Oil Price Drop: Bad News and Faulty Inferences

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Includes: OIL, USO
by: Alpha Author

I’m not much of a macro guy (my specialty is firm strategy), and I do not pay too much attention to oil prices. After all, I live in NYC, so I don’t drive all that much. Further, I rent, so I don’t have to think too much about the cost of heating, cooling, and powering my apartment.

Not only that, but in some ways, I would almost prefer oil cost $1,000 per barrel. I don’t mean to be cavalier about that. It’s not because I feel like we should stick it to the little guy, whose life depends so much on the availability, and use, of oil. I get that, and I understand how much strain high oil prices have caused to the economy. However, my view is that $1,000 oil would incentivize us to find an alternative to fossil fuels, …and quick.

My philosophical bent is that we need to find, and encourage, alternatives to fossil fuel-based energy, for the end of our dependence on oil (foreign or domestic) can’t come quickly enough. It is my hope that we can reverse the degradation that years of carbon pollution has caused to our environment for the sake of future generations.

Now you know my bias.

But given that information, what do I make of oil’s precipitous drop from nearly $150 to $120?

Frankly, I think many who have made inferences in the wake of oil’s drop have gotten it wrong. I’m tired of hearing what a wonderful thing it is for our economy that the price of oil has been going down - as if it will cure all our ills and will help us avert a recession. Analysts have used this to explain why the market has gone up in recent days. For example, as reported just yesterday by Yahoo! news (see Stocks Advance Following Sharp Drop in Oil Prices):

Investors expect that a sustained pullback in oil prices would give a crucial boost to the economy.

Hogwash!

People are confusing cause and effect. People are buying into the story that lower oil prices causes increased economic activity. In normal times, sure. I buy that. However, in my opinion, this is not what has caused oil’s recent slide, nor is it what will likely drive oil’s continued decline in price (barring escalation of geo-political tensions in Iran, Nigeria, etc.).

What has caused oil to tumble is a drop in demand. Plain and simple.

American consumers are obviously in a bad way (see Rising Household Debts, Defaults Straining US Economy). My view is that we are currently in recession. During recessions, demand for a whole host of goods drops, oil included. But now that much of Europe is in, or near, recession (see Roubini’s excellent post on Global Recession Watch), European demand for oil (and other goods) is waning as well. Add the double-whammy of recessionary US and European economies, and it becomes obvious why the price of oil has dropped.

So the erroneous inference is that decreased oil prices will lead to increased economic activity. The correct inference is that decreased economic activity has caused a drop in the demand for oil, which causes oil prices to drop.

The drop in oil prices is therefore neither good news for the US economy nor Europe’s economy; but rather, bad news that indicates just how fragile those economies have become.

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