Major Determinants of Oil Price - Coursework Example

REDUCTION IN OIL PRICES Introduction Since June last year, oil prices have reduced by 40% and have declined to be restored. It is a norm now days that demand of energy is closely related to as economic activity in counties found in the southern hemisphere and during summer in those countries that rely on the use of air conditioners. Supply is also affected by weather and geopolitical unrests and rises. A constant high price of oil encourages producers to invest more, this causes lag which boosts supply. Decrease of oil prices has been affected by four major reasons. Demand of oil has reduced. This is because individuals are relying on other forms of energy rather than just oil alone due to efficiency (Zanoyan 1986, p.92). Secondly, the combination of Iraq and Libya, the turmoil produces four million barrel per day has not affected the output of oil. Thirdly, America becoming the world’s largest producer of oil, this reduced the demand of oil in that country as it imports very little oil. It also does not export crude oil hence creating much of spare supply in the oil in the world (Powers 2012, p. 239). Lastly the Middle East countries have refused to sacrifice their own market share so that they can bring back oil prices as before. These four major factors are the cause of slumping of oil prices being experienced worldwide. Demand, supply and expectation are the major determinants of oil price in the long run. Market expectations and sentiments in the short run also determine the prices. The world is facing energy descent, the demand of oil has fallen and the energy transition where people are not relying on oil as the only source of energy. Substitutes like shale gas and synthetic oil are causing the decline of oil prices majorly. Determination of oil prices According to Poghosyan and Hesse (2009), the cost of crude oil determines majorly the price of oil products in the long run. In addition recently, market place forces from competition, supply and demand have also influenced the prices in the market significantly. The following are the determinants of oil prices. The cost of crude oil has risen drastically. It has been caused by increase in demand in oil products. Political stability in countries producing oil causes scarcity of oil hence influences greatly the cost of crude oil. If the cost of getting crude oil is high definitely prices will be will be high. Increase in international oil demand. Economic growth has sparkled off increased demand of oil. This hence increases price since supply is low (Poghosyan and Hesse 2009, p.84). Due to increase in prices, economies are considering other ways to generate energy hence reducing demand in the commodity. This results in high supply but low demand. This causes a fall in the price in the commodity. Other factor that determines the price of oil is tax imposed on the product, foreign exchange, geographical location and competition as highlighted in a report released by the United Nations. Economic effects of scarcity of oil to an economy Oil is generally scarce when its supply does not meet of its specified level of demand. Oil prices generally obey and follow the economic law of demand and supply. If the demand of oil rises, given there is a constant supply of oil, prices will then rise automatically. This will result in an increase in supply which will cause the drop and reduced demand in oil price (Powers 2012, p. 67). Usually price of oil and its product reflects the opportunity cost of bringing in an extra oil barrel in the market place. Usually high prices of oil imply that there is scarcity of these products and the decrease of oil prices implies that the commodity is abundant. The following are the implication of oil if it does not meet demand. Decreased state income Decrease in oil prices means that those countries that depend on oil exportation like Russia, Venezuela and Nigeria as the main income earner will be affected negatively. It implies that income from tax revenue will drop significantly. This will result in necessary cutbacks in daily consumed products like food products and other programs to fill in the deficient that is realised by dropping of oil prices. It may sparkle of political instability hence affecting the production of oil (Zanoyan 1986, p.141). For instance, the case of the Soviet Union in 1991 where the central government was disbanded greatly affected oil production. Russia for instance has lost approximately two billion dollars in revenues for every dollar fall in the price of oil. The World Bank has warned it that its economy would collapse by 0.6% by the end of this year if the prices of oil does not improve and go back to where it was. Cost of input Reduction of prices of oil decreases energy cost generally. Prices of the commodity substitute and competition from other forms of energy materials are usually forcing it to reduce consequently. Since oil powered electrical power is easily and cheaply produced (Zanoyan 1986, p.63). Furthermore, since oil is a major and fundamental requirement of many sectors bit aluminium, paper or petrochemical. A reduction in the price of oil will definitely affect a wide range of semi processes and processing inputs. Petrochemical, transportation, agricultural and manufacturing industries will benefit at large when there is a decrease in oil prices. Shift in real income Increase in demand of oil will increase supply of oil. Continuous supply will decrease demand and eventually fall in price. This will result in change in real income. Therefore this will benefit those importing countries while affecting negatively oil exporting economies (Pahl and Richter 2009, p. 75). The shift that occurs is importers who usually have a high propensity to spend and exporters whose saving rates are high. Despite this