Crude Oil Price Influence on Inflation - Essay Example

Crude Oil Price Influence on Inflation Crude oil prices and its influence on economic performance is an analysis thathas warranted several studies by many scholars. Oil is the world’s leading source of energy which accounts for over 85% of the world’s energy. It is the world’s main source of non-renewable energy providing the most needed industrial energy to both developed and non-developed nations in the world. Industrialized countries heavily rely on crude oil as their main source of industrial power for their manufacturing industries. The overreliance on crude oil products as the main source of energy and power by developed economies has led to frequent economic fluctuations in the international markets. Crude oil is valued in terms of dollars per barrels of gallons in the international markets (BALKE 1997). The aim of the research here is to analyze the influence of shifts in Crude oil prices to the general economic performance due to its immediate influence on the World’s leading stock markets. The study is aimed at finding the changes that do occur in the stock markets which are related to increases or fall in the crude oil prices. The data gathered in the study will be analyzed to a certain the influences of fluctuations on Crude oil prices on inflations (BALKE 1997). Research Question Do fluctuations in Crude oil prices have an impact in commodity prices? Can Crude Oil price increase results into inflation in an economy? Does stability in Crude Oil prices result into stability of commodities in the entire economy? CHAPTER ONE Background information Crude oil prices stability in the international market is always short term in nature. As a result such fluctuations have always shown influences on the world commodity prices in one way or the other. From mid-2010, there was a considerable increase in commodity prices as oil prices rose by 40%. During this time there was an incredible increase in food items costs and other farm products, metals and precious commodities like minerals and gem stones rose at a faster rate than ever experience before the energy price changes. Increase in energy prices therefore resulted in the upsurge of prices for food commodities due to the high demand for energy in the production of grains (BALKE 1997). Fluctuations on oil prices do occur following developments on the equity markets which is influenced by crisis in the market such as those of European debt crisis. During this time, the OPEC Reference Basket showed an average of $ 106.32/b, which represented a decline in the previous price level by over $ 5.30. In this period the crude oil future market, the Nymex WTI front-month rose to average $ 86.43/b. Crude Oil price hikes sometimes can be attributed to other factors such as demand. Increased demand for energy in the international markets can be attributed to the increasing economic growth in the emerging economies and the need for greater amounts of energy for their production firms. Depression in US dollar also leads to an upsurge in Crude oil prices in the international markets (BALKE 1997). Supply disruption concerns also may drive oil price upward. Spare capacity would suffice to compensate for production losses from Oil producing zones. The assurance given by some oil producing countries on their ability to compensate for supply during short falls often calms the market to some levels as it reduces speculation on oil shortages. Incase the spare capacity is depleted, further oil price hikes occurs which increases the price volatility. The effects of hikes on oil price on volatility and inflation as gauged by the OECD model have shown different outcomes over the years. This is an indication that $ 10 hike in the oil price may lead to a reduction in the performance in OECD by up to two-tenth percentage point. Higher prices of oil often impacts negatively on the overall growth and development of an economy. This is because it leads to increase in transportation costs which in turn increase the costs of inputs in the market (BALKE 1997). The monetary authority’s ability to control inflation expectations may reduce the inflationary impacts of oil price hikes in the market. The experience of 2008 provided a practical indication of how well anchored expectations can be used to tame inflation incase of a sharp increase in oil prices. If inflation expectations were to change, the effect of oil price fluctuations could be stronger than was seen. As such at low levels of inflation and speculations, the need for monetary policy reactions to the oil price hikes may be slim (BALKE 1997). Aim/purpose of study The aim of this research is to understand, evaluate, and analyze the effects of changes of crude oil prices on other commodity prices. The study will aim at analyzing the past and present trends in prices of other commodities in relation to oil price fluctuations. Objective of the study To evaluate the influence of increase in oil prices on prices of other commodities To analyze the relationship between fluctuations of oil prices and changes in other commodities prices To understand the impact of changes in oil prices on the global commodity price changes Hypothesis of the study There is no correlation between oil price fluctuations and prices of other commodities in the market Fluctuations in the oil prices do not have any influence on the performance of an economy There is no relationship between changes in oil price and other commodity prices in the market Justification of the study The objective for this study is to analyze the influence of oil prices on commodity prices and cost pull inflation at large. Market interconnectivity in the world’s economy has become noticeable in the commodity market. Oil is the most traded raw material which plays a critical role in shaping the world’s economy. The connection between oil and other commodities in the international market have been in existence since the history of trade begun. This was depicted in harness in 1993 when the original oil concession when gold was the only means of trade for oil in Saudi Arabia. Due to these historical developments, significant relationships have developed between oil and other commodities (HOOKER 2002). Currently, oil is predominantly valued in U.S dollars. Major players in the oil market such