Free Market And The Price Of Oil

What in the heck is going on with the price of oil?

price of oil graph

The Economy

Yes, the world economy is in the toilet right now so that has to be a big piece of this. But the world was going through a much worse crisis in 2009 and the price didn’t drop near the level that we are seeing right now so that isn’t the complete answer.

Fuel Efficiency

Yes, the response to the high gas prices of 2008 caused the auto industry to ramp up supply of hybrid and all-electric vehicles to meet the demand and for sure many more folks are driving these fuel efficient vehicles and that lowers the demand somewhat but that can’t explain the recent dive in oil prices. There were 507,272 hybrid vehicles sold in 2014 but that is a tiny fraction of the 17 million vehicles sold in the US in December of 2015 alone.

The Free Market

I think the bigger contributor to this drop in oil prices is due to the Free Market.

Econ 101 teaches us that price of any good in an unregulated free market is set based purely on supply and demand. An increase in supply with demand constant or increasing means the price goes down. A decrease in supply with demand constant or decreasing means the price goes up. And with regard to the demand for oil, the demand is either flat or increasing as more countries move into the developed classification so supply is the main driver in the price of oil.

Up until about 10 years ago OPEC could set the price of oil in some degree because they controlled the majority of the supply and chose to increase or decrease their production to match a price that they desired. But starting in 2008 something happened in the US that confounded OPEC’s tenuous monopoly. That was when the US started increasing their oil production from shale oil (i.e. “Fracking”).

Take a look at oil production by country over the past 22 years:

oil production large

That green line showing a spike during the last 8 years is the US. Let’s look at the graph of only the top 6 producers of oil.

oil production small

Notice how the US almost doubled our oil production from 2008 to 2014? That increase came mainly due to Fracking and we are now the 3rd largest producer of oil.

And what exacerbated this increase in supply is the decision by OPEC to not reduce their production in hopes of pricing the US out of the market. Shale production is much more expensive to produce than normal oil drilling methods so OPEC was playing a financial version of chicken hoping the US would blink. But the US didn’t blink and now we, the consumers, are the beneficiaries of OPEC’s miscalculation.

From the Marketplace story entitled “Is OPEC still doing its job?”:

“Until recently, OPEC has been a sort of central bank for oil – managing supply and stabilizing  prices. But industry consultant Bob McNally, president of the Rapidan Group, said the cartel has been AWOL since 2008.”

“OPEC failed to prevent oil prices from spiking and contributing to a great recession,” McNally said. “We are now paying attention because since October of 2014,  OPEC has failed to put a floor under oil prices.”

Remember when Obama said in 2012 that we were total saps for thinking we could drill our way to lower gas prices?

While some may have thought The One was lying, I just think this is another example of how ignorant he is with regard to Free Markets.

In the case of recent oil price drops, the Free Market proved once again to be the best system we have to deliver the best product at the lowest price.  Free Markets work!

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