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As many Americans traveled home this Thanksgiving holiday, some may have been surprised by the unexpectedly low gasoline prices at the pump.

According to the Department of Energy, regular gasoline prices are now around $2.89 per gallon, having crossed the psychologically important level of $3.00 about one month ago.

The falling price of the underlying input, crude oil, has spurred animated discussions for financial and political analysts alike, as both the economic and geopolitical implications are extensive.

It is in fact ironic that, despite all the conspiracy theories about the United States intervening in Iraq for access to oil, it was investments on American soil that changed the global oil supply-demand balance.

The shale revolution that has come to force over the past seven years has redefined the oil market by growing U.S. production from 5 million barrels a day to 9 million. To put this increase in context, consider another important oil supplier that has been in the headlines, Libya; the growth in U.S. production is equivalent to adding a new Libya every year!

The main drivers of this staggering development are the engineering innovations and large-scale capital expenditures that have taken place. As a result, U.S. crude supply has become the swing factor in markets, namely, the lever that will increase or decrease to meet demand shocks.

All this is very good news for American consumers, of course. The more convinced consumers are that prices will stay low for a long time, the more likely they are to convert some of their newfound savings into spending. I admit I am not yet convinced myself about the sustainability of prices at current levels.

The price of the benchmark WTI oil contract has dropped more than 30% since the summer, and obviously global growth has not contracted by an equivalent amount. So, clearly a large part of this precipitous decline comes from speculation, from traders who have been stopped out of their positions and are rushing to cover them. It also comes in spite of any consumer hedging (think airlines, cruise lines, industrials, etc.) that may have taken place.

Saudi Arabia’s decision not to cut production levels took many in the market by surprise, even though most experts held exactly that expectation going into the November 27th OPEC meeting.

Now, we need to see how lasting that decision’s ripple effects are going to be, as there is always the possibility that Saudi Arabia changes its mind outside the purview of the OPEC cartel. My skepticism for the viability of current prices originates more in crude’s price action than in its fundamentals.

On a cash basis, U.S. shale oil producers are profitable above $60 per barrel, so there is still plenty of way to go until they start considering production cuts. The disorderly decline of the commodity’s price, on the other hand, is worrisome, as it implies frothy markets that may be prone to a quick bounce. That said, it will certainly take a while for the market to reach the levels it started the year with.

There are obvious geopolitical implications that accompany such a drastic change in arguably the world’s most important commodity. Some analysts believe Saudi Arabia is actually after the U.S. shale boom, aiming to send a strong signal to current and potential U.S. producers that its flagship industry will protect its market share and will not do them any favors by cutting production to keep prices elevated.

The extraction cost in the Middle East is about $15 or $20 per barrel, so clearly Saudi Arabia can afford to play this game (plus the Kingdom has an enormous amount of foreign currency reserves). There is no doubt American shale developers are now going back to the drawing board, balancing the benefits of possible efficiency gains with a scenario of sustained low prices.

This is not a positive development for U.S. growth, which has been boosted by the oil and gas industry’s revival. The jobs created over the past seven years thanks to the shale revolution are also high-paying jobs, so the opportunity cost of not creating new ones is significant.

Nevertheless, at a time when the Federal Reserve has just ended its quantitative easing program, lower costs to consumers take on a prominent role, one that can more than offset a deceleration in the domestic energy sector.

The biggest beneficiary of this situation lies between the Saudis and the United States, and it is Europe. The continent, traditionally highly dependent on foreign suppliers for its energy needs, could not have received a better present from the markets as it nears a widespread recession.

The potential improvement in private spending can be critical in alleviating disinflationary pressures. And to add to the benefits, Russian President Vladimir Putin, who has caused European leaders plenty of headaches this year, is now scrambling to protect his country’s economy, which is highly depending on oil exports.

I suppose conspiracy theorists are right about one thing: oil really does make the world go round.

The post Oil’s Well That Ends Well? Check The Pump Again Later appeared first on The National Herald.

Source: The National Herald
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