Why Oil Matters

C Adam Pfander

It’s no secret that the stock market is hurting right now—and we can place a lot of the blame on low oil prices. The explanation appears counter-intuitive at first; cheap oil spells cheap energy, which means we all save on gas and heat and anything plastic. That should improve our wealth, not damage it, right? Yes. In fact, the Economist reports that declining oil prices have historically resulted in economic growth. So why are stocks tanking?

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The current upheaval in the stock market represents the decoupling of finance from economics. While our economy is gaining strength, some of the world’s largest companies, along with once-prosperous oil-producing nations, are struggling with depressed oil prices. These companies are, most notably, energy manufacturers like Chevron and Exxon Mobil. The nations that are suffering are export based-economies like Russia, Saudi Arabia, and Venezuela - the latter two are members of the Organization of the Petroleum Exporting Countries [OPEC].

The economic well-being of these countries and companies rises and falls with the price of oil. Adding to the uncertainty, many oil-producing nations are politically unstable. Venezuela recently declared an economic state of emergency, and while governments in the Middle East are in a tenuous situation now, conditions will worsen if their main source of income dries up.

What is behind the plummeting oil prices? The market forces of supply and demand. In the past 18 months, oil producing nations have been manufacturing full-tilt. Pair this with the rapid expansion of natural gas production in the United States, and the market is simply flooded with oil.  According to the New York Times, approximately one million barrels of oil are produced (supplied) in excess of what is bought (demanded) each day. One million barrels of excess oil act like one million anchors, dragging the price of oil down to historic levels.

The depressed oil market does not alone affect a small group of energy producers and oil-exporting nations. Fossil fuels lie at the heart of the US economy, so trouble in the oil market threatens the US economy as well. Cheaper oil means less energy exploration and extraction, a significant source of fixed capital investment – that is, sales of machines in the economy.

All of this unrest spooks financial markets. If oil companies stop expanding production today, then they could fail to meet their debts in the future, which can cause bankruptcy. Investors grow wary of whether or not they will get their money back from these companies. Should the Middle East erupt into political turmoil due to decreased oil revenues, then emerging market investors also become worried of losing their money. This concern over the future is contagious, and has spread to financial institutions across the globe.

Last month, oil reached a low of $28.35/barrel in mid-January - that is less than a 20-piece bucket of KFC chicken. Recently, the per barrel price has risen to the mid-$30 range largely due to rumors that Russia is negotiating with OPEC to curb oil production. This is not the first time that Russia has attempted to influence OPEC, but previous attempts have failed. Each day that oil prices remain low causes oil based countries, companies, and investors to worry more. This could change if Russia succeeds in its talks with OPEC, but the talks seem like a ‘hail-mary’ in the oil game.