Oil Price Fluctuations and Its Effects of Alternative Energy Resources - Case Study Example

Oil Price Fluctuations - Its effects of alternative energy resources I. Introduction Crude oil is the most important form of energy for all the countries, mainly for developed and developing countries. The importance of crude oil is such that it is used in day to day activity of individual as well as the economic development of the nation. Of late, the GDP of China and India reveal that the economies of both these countries are growing at faster pace and are the big consumers of crude oil in the world market. Therefore the increase in oil prices inadvertently affects the GDP and economy of the countries. During 2008 world witnessed the growth in the prices of crude oil reaching a new high threatening the world economy at large, thanks the financial crisis, the recession has brought it down again. It may be exaggerated that increase and decrease in the oil price effects the world economy which is makes it necessary to study its impact on the world economy and how it effects the alternative energy resources. OPEC reports that the recent surge in the oil prices occurred at the time when there was absolutely no shortage of oil at all. The price upsurge accompanied with volatility has been recognized in all commodity groups including energy, metal or agricultural products with prices doubled since 2005. OPEC reports that it has increased the supply of crude oil by 4 mb/d since 2003 and further increased it by more 1 mb/d with absolutely no shortage of crude oil in the market. (World Oil Outlook, 2008)1 Some reasons for upsurge in crude oil prices Many elements have led to this volatility in crude oil prices. Keeping aside the demand and supply elements, fluctuations in the dollar value has been the main cause for increase in the prices of crude oil. Ray and Olga (2004) reported that oil prices are the source of major developments in the world economy that can trigger inflation and recession as in 1974 and 1979 which resulted in slowdown of world economy.2 According to Chandrasekhar (2005), the primary cause of increase in the crude oil prices is the rapid development of United States of America, China and India, forcing the industry to extract and refine more oil from the reserves. It is also reported that global demands have risen by 2.7 million barrels per day during 2004, highest since 1976. Some factors that have helped the price upsurge include US occupying Iraq, Saudi Arabia being attacked by terrorist temporarily affecting oil supplies, speculative investments by financial investors.3 Decline in OPEC's Surplus Oil Production Capacity Increases in global demand for the crude oil have forced the oil producing nations to produce more crude oil in order to meet the demands. The above figure shows that there has been drastic decline in the oil production of OPEC countries; this demand/supply factor is the main reason for increase in crude oil price touching $140 per barrel.(Hiromi Kato, 2005)4 As per the BPs Statistical Review of World energy for the year 2007, it is revealed that demand for the world touched 83.7 million barrels/per day or 3.9 billion tons/year which is equal to five times the annual household water consumption. The above figure shows that the increasing demand has led to upsurge in crude oil price which rocket from mid 2005 till 2008. As per the figure, oil price didn't had any upsurge till late 2000 but due to increased demand in Asian countries, the crude oil price escalated. Trends in Oil Prices Roncaglia using Hotelling theory explains that the equilibrium price of the scarce resource net of extraction costs rises over time at the rate that is equal, year after year, to the interest rate.5 It is understood from this statement that price of the scarce commodity increases at the rate year after year with the added interest rate. The crude oil is an important ingredient in the growth of world economy. It is learnt that commodity traders are responsible for oil prices who bid on oil futures contracts by looking into current supply of oil in terms of output, oil reserves as to know what is available and demand of oil, mainly from United States.(Kimberly Amadeo)6 According to OPEC Monthly Oil Market Report released for August 2008, it is highlighted that OPEC Reference Basket (ORP) rose to $2.89/b or 2% during July 2008 to $131.22/b with US dollar weakening and geopolitical tensions dominating the upward trend. However due to weakening economic conditions, recovery in US dollar and increased OPEC oil exports, the price came down to three month low of $109/ b. According to OPEC, the world economy will grow at 3.8% in 2009 as against 3.9% in 2008. It also reports that developing countries growth rate remains unaffected at 5.6%. India's growth is up at 7.7% as against to unchanged China at 9.2%.(www.opec.org)7 The graph represents the trends in crude oil prices from 2006 to 2008. The figure indicates that an oil price in 2006 was $50 to $70 per barrel as compared to $50 to $90 per barrel in the year 2007. The increase in oil price can be seen from fourth week of August 2007 which touched $90 per barrel at the end of 2007. This trend continued in the year 2008 with the price touching to $140 per barrel mark in second week of July. However, some controlling factors and increased export from OPEC suppliers, gave some relief with steep fall in crude oil price up to $118 per barrel during fourth week of August 2008.