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The Oil Price Fall: An Explanation in Two Charts

Don't worry.  It's not complicated.

I offer a simple explanation for the recent fall in oil prices in just two charts.  

Oil prices move up and down in response to changes in supply and demand.   If the world consumes more oil than it produces, the price goes up.  If more oil is produced than the world consumes, the price goes down.

That's where we are right now.  The world is producing more oil than it is consuming. The price of oil goes down.  It's that simple.

The chart below shows when the world has been in a production surplus and a production deficit since 2008. Right now, we are in a production surplus so the price of oil is going down.

(Click image to enlarge)

The important thing to take away from this chart is that the production surplus is smaller so far than the last time this happened between March 2012 and March 2013.  Then, oil prices fell quickly but recovered in about a year.  The difference between these two events, however, is that monthly average oil prices have fallen 27% so far but only fell 18% in 2012-2013.

The difference is found in quantitative easing (QE), the Federal Reserve Board's policy of pumping huge amounts of money into the U.S. economy.

QE ended in July 2014, the exact month that oil prices started falling.  What a coincidence! This is shown in the chart below.

(Click image to enlarge)

What is the connection between QE and oil prices?  World oil prices are denominated in U.S. dollars so the more the dollar is worth, the lower the price of oil and vice versa. That's a well-known fact.

When the Fed started printing money like crazy after the Crash in 2008, the value of the dollar was kept artificially low compared with other currencies.  The ever-weakening U.S. dollar dampened the impact of production surpluses and deficits on the price of oil.

When QE ended in July 2014, the dollar got stronger and the price of oil went down as it always does when this happens. The coincidence of the end of QE with the onset of a production surplus created a perfect storm for oil prices.

There is nothing especially different about this latest oil-price fall compared to any of the others except the end of QE.  It's not really about shale or the Saudi decision not to cut production.  It's about a relatively ordinary oil-production surplus that happened at the same time that QE ended.

What's the message?  Oil prices will recover and I doubt that we will see years of low prices as many have predicted.

What do you think? Leave a comment below.

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