Cheap Gas May Not Last For Long

  • Tuesday, 30 December 2014 00:00

There's no denying that consumers have had one of the best holiday seasons in years thanks to the dramatic fall in gas prices. But new developments suggest that low prices at the pump won't be a permanent fixture.

According to a recent report by the Wall Street Journal, crude oil producers in the U.S. have begun scalling back on production. Indeed, the report, citing Baker Hughes Inc, says onshore drilling rigs have been reduced for three consecutive weeks with 37 rigs dropped last week alone.

The drop in rigs may be an attempt by U.S. producers to stabilise (read : increase) crude oil prices. With oil prices some 60 percent lower than what they were in June, domestic producers are undoubtedly seeing revenue and profit margins diminish.

It's important to note that the last time prices were this low (2008) the world was undergoing one of the most severe economic recessions since the Great Depression. As a consequence, the global appetite for oil fell and fuel costs spiralled downwards in tandem.

This time around, however, the global economy is in a much healthier state even if economists believe the overall European economy will remain sluggish in 2015 and growth in Asia slows down. No doubt both those factors would suggest global demand for oil next year to be lower than this year but that surely couldn't have sent gas prices to a five-year low.

Instead, as pointed out in this story by the Financial Times and other publications, consumers are being caught in a standoff between Saudi Arabia and U.S. shale producers. The shale boom has helped grow domestic crude oil production to over 9 million barrels a day, which is close to what the Saudis produce.

But unlike it's usual practise, the Saudis and OPEC have not scaled back production to prop crude prices up. Instead, they have allowed it to slide and it's a case of who will blink first at this point - the Saudis or shale producers? As suggested in the Financial Times story mentioned above, Saudi Arabia is flush with cash and will be able to withstand whatever damage its economy takes from low oil prices. Local shale producers don't necessarily have the same luxury.

So what does all this mean?

One one hand, it means that the gas prices we've been paying for years were artificial because they were dictated by OPEC who used production as a means to keep prices artificially high. But it also means that the current downtrend in prices may not last long. At some point, someone is going to start reducing production and as indicated by the Wall Street Journal, oil producers in the U.S. have already begun scaling back the number of rigs in operation. 

But it also means increased domestic production may not lead us to cheap gas prices as the prices we pay is determined by the global market and its players. Oil producers, be they domestic or foreign, are in the business for one thing - to make profits. 

On the other hand, the one constant factor that has reduced pump prices the last five years has been ethanol. As Iowa State University's Center For Agriculture and Rural Development points out, ethanol suppressed the price of gasoline by $1.09 per gallon on average in 2011.

Even with depressed gas prices, higher blends of ethanol are still being sold at a discount at retail stations. E15 is still being sold on average at 10 cents less per gallon than regular 87-octane unleaded fuel while a Cenex in Alexandria was still selling E85 at a dollar less per gallon.