Does The World Really Want High Oil Prices?

Posted: December 16, 2020

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Abstract

With global economies opening back up with the release of a vaccine for the global pandemic, global oil demand is returning and with it, higher oil prices. Unfortunately for consumers, higher oil prices mean higher prices at the pump in addition to increased costs of many manufactured goods. Since hydrocarbons are wound deep into nearly every facet of our society, price changes are inevitably felt in many sectors of the economy. As oil prices rise, associated production costs will be passed through to consumers rather than kept at the bottom line of operators or refineries. When oil prices rise in the near term, it will be better for investors and the remaining companies in the industry at the expense of people consuming the final products produced. 


Key Points

  • As energy prices rise, the end consumer will ultimately pay the price. In the near term, if oil prices rise it will be better for investors and energy companies because additional costs will be passed through to consumers.

  • Higher oil prices mean the cost of gasoline and diesel rises, resulting in a larger amount of a household or business’ budget is spent on transportation fuel. Inversely, lower oil prices allow for a reduced allocation for travel costs and more spending elsewhere. As crude prices spike, costs for goods follow suit because this additional overhead is correlated to transportation and manufacturing costs.

  • The groups that tend to suffer when oil prices drop are the banking and investment sectors in addition to the actual oil companies themselves. While well versed in these risks, banks and investors have a lot to lose if capital lent to oil companies is lost or destroyed from low oil prices. Since these institutions are the source of capital, once prices eventually rebound, their subsidiaries often pass along the price to consumers to recoup potential losses.

  • Low prices may be beneficial for consumer goods and services, but since the U.S. became an exporter of crude, it also has an impact on domestic jobs and GDP. Less drilling and exploration activity can lead to layoffs which will eventually trickle down to reduced revenue for local businesses and communities supporting the industry.

  • Oil prices are directly correlated to the prices of goods in the petroleum product supply chain and indirectly affect overall costs for transportation, manufacturing, and heating. These cost fluctuations can in turn affect the prices of a variety of goods and services, many unrelated to oil and gas, as producers tend to pass production costs on to consumers. A drop in the price of oil will never be seen at the consumer level nearly as much as the impact following an increase in price.

  • Until investor confidence in allocation of capital is restored in the oil and gas sector, companies must generate long term profit streams and growth. A simple way to do this will be by passing through production costs on existing operations to the end product as commodity prices rise.

Introduction

With drastic declines in consumer demand, the coronavirus pandemic has created a difficult new world for the oil industry. Consumers tend to benefit from lower oil prices as it lessens the cost of many goods and services. But as an oil-producing country, not just an oil consumer, the United States now also feels an unpleasant pinch when oil prices drop. While greater domestic oil production is a net positive for the United States, the temporary negative prices had producers worrying briefly about paying buyers for their oil. Now they face longer term concerns, such as having to curtail output, shut down producing wells and defer new well openings, put off exploration, file for bankruptcies, or get acquired in a wave of consolidation [1]. Since oil price is a two sided coin, the question becomes: what impact does a return to high oil prices have on the end consumer? With global economies opening back up from the release of a vaccine for the global pandemic, global oil demand is returning and with it, higher oil prices. Oil prices will fluctuate in the coming years, but the long-term trend is likely bullish. Once high oil prices return, those costs will be passed through to consumers rather than the bottom line of operators or refineries. 


Dan K. Eberhart – Switching Gears

This is a similar stance to the one proposed by Dan K. Eberhart back in October 2020 when he released his book titled Switching Gears: The Petroleum-Powered Electric Car. Mr. Eberhart holds a Bachelors of Science in Economics and Political Science from Vanderbilt University as well as a Law Degree from Tulane University. His diverse background managing a private equity firm and Chief Executive Officer role at an oilfield service company has made him a frequent speaker and panelist focusing on mergers and acquisitions, oil and gas, business development, and other related topics [5]. His background on the energy engine is so extensive, Eberhart decided to write a book on his vision of the future. In his work, Eberhart envisions a successful energy revolution where we learn from our mistakes and solve our puzzles, as we work toward a future that allows us to be conscientious, powerful, and energy-savvy all at the same time [2]. 

Figure 1: Switching Gears: The Petroleum-Powered Electric Car by Dan K. Eberhart [2]

While his work mainly focuses on the energy transition and the rise of electric vehicles, he argues that as energy prices rise, the consumer will ultimately pay the price. Taking that a step further, the argument can be made that as oil prices rise, associated production costs will be passed through to consumers rather than kept in the bottom line of operators or refineries. As a result, if oil prices rise in the near term, it will be better for investors and the remaining companies in the industry at the expense of people consuming the final products produced. 


Oil Price’s Ties to Everyday Goods and Services 

Let’s take a step back to understand how oil prices affect consumers and businesses in addition to investors and oil producing companies. Historically speaking, cheap oil was great for American consumers as well as the manufacturing sector. On a consumer level, the easiest comparison for low vs. high oil prices is to consider the cost of gasoline. When oil prices are higher, the price of gasoline is noticed by consumers because gasoline purchases are necessary for most households. When gasoline prices increase, a larger share of a household’s budgets is likely to be spent on it, which leaves less to spend on other goods and services [3]. The reverse is also true, lower oil prices lead to a reduction in budget allocated to travel, which allows for more to be spent on goods and services. Figure 2 shows the strong correlation between oil and gasoline prices since 1985.

