Price at the Pumps: What’s the Explanation?

January 25, 2015

By: Robert Hills

There is no denying the fact that consumers have been enjoying low prices at the pumps over the last several weeks. However, even with prices at a four year low, analysts are still forecasting further easing. And it is not only consumers who are enjoying the relatively low prices, but the economy as a whole. Specifically, the low prices will help juice the economy by boosting consumer spending. According to David Madani of Capital Economics in Toronto, “Faster income growth and lower gasoline prices bode well for household spending prospects this holiday season.” Mr. Madani is not alone in his thinking – the Wall Street Journal recently quoted that the “easing pump prices in the past half-year is equivalent to a $75-billion tax cut. Based on the “multiplier effect” from Economics-101, the analogy of a tax cut of this size translates into a large boost for Canada’s GDP.  But do not let this deceive you, as not all sectors of the economy will prosper. While the low cost of energy combined with a weaker dollar can help business in many Canadian provinces, it will create turbulence for Canada’s oil and energy-producing provinces.

What explains the large drop in gasoline prices over the last several weeks?  As you may have guessed, it is primarily due to the global price of crude. Specifically, approximately 68% of the price of gasoline can be attributed to the global price of crude. Shifting our attention over the price of crude, there has been a recent drop over the last several weeks, and this is attributed to high global oil supply and weaker than expected demand – again, another lesson from Economics 101. The increased global supply has been primarily associated with the Iraqi and Libyan recovery in production as well as the booming U.S. shale oil production. Conversely, the decrease in demand has been partially attributed to the slowed growth rates of the Chinese and European economies, in addition to Japan’s recent slide back into a recession.

In the past, the Saudis have typically been in a position to affect prices by cutting supply. Therefore, it was expected that during the Organization for Petroleum Exporting Countries’ (OPEC) meeting last week, its members – in particular, Saudi Arabia – would decide to reduce the production of oil. However, reports indicate the country’s refusal to limit production to force the price back up. Why would a country in a position of power to raise prices refuse to do so? Analysts suggest that it is because in doing so, Saudi Arabia would lose market share to non-OPEC oil producers such as Russia, or the United States with their recent shale oil boom. Therefore, if the world’s richest oil producing nations are refusing to decrease supply, the only way for prices to rise, at least in the short run, is for the demand for oil to rise, which is highly unlikely.

In the long run, however, the price cannot endlessly fall. The reason for this is that the price war between OPEC and non-OPEC oil producers is severely effecting their bottom line. While producers with large cash reserves (e.g., Saudi Arabia) will have a greater ability to absorb price drops than those producers with smaller reserves, both will eventually reach a breakeven oil price at which point, any further drop in the price will make it difficult for these producers to continue operations. Therefore, this “price floor” means that at some point one of the nations is going to have to budge. So consumers, enjoy the savings now as the inevitable rise in the price of oil will soon translate into surging prices at the pump.

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