as OPEC have agreed to exclusively sell their oil products in U.S dollars. The objective for this research is to find out how changes in oil prices affect the prices of other commodities in a local market place. The findings of this study will add into the knowledge of the influences that oil price fluctuations have on the prices of other commodities related or non-related to oil (HOOKER 2002). CHAPTER TWO 2.0 Literature Review Parts of existing studies have looked into the correlations and co-movements between crude oil prices and other commodities such as gold. Some studies have investigated if there is a relationship in the long-run between spot price and price controls in crude oil markets. Most of these analysis have used time series models with a few using new methods of examination of asymmetrical processes. The strong positive correlations that exist between seven commodities tested by Cashin et al (1999) from April 1960 to November 1985 have resulted into an empirical result. The result of that study has demonstrated that there is a strong positive correlation between oil and gold prices in the market. The persistent increase in the demand for energy has made the prices of oil to remain high as its demand continues to grow every day. The current trends in industrial growth is expected to increase demand on oil thereby making prices to sky rocket as more energy becomes a serious requirement (HOOKER 2002). A weak performance of global crude oil market as a result of the European debt crisis saw a downward movement on the on the OPEC Reference Basket to below the significant $ 100/b. But this was reversed when the Basket started to track developments in the equity market. As this was continuing, crude oil futures markets gave a mixed reaction with ICE Brent having a decline as the European crisis deadened and the crude production by European gained track (HOOKER 2002). Most studies have shown that there is a link between commodities’ prices and oil prices in terms of inflationary influence channel. These links of study have been established empirically and have found that when oil prices rise, almost every price rises. It therefore implies that when inflation rise, the prices of other goods rises as well. A research conducted by (Melvin 1990) has found that when oil price rises, the revenue from oil rises to the oil exporters. This has implications in the other goods price level especially those whose portfolio are shared by oil exporters such as gold. This study will include the study of these relations with respect to the data in the recession and inflation years (Wurzel 2009). Oil has overtime earned a permanent place in the investment portfolio due to the changes from its initial nature for trade. Crude oil products are characterized with high liquidity, volatility, and high profit opportunities for investors. The determination of the prices of these products is through market mechanism as price formation is an important factor in this sector of trade. Studies have shown that oil markets are differentiated from the markets of other commodities in certain ways unique to the product. It portrays considerable deviations from perfect market, where range in prices is just above marginal costs. This is as a result of price controls practice by the main producing nations (Wurzel 2009). Oil market is highly characterized by both national and international political and economic stability in both the producing as well as consuming countries. Oil prices in these markets have been influenced by the demand levels in another similar country. Changes that may occur in these prices are due to differences in transportation costs and quality. The highest consumers of oil are developed countries with huge industrial demands for energy. The global changes in the demand for oil are in most cases caused the high demands for this commodity in these countries. Other economic matters that affect these prices are exchange rates with respect to the major world’s currencies. Since most trade oil is conducted in U.S dollars, it has established that there is a negative correlation between the dollar and oil prices. Research findings have indicated that oil consumption is dependent on season as interests do increase over the summer (Wurzel 2009). The total supply of the oil is determined by the limited nature of its reserves. Over a long period of time, oil supply becomes the function of the level of investments in the processing industry as influenced by profitability and risks. While the developed economies are the determinants of oil demand, oil production is determined mainly by the OPEC countries. The major study of the correlation of oil prices and other commodities such as gold has shown appositive movement. However recent trends have shown unconventional developments in the movements (Wurzel 2009). Oil and Gold prices are influenced by some specific factors, like other commodity prices the price of crude oil often experiences swings during shortages or oversupply. The life cycle of crude prices sometimes extend over long years in response to changes in demand and OPEC and non-OPEC supply. During the twentieth century, U.S petroleum prices heavily regulated oil production. While since 1969 U.S crude oil prices have continually adjusted for the inflation. Fifty percent of the prices at the time in both U.S and the world were below the average median oil prices of $ 24.58 percent (CASHIN 1999). Researches findings have indicated that interests rate do not have an impact on the development of oil prices and do on other commodities. Although the findings from studies have indicated that gold/oil ratio analysis, it is necessary to indicate the causality in of the two variables on each other with the use of Granger Causality. Scientific analysis of descriptive statistics has often indicated that price level of gold may rise more than that of oil on average. The growth rate of oil price has been found to be volatile because both time series used in the comparison are skewed to the right and are more pointed than in a normal distribution (CASHIN 1999). The relationship between oil prices on oil prices and economic performances and adjustments have several correlated outcomes. In the absence of price controls, the U.S. price would tackle world price average of up to $ 30.54. The long term