The magic of self-correcting markets

I love studying markets. They fascinate me. Not just the stock market – all economic markets, from garage sales to global commodities. Markets provide the opportunity to observe the combination of finance and human behavior (rational and irrational alike) like nowhere else.  And every year (almost every day) we get some opportunity to watch market reactions unfold in real time.  And right now we are getting a master class in the basics of supply and demand, courtesy of oil prices.

In the years leading up to the financial crisis, there was a singular narrative about energy: we need more resources.  The US and China were simply blowing through the world’s daily energy production, with no signs of letting up.  Global middle class demographics were exploding.  Auto fleets in China and India were growing at a face-melting rate.  In sum, this:

 

So what happened?  Oil prices rose.  That’s basic economics, from a shortage of energy resources to Uber surge pricing.  When there isn’t enough of something to go around, the price goes up.  Those willing (and able) to pay more for the resource get the resource.  Markets at work.

fredgraph WTI

What happens next?  High oil prices incentivize producers to get busy producing.

daily oilfield production

There is a significant lag effect here. Prices are skyrocketing around 2007-2008, but production doesn’t really start to ramp up until 2010-2012.  It takes a long time to order equipment, explore, hire workers, drill and start producing.  But market participants responded to high energy prices exactly as we would expect them to.  As a result, US and global daily energy production goes through the roof.

We all know what has happened next.  Thanks to higher prices, a huge recession, improved fuel economy, changing US driving behaviors (in part influenced by demographic trends) and a myriad of other factors, demand growth begins to slow, but energy production keeps shooting up.

And so, in 2014, we get this.

fredgraph wti 2014

Oil prices have fallen off of a cliff due to perceived excess supply and slowing demand growth.

What should we expect next?  If the cycle is any indicator, lower prices will lead to less production (it will be much less profitable to drill for $60 oil than it was at $100) and more demand as lower gasoline prices can help consumers relax about driving habits and fuel efficiency of their vehicles. Changing prices change incentives for both producers and consumers.

Up to this point, we’ve just looked at energy prices and supply and demand in a silo.  But that isn’t how economies work.  Especially for something like energy, which is an input to practically all production of physical goods (and many services).  So not only do changing prices in oil change the behavior around this sector, but it affects how market participants behave in all sectors!

Maybe high energy prices led people to drive less and stay home more.  So maybe those consumers spent money on smartphones and apps and bigger TVs and Netflix subscriptions instead of cross-country road trips to Mount Rushmore.  For producers, high energy prices encouraged huge investment in new drilling capacity, but less investment in far-reaching suburban home development and roads to get there.

Low energy prices could do the opposite.  More money in consumer pockets might mean a resurgence in consumer discretionary spending, light truck sales and airline travel. Less money may be invested in oil production capital expenditures, but more money may be invested in single family home construction, replacing aging fleet vehicles, long-deferred road improvements and new consumer discretionary goods.

My point here isn’t that we should be speculating about the global economic impacts of lower energy prices or how falling gas prices might lead to higher revenues for Target (plenty of people are already fighting that fight, we don’t need to join the fray).  But this is markets at work – competing forces looking for profit and creating opportunity; the constant shifting of price and supply and demand hunting for equilibrium that will never be fully settled. It takes time, and speculation often leads to overshooting the “ideal” balance, but markets eventually work themselves out.  In the interim, those of us watching should enjoy the study and understand that trends are rarely permanent thanks to the hard work of market forces.

 

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