Lower Oil Prices Lower Production Costs For Other Commodities

Oil splash
Henrik Weis/Getty Images

Since June 2014, the price of crude oil has plunged. Way back then, the price of active month NYMEX crude oil futures stood at over $107 per barrel. By the middle of February 2016, the price was languishing below $30 per barrel. Crude oil is perhaps the most important geopolitical commodity in the world because of its far-reaching effects on individuals, companies and economies around the globe.

Lower oil prices have a direct effect on our pocketbooks.

It now costs a lot less than it did a year ago to go to the gas station and fill our automobiles with gasoline, which is a processed product of gasoline. Wholesale gasoline prices have fallen from over $3 per gallon wholesale to just over $1. That means that while it used to cost $75 to fill up many cars, it now costs one-third of that. The lower oil prices also means that it costs those of us who heat our homes with heating oil a lot less these days. This all amounts to a huge savings and more discretionary income -- more cash in our pockets.

When it comes to businesses, energy is generally an important factor in calculating the cost of goods sold of products. Lower oil means it costs businesses less to produce manufactured products. Moreover, business must transport those products to market. The costs of transit via various forms of carriers has dropped with the price of oil. That is the good news in terms of a lower oil price.

Lower oil comes at a price. There are so many companies around the world that are involved in the exploration, production, and processing of crude oil. Others supply these businesses with services and equipment. The falling oil price has weighed heavily on the companies that make a significant percentage of stock indices in the United States and around the world.

Falling equity prices due to lower oil, therefore, has caused losses in portfolios of many who are saving for retirement and other financial goals. Additionally, since the majority of oil reserves in the world come from the Middle East, the plunge in oil prices could have a devastating effect on economies in that part of the world further destabilizing an already turbulent region.

The swoon in the price of oil is a deflationary pressure on the global economy. Deflation is an economic condition where prices on all assets move lower. As perhaps the most important energy commodity, crude oil is not only an important cost of goods input for manufactured goods, it is also a key cost component for the production of other commodities. The production of all metals, precious, nonferrous and ferrous depends on energy for their respective production processes. Agricultural commodities also depend on energy in terms of production cost. Fertilizer spreading equipment, tractors, and other farm equipment do not run on air.

One of the most influential oil traders of the twentieth century, Marc Rich, once said, "Oil is the blood that runs through the veins of the world". At the beginning of 2016, the price of crude oil has fallen to the lowest level in over a decade.

The price is down over 72% in less than two years. We have seen a correction in equity prices at the beginning of the year. Global economic pressures continue to weigh on markets. At the same time, the prices of other commodities have fallen to new multi-year lows. As an example, copper, a commodity often seen as a harbinger of global economic activity fell below $2 per pound for the first time since 2009 in the first month of 2016 and remains around the $2 level. Lower oil means that it costs less to produce a pound of copper, which means that producers can sell at lower prices. Copper is just one example of many.

Many commodity prices began 2016 by moving lower in the fifth straight year of a secular bear market for industrial raw material prices. The lower crude oil price is adding another level of negativity to an already bearish raw material market. On a macroeconomic level, lower oil prices are therefore depressing the economies of those nations that rely on commodity production of oil and other raw materials.

Between June 2014 and the end of 2015, the price of crude oil fell by just over $75 per barrel. The good news for crude oil at the February 12 price of around $29 per barrel is that is cannot drop by even half that much from that level.