pumped less oil and cut back on new projects when the price is low. 

This attempt to counter the influence of consumers of oil causes prices to be volatile, as the lag between recognizing a new reality and responding to it causes the market to whipsaw back and forth...

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