Oil’s Plunge Could Help Send Its Price Back Up

If something is cheaper, people will likely buy more of it. That core principle of economics is proving to be especially true with oil after its recent plunge.

Over the past six months, 53% of vehicle purchases in the U.S. were light trucks or sport-utility vehicles, which tend to consume more gas than cars, according to Commerce Department data. That was the highest share in a decade and up from 51% last June, when oil prices peaked for the year. The Transportation Department estimates Americans drove more than three trillion miles in the 12 months through November, the most since mid-2008 and the biggest annual increase—38 billion miles—in a decade.

Falling oil prices aren’t only a sign of too much supply and not enough demand. The more prices fall, the more people can afford oil, an effect that can goose demand and ultimately help push prices back up. This looping logic of falling prices perplexes forecasters and underscores the unpredictability of the course of oil markets.

“The longer prices stay low, the more you’re going to get a response of people purchasing less-fuel-efficient vehicles,” said Jason Schenker, president of Prestige Economics, a commodity and financial-markets research firm. “It won’t be just the U.S. doing it.”

Oil prices fell and stayed low in the 1980s and 1990s, gradually reducing worries about energy consumption. That fueled a boom in exurban housing developments and left industries less cautious about their fuel use. Economists call this a “demand response.” The changes took years.

“You don’t end up changing your plans today,” said Bricklin Dwyer, senior U.S. economist at BNP Paribas. “There’s a very small effect on short-term behavior, and then in the longer term, it becomes larger.”

When oil prices were rising in 2011, the International Monetary Fund estimated that every 10% increase in the price of oil quickly reduces demand for oil by about 0.2%. Over years, people have more ways to adapt: new cars, rearranged commutes, reimagined corporate fleets and different industrial fuel sources. If the increase proves lasting, the change grows to about 0.7%. Economists consider it a clear case of a product whose demand is “inelastic” in the short run—that is, changes relatively little in response to price—but “elastic” in the long run, meaning it can eventually change quite a lot.

Those elasticities work in reverse, too. Instead of the 10% decrease modeled by the IMF, oil prices have declined by about 50%.

The effect is estimated to be slightly larger for developed countries, and smaller in developing countries. All told, demand for oil could rise by 1.25% in developed countries in the short run and 4.7% if the price stays so low.

Also working against the forces that would otherwise dictate more oil consumption is the global economy, which has been weakening in many regions. Many oil experts believe today’s decline in oil prices has resulted primarily from increased oil production, particularly in the U.S. states of North Dakota and Texas, rather than a demand collapse.

A turnaround in demand could eventually help put a floor on prices in the oil market. Benchmark U.S. crude prices fell below $45 a barrel in late January, and have since climbed, ending last week at $50.34. For now, any boost from rising demand has been offset by supply that continues to climb. The U.S. Energy Information Administration last week said U.S. crude inventories have reached the highest level for this time of year in at least 80 years.

Earlier this month, the Organization of the Petroleum Exporting Countries reversed its forecasts that energy consumption would decline with the weakening economy. Instead, the lower prices will boost consumption of OPEC oil, the cartel said.

“In 2008, prices fell sharply starting in the summer with the onset of the financial crisis and the global economic recession, which also led to a deterioration in demand,” the OPEC report said. “This time the sharp fall in prices has been mainly driven by excess supply. As a result, lower prices are likely to help to accelerate the pace of oil demand growth this time.”

Few experts see demand increasing so quickly that oil prices rise rapidly. More likely is that some oil producers will be unable to achieve a profit with oil prices so low, and they will curtail production.

“Historically, the initial response of consumers is to increase purchases of other items rather than use more gasoline,” said James Hamilton, a University of California, San Diego, economist who specializes in energy economics. “That is why most of the short-run adjustment in oil markets will have to be on the supply side, as high-cost producers are forced out. And until that happens, low prices will continue.”

The bad news for oil companies, however, is good news for many consumers around the world, who see less of their paychecks lost at the fuel pump. “Americans are a lot more keen on driving than the Europeans, but nevertheless it does help matters,” said Howard Archer, the chief U.K. and eurozone economist for IHS Global Insight. “The eurozone has been really struggling for growth, and low oil prices are a real help.”

WSJ