Oil prices are primed to drop

Consumers will love paying less at the pumps, but investors in these sectors will be the clear winners.

By StreetAuthority May 10, 2013 9:58AM
Gas station © Purestock Purestock Getty ImagesBy David Sterman

Remember the "super spike?"

That phrase entered our vocabulary five years ago this month when crude oil prices suddenly surged to $120 a barrel. By July 2008, prices surged to $140 a barrel, which surely played a role in pushing the global economy into a deep crisis.
Consumers had to slash discretionary spending to have enough money to fill up their gas tanks, airline carriers were hit with a rising tide of losses, and many companies saw their profit margins squeezed as costs rose faster than revenues. Though crude oil prices tumbled to just $40 a barrel by year's end, the global economic damage was already done.

Now, as the U.S. economy starts to percolate again, some have expressed concern that the world's largest economy may again lead a surge in demand -- and prices -- for crude oil. Yet a pair of factors implies that it's quite unlikely we'll see another super spike and we may in fact be on the cusp of sustainably lower oil prices.

Those reason lies in these two factors: increasing energy efficiency and rising domestic energy production.

Falling marginal demand for gasoline
When the super spike hit in the summer of 2008, the average new car got 21.4 mpg (on a combined highway/city cycle). By the end of 2012, that figure had risen to 23.9 mpg, and based on current trends, should exceed 25 mpg by 2015.

The rising efficiency has led the Energy Information Administration (EIA) to predict that U.S. gasoline consumption will be 5.9% lower this summer than it was in 2007 and at levels not seen since 2001. (As an added benefit, greenhouse gas emissions from automobiles have fallen 22% since 2007, according to the University of Michigan Eco-Driving Index.)

You can already see the effects at the pump. "The annual average regular gasoline retail price is projected to decline from $3.63 per gallon in 2012 to $3.50 per gallon in 2013 and to $3.39 per gallon in 2014," predict the EIA's economists.

And even that forecast is starting to look too conservative. Simply put, rising production could push gasoline prices to just $3 a gallon by next year. Let's do the math.

Shale: There's oil, too
Much of the analysis of the recent shale/fracking revolution has focused on its stunning alteration of the natural gas landscape. Yet many gas wells also produce prodigious amounts of crude oil as well, which explains our nation's steady surge in oil production. The U.S. produced 6.5 million barrels of crude every day in 2012, and the EIA expects that figure to rise to 7.3 million this year and 7.9 million in 2014. That's a 22% increase in just two years.

Of course, rising domestic production means that oil importers will send less crude our way. Yet oil is a globally fungible commodity, and as more oil is redirected to other markets, the stage may be set for a glut that send global oil prices well lower.

The long-term picture gets brighter
Now, let's look at these two factors over the longer haul.

First, domestic oil production is expected to keep on rising, as the shale revolution grows yet deeper. That's why some economists think we may become energy-independent within five or six years. The United States is the world's largest oil importer, and removing the largest buyer from the market would have profound effects in pricing and demand.

Second, automakers face ever-tightening fuel standards, which will make a serious dent in U.S. gasoline consumption. In August 2012, the Obama administration and 13 automakers agreed on new corporate average fuel economy (CAFE) standards for small and large cars and light and big trucks (which are aggregated here into just two categories).

                     Blended CAFE Standards For Cars And Trucks

As you can see, the average new car on the road will be subject to an increase of roughly 1 mpg each year for the next decade. As a result, U.S. energy consumption is on track to keep falling at a steady pace.

Winners and losers
Frankly, rising domestic energy production and increasing energy efficiency will generate few losers. The global energy producers, especially in the Middle East, will suffer from falling demand and pricing. And any automaker that struggles to meet increasingly stringent fuel economy regulations may pay hefty penalties.

Yet the consumer will be a clear winner. And we can get a clear read how consumers will benefit.

Let's look at a typical consumer who drives 12,000 miles a year in a car that gets 22 mpg and pays $3.65 for a gallon of gas. The total annual fuel bill comes to $1,989. Fast-forward three years and assume that consumer buys a new car that gets 30 mpg and that gasoline prices fall to $2.80 a gallon. The annual gasoline tab falls to just $1,120. That's $869 of new-found money.

Consumers who use oil to heat their homes also stand to benefit from a drop in crude prices. Other beneficiaries include consumer discretionary companies such as restaurant chains, travel and leisure firms in the lodging and hospitality segment, and entertainment companies. Trucking firms would also benefit as falling diesel prices helps to make them more competitive with their rail-based rivals.

Also, don't forget the airline carriers, who will benefit from a more flush consumer and also from falling jet fuel prices. As I noted a year ago (StreetAuthority), airline carries saw their collective fuel bill rise by $1.8 billion in the first quarter of 2012 (compared with the year-ago quarter), though fuel bills are now dropping, and as crude oil prices move lower, could become a powerful tailwind for airline industry profits. (Indeed, Delta Airlines' (DAL) unexpected announcement of a dividend and share buyback program shows just how profitable this industry has already become.)

Risks to consider: Middle East tensions are always a threat to derail the oil markets. And if China's economy starts to accelerate, then it might see an upturn in oil demand that offsets U.S. reduction.

Action to take --> It's time to start researching companies that might be affected by a steady drop in crude oil prices. In addition to the companies noted above, many manufacturers use a large amount of crude oil in their production.

David Sterman does not personally hold positions in any securities mentioned in this article. 

More from StreetAuthority
May 10, 2013 7:17PM
Investors should consider making money another way besides oil.  How can you consider yourself wealthy, when your money is made off of the American families necessities?  The greed has went on too long.
May 10, 2013 10:31AM
I can't tell.  It does not conform to any logic except speculators.
May 10, 2013 12:44PM
The author seems to fail to take into account several significant factors that could negate some of the downward pressure on prices mentioned. For one, as gas prices so does average MPG of new car sold as shown by a recent U of Michigan study - this could negate the marginal demand factor mentioned. Also, yes domestic production is rising and is largely expected to continue to do so. Despite this we still aren't meeting even half of our own oil demand, even if production goes up by say an additional 1 million barrels per day, we'd still be far short of meeting our own demand especially if our demand increases as the economy improves. Also, the increased supply is a result of high oil prices. If prices drop, the expensive new oil fields would go off-line because they would no longer be profitable. Deep sea drilling and shale oil in North Dakota is much more expensive to drill than Saudi Arabian oil. So the new American supply essentially raised the "price floor" of oil.
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