Oil Prices and the World Economy - Dissertation Example

INTRODUCTION Oil serves to be a factor necessary to trigger investment and production in modern economies. Without an unimpeded supply of oil, an economy can barely proceed on the path of economic growth and stability. Over the last few decades, oil has become a crucial aspect of the economy of developed as well as developing countries. This has led to a tremendously increased demand for oil in the world, which is supposed to be met by the same oil producing and exporting countries. The impact of this rising demand for oil combined with declining reserves of world oil can be seen on the price at which oil is being sold and purchased in the international markets. This hike in price of oil comes with several causes as well as consequences. There are many factors that lead to a significant rise in oil price when the cost of producing it remains constant. Also, a rise in price brings with it several challenges to the economies of net importing countries and opportunities for exporting countries. The factors affecting the oil price in an international scenario tend to be on the demand as well on the supply side in both short and long run. The effects of oil price happen to be on the business side, consumer side and pure macroeconomic side. This paper investigates into the major factors that bring about a change in the price of oil, in particular, in the recent scenario of oil price hikes. It emphasises what actually has led to such unexpected oil price shocks in the recent years. The paper also sheds light on the effects of changes in oil price on businesses and economies around the world by way of affecting production, consumption, investment and major macroeconomic indicators. FACTORS AFFECTING OIL PRICES IN SHORT AND LONG RUN The recent dramatic rise in oil price has led the scholars to investigate into the factors affecting the price of oil in short and long term. The price of oil in international market is affected by both demand and supply forces for example consumption of oil and production capacity of petroleum exporting countries. These forces tend to affect the price of oil in short and long term. Along with the forces of demand and supply, there happen to be certain artificial factors that particularly cause the world oil to become expensive for oil importing countries, for instance, geopolitical factors and disruption in oil supply. The major demand-side factors that affect the price of oil are economic growth and increased consumption etc. On the other hand, the major supply-side factors playing a role in increasing oil prices are incapability of OPEC to produce more, inability to gauge future demand and political factors etc. Other important factors influencing the price of oil are speculation and futures trading. The point that is important here is that both the demand and supply related factors as well as some apparently uncontrollable factors combine to cause such unexpected hike in international oil price as witnessed in the last few years. In the beginning of last century when oil was considered to be sufficient for world consumption, the economic growth was limited to a few countries. Most of the oil was imported to the highly developed countries of that time to fuel their industries and transportation etc and the consumption of oil was also limited as compared to present times. As the time passed, major changes in the world economy began to mark their presence. More and more countries entered the race of economic growth with certain prominent countries like the United States, Britain, and other European countries accelerated their economic growth. Barrell and Pomerantz also propound that "changes in oil prices have been associated with major developments in the world economy" (2004, p152) This economic growth came about through obviously a thorough industrialisation process in these countries enhancing the demand for more and more oil. Thus, a rapid economic progression of already developed countries has led to ever rising consumption of oil, causing a deterioration of world oil reserves. From the demand perspective, an examination of the major cause of recent hike in oil price has itself been a growing demand for oil at a tremendous pace. As Brook et al. suggest that "an important contributor to the recent spike in oil prices has been unexpectedly strong demand for oil" (2004, p13), a magnanimous rise in the world consumption of oil over the recent years reflect the pre-eminent factor affecting the oil price. The demand for oil has generally not been from the side of developed economies because they have largely shifted to more energy saving industries and technologies. Surprisingly, this tremendous growth is being demonstrated by the developing Asian economies that are gradually progressing towards industrialisation. Recently, high economic growth displayed by emerging Asian economies like China and India are further aggravating the global demand and consumption scenario. These countries are moving more and more towards industrialisation with enhanced fuel consumption needs. Due to high population density and visible economic growth, the consumption of petroleum for transportation has also been on the rise. Verleger says that "increased industrial output and a more affluent citizenry in these countries [India and China] have boosted energy demand, particularly for petroleum, at record rates in both countries" (2004, p23). The latest price and supply shocks in oil market have greatly been brought about due to enhanced demand and consumption of petroleum unexpectedly exhibited by these countries. This rapid growth exhibited by China and India has had a short-term impact on price of world oil. At the supply side, the OPEC (Organisation of Petroleum Exporting Countries) appears to be the major player. The price of oil in the international market is also largely affected due to supply of