The sharp drop in crude oil prices has caught many economists by surprise, myself included.
Just two weeks ago I was heralding lower gas price volatility in a talk to a forecasting group. With crude oil dropping to below $70 a barrel, from nearly $100 just a few months ago and in the low $80s last week, lower volatility is hardly the phrase I’d now use.
There is both good and bad news in this price decline, but more importantly this is a clear example of an often-misunderstood economic principle at work. Thus, this is a good time for an economics lesson. I start with the bad news.
Petroleum prices are set in a world market in the functional equivalent of an auction. While the OPEC cartel controls much production, it has a hard time of it because the costs of production and the interests of each member nation are very different. Add to that American production (which is now ahead of Saudi Arabia), and OPEC is weakening.
The natural result is increased production. This alone reduces prices, but supply is only part of the story.
The rapid decline in petroleum prices is also due to weakening demand. This is the bad news.
Most petroleum is used to move goods and provide services. So, a slowing of the world economy means less energy will be used. Even a modest slowdown can have a large impact on oil prices because oil is so costly to store. The profit margin on petroleum is small and disappears quickly if you have to rent holding tanks.
Still, this price decline is unusually swift and deep. It is not as severe as the price collapse in 2008, but it is otherwise as big a decline as we’ve seen in two generations.
If it drops to $40 a barrel as some forecasters suggest, it’ll be the third biggest drop in a century. This certainly means that the world economy is far shakier than it seemed even two weeks ago. This leads to the real economic lesson here.
Like many Hoosiers, I drive a pickup truck and so am pleased with lower gas prices that might drop even further. My family and many others will now have more income to spend on other items. This gets us to the economic lesson.
The free movement of prices is the fastest and least costly way for markets to move back into balance — or “equilibrium” in economic terminology. There are two effects. First, the lower price will induce less oil drilling since it is less profitable. This will cause prices to slowly begin to rise as supply shrinks, rebalancing oil markets.
Second, the broader effect will be on overall demand. Lower petroleum prices frees up income to buy other goods and services. This helps dampens the effect of a slowing world economy. Thus economies tend to “self-correct” naturally in response to price changes. This idea of markets moving themselves back into balance is a central, necessary and often misunderstood element of the work of markets.
Michael Hicks is the director of the Center for Business and Economic Research and an associate professor of economics in the Miller College of Business at Ball State University. Send comments to firstname.lastname@example.org.