Santa’s Sled Runs on Unleaded: Explaining Gas Prices

Up until this year, Santa Claus has relied on holiday spirit and the dreams of anxious children to power his sleigh around the globe. But now, Old Saint Nick might be switching over to a cheaper alternative to spread his yuletide cheer: unleaded fuel.

Over the past several months, and especially over the past week, we’ve seen a dramatic decline in gas prices around the country. I like to think of it as a little pre-holiday gift from our friends in the oil industry.

So, yes, happy holidays to all of our wallets. But before we all get jaded, I think it’s important that we all stop and think, “What’s the catch?” That’s why I’m going to break it down. Right now.

Setting the Stage

Last week, adding even more fuel to the price decline—pun intended—the Organization of the Petroleum Exporting Countries (OPEC), announced that its members will keep oil production at current levels. This power move is most likely an attempt to test US oil production that has lately seen a huge increase due to the shale oil boom in North Dakota.

Essentially, OPEC figures that if they keep production where it is, the price will drop so low that US oil companies will have no choice but to either cut production or drop out because they can’t afford to keep going.

Back to Basics

In order to understand what’s going on with the shift in the price of oil, we have to look to the basics of economics: supply and demand. When supply of a good (in this case, oil) shoots up and demand falls we see a surplus. The price must then fall accordingly to match the buyers’ demand.

Right now, the supply of oil is skyrocketing due to the combination of OPEC’s refusal to slow down production in the Middle East and the shale oil production boom going on in North Dakota. Global demand for oil is down due to weak global economies, and the upswing in production has caused the price to drop significantly from over $100 per barrel to hover around $63 per barrel.

Gasoline is now selling at a national average of $2.64 per gallon, which is 30 cents lower than it was just a month ago. But don’t rely on that number too much, because at this rate it will probably have dropped another 10 cents by the time you finish reading this blog. Last Thursday, a station in Oklahoma City was the first to see gas prices drop below $2. Craziness.

As supply continues to increase, it stands to reason that the price will continue to drop and Arnold Schwarzenegger can go back to blissfully guzzling gas in his Hummer.

The Key Players

There are two major entities involved in the oil price war: The United States and OPEC.

I don’t think I need to dive too deep into explaining the former. Just know that right now the US is using new technology and techniques, such as hydraulic fracturing, to reach pockets of oil that had previously been impossible to access. It’s caused a tremendous burst in North Dakota’s economy and has bolstered the country’s energy supply.

Then, there’s the Organization of the Petroleum Exporting Countries, or, “OPEC”. OPEC is, as you might expect, an international organization whose mission is to coordinate the policies of the oil-producing countries. They collaborate to influence the world oil prices to secure a steady income to the member nations.

The main members are Saudi Arabia, Venezuela, Kuwait, Iraq, and Iran, but there are several others. Basically, they’re a cartel—a practice illegal in the United States—that works together to set the price of oil. The members of OPEC monitor their oil production to ensure prices are favorable to their economies. Because the countries that comprise OPEC are the primary oil-producing nations, the rest of the world has largely been at the mercy of their decisions.

So, What’s the Problem?

That’s a fair question. If gas prices are their lowest seen since the beginning of the recession and continue to drop, why even worry?

Because it’s not all just butterflies and rainbows from here. Let me explain.

OPEC has kept the price per barrel of oil above $100 for the past seven years. Now, instead of cutting back on production to artificially raise the cost of oil, they’re intentionally depressing the price in the hopes that excessively low prices will force many US oil producers out of the market. That would be bad.

As it stands now, a gradual decline in the price of oil would be much easier to digest for US producers. A big ol’ plunge like we’re currently experiencing suggests a bit of an issue. According to a report by the International Energy Agency last month, most major shale oil producers in the States will remain in the black (read: turn a profit) as long as the price per barrel stays above $42.

If US producers are making money, even if it’s not as much as they were before, they’ll keep going. Not to mention the fact that they’re probably enjoying seriously screwing with OPEC, which sounds like way too much fun to pass up on.

The problem is that there are still a good deal of smaller US producers who can’t compete if the price per barrel drops any lower than it is now. If it does hit that $42 breaking point, what then? I’ll tell you what: OPEC wins.

The US submits, shale oil production calms down, and our lovely holiday present is ripped away from us like that last slice of pizza your older sibling just decided was theirs instead. More seriously: should prices continue to decline, smaller producers will continue to get absorbed by larger ones or simply go bankrupt. That’s not great for us in the long run.

What This Means for You

For starters, this means big-time savings for US drivers. Since so much money can be saved on gasoline, this allows American consumers to allocate those funds towards other things. In effect, this acts like a large-scale tax cut.

Another thing–and I say this at the expense of Mother Nature—is that people can drive more and do so in less fuel-efficient vehicles (so start planning that cross-country road trip in your VW bus).

As consumers, it’s time to capitalize on this trend and enjoy it while it lasts, because it may not last forever.

For now, there’s not really any cause for concern. OPEC tried to call the United States’ bluff, but it turns out no one was bluffing. Enjoy the savings and take solace in the fact that you live in a country whose sole resource isn’t oil (here’s to you, Venezuela).

In the end, regardless of what comes of this oil industry pissing contest, the most important thing to take away from all this is the concept of how the pricing of oil works. Oil prices aren’t simply mandated by the president or voted on by a committee. They’re not set by one single entity, despite OPEC’s best wishes.

The price of oil is determined through supply and demand like almost every other commodity. Even the strongest cartels are subject to events such as the discovery of new resources or technological developments. An entity like OPEC can have a major influence because it dominates a market for a while, but new players are constantly entering and leaving, resulting in significant shifts in how the game is played.

Be happy that it is what it is for now, but know that this was not an act of divine intervention or some arbitrary decision that made it so. We all factor in to this thing we call the global economy.