oil. The world's oil reserves are already found to be depreciating. The oil exporting countries in the world are unable to completely meet the growing world demand. According to Brook et al., OPEC's excess resources are so limited that seems to be "providing little cushion in the event of unexpected oil market disruptions" (2004, p14). When the world demand and consumption of oil in China and India rose unexpectedly, the OPEC felt unable to meet the increasing demand for oil because of its incapacity to do so. The oil exporting countries had very little oil reserves to meet the demand and thus caused the price to rise. Another supply side weakness that has severely affected the oil price happens to be growth anticipation and appropriate investment in enhancing the reserves of oil. Verleger puts forward that "OPEC nationals and the large multinational companies-did not anticipate the demand growth and have failed to expand capacity at an adequate rate" (2004, p23). The failure to anticipate rising world growth of demand and consumption of oil particularly led to price and supply shocks. Furthermore the failure of demand anticipation constrained the big multinational corporations to enhance their investment in oil-extracting projects and plants. Even now the investment plans to meet future demand for oil happen to be significantly insufficient to do so. The reason has mostly been the environmental regulations in certain countries, which hamper the course of investment in oil extracting and refining industries. These factors are also responsible to affect the global oil price (Berkmen, Ouliaris and Samiei, 2005). A crucial factor encompassing the oil price shock is the recent geopolitical tensions between countries affecting those on the supply side of the market for example Middle East. Oil companies confront with severe problems in their way enhance the oil production such as antagonistic attitude from these countries towards western companies and attempts to disrupt the oil supply. Brook et al. propound that "geopolitical tensions and uncertainty stemming from acts of sabotage on oil facilities in the Middle East and fears of disruption in other oil producing counties have added an additional "risk premium" to the oil price" (2004, p16). Recently, oil supply has greatly been affected due to rising fear of terrorism in Middle East countries. The aggressive environment prevailing in Iraq etc also have a crucial bearing upon the production and supply of oil to the world. The greatest misfortune for the oil importing world is that the major reserves of oil are located at places that are highly vulnerable to political instability. Verleger asserts that "political circumstances in a number of key oil exporting countries are precarious" (2004, p23). The prevailing political conditions in most of the petroleum producing countries hamper the way of further investment because of high level of uncertainty with respect to future conditions and safety of production plants etc. Furthermore, isolated oil producing economies also fail to induce investment from multinational corporations (Berkmen, Ouliaris and Samiei, 2005). The futures trading of crude oil in the United States has proved to be a rather irrelevant as well as crucial factor influencing the price of oil. The futures trading in the United States has been significantly on the rise since 1980s. Due to increased investment into hedge funds and futures contracts, significant concerns arise as to the speculative nature of the market which could profoundly impact upon the futures prices. These have, in reality, influenced on a larger part the future-dated prices rather than the spot prices. Hence, futures trading in the United States go a long way in determining the extent of speculation, future expectation and consequently the oil prices. IMPACT OF OIL PRICE ON BUSINESS AND ECONOMY Oil happens to be a driving force in major countries, in particular for those heavily relying on industries as the backbone of their economy. Most developed economies have switched from heavy oil dependence towards energy saving technologies and endeavoured to replace oil with gasoline, especially for transportation. However, still these countries are largely dependent on oil for smooth running of their economies. Price of oil is visibly reflected in almost all the sectors of the economy and change in price has a great impact upon the economic activity of a country. The effect of oil price changes is certainly different in oil exporting and importing countries. Exporting countries earn high revenues at high prices, whereas net importing countries have to pay more to meet their fuel expenditures. Due to this fact, a change in oil price heavy influences businesses and economies around the world. It affects costs, production and prices from business side and major macroeconomic indicators like inflation, GDP, income, investment and consumption etc. from the economic perspective as elaborated below. Although both increase and decrease in oil prices tend to have a considerable impact on business and economic activities in a country, an anticipated or unanticipated increase in the price of oil has a much larger impact. Barrell and Pomerantz also propound that " oil prices and economic activity are negatively correlated, but oil prices increases tend to be followed by larger changes in activity than oil price declines" (2004, p160). It is because of the fact that increase in oil prices increase business and economy as a whole are more responsive to expenditures, which directly affects households, business people and governments collectively. In essence, increase in oil price has more apparent impact on different sectors of an economy. Oil prices have a significant impact on businesses because it happens to be a major factor behind all business activities. It is present in almost every business in different forms such as input for production and