history in oil prices can be used as a guide to the dramatic price fluctuations in the global market. The frequent oil price increase can be attributed to the “demand shock” with its origin being from heavy consumptions of developed economies as well as emerging economic markets huge consumption ratios. Standard analysis on macro factors and crude oil returns have shown that there is a strong evidence to an increased demand shock in 2008 from China and Asia which attributed to the increased oil prices in that year (CASHIN 1999). The extended analysis and consideration set of macroeconomic variables of emerging economic giants have indicated an increased demand for energy resulting to greater demand pull inflation in the oil market. This inflation has in turn crept into the world market leading to the increased commodity prices as result of high transportation costs due to the shortage. The question on the reality of the usefulness of a large set of international real and nominal variables in the returns of crude oil is explained by the analysis of market behavior in response to oil price changes (CASHIN 1999). The trends in the interconnectivity of markets in the global market has had led to the influence of changes in the prices of commodities as a result of a change in one commodity such as oil or gold. Certain commodities are so interconnected in the market that a change in price by a smaller margin results into bigger changes in the entire global market in terms of prices of commodities. As such, the interconnectivity provides a very tricky situation in the markets that are open where the forces of demand and supply take control (CASHIN 1999). CHAPTER THREE 3.1 Research Methodology The research Philosophy in this study is a design for focusing on the analysis of the existing situation in the world’s commodity markets and the correlations between prices that influences the entire commodity prices in the market. It provides a step forward toward the knowledge of the influences that some commodities exhibit in the international price ceiling of other commodities and the effects towards inflation (OECD 2011). 3.2 Research Approach The approach in this study will involve a continuous study through interviews and observation of the trends of prices of certain commodities such as gold in relation to changes in the prices of oil in the international markets. This will involve a long term observation of up to second quarter of the year in the market financial operations (OECD 2011). 3.3 Research Strategy The study method here will involve a combination use of interviews and observations of how commodity prices trend in the World’s market. This will be conducted at two levels involving a continuous observation of price fluctuations in the global stock markets such as new observation of the price movements in the World’s leading stock markets in New York Stock Exchange and the London Stock Exchange. This will enable the creation of an understanding of the relationship between some commodities in the market and there influence in the World’s economic performance. The interviews will be allotted to the workers in the stock markets as well as economic professionals in regard to the effects of oil price fluctuations on other commodity prices (OECD 2011). 3.4 Data collection Methods The main source of information in this study will be primary and secondary data. Primary data will be obtained through the interview process of stock exchange market workers as well as the interview of professional consultants in the field of trade. The interview will take the form of face to face or through phone calls as may be convenient to the interviewee. Direct observations will also be done on the stock markets to monitor the trends on the price fluctuations. Along with quantitative data, qualitative data will be collected through the analysis of secondary data concerning the effects of the relationships between oil price changes and other prices of other commodities such as gold (OECD 2011). In addition, the interviewer will decode the expected results and determine if they are synchronized with the real current situations in the market place. The data will be analyzed in order to determine the effective means of putting inferences of the study that adds to the bank of knowledge in this field of study. It will also aim at analyzing the impact of market price fluctuations and influences on the performance of the entire economy (OECD 2011). 3.5 Data Analysis Procedure The primary data from interview and observations will be analyzed using Statistical Package for Social Scientists (SPSS) the new version. This will enable the determination of correlations between oil price fluctuations and other commodity prices. Descriptive statistics will be used in the analysis to obtain frequencies and measures of central tendencies. This will involve the use of gross margin method in the determination of levels of economic returns due to these correlations in commodity prices. 3.6 Ethical Issues Today there is a lot of global outcry focused towards the use of oil as the source of energy running the World’s economy. This is because of its crude nature resulting into environmental pollution. There have been attempts to replace crude oil energy with bio-fuel energy in an effort to minimize environmental pollution. This research will also help to bring the knowledge of the extent of the world’s dependence of crude oil as its energy source that runs the economies of both developed and developing countries and the impacts of its absence in the current economies (OECD 2011). 3.7 Limitations of the study The study here is limited to the extent of the researcher’s financial endowment and ability to provide logistic issues for his movements during data collection. The reliance on secondary data so obtained may not reveal a clear picture of the market trends as it is in the market place. The research involves a long period of time for proper data collection and analysis a factor which may be a constraint due to the limited time available for the study. 3.7 Research Plan Months January February March April May June July August September Interview Design Stock Market Observation Stock Market Observation Data Organization Data Analysis Report Writin& Presentation. 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