(www.opec.org)8 Average Annual Growth of Oil Consumption As seen in the above table, China is the major consumer of oil at an overall growth rate of 6.0% from 1974 to 2003. The table shows that most of the nations have increased their consumption from 1974 to 2003, but overall consumption of world has increased by 1.1% during 2001-03 as compared 1.5% during 1991-2000 down 0.4%. The total annual growth in oil consumption from 1974-2003 has increased by 1.1%. (Ray and Olga, 2004)9 Crude oil prices affect the terms of trade as higher dependence on oil imports raises the impact on nations GDP, impact of saving and investment are greater, tax revenues and solvency are affected. The rapid increase in the crude prices from 1973 to 1981 was led by United States for its energy policy for post Embargo period. The crude oil prices plummeted due to 9/11 attack which weakened the US economy and resulted in the reduction of quota by 1.5 million barrels per day. The figure explains the factors resulting in volatility of crude oil prices increasing from below $30 per barrel to $60 per barrel during 2005-06.(www.wtrg.com)10 Many factors have led to increase in crude oil price right from Iran - Iraq war, the great depression, Venezuela crisis, Gulf Hurricane, increased demands, etc. It is necessary to assess the consequences on alternative energy resources due to increased oil price. According to the OPEC report, developing countries maintained their demand for the oil at 71% of total world oil demand growth in the year 2007. It was also mentioned that OECD stocks declined by 66mb to 4,111 mb by the end of 2007. (OPEC, 2007)11 Effects of increasing oil prices on Stock Markets Oil price shocks effect the economies in different ways like supply, demand and trade. (Martin Schneider)12 Basher and Sardosky (2006) look upon oil as the lifeblood of modern economics.(Mehmet, 2009) 13 The world is globalizing in every aspect and people are migrating in search of livelihood and employment. In this scenario, nations are responsible for providing them with employment and better living conditions which means more urbanization and modernization. Increase in population will automatically lead to creation of more industries, houses, vehicles, transportation, etc. which require oil as the primary product to run the economy. It is reported by Basher and Sardosky (2006) that China, Turkey and India are fastest growing economy and are expected to demand and consume the most of the world's oil.(Mehmet, 2009) 14 Oil Consumption for Turkey, China, India, USA and World The above table shows that United States is the most developed nation with 23.9% of oil consumption out of total world consumption in the year 2007. Whereas the total share of the world oil consumption for China, India and Turkey was only 13.4% in the year 2007 with China 9.3%, Indian 3.3% and Turkey 0.8%. Many experts stated that oil price changes and shocks have direct or indirect effect on the economic activity. Mehmet (2009) states an increase in oil prices leads to an increase of cost of production which decreases the growth of output and productivity. The increase in oil price leads to increase in demand of money, increase in inflation rate, decrease in investment and decline in GDP. In view of the increased global demand and political insecurity in oil rich countries, concern about global warming are the force behind changing oil prices which may help spur the greater demand and supply of alternative energy. The development process leading to industrialization has increased the concentration of CO2 levels in the atmosphere which has significant effect on oil price movements. Such developments in the trends of oil price, its consumption and increased level of CO2 in the atmosphere makes it critical to understand the development of alternative energy in the years to come and effect of oil prices on the stocks of alternative energy companies.(Henriques and Sardosky, 2007)15 Auto Regression Analysis The aforementioned points of discussion reveal that oil prices have a definite impact on the alternative energy. To know the impacts, many analyses were carried out by many research scholars. Henriques and Sadorsky (2007) through vector autoregression (VAR) empirically investigated the relationship between stock prices of alternative energy companies and oil prices. The WilderHill Clean Energy Index (ECO) was used to measure the stock performance of alternative energy companies. The Arca Technology Index (PSE) was used to measure the performance of technological companies. The researcher, for the ease of comparison set the starting point as 100 so the changing price trend and its effects can be measured. From the below figure, it could be clearly understood that though there is rapid, drastic and high increase in oil prices from January 2001 to April 2007, the stock prices of technology companies (PSE) and alternative energy resources (ECO) are not affected at all and are unchanged. The findings of Henriques and Sadorsky revealed in the figure explains that ECO correlated with PSE with coefficient of 0.83 and correlation between ECO and oil prices is 0.43. In another VAR analyses, consisting for four variables ECO, PSE, U.S. West Texas Intermediate Crude Oil Futures Prices (OIL) and the Interest Rate (RATE). The researcher in order to lessen the confusion named the above variables in natural logarithms as LECO, LPSE, LOIL and LRATE. Granger Casualty tests using LA-VAR showed that alternative energy stock prices are explained by past movements in oil prices, technology stock prices and interest rates. The tests indicated that lagged interest rates showed some significant impact on oil prices as a result of increased economic growth. Henriques and Sadorsky (2007) through the four variable VAR model, it was found that oil price movements were not important once the investors had confidence in alternative energy companies as similar to technological companies. It shows that one standard deviation shock to the interest rate variable had a positive and significant impact on the alternative energy stock prices and one standard deviation shock to energy stock prices had same effect on technology stock prices. The simulation results in vector autoregression analyses carried out by Henriques shows that stock prices of shocked alternative energy companies had impact on technological companies stocks, but it did not showed any impact is occurred