Oil prices, one of the most basic resources in the commodity marketplace, and their impcats on the markets are important to learn. As one of the market movers in today’s marketplace, we must take a closer look at oil in order to continue to build towards financial fluency.

 

To analyze oil prices, we need to take a trip back to the 1970s when the Organization of Oil Exporting Countries, or OPEC, cut down on the supply of oil and sent the prices skyrocketing. As simple economics dictates, when supply goes down, demand goes up and therefore the prices rise.

In June of 2014, oil was $115 a barrel. Six months later it was down nearly 40% to about $70 a barrel. So what caused this rapid decline in a commodity?

Same thing that sent the price skyrocketing in the 70s: Supply and Demand. The surging U.S. Shale oil manufacturing caused the supply of oil to rapidly increase, and there simply was not enough demand to keep up. OPEC has refused to cut production in an effort to slow U.S. production by making certain reserves unproven that were previously proven reserves. (In the oil and gas industry, reserves that are proven reserves have a rather high certainty of being able to be profitably recovered when factoring in cost to extract and the price oil can be sold at.)

But how do the prices of oil impact our investments? Let’s take a closer look as we continue to strive towards financial fluency.

Why Does Low Oil Prices Matter?

Economist debate whether low oil prices are good or bad for the U.S. economy. With low prices, consumers save money at the pump and companies that rely on transportation of materials have lower shipping costs. On the other hand, when oil is priced higher it benefits the growing U.S. oil and gas industry. According to the American Petroleum Institute, the oil and gas industry in the U.S. supports around 9.8 million jobs and makes up 8% of the total GDP in 2016. Large oil companies such as Exxon Mobil (XOM), Shell (ADR), and BP (BP) use a special type of investment product called a futures contract to hedge fluctuations in oil price.

What is a futures contract you might ask?

futures contract gives the buyer of the contract, right, and obligation, to buy the underlying commodity at a price at which the futures contract was bought at. Major oil companies use these to keep oil prices more stable so they can better project profits and keep revenue stable.

The Future of Investing in Oil

Petroleum currently supplies about 32% of the global energy use. One may think that investing in oil may not be a good idea due to the fall in oil use by the increase in renewable resources, but many oil companies are adapting quickly. Exxon Mobil, XOM, has made significant investments into wind, geothermal, tidal, and more renewable resources. They have moved away from an “oil company” to an energy company. They are even investing in how Algae can be used to clean CO2 from the air while generating energy.

Despite rapidly increasing alternative energy production methods, the U.S. Energy Information Administration still predicts oil to be responsible for roughly 12% of global energy consumption. Looking to the more near future price of oil, some analysts projected oil could rise from its current $45 a barrel to more normal historical levels of $70-$100. The path for this to happen would be if more U.S. shale producers go out of business due to the low price of oil and Iran is unable to deliver on what they said they could produce. By surrounding yourself with a greater understanding of the markets, you can continue to step closer to financial fluency.