National Public Radio’s Morning Edition recently aired an interesting piece by White House correspondent Scott Horsley on the state of U.S. automobile fuel efficiency. Horsley’s report describes how the average fuel efficiency of new cars rose from 22.6 miles per gallon in late 2011 to 25.8 miles per gallon by mid 2014 – a respectable 14% increase. However, average fuel efficiency at the end of 2015 is estimated to have dropped below 25 miles per gallon. The reason? Consumer preferences have changed with low gas prices; a direct result of the dropping price of oil. SUV sales are now through the roof again.
The declining price of oil has been a key feature of financial reporting for over a year now. The drop has been persistent and the total decline has become unsettling for some people. As with much news media today, reporting on financial matters tends to gravitate to the sensational. A recent trend in reporting has been speculation about just how low oil could go, how bad a signal the low oil price is of China’s slowing growth and – if you can believe it – whether it indicates that we’re heading back to 2008.
2016’s weak stock market performance and the recent drop in oil prices are absolutely not indicative of another 2008. The stock market’s long-run slope is positive, but it never follows a straight line. But more significantly, the financial system is stable, and people are working.
The market for oil is starting to become very illustrative for how price, quantity, demand, and supply normally function together. Please refer to the graph below. The price of oil and the quantity of oil sold are functions of demand and supply.
- In the graph, let’s assume that the 2011 market for oil is represented by point #1.
- Persistently high energy prices drew investment capital into producing more oil in the U.S. As U.S. land production increased, this increased the global supply of oil. The graph shows the increase in supply by shifting from S1 to S2.
- Point #2 shows that as more oil became available, the price of oil also declined and – at least initially – more oil (quantity) was being sold.
- However, as China’s economy began to slow, the global demand for oil began to decline: we show this decrease in demand in the shift from D1 to D2. Point #3 illustrates the new price & quantity level.
Are we in for permanently lower energy prices now, or will we be stuck at Point #3 forever? Hardly. As a result of low oil prices, several small, deeply indebted oil producers have already filed for bankruptcy. This has the effect of cutting the supply of oil. And as we know from the NPR story, consumers buy more SUVs because oil is cheap, yet fuel efficiency is declining. This has the effect of raising the demand for oil.
Where we are right now in the cycle is the $64,000 question – sort of. If your view is 2-3 years or longer, where we are right now isn’t as interesting as the fact that we’ve already begun to see evidence that the energy market is working, just as basic economics text books say it should. While the media gravitates to the sensational, investors are better served by taking a longer view.