Do Oil Prices Affect The Auto Industry?

In economic theory the use of complementary goods is associated with the use of another good, while substitute goods are goods viewed by consumers as similar or comparable in some way. Within the auto industry, vehicles and petroleum are considered complimentary goods whereas gas-guzzling trucks and SUVs are similar enough to their smaller more fuel-efficient counterparts to be considered reasonable substitutes. Understanding these two distinct categories of goods is helpful in thinking about how price changes affect the demand for different types of goods. With the significant decline in the price of oil over the past year, this distinction is essential in understanding how the auto industry has and will be affected.

As gasoline is a petroleum-based product, price changes in crude oil directly affect its price. A decrease in the price of gasoline means automobile owners have more disposable income to use for other purchases. Owners who may have been trying to stretch out the lifetime of their vehicle may just decide that the extra income they save from lower fuel prices can be used to finance the purchase of a new vehicle now. For those who were unable to afford the expenses of vehicle ownership, depressed fuel prices makes driving a lot cheaper and consequently, vehicle ownership becomes much more attractive. (For more, see: Companies Affected Most By Low Oil Prices.)

Yet, the affect of lower fuel prices on vehicle consumption will vary depending on different markets. Consumers in a high fuel-tax nation such as Norway, although experiencing the exact same absolute price change as consumers in the lower fuel-tax US, face a lower overall percentage change in the price. The price change will thus not appear as significant in Norway as it does in the US, and this consumer perception should result in more significant changes in American vehicle purchases than Norwegian ones.

Further, some would argue that in periods of highly volatile oil prices consumer uncertainty about the future direction of prices increases, and consequently current price changes have a limited affect on new vehicle purchases. From this perspective, changes in automobile sales may reflect consumer expectations of fuel prices more so than current prices. While the recent increase in overall automobile sales could reflect expectations that prices will remain low, most industry experts are directly crediting the increase to the recent plunge in fuel prices arguing that American automobile consumers are much more short-sighted than some would like to think. (For more, see: How Low Can Oil Prices Go?)

While overall automobile sales in the US have increased due to the lower fuel prices, it has been the gas-guzzlers that have been growing more rapidly than their more fuel-efficient substitutes, as one would expect. Lower fuel prices make the difference in the cost of driving a low fuel-economy vehicle versus a high fuel-economy vehicle less significant and thus consumers opt for the advantages – extra space and greater feeling of safety –that come with owning the bigger, less fuel-efficient vehicles.

American automobile manufacturers are not indifferent to the types of vehicles consumers purchase, and the trend towards SUVs, trucks and bigger cars are a real boon for the industry for a couple reasons. Firstly, US automakers have generally offered vehicles with lower fuel economy than their foreign counterparts and are thus going to benefit more from the trend towards these vehicle types. The other reason is that profit margins on smaller vehicles are generally less than those on larger ones, while losses are generally suffered on electric vehicle sales.

While American automakers are soaking up the higher profits now, there is some worry that they could face penalties from regulators in the future. New fuel economy standards are to take effect in 2016 and the federal government is aiming to see new vehicles with a fuel economy of no more than 54.5 miles per gallon over the next decade. While enjoying high profits now, without a plan to improve overall fuel-efficiency in their vehicles, auto-manufacturers could face heavy fines in the future. Future regulations and/or subsidies that incentivize the purchase and manufacture of greener vehicles could be a potential limiting factor in the substitution effects of lower fuel prices. (For more, see: How New Fuel Efficiency Standards Will Affect Americans.)

Based on an understanding of complementary and substitute goods, the American auto industry is exhibiting expected effects from the recent plunge in the price of oil. Lower fuel prices make driving cheaper, consequently making automobile ownership more appealing. The reduced cost of driving also means the difference between the gas-guzzlers and the smaller fuel-economy substitutes less significant, creating a shift in consumer preferences towards bigger and more powerful vehicles. While American automakers are enjoying the significantly higher profits from this trend, they would be wise to invest these increased earnings in strategies that improve the fuel-efficiency of their vehicles in order to comply with greener standards.