shift occurring, it will be different in different countries and overtime many exporting countries will be needed by financial difficulties to expand to both government spending and imports suddenly in the short term. This will benefit the importing economies as they will diffuse and start off by an increased precautionary saving if the confidence in recovery remains down. Monetary and fiscal policies In oil importing economies where there is a reduction in oil prices, prices could lower middle term inflation targets and expectations as low those set target. Therefore through there central banks, they can respond back by loosen monetary policies. This will lead to a growth in the economy. An increased output and low inflation combined together will result eventually in a favourable short run policy outcome (Pahl and Richter 2009, p. 192). Oil exporting economies on their hand, reduction in prices of oil may start off contractionary fiscal policies measures. This can be prevented by putting up necessary measures to protect expenditures resulting from the reducing tax revenues from the oil sector. These strategies usually operate with distinguished strengths and weaknesses across different economies. It appears clearly that reduction in prices of oil usually have lesser output effects on oil importing economies than when oil prices increases(Poghosyan and Hesse 2009, p.84). This effect may be as a result of the frictions and changes in cost that relate to change in oil prices. Change in oil prices will also affect output will also be different from one economy to another, that is, it is different from developed countries and developing countries. Developing countries will benefit more when oil prices reduce since there output is high and they need more and intensive energy. This will be a cost saving to them (Powers 2012, p. 45). In developing economies, household inflation expectations are usually and generally higher responsive to the changes in the prices of oil than in those already developed countries. It will be more expensive when in it comes to food and fuel for these households in developing countries. Therefore in general demand creates self-driven changes in prices of oil and these changes tend to have very less effect on growth in the economy. Restricts monetary policy support as it is limited The loosening monetary policy that were created initially by the central bank that originally were associated with increased demand after a reduction in oil prices will not be applicable in the long run. If the oil prices continuously reduces reducing inflation. The interest rates which central banks are operating are low and additional or extra application of monetary policy to ease the situation will be limited completely. Low response of demand Households may not be sure of future crisis associated with sudden debt growth, increased level of unemployment, vulnerability to financial constraints and slow long term growth may influence individuals and corporations in an economy to save more income gains that result from declining oil prices rather than to make investments or consume the income (Pant, Mhleisen and Thomas 2010, p. 205). Causes of drop in oil prices There are four major causes of behind the drastic fall of prices of oil recently: Objective change in OPEC: Middle East countries for a long time had acted as the major determinants and producer of oil. They capitalized on this opportunity therefore to determine the quantity of oil supply and determined prices of oil as they wished. This was changed suddenly in late 2014 after the members of OPEC failed to agree on production cut (Park 2004, p. 243). The OPEC agreement to maintain its production level showed a significant change in the member’s policy objectives from focusing on oil price and shifted to maintain market share. Demand and supply trends: Increased supply of oil anticipation and less anticipated demand is the real cause of drop in oil prices. This was caused by the shale oil production which caused unexpected increased supply of oil that exceeded demand. Countries like England reduced their imports capacity of crude oil since the start of using shale oil and this caused over supply. Economic growth has also not improved therefore lowering down the demand of oil in Britain and other developed countries (Poghosyan and Hesse 2009, p. 84). Economic growth globally in 2015 is being anticipated to remain low therefore implying that oil prices will remain low. Appreciation in currency: The appreciation of the dollar in 2014 had a negative impact on the prices of oil. It appreciated by almost ten per cent (Pant, Mhleisen and Thomas 2010, p. 54). This affects countries that purchase import or export oil experience an erosion in their currencies due to demand decrease. It is approximated that if the dollar appreciates by 10 % it is forecasted that it will reduce the oil prices by the same percentage. Political instability and supply disruptions: Conflict aroused in many countries in the Middle East during mid last year. This caused minor shortage of supply of oil as it was not expected. For example in Libya and Iraq where they were torn in war, the supply of oil decreased but not as much expected (Park 2004, p. 167). Furthermore, the sanctions and other restrictions that were imposed on Russia in June 2014, they did not affect the markets of oil and natural gas as they were expected. Therefore this maintained a lot of supply of oil globally causing the demand to fall hence a decrease in oil prices. Externalities that arise from consumption of oil: An externality can be defined as a negative effect or a positive effect to a third party which is resulting from an event for example oil spills. It is required that the third party is usually not part of the activity or event. Externalities are the consequences and