transportation for distribution etc. Most of the time, oil happens to be a variable cost of production. Jimenez-Rodriguez and Sanchez elaborate this point as "the supply side effects are related to the fact that crude oil is a basic input to production, and consequently an increase in oil price leads to a rise in production costs that induces firms to lower output" (2005, p201). As apparent, a rise in price of oil will lead to a double impact on business activities in the economy. Firstly it will enhance the cost associated with production and secondly it forces low profit businesses to reduce their output level so as to keep the cost down. Businesses having extremely low profit margin might also be forced to shut down because of unexpected hike in prices. When a business decides to produce less than its capacity in order to curtail production costs due to a considerable rise in the price of oil, this would bear significant consequences for the economy. The level of unemployment is likely to rise in such a situation, as Walton says that "this may result in an under-utilisation of resources and higher unemployment during the adjustment process" (2006, p11). A high level of unemployment signifies that the businesses are producing less than their capacity to produce, lowering the level of output produced in the economy. This would further lower the self-sufficiency of the country and minimise exports. Oil prices does not affect only producers and businesses, but also curtails the purchasing power of consumers. High oil prices lead to high cost of production, which ultimately results in hike in price of consumer goods. In this way, people are forced to pay more for the same amount of goods purchased. Walton says that "high oil prices act like a tax, transferring money from consumers to oil producers, leaving many of us worse off" (2006, p11). The income of consumers is generally assumed to be limited and a rational consumer always endeavours to spend within his income level. Thus, a significant rise in price of oil would lead to decline in consumption also. Jimenez-Rodriguez and Sanchez emphasise that "oil price changes also entail demand-side effects on consumption and investment" (2005, p201). This would further have serious implications for an economy in the form of reduced demand and lowered investment. A decline in consumption and demand from consumers' side in response to adverse effects of oil price on prices of consumer goods, also in turn has significant consequences for businesses. A rise in price of consumer goods diminishes labour's purchasing power and induces them to demand higher wages. Thus, rise in oil price impacts upon two major variable costs of production viz. cost of inputs and cost of labour. Barrell and Pomerantz say that "workers may respond asymmetrically to oil price increases and declines, pushing for higher wages to resist the declines in their real consumption power that result from positive oil price shocks" (2004, 160). It would be natural on the part of labours to demand higher wages in response to a decline in their purchasing power. In this way, changes in oil price significantly affect businesses by way of increased production costs. Economic activity around the world is significantly affected by oil prices. A rise in oil price generally shifts the focus of investors from high fuel-intensive industries to fuel-efficient industries. Jimenez-Rodriguez and Sanchez mention this point as, "the increase (decrease) in oil prices would generate an expansion (contraction) of energy efficient sectors relative to energy-intensive sectors" (2005, p202). This was displayed greatly on the part of developed economies after the oil crisis of 1973 and 1979. These countries shifted gradually from high energy consuming towards energy saver technologies and industries. This shift of investor emphasis from a certain industry to another marks a significant change in the overall structure of an economy. There are countries that heavily rely on fuel intensive industries, for instance, the United States. Hence, it is not always possible for economies to completely shift their focus from energy-intensive to energy-efficient industries. Expectations with respect to high rise in oil prices could render the investors from investing their funds in industries. Expectations concerning future changes in oil prices enhance uncertainty among investors with regard to impact of oil price on production and revenues, which minimises the trend of investment in an economy. Walton asserts that "if firms postpone investment decisions because of increased uncertainty, this will reduce temporarily the growth of the capital stock and the growth of potential output" (2006, p11). Reduced investment blocks the economy's capital, hampers future growth and halts the level of output produced. Consumption would also play a role in determining the level of investment. Consumption is likely to lower down in response to high prices, causing a significant decline in demand and investors would not be induced to invest in a low demand economy. Macroeconomic impacts of oil price changes in the short as well as long run also happen to be of significant importance. Oil importing countries also confront with economic effects of changes in oil price along with the business effects. McKibbin and Stoeckel illustrate that "the adverse change in the terms of trade for oil importers reduces incomes, lowers real consumption, causes a deterioration in the balance of trade and puts downward pressure on exchange rates." (2004, p2). As discussed above, a rise in oil prices leads to a significant decline in consumption. Apart from that, a lower level of output produced in the economy in response to oil price shocks lowers down the exports which affects the country's balance of trade. Hence, macro economic impacts of changes in oil prices are highly related to the changes in business and production