The truth about the price of oil

A wise man once told me, “If you want to know the truth about anything, follow the money.” 

This explains the slump in oil prices. Sort of. I have been educating myself about world oil prices as best as I can. If I sound like a six year old this is because that is about where my understanding of these sorts of things is.

Prevailing wisdom is that the supply of oil is high and the demand for oil is low, driving the price down. Supply is high because the U.S., Canada, and other countries have begun to produce a lot of oil. Demand is low because world economies have not been doing well and there is less need for oil. Not to mention the trend towards renewable sources of energy.

As oil prices slide, where is the money going? It is leaving oil producers and winding up with consumers – both individuals and businesses. I benefit because I pay less for the diesel in my car. Airlines benefit because they pay less for the fuel in their plans and, thus, their profits increase. 

Oil producers suffer as their profits decline. Those that produce expensive oil suffer the most. In the worst cases, the most expensive producers move from profit to loss and are driven out of business altogether. The Canadian Oilsands are the most costly oil production in the world. 

What causes oil prices to go back up? Reduced supply and/or increased demand. Saudi Arabia has declined to cut production. They don’t have to because their oil is cheap. Their profits are reduced but they remain profitable. Expensive oil producers (American and Canadian) are forced to take quick steps to decrease production and exploration (translation – decrease costs as revenues declines).  The expensive producer – Canada – has to reduce costs or go broke. The sweet spot for Saudi Arabia is a price that maximizes their sales and minimizes Canadian sales -- they make less per barrel but they sell more barrels in total.

Eventually supply will reduce enough that the price will stabilize as the expensive oil (the extra supply) is driven out of the market and supply and demand come back into line. 

But there is part of this simple analysis that does not make sense to me.

The demand for oil surely changes. It moves up or down based upon a lot of things. But, I cannot imagine that the demand for oil moves as quickly as the price drop. In the last two months the price of oil has decreased by about 50%. The reduced demand for oil has not been that precipitous. In other words, demand has been gradually decreasing for some time and supply has been gradually increasing for some time but all of a sudden, in an instant, prices drop. This means that the price was artificially high and was high for some reason other than simple supply and demand.

Gnomes. It could be gnomes.

Or, it could be something so completely obfuscated that I will never understand it. It’s probably the latter.

I will now give up on attempting to understand this and go back to cute cat videos.