The popular consensus seems to be solidifying - the worst may not be over for oil. Does this pervasive negative sentiment actually mean that oil prices may finally be near the bottom?
As investment themes go, the direction of oil prices may be about as far-reaching as they come. Obviously, commodity speculators have skin in the game, but so do depositors shopping for certificate of deposit (CD) rates, people looking to buy or refinance a home and stock market investors. Even if you don't fit into any of those categories, if you own one of the 250 million motor vehicles in the United States, you have a stake in this, too.
Widespread impact of low oil prices
There are both winners and losers when oil prices rise or fall.
Who benefits from high oil prices
Commodity investors. If oil prices were to rise, commodity investors with long positions would benefit, but given the extended fall of oil prices, there are also a great many short investors who would get hurt.
The stock market. The stock market would probably consider an upturn in oil as a good sign, given that the plunge in oil prices over the last couple years has been viewed as a symptom of global economic weakness.
Who is harmed by high oil prices
CD account holders. On the negative side of the coin, people who locked into high CD rates would likely be kicking themselves, as an inflationary oil price rise would be likely to push rates on newer CDs higher.
Homeowners and homebuyers. People who did not pull the trigger on buying or refinancing a home might find themselves on the outside looking in, as an inflationary environment would be almost certain to send mortgage rates higher.
Car drivers. Of course, all those motorists who have been enjoying lower gasoline prices would find themselves once again paying more at the pump.
How low can oil prices go?
In less than two years, oil prices have dropped from over $100 a barrel to around $30. The question is, which of those extremes is closer to normal, and how much lower could oil go?
Over the past 30 years, oil prices have averaged around $53 a barrel after adjusting for inflation. So, while today's prices are below average, they are actually closer to normal than when oil was at $100.
As for how low they can go, on an inflation-adjusted basis, oil prices in late 1998 fell $37 below their long-term average. At today's prices, that would be the equivalent of oil getting down to around $16.
Why oil prices are difficult to turn around
Of course, historical price ranges are just an indication of how oil typically behaves. They are not formal boundaries that confine today's prices. Even with oil dropping well below its inflation-adjusted norm, it may take a while before prices turn around. At extremes, oil prices tend to acquire a momentum, which means they are as difficult to turn around as oil tankers.
Here are three reasons why:
U.S. oil inventory is at an all-time high. Think of this as an overstocked store - until some of that inventory is sold off, supply and demand fundamentals are not going to put upward pressure on prices.
Some oil wells, especially those requiring special measures like hydraulic fracturing (fracking), are not profitable to drill at current oil prices. This means that low prices over time will start to thin out the numbers of wells in production, but those that are already up and running can continue to be exploited until they run dry. This is another reason why supply and demand fundamentals take a while to reshape.
Besides the pricing forces oil is subject to as an essential commodity, it is also a popular investment for speculators, meaning that investor sentiment can drive prices further than they would go based on fundamentals alone. This means that the turning point often does not come until investor sentiment - good or bad - has peaked.
Current oil prices are nearly 17 percent below futures prices just six months out, suggesting that there is a great deal of short-term speculation depressing current prices. A look at all the negative media coverage lately about the outlook for oil also supports the impression that bearish sentiment is reaching a peak.
One thing about oil - it certainly commands a starring role on the world economic stage. A couple years ago, it was causing consternation as its price soared above $100 a barrel. Now it is a cause for concern because its price has moved so radically in the opposite direction. Still, enjoy the low gas prices and low mortgage rates that come with cheap oil because it may not be long before oil prices take another dramatic turn to reshape economic conditions.