Gas prices in 2005. Source: Ben Schumin
Almost every American knows that cheap oil should lead to cheaper gas, and that it should also lead to cheaper goods at stores. And with many people still feeling the pinch of the recession as wage stagnation remains a problem, seeing your dollars go a little farther is a good thing.
However, since the price of oil started falling in mid-June, the stock market has also trended down:
WTI Crude Oil Spot Price data by YCharts
If cheap oil prices are good for the economy, why is the stock market down? Well, it's a little more involved than that. Let's take a deeper look at this very important question that affects us in more ways than just the price of goods and gasoline.
Oil, gas, and the price of everything you buy
Energy costs influence the price of every good and service that you pay for. Using something like a pack of chicken as an example:
- Natural gas is used to make the fertilizer that is used to grow the feed for the chickens, and to heat the chicken houses in cold weather.
- Diesel fuels the tractors at both the farms that grow the feed, and where the chickens are raised. It also fuels the trucks and locomotives that transport the feed, and the chickens.
- Coal and natural gas power the electricity that runs the processing plant where the chickens are processed and packed for retail customers.
- More diesel getting the chicken to a regional distribution center your grocer uses, and then more diesel in its delivery trucks.
- Gasoline in your car to get to the grocery store, which uses coal or natural gas for its electricity.
In short, every part of the chain is affected by the cost of oil. For the locomotive operators, diesel fuel is usually the most expensive line item on the budget, and it can often be the same for trucking companies. And since these companies pass along a fuel surcharge to their customers like the grocery chains and farm operators, the price gets passed along to consumers.
Oil as an ingredient
A few things made from oil derivatives. Source: Phillips 66 / Chevron partnership, CPchem
This is often overlooked by consumers, who usually think of oil as just gasoline or diesel. However, so many of the products you use every day also feature an oil derivative as an ingredient.
The majority of plastics are made with ethylene, which can be made from both crude oil and natural gas. Ethylene is the most widely used organic chemical in the world, and more than half of it is used to produce polyethylene, the most common plastic in the world.
Ethylene is also used to make tires, the soles of your shoes, antifreeze, and hundreds and hundreds of other things that you rely on everyday -- and probably 90% of which you never even think about. Ever heard of polyester? Rayon? There's a likelihood that the synthetic flooring in your house or office is oil-based.
So how is cheap oil not a good thing?
Oil is a globally traded and priced commodity. While production in the U.S. has grown like wildfire in recent years -- did you know that the U.S. will produce more oil than Saudi Arabia in 2014? -- we still consume much more than we produce. Furthermore, a big part of the American oil business is refining, i.e. taking oil and turning it into gasoline, diesel, and other distillates which are used to make ethylene and dozens of other ingredients for manufacturing.
So yes: lower oil costs do make almost everything cheaper, so in most ways it's a great thing. However, when oil prices are falling so quickly, it's an indicator that other things that aren't so good.
German Bosch benefits from cheaper oil, but a weak Europe is bad for business. Source: Timo Engelmann
For the most part, oil prices are largely the product of supply and demand. While the supply side -- largely as a result of North American production growth in recent years -- is in pretty good shape, demand is weakening. If it were simply weakening due to the growth of renewables or alternative fuels like natural gas, that would be one thing. But when falling demand is the result of economic weakness, that's a concern.
Recently the International Energy Agency (IEA) reduced its oil demand outlook for the next year by a whopping 20%, citing a weak European economy, and the slowing of growth in Asian countries like China. Germany -- by far the strongest economy in Europe and also the largest -- has slashed its forecast for growth this year and next, largely due to falling demand for its industrial output in neighboring countries, its largest market. There is actually concern that some European countries could fall back into recession.
750 million Europeans command $37 trillion in wealth. That matters to your retirement account.
Why does this matter to Americans? In short, Europe is a big customer for American companies, including the oil and gas companies that employ hundreds of thousands of people in the U.S., both directly and indirectly. Weakening demand for oil, and falling oil prices, could lead to production cuts, or at least slowing production growth, and that's not good for American jobs.
And if prices stay down for the long term, it's because demand isn't rebounding. That's not good for companies that do a lot of business in Europe -- the world's richest continent -- and Asia. So while the U.S. economy remains relatively strong, even if the recovery has been very slow and isn't nearly complete, domestic oil and gas production has been a real bright spot. And that could come to an end if oil prices keep falling.
The impact you might not see today, but could feel later
While it's easy to think that weakness in Europe doesn't matter much here, or that those big companies' problems don't really affect you, that's probably less true than most people realize. Almost 100 million Americans have invested in a mutual fund, and the vast majority of mutual fund holdings are stocks in multinational companies. So even if your employer doesn't do business overseas, chances are your retirement nest egg is exposed to international economies. On average, half of the net worth of those who own mutual funds is held in those mutual funds.
So while cheap gas is nice, oil prices falling sharply isn't the kind of thing that anyone should want to see -- especially if it continues for a long period of time, because that means one of the world's largest economies is struggling. Oil is a major ingredient in the global economy -- stability is much more important, and better for everyone.