due to shocks to oil prices. Rafik and Sonia (2008)16 attempted to assess the relationship between oil prices and macro economy by analyzing the impact of recent oil prices fluctuation in Tunisian economy through VAR model from 1993Q1 to 2007Q3. In his findings it is reported that oil price didn't had any effect on economic activity. The main cause for economic shock was governments spending which led to economic recession, allocated subsidies made the oil price shocks as the principal source of violability. The findings in his report stated that impact of oil price shock on economic activity is indirect. Kilian (2007) argued that regressions of macroeconomic aggregates on unanticipated energy prices are likely to mislead as they fail to account for the declining share of energy in value added. The analysis carried out by Kilian suggests that most oil price shocks have been driven by a combination of strong global demand for industrial commodities shifting the expectations from demand for crude oil. It is also argued the shortage of crude oil is inevitable under the circumstances of excessive future demand of crude oil. Another finding by Kilian is that precautionary demand shocks driven by expectation shifts, unlike other oil demand and supply shocks can have immediate effects on US economy. Another observation made in his work by Kilian was that the effects of energy price shocks have weakened resulting in total real consumption drops from-30% before 1987 to -0.08% after 1987.17 In another empirical effort, to study the impact of oil price shocks on the stock markets in US and 13 other European Countries related to data on stock prices, short term interest rates, consumer prices and industrial production which are received from OECD. The researcher used unrestricted VAR model with four variables as first log difference of short term interest rate (r), real oil price (op), first log difference of industrial production (ip) and real stock returns (rsr): VAR(r, op, ip, rsr)18. (Jung Wook et.al, 2007) The above VAR analyses carried out by the researcher's show that shocks in oil prices do not have direct or indirect effect of alternative energy stocks but shocks to energy stocks had significant impact of technological stocks. Conclusion Crude oil is gaining its important as a lifeline to the world's economy in general and to some of the nation's economy in specific. It acts as a nutritious diet so that it world economy can be healthy. Increased oil prices have definite impact on world economy through employment, rising inflation, decrease in dollar value all of which combine to economic slowdown. Robert and Pavlos (2008) in their working paper, have concluded that even though there were similarities between oil market developments during 1970s and 1980s and the current market, the oil prices are not likely to decline. 19 Henqriques (2007) suggests that governments can formulate some framework or policies to bring the alternative energies into the market through fiscal policy that taxes carbon and subsidizes alternative energy. This will encourage the producers to provide carbon free energy so that they can have the benefit of subsidized purchase of alternative energies. The crude oil prices though have declined recently, but it is likely to increasing as the world demand is increasing day by day and more importantly Asian counties, China and India, most developing economies of the world, need it vigorously. Through the various vector autoregression analyses of the various researchers, it can be assumed that the stock prices of alternative energy companies do not effect which is beneficial to the investors. References 1. World Oil Outlook (2008) Organization of the Petroleum Exporting Countries, www.opec.org 2. Barrell, Ray and Pomerantz, Olga (2004) Oil Prices and The World Economy, NIESR, London, p.2 3. C.P. Chandrasekhar (2005) Oil Prices and The World Economy, People's Democracy (Weekly Organ of the Communist Party of India[Marxist]) Vol XXIX, No. 35. http://pd.cpim.org 4. Hiromi Kato (2005) Effects of the Oil Price Upsurge on the World Economy, IEEJ 5. Alessandro Roncaglia,(2003) Energy and market power: an alternative approach to the economics of oil. EBSCO Publishing, 6. Kimberly Amadeo, How are oil prices determined' About.com. US Economy. http://useconomy.about.com/od/commoditiesmarketfaq/f/oil_prices.htm 7. Monthly Oil Market Report August 2008, The oil market moves towards fundamentals, OPEC, Austria, www.opec.org. 8. Monthly Oil Market Report August 2008, The oil market moves towards fundamentals, OPEC, Austria, www.opec.org 9. Barrell, Ray and Pomerantz, Olga (2004) Oil Prices and The World Economy, NIESR, London, 10. Oil Price History and Analysis (Updating) http://www.wtrg.com/prices.htm 11. OPEC Annual Report 2007. 12. Martin Schneider, The Impact of Oil Price Changes on Growth and Inflation, Monetory Policy, The Economy, Q2/04 13. Mehmet Eryi'it (2009) Effects of Oil Price Changes on the Sector Indices of Istanbul Stock Exchange, International Research Journal of Finance and Economics, EuroJournals Publishing, Inc, http://www.eurojournals.com/finance.htm 14. Irene Henriques and Perry Sadorsky (2007) Oil Prices and the stock prices of alternative energy companies, Schulich School of Business, ScienceDirect. www.sciencedirect.com 15. Rafik Jbir and SoniaZouari-Ghorbel (2008) Recent oil price shock and Tunisian economy, Energy Policy, Department of Economics, Tunisia, www.elsevier.com/locate/enpol 16. Lutz Kilian (2007) The Economic Effects of Energy Price Shocks, University of Michigan and CEPR. 17. Jung Wook Park and Ronald A. Ratti, (2007) Oil price shocks and Stock markets in the U.S. and 13 European Countries Department of Economics, University of Missouri-Columbia, USA. 18. Robert Kaufmann Pavlos Karadeloglou, and Filippo di Mauro (2008) Will Oil Prices decline over the long run' Occasional Paper Series. No. 98/October 2008, European Central Bank, Eurosystem. Read More