Figure 2: Oil Price (Blue) and Gasoline Price (Orange) Relationship [6] 

The same goes for businesses where goods must be shipped via freight or businesses with a large portion of operating costs determined by fossil fuel commodity prices, such as the airline industry. Higher oil prices tend to make transportation more expensive for businesses, just as they make it more expensive for households to do the things they normally do [3].  So when oil prices spike, you can expect the price of many consumer goods to spike as well. This can be seen through the value chain as it affects the costs faced by the vast majority of both households and businesses. 

Additionally, the price of oil influences the costs of production and manufacturing across the United States. As many industrial chemicals are refined from oil, lower crude prices benefit the manufacturing sector. Similar to transportation, a drop in the price of oil is largely viewed as a good thing since it reduces the cost of the manufacturing. Taking it a step further, these reductions in costs could likewise be passed through to the consumer. Now that the United States has increased its role in global oil production, lower prices also hurt U.S. oil company revenues and affect domestic energy industry workers [4]. Conversely, high oil prices add to the operating cost of doing business and these costs are ultimately passed on to customers and businesses purchasing the final product. Industries far and wide are affected by this balancing act – more expensive airline tickets, more expensive goods imported from overseas, and even retail gasoline. Therefore, high oil prices can result in higher prices for products and services seemingly unrelated to the energy industry.  


Investment Dollars and The Economy 

But what is the reason these price fluctuations are passed along to the consumer instead of ending up on an organization’s bottom line? It is pure business. The groups that tend to suffer when oil prices drop are the banking and investment sectors in addition to the actual oil companies themselves. There are a lot of different companies drilling and servicing wells in the oilfield, and many of these companies finance their operations by raising capital and taking on debt [4]. This means investors and banks both have money to lose if the price of oil drops below profitable levels and the companies dependent on drilling and service go out of business [4]. Of course, investors and bankers are well-versed in risks and rewards, but the losses can still destroy capital when it happens. Between job and capital losses, a dip in oil prices now has the ability to trim the growth of the overall U.S. economy. 

Figure 3: Oil Price and Growth of The Economy [7]  

The exploration and production of U.S. shale deposits have been a strong source of job growth over the past couple decades. In addition, as these wells naturally decline rapidly, reserves replacement creates almost constant new drilling activity. All this activity requires labor including drilling crews, truck drivers, mechanics, and field operators. Furthermore, the people working in the oilfield tend to support local businesses like hotels and restaurants. So while lower oil prices mean slightly cheaper goods and services, it also means less drilling and exploration activity. Less activity can lead to layoffs which can hurt the local businesses and communities that catered to these workers [4]. Since oil can only be economically produced at a certain price-point and the depletion of minerals yields less revenue over time, low oil prices eventually have diminishing returns. While they do not necessarily need to be astronomically high, prices must be higher in the long run to lead to more economic success regardless of whether or not costs are being passed along to the end consumer.

Since these institutions are the source of capital, once prices eventually rebound, their subsidiaries pass along the price to consumers to recoup potential losses. It is inevitable. Luckily, higher oil prices lead to increased economic activity and additional jobs. Even though the cost of goods will increase with higher oil prices, the long term benefits are also passed along.  


Conclusion 

Oil prices do have an impact on the U.S. economy, but it goes two ways because of the underlying complexity of this key commodity. High oil prices can drive job creation and investment as it becomes economically viable for oil companies to exploit higher-cost reserves. Alternatively, high oil prices also impact business and consumers with higher transportation and manufacturing costs. Put simply, oil prices are directly correlated to the prices of goods in the petroleum product supply chain and indirectly affect overall costs for transportation, manufacturing, and heating. These cost increases can in turn affect the prices of a variety of goods and services, many unrelated to oil and gas, as producers tend to pass production costs on to consumers. The extent to which rising oil price leads to an increased cost in consumer goods depends on the importance of crude in the production of a given type of good or service [3]. 

Since hydrocarbons are wound deep into nearly every facet of our society, price changes are inevitably felt in many sectors of the economy. As consumers of oil, lower prices still benefit most consumers with cheaper gasoline and travel as well as lower prices of many manufactured goods. Oil companies and the investment institutions behind them feel the downward pressure even more as their bottom lines inch towards breakeven. As a result, a drop in the price of oil will never be seen at the consumer level nearly as much as the impact following an increase in price. This is a direct result of the revenue stream. As the price of crude increases, transportation costs to deliver products necessary for oil production also increase which cuts into the profit margin. Therefore, they must pass along more of the uncontrollable costs to the consumers to meet investor expectations. Companies will continue to support their bottom lines as oil prices rise in the near term, so returns will be better for investors and the remaining companies in the industry at the expense of people consuming the final products produced. In order to remain viable into the future, companies must generate long term profit streams and growth. A simple way to do this will be by passing through production costs as commodity prices rise. 


References 

[1] https://knowledge.wharton.upenn.edu/article/oil-price-shock-means-producers-consumers/ 

[2] https://www.goodreads.com/book/show/55766563-switching-gears 

[3] https://www.frbsf.org/education/publications/doctor-econ/2007/november/oil-prices-impact-economy/ 

[4] https://www.investopedia.com/articles/investing/032515/how-oil-prices-impact-us-economy.asp 

[5] https://www.linkedin.com/in/dankeberhart/ 

[6] https://www.macrotrends.net/2501/crude-oil-vs-gasoline-prices-chart 

[7] https://fred.stlouisfed.org/graph/fredgraph.png?g=yAkh

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