The Oil Price Drop is Mostly a Ploy
As you have likely noticed, gas prices are falling as are spot oil prices. This is passing through into the prices of everything and is the primary cause of the slowing of inflation in July. I’m sure that many people are breathing a sigh of relief and they really shouldn’t. Essentially, you are getting played by the U.S. Democrats. As usual, everything is multivariate, including changes in oil prices. So, the run up in prices during the Biden Administration and the drop in gas pump prices over the last month in the U.S. are not caused by any one thing. Having said that, and I will strive to explain the dynamics in greater detail, the run up in price was primarily the result of the U.S. electing a President who had quite openly declared war on fossil fuels. The current fall in prices is, to a substantial degree, the result of releasing one million barrels per day into the supply from the Strategic Oil Reserve. That, however, ends in October and one would expect that taking that oil out of the market will cause oil and gas prices to increase again. However, by then, the midterm elections will be over. Cynical? Perhaps. Accurate? Likely so.
Though I’ve explained this before, it is worth repeating for new readers. Suppose you own an oil well and you are pumping oil and selling it for $40 per barrel. Now, you believe that the new administration will cause the price to go up to $100 per barrel over about the next six months. Obviously, you will be tempted to save today’s barrel of oil with the intent to sell it for $60 more in six months. At the same time, speculators will expect this to happen as well, so they will start buying oil futures. This, then, becomes a classic example of increasing demand and falling supply, so prices will go up. It is also a case of self-fulfilling prophesy. When Biden took office, and as promised, took actions that curtailed supply, prices did, in fact, increase to $100 per barrel. In fact, temporarily, they went as high as $120.
Of course, this didn’t happen in a vacuum. The U.S. Congress was deficit spending well beyond the maximum prudent amount of 800 billion USD per year. For some very complex reasons, previous ‘COVID rescue plans’ didn’t immediately translate into inflation. However, the last round of COVID related bills in the spring of 2021 was just too much and it started creating ‘monetary inflation’ on top of the oil ‘scarcity inflation’. This became a bit of a feedback as higher oil prices raised costs which added to the monetary inflation. It is important to understand that when people pay more for their energy, they don’t have as much money for other purchases, so a demand side recession becomes a real possibility. This recession, because nearly all countries are suffering from higher oil prices and increased monetary inflation, will likely be global or nearly so and is nearly inevitable. Fed chairman has said that he will tamp down inflation no matter the cost to economic growth. This will cause interest rates to increase and depress interest sensitive purchases such as houses and cars. This, also, will add to the recessionary pressures.
Now, oil prices have fallen from a high of around $120 to around $94. While higher prices usually mean lower demand, that has been negated by increasing demand because of an end to COVID restrictions over much of the developed world. So, people are travelling again. However, to repeat, oil prices are determined by a multivariate function. When oil was $40 per barrel, you, the hypothetical producer, stopped selling much of your oil in anticipation of higher prices. When prices hit $120 per barrel, it was time to sell those barrels. Consequently, production increased and prices began to fall. However, there is a natural, rather than simply a tactical, force that results in increased production.
When a reserve of oil is found, there are three, perhaps four, categories of oil. The first is the primary oil reserve. This is oil that comes out of the ground very easily and is cheap to lift. Next, there is secondary oil. It needs to be encouraged, usually by pumping, to come out and lift costs are higher. Lately, much of oil production is coming from tertiary oil reserves which require more sophisticated technologies and higher costs to produce. When oil was first an important economic commodity, oil companies ran through the U.S. and produced oil from shallow wells and only the primary reserves. As a rule of thumb, primary reserves are about 1/3 of total oil. So through the 20th century, oil companies needed to drill for deeper reserves , offshore reserves, etc. in order to find more primary reserves. However, simultaneously, the industry understood that there was about as much reserves left in the ground as they had originally pumped, but it required the development of secondary and tertiary recovery technologies.
Those technologies were developed and tertiary reserve production came online. However, these reserves require higher oil prices to be profitable. With oil in the range of $40 per barrel, most of these tertiary reserves stayed in the ground. However, if there is a belief that oil prices will stay above about $70 per barrel, the industry will make the long term commitments that are necessary to produce tertiary reserves. This will, over time, bring additional supply online and cause downward pressure on prices. Currently, oil is quoting around $94 but Janurary 2023 futures are trading at $86. This is a recognition that sustained higher prices will bring more tertiary production online.
In the partisan arena, Biden is blamed for high gas prices. He tries to blame it on Putin, but this is neither correct nor generally accepted by the voters. However, those on the Right who wish to suggest that bringing Trump back in 2024 will return oil prices to $40 are not being realistic, either. Even when Biden stops flooding the markets with Strategic Oil Reserves, the $86 per barrel is only slightly optimistic. Trump policies, if they returned, would lower oil prices but they would bounce off of about $70. Essentially, below that tertiary oil production would fall dramatically but if it goes higher tertiary oil production would resume. So, there is likely an equilibrium price around $70 per barrel and a return of Trump would probably keep oil in the $70 to $75 range. That is better than the likely long term Biden oil price of $90 to $95 per barrel, but those who wish to compare Trump’s $40 to Biden’s $100 are misunderstanding the pricing dynamics.
So, the current reduction in oil prices and the related gas prices at the pump are not entirely the result of Biden’s ploy of adding one million barrels per day from the Strategic Oil Reserves, but its contribution to short-term price reductions is not inconsequential. Prices will rebound after the election. I’d like to think that voters won’t fall for the ploy, but they probably will.