falling crude oil prices

It late February, the West Texas Intermediate oil price was $110 a barrel.  Now it’s $80.

North Sea Brent crude, which is much easier to refine and therefore sells at a premium, was at $120 four months ago.  Now it’s at $92.

That’s a price drop of around 25%, even though June is seasonally stronger period for demand than late winter.

That’s good news for consumers, especially in the US.

Here’s why.

a thumbnail sketch of the oil market

Petroleum is a peculiar commodity, for several reasons:

–huge size.   The world uses around 80 million barrels daily.  At the current $80 each, that’s $6.4 billion a day in value, or $2.3 trillion a year.

–disproportionately large consumption by the US.  The US makes up about 4.5% of the world’s population–but uses over 20% of the global oil output.  How so?  It’s partly because the US is a rich country.  But it’s mostly, in my view, the result of long-standing (and misguided) policy in Washington to subsidize an inefficient domestic auto industry.  (We’re the only industrialized country without an effective energy policy, and we’ve been like this for forty years–but that’s a topic for another day).

–supply is very inflexible.  Most pools of oil are buried under great pressure deep beneath the earth.  Draining these reservoirs without drilling a gazillion wells in each is a complex process that involves starting–and keeping for years and years–a steady flow of crude from all parts of the field toward the surface.  In almost all cases, stopping, or even trying to slow down, the flow can be disastrous.

As a result, when demand slows, as it is now, the only way producers can sell their surplus output is to lower the price–sometimes by a lot.

implications of falling prices

There are two major ones for stocks:

1.  Most oil (and natural gas) companies make the bulk of their money from developing oilfields and selling the output.  Lower prices translate directly into lower profits.  There may be different shades of bad, depending on whether the producers own the oilfields outright or have production-sharing agreements with third parties.  But it’s not good.

The one exception is companies that whose business is completely “downstream, ” that is, who refine and sell petroleum products, especially gasoline.  They’re buyers of crude oil, so their margins may expand as prices fall.  Ultimately, though, competition forces them to pass on almost all their lower costs to customers.

2.  Falling oil prices are a boon for consumers, particularly in the US.  Sustained over a year, a $30 per barrel reduction in the oil price means an extra $1,700 in spendable income for the typical US household.  That’s the equivalent of a 6%-7% pay raise.

think modest

That’s not enough for the Porsche or the Tiffany tiara you’ve been eyeing.  And the extra income won’t be particularly noticeable to the affluent.  But it will be an important boost, I think, to the everyday buying of ordinary Americans.  So Wal-Mart and Disney (I own DIS) should benefit.  Generally speaking, average citizens should continue to feel better about their economic circumstances, even as the economy shifts into a lower gear (is there one?) and job growth slows.  So retailers who sell low-ticket items should have the wind at their backs.