Are Falling Oil Prices Driven by Rising Supply or Falling Demand? (Yes)

It’s been impossible to miss the headlines screaming about oil: Prices Plunge! Multiyear lows! Supply glut! Dollar rally!

My concern is less about a supply glut and more about falling demand. Despite a dearth of signals that a recession may be on its way, falling oil prices can be a sign that consumers are getting tired or are running out of discretionary income. In a post-credit-crisis recovery, where households have been deleveraging, this could have far-reaching ramifications.

We know that Europe’s economy has slowed as austerity bites. Reduced spending by both households and governments is cutting energy consumption. Add to that slowing growth in China, which also is causing ripples through the rest of Asia, and you have the conditions for falling crude prices.

Declining demand puts pressure on prices, but what about supply — how much is that driving prices lower?

Consider Saudi Arabia’s recent actions. Rather than defend prices by lowering production, it chose instead to cut prices last month. The Saudis appear to want to avoid repeating the mistakes of the 1980s. The strategy now seems to be to let prices fall to a level that might spark more consumption.

There’s the rub: Oil prices have remained stubbornly high the past decade, causing a massive search for more oil, as well as its possible alternatives. The net result is a world awash in energy products: Shale oil and tar sands have added to the supplies of crude. Let’s also add that the U.S. automobile fleet is much more efficient. Fracking has created a huge supply of natural gas in North America, a cheap and cleaner alternative to oil, especially for home heating and electricity production. Add coal-based liquefied natural gas to the mix, and suddenly OPEC looks more vulnerable than it has in decades.

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