patterns. High prices in response to increase in production costs characterise increase in the rate of inflation. Different consumer goods involve oil as a major portion of cost of production or cost of service. Walton points out that "higher oil prices have a fairly immediate impact on consumer price inflation working through higher petrol prices, heating bills and transport services" (2006, p10). According to the author, the impact of oil prices on the rate of inflation becomes evident in a very short period of time. It is so because businesses would be inclined to increase the prices of consumer goods as soon as the cost tends to rise. A rise in Inflation affects the real income of all the individuals, groups and organisations in the economy. The real income of an economy reduces in response to inflation, which is affected by high oil prices. The decline in purchasing power of individuals due to inflation causes the real income of members in an economy to fall down. Weale says that "increases in the price of oil have the effect of reducing real income in any country which imports oil" (2005, p5). Net oil importing countries face decline in real income after an increase in oil price. It does not only raise the government's expenditure on purchase of oil, but also reduce the real income of individuals. On the other hand, oil exporting countries gain more revenues at a higher oil price because most of the time the price rises because of increased demand or deficient supply, whereas the cost of oil production almost remains constant. Weale says that "with high oil prices, oil companies make high profits and the tax revenue on these raises revenue high prices also raise consumer expenditure on highly-taxed petrol relative to other commodities" (2005, p7). The economy of net importing country as well as exporting country is influenced in response to a rise in oil prices. The exporting countries and oil producing companies are affected positively whereas net importers are affected negatively. Gross Domestic Product is one of the most crucial economic indicators of any country. Oil prices tend to have a major impact on the economies of net oil importing countries. Rise in oil prices affect GDP through decline in consumption, reduction in investment, minimisation of output and capital stagnation. Jimenez-Rodriguez and Sanchez also propound that "an increase in oil prices is found to have a significant negative impact on the GDP growth in all oil importing countries" (2005, p203). All the macroeconomic factors discussed above lead to a decline in the country's GDP as the oil prices rises significantly. CONCLUSION This paper discusses the major drivers in the international scenario that cause the price of oil to fluctuate so often, as in the case of last four decades. The major drivers of change in crude oil prices happen to be mainly the forces of demand and supply. Increasing economic development in different parts of the worlds, surprising growth demonstrated by emerging economies like China and India, and enhanced industrialisation have pushed the OPEC countries to increase the supply of oil to meet the strengthening demand. The fact that oil exporting countries are unable to completely cope with the rising demand increases the price of crude oil. There happen to be several supply side factors that affect the supply and consequently the price of oil. The declining capacity of OPEC to meet the rising demand tends to be an important factor. Along with that, the oil producing companies terribly failed to anticipate the demand growth and invest in enhanced production and refining projects. Also, factors like geopolitical environment, increasing tensions in Middle Eastern region and political elements hamper the oil producing companies to fully exploit these countries' oil reserves. The price at which a country purchases the oil has a significant impact on its business and economic activities. Oil being present in the government's import bill and businesses' cost of production tends to have a profound impact on the entire economy. The price of oil affects production costs in the form of input and labour, consumption in the form of inflation and purchasing power, investment, level of output, exports, GDP and real income of an economy. This evidently suggests that the effect of oil price spans over different and distinct aspects of an economy through various means. This paper therefore illuminates what actually brings about changes in oil prices and how critical a change in oil price can be for the stability and growth of an economy. Reference List Barrell, R. and Pomerantz, O. (2004). "Oil Prices and the World Economy." Focus, pp. 152-177. Available at http://www.niesr.ac.uk/pubs/dps/dp242.pdf Jimenez-Rodriguez, R. and Sanchez, M. (2005). "Oil Price Shocks and Real GDP Growth: Empirical Evidence for Some OECD Countries." Applied Economics, 37, pp. 201-228 Verleger, P.K. (2004). "Why Oil Could Go to $60." The International Economy. Fall, pp. 22-27. Available at http://www.pkverlegerllc.com/publications.html Walton, D. (2006). "Has Oil Lost the Capacity to Shock" Oxonomics, 1, pp. 9-12 Weale, M. (2005). "Commentary: Oil and the Economy." National Institute Economic Review, 194(4), pp. 4-7 Brook, A.M. et al. (Dec 2004). "Oil Price Developments: Drivers, Economic Consequences and Policy Responses." OECD Economic Outlook No. 76, pp. 1-29. Available at http://www.oecd.org/dataoecd/19/6/34080955.pdf McKibbin, W. and Stoeckel, A. (Dec., 2004). "Oil Price Scenarios and the Global Economy." Economic Scenarios, Issue 9, pp. 1-8. Available at http://www.economicscenarios.com/pdfredir_sample.aspissueNo=9 Berkmen, P., Ouliaris, S. and Samiei, H. (Sep., 2005). "The Structure of the Oil Market and Causes of High Prices", International Monetary Fund IMF. Retrieved January 31, 2007 from the World Wide Web: http://www.internationalmonetaryfund.com/external/np/pp/eng/2005/092105o.htm Read More