affects that other parties arising from industrial and commercial activities and in this case, oil, that are being reflected to the cost of the product. Although oil is used mostly globally as the major source of energy, there are both negative and positive effects that have been associated with (United nations 2007, p 6).These effects further can be divided into two categories. That is, long term global externalities and short global externalities. For example the pollution of air from emissions of oil products is a negative externality while positive economic growth is a positive externality. Government impact on externalities There are four ways on how the government can influence negative externalities. Taxation One of them is the application of pigouvian tax model to decrease the use of oil products. A rate of tax will be imposed on oil to discourage consumers from purchasing these products. This will increase government revenue hence lowering the effect of the externality. Introduction of environment protection policies and regulations: The government can permit a certain level of pollution caused by oil products hence baring away those products that cause more harm than other products hence lowering the effect of externality. Application of law of tort and cost internalization Short term local externalities of consumption of oil: These are externalities in which the positive and negative impacts are fairly equal. These therefore give individual the opportunity to make a conclusion on which form of energy to use according to the effects. For instance if pollution of air from oil products through emissions outweigh the benefits of oil then other reliable forms of energy exists, individuals will prefer to the other form of energy then to cub the issue of pollution (Carollo 2012, p. 53). This simply means that individuals trade for more expensive energy for a good air but since both other forms of energy and pollution of air are short term consequences, there will be a meaningful and significant well informed trade. This can be illustrated by use of a graph showing emissions from using fossil fuels in America when individuals forgo the use of coal due to pollution as described in the graph below. Long term local externalities of consumption of oil: This type of externalities is different from the other. There exist a very bad relationship between the negative externality and the positive externality (Grant 2013, p. 152). For instance, taking an example of oil spill and rapid economic development, the effects are bad that need to be addressed immediately. The effects are bad that need to be addressed immediately. The above model is fund pollutant which focuses on negative externalities. It takes in to account damage cost and control costs. Positive externalities of consumption of oil The positive externalities of consumption basing on an example of oil spills include, better oil field operation and activity practices will be enhanced to avoid future disasters. There will be employment opportunities created. For instance consultancies from oil spill will be required and cleaners will be hired hence creating up job opportunities (Irwin 2009, p. 146). Furthermore, income will be earned from the rentals, portable toilets and salary of those working around therefore raising the living standards. There will be also income from treatment and storage of the restored oil hence will earn more income realized. Opportunity for research will be developed since there will be need to know the amount of toxicity in water or land hence institutions will be built (Hirschey 2009, p. 211). Manufacturers of scoopers and respirators will find market hence benefiting from the market niche. Local materials in the affected area will contain oil molecules for example saw dust, coconut husk, chicken feathers and hair. It will also improve containment technology level as devices and more devices will be applied to contain the oil spill under given conditions. Lastly, there will be increased profits will be realised after sales of oil, and other products (Streifel 1995, p.98). Negative externalities of consumptions of oil Oil prices will be high since supply is less than demand therefore prices will shoot up. It will reduce the fishing opportunities if oil spill occurs in water outlets. It will be an expense to the government as the economy will spend revenues to clean up the environment (Carollo 2012, p. 143). There will be loss of lives of wildlife hence affecting tourism leading to a loss. There will be also a loss of ecological functions. Conclusion Oil has been a source of energy for a long time. Recently it has seen a drop in its price due to various reason created by demand supply and market expectations. Other sources of energy like shale oil being explored by non-producing oil economies has also reduced the demand of oil globally hence oil being supplied in large quantities it has made it for the reduction of oil prices (Hirschey 2009, p. 23). Other factor like appreciation of the dollar value, disagreement among the OPEC members, and war has also contributed to the fall of prices of oil generally. Externalities that are brought by consumption of oil may be long term since they don’t happen so frequently. Short run externalities have been brought about by the environmental concerns. The government has come up with policies that minimize and prevent the negative externalities Bibliography Carollo, S 2012, Understanding oil prices: a guide to what drives the price of oil in todays markets. Grant, S 2013, Cambridge international AS and A level economics: revision guide. 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New York, United Nations. Zanoyan, V1986, Oil prices: where do we go from here? Kuala Lumpur, Malaysia, Institute of Strategic and International Studies Malaysia. Read More