The price of oil is falling to levels last seen when the Dow Jones Industrial Average (INDEX: ^DJI ) fell below 11,000 and the S&P 500 (INDEX: ^GSPC ) fell below 1,150 near the end of last year. At less than $80 per barrel for West Texas Intermediate, should we expect a similar pullback in the markets? Or will the low price of energy help businesses expand? Let's look at the causes of the drop in oil to find out.
Causes No. 1, 2, and 3
In May, the Organization for Economic Development cut its GDP forecast for Europe's growth from 0.2% to -0.1%, indicating a shrinking economy. For 2013, it cut its growth forecast from 1.3% to 0.9%. With fewer factories pumping out fewer goods to fewer trucks, trains, planes, and ships, there is less demand for energy and oil. Add to this that the European Union is the second-largest consumer of oil behind the U.S., and Europe weighs heavily on oil's demand.
But Europe is just one region where growth is slipping. The third-largest consumer of oil, China, is also slowing down.
Unfortunately for China, the EU is its largest export market. With fewer Europeans buying Chinese goods, China's own GDP growth forecast of 7.5% is at a level last seen in 1990. China is fighting this slowdown with its own central bank measures of cutting interest rates, but industrial activity has been shrinking for eight straight months, according to HSBC figures.
And of course, American growth has also been shaved. For the top oil consumer in the world, the Federal Reserve's most recent forecast for U.S. GDP growth fell from a range between 3.1% and 3.3% to a revised estimate of 2.7% to 2.9%.
Falling demand, falling supply
With falling demand pushing prices lower, what's happening with supply? The world is actually producing the most oil ever:
According to CNBC, the world is producing 91.1 million barrels per day while consuming 89.9 million barrels per day. With falling demand from the top oil consumers and a supply that outstrips demand, it's difficult for oil to maintain its price near $100 per barrel.
One problem that may lower production is the status of Iran. The U.S. and the EU have issued sanctions on Iran with the hopes of convincing Iran to curtail its pursuit of nuclear weapons. While the countries have failed to reach an agreement, the EU's embargo will take effect on July 1. Mitigating this potential issue, however, is Saudi Arabia, which is engaging in its own world economic stimulus package by producing the same amount of oil, even with the lower prices. Saudi Arabia is able to do this because of the profits earned previously in the year, and according to Reuters, the country only needs prices at $75 to $80 per barrel to balance its budget.
With the dismal outlook for growth, it would appear the slack in demand has already been priced in, and while we're producing the most oil ever, we're also consuming the most oil ever. And though Saudi Arabia seems to be generous with its supply, it still must maintain prices above $75 per barrel for its budget. For these reasons, I believe oil won't fall much further in price without a major unexpected event. Who will benefit and who will lose from these lower oil prices?
Industries where fuel makes up a large portion of expenses could be winners, including the transportation sector. Airlines like Delta Air Lines (NYSE: DAL ) , whose fuel accounts for almost 30% of expenses, will benefit from lower fuel prices -- if fewer passengers in a slower economy don't hurt them. Logistics king United Parcel Service (NYSE: UPS ) , even though it has the largest private fleet of alternative fuel trucks, has fuel expenses that claim 22% of its total costs. If shipping volume maintains its levels -- or at least falls slower than fuel prices -- UPS could enjoy cheaper gas.
On the other hand, the market looks down on oil producers. According to Bloomberg, "Energy companies are the only U.S. industry whose earnings forecasts have been revised from growth to contraction in 2012." For example, Baker Hughes (NYSE: BHI ) had a net profit margin of 7.1% in its most recent quarter, compared to last year's profit margin of 8.8%, and this year it has shed more than 20% in market value.
An oily crystal ball
Predicting where oil is headed can be a flip of a coin, and the energy stocks that have been punished may actually be ready to pop if oil rebounds. Given the uncertainty surrounding oil, you may rest easier investing in outcomes that you believe are more certain, like a more efficient and wealthier world that needs more food. Or you may look for quality companies that don't carry the risk of commodity prices.
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