A global glut of oil created by a stagnant world economy and material increase in production arising from the technology-driven hydraulic fracturing of shale formations is driving down crude oil prices and ultimately gasoline costs – both of which are coming soon to a town near you.

No doubt the plunge in oil price pressures some countries, such as cash-starved Russia, to produce even more as the price declines. Offsetting the lower price with increased production to achieve the same total revenues further augments the glut and depresses the price even more.

Now throw in the disconnect within OPEC among individual member countries ignoring production guidelines, and the perfect storm is in play – as far as oil prices are concerned. A cartel such as OPEC works only as long as the members abide by the group decision on production and pricing. But with no enforcement mechanism, a cartel will eventually fail in the long run, from an economic perspective. That is what we are seeing today.

The first obvious question to address is “How quickly do gasoline prices adjust to changing oil prices?” To answer that, several correlations were run taking the weekly average oil price and then calculating the Pearson Product Moment Correlation Coefficient to gasoline prices. The corresponding price of gasoline was compared weekly across:

the same week

lagged one week

lagged two weeks

lagged three weeks

lagged four weeks

lagged five weeks

If there was a delay (or lag) between changes in oil prices and changes in gasoline prices, then the correlation coefficients would be greater as time progressed.

Just the opposite was observed, as shown in the correlation coefficients between oil prices and the various lag times in gasoline prices in the following table. Therefore, changes in oil prices are immediately (within a week) reflected in gasoline prices.

So where will gasoline prices end up as oil prices drop? To answer that, a regression was run based on the weekly average prices of oil (West Texas Intermediate Crude priced in Cushing, Oklahoma) and U.S. regular gasoline (all formulations), as obtained from the St Louis Federal Reserve.

The following table shows the price of a barrel of crude oil in (bold) and within the inside box the corresponding price of a gallon of gasoline. Thus the current $82 per barrel oil (at the time of this writing) portends a national average $2.97 per gallon regular gasoline price. If oil does reach my expected $60 per barrel, then gasoline should be approximately $2.35 per gallon. Wow.

In essence, every $1 decline (increase) in the price per barrel of oil results in a 2.95 cents per gallon drop (increase) in regular gasoline. The model, based on weekly averages since 1991, is able to explain almost 98 percent of all variability in the cost of gasoline by just knowing price crude oil.

For the statistics related readers of the blog, the regression results were as follows:

To see the actual data click:

http://www.research.stlouisfed.org/fred2/series/GASREGW

http://www.research.stlouisfed.org/fred2/series/DCOILWTICO

Do keep in mind that due to differences in supply, demand, gasoline formulation requirements (either weather or clean air issues), competition and respective variations in state gasoline taxes, there will always be a differing price per gallon of gasoline across markets. Take a look at a previous blog this year contrasting state-by-state gasoline excise taxes http://blog.stewart.com/stewart/2014/06/07/another-top-10-list-state-gasoline-taxes/

So what could change all of this? There are numerous items, some which might include:

major middle east oil producing country taken off line by internal or external conflicts (war)

severely cold winter depleting current storage levels and ratcheting up the demand and ultimate cost of all energy types

added technological changes in energy efficiency and production (though this is longer term phenomenon)

cartel success in supply restrictions and pricing power

Finally, what are the economic ramifications as far as the economy goes? As energy costs decline, consumers in aggregate all have greater spending power and the ability to drive the economy even higher. However, as oil costs decline, there may be less development and production of shale formations across the country negatively impacting those communities. If oil drops below the actual cost to bring new production online, then drilling will either cease or at the very least contract. Texas and North Dakota may see a softening in their current booming economies. Countering such a potential economic contraction is the reduced feed stock cost for the U.S. petrochemical industry. Just 10 years ago the U.S. was the largest importer of plastic in the world, while 10-years from now it may be the biggest exporter.

As noted before, Newton’s Third Law of Motion comes into play: For Every Action There is an Equal and Opposite Reaction.

Tighten your seat belts folks, the ride is just starting.

Ted