Markets and Economy

What’s Driving Up Oil Prices?

As developing economies grow their middle class, more international consumers are getting behind the wheel—and driving up the demand for oil. But unlike in decades past, today’s rising prices reflect a strengthening global economy rather than a lack of supply.


In 2014, oil prices collapsed, giving US commuters an unexpected windfall at the pump. This spring, however, oil prices began to rapidly recover, pushing back above $70 per barrel. Gasoline prices have risen in tandem, up 50 cents per gallon over the past year. Consumers are naturally concerned about what higher fuel prices could mean for household budgets, but rising prices at the pump reflect a benign economic environment of stronger growth abroad and surging capital investment at home.

 

The forces behind today’s rising energy prices are likely to unfold gradually, and stronger global demand for oil could have a mixed impact on the broader US economy.

Supply Catches Up With Demand

Oil prices are ever-present in the minds of consumers—everyone who drives is aware of the cost of gasoline. No other volatile commodity has every price fluctuation posted on billboards along the highway. And in past decades, oil supply shocks have hamstrung the economy by driving fuel prices to unsustainable levels.

Fortunately, oil’s current rebound is largely due to rising global demand, not supply cuts. While OPEC nations agreed to reduce supply by 1.8 million barrels daily in the winter of 2016, their cuts were almost entirely offset by increased production from new US shale fields. OPEC’s move helped stabilize the oil market, but it did little to push prices higher.

Instead, prices are rising as growing demand overseas finally absorbs the mid-decade supply glut. Global vehicle sales neared 90 million last year, and across the developing world, new members of a vast middle class are eager to get behind the wheel. As a result, global demand for oil outstripped the modest increase in supply; demand rose by 1.75 million daily barrels between 2014 and 2016, and likely increased by even more last year.

The world’s new drivers are hiking up the price of oil, but these consumers also represent a tremendous opportunity for US businesses. On the whole, the many benefits of living in an increasingly prosperous world should more than compensate for higher gas prices.

Currency Rebalancing

Rebalancing foreign exchange markets have amplified the swing in oil prices. In 2014, just as the oil glut emerged, the Federal Reserve began to taper its quantitative easing program and announced plans to normalize interest rates, sending the dollar up against the euro and yen.

Since oil prices are set in dollars, the currency’s rise made oil relatively cheaper in the US and more expensive abroad. Now that Europe and Japan are beginning to normalize their monetary policies, the dollar is weakening—and oil prices (in dollars) are naturally climbing.

The rebalancing of foreign exchange markets will create economic crosscurrents. A weakening dollar makes all imports—including oil—more expensive for US consumers. But the dollar’s decline has also made US exports more competitive on the global market. More broadly, the return of synchronized growth across the industrialized world should create new opportunities for domestic businesses.

Where Is Oil Headed?

Prices per barrel are hovering near $75, which many analysts believe is the breakeven price for new shale drilling. During the oil glut, domestic drilling activity fell steeply. In many of America’s most promising shale formations, expensive horizontal drilling and hydraulic fracturing techniques are only profitable when prices are relatively high.

This means that higher fuel prices could generate a wave of capital investment in oil-patch communities. Already, drilling activity is beginning to rebound, with the nation’s rig count climbing almost as rapidly today as during the height of the early-decade shale boom. Rising domestic output should temper the increase in prices—the more expensive oil becomes, the more incentive there will be for new drilling, and supply will eventually rise to meet global demand. The US is poised to become the world’s top petroleum producer in the coming years, and higher prices should only accelerate the domestic industry’s rise.

Overall, the American economy benefited from the oil glut—the US is a net importer of oil, so falling fuel prices freed up money for domestic consumption. All things being equal, higher energy prices will become a drag on growth. But all things are not equal—oil is rising in tandem with synchronized global growth, which is creating new wealth at home and abroad. On the whole, we likely have little to fear from today’s demand-driven rise in energy prices.

View our economic commentary disclaimer.


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