What’s Behind (and Ahead for) the Plunging Price of Oil

It doesn’t feel like it, but we got a raise this week. The plunging price of oil, which prompted OPEC to announce a 1.5 million barrel a day production cut, has put money in the pockets of recession-worried consumers. “It follows that there’s going to be some spending effect,” said Francisco Blach head of commodities research at Merrill Lynch in London.

Oil demand in the U.S. has dropped 10% in the few weeks, continuing a year long trend. According to the U.S. Department of Transportation, Americans drove 15 billion fewer miles in August, or 5.6% less than they did the year before. DOT says it’s the largest ever year-to-year decline recorded in a single month. Over the past 10 months, Americans have driven 78 billion fewer miles than they did in the same 10 months the previous year — sure proof of what economists call “demand destruction.”

Coping with $4 a gallon gasoline has drastically altered driving patterns, perhaps permanently. “We are seeing changes in habits,” says Julian Lee, senior energy analyst with the Center for Global Energy Studies in London. “The sales of big gas-guzzling vehicles have collapsed. If we see that kind of change it becomes a much longer term issue with long-term demand destruction.” In the short term, there’s simple math. The average driver goes about 12,000 miles a year at 20 miles per gallon, says Ken Medlock, an Energy Fellow at the Baker Institute at Rice University in Houston, Texas. If gasoline drops $1.50 the $900 that Joe Average Driver saves would amount to a big stimulus package. According to Ed Leamer, director of the UCLA’s Anderson Forecast, the current price slide could drop another $200-to-$250 billion into consumers’ pockets, given that as of the second quarter personal spending for gas fuel oil and other energy was about $442 billion on an annualized basis. By way of comparison, Wal-Mart’s U.S. stores took in $240 billion in the last fiscal year. “For consumers, it’s welcome relief,” says Medlock. And because the U.S. is out of its peak summer driving season, there’s not too much of an incentive to drive a lot more just because gas prices are down.

Falling worldwide demand, especially in emerging markets, is the reason that the oil market made road kill of OPEC’s production cut. Oil dropped yet again to $64 a barrel — its lowest level in more than a year. For months leaders of oil-rich countries have watched nervously as world oil prices have tumbled more than 50% from the all-time high in July of $147 a barrel.

All of which spells crisis for OPEC. Since last month oil ministers in Iran and Venezuela — both of which are heavily dependent on oil revenues — have pushed fellow OPEC members to make big enough cuts in production to reverse the plunge in prices; both argued for a cut of two million barrels when they arrived in Vienna on Thursday for OPEC’s emergency meeting. OPEC countries set oil production quotas, and their tactic of fixing their combined output has for years hugely influenced world prices, since OPEC’s 13 members account for about one-third of the world’s total oil supplies.

(Click here for a Gallery of 10 Things to Like About $4 Gas.)

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Another worry is looming for OPEC officials: A possible slowdown in China, whose soaring economy this decade has sent oil prices rocketing, and helped to ignite a scramble for new oil exploration and drilling in numerous developing countries from Ecuador to Angola, whose economies have surged along with the oil prices. “OPEC needs to see China maintain its rate of growth,” Robert Johnston, energy director for the Eurasia Group in Washington said before the OPEC meeting. Without China’s continued thirst for new oil, OPEC production cuts will have a limited impact.

If demand for oil is off 10% worldwide, why are prices down more than 50%? It’s not a one to one relationship — small demand swings can cause large price swings, says Blanch. And the unraveling of oil is the other side of the credit crunch. Banks, investment banks and speculators have pulled money out of oil futures, further driving oil prices down; that’s one reason why prices have fallen far faster than demand.

Despite the speed of the oil boom, the price crash has jolted OPEC countries, which appear to have assumed that high prices were here to stay. Nigeria and Iran have both set their national budgets according to prices of about $80 a barrel, and Qatar’s expectation has been $90 a barrel. “Producers very quickly got used to $100-plus prices,” says Lee. “They thought of it as normal and justified. They seem to have very short memories.”

Several oil analysts — who predicted earlier this year that oil would reach $200 by year’s end — have recently said that oil could drop to $50 a barrel. Merrill’s Blanch had oil pegged at $90/bbl for 2008 last month, but he can easily see $50/bbl if there’s a global recession. That could be more welcome news for drivers next year. “That’s where you could see people use that disposable income to do things like go on vacation,” says Medlock. That’s assuming they have a job to get away from. But one thing low oil prices can’t do is get the U.S. out of its credit crisis.

(Click here for a Gallery of 10 Things to Like About $4 Gas.)

(Click here for Pictures of the Week.)