Causes and Consequences of Oil Price Fluctuations - Essay Example

Causes and Consequences of Oil Price Fluctuations Name Institution Affiliation Causes and Consequences of Oil Price Fluctuations Fluctuations in the price of oil are often caused by a multiplicity of factors ranging from political instability in the Middle East to the changes in the forces of supply and demand (Kilian, 2016, n.p). Given the significance of oil in the global economy, such fluctuations in oil prices often lead to several consequences in the economy especially with regards to the price of other commodities owing to changes in costs of energy. The significance of oil as an important commodity in the world has made macroeconomic variables in all economies around the world very sensitive to the changes in its prices due to the intensity of its perceived consequences. The causes and consequences of oil price fluctuations are related and sometimes the cause-consequence nexus is only influenced by certain country-specific intervening factors. This paper undertakes a critical examination of the causes of oil price fluctuations as well as the consequences of such fluctuations. Causes of Oil Price Fluctuations One of the greatest causes of fluctuations in oil prices in the world is the Organization of Petroleum Exporting Countries (OPEC), a consortium of oil producing countries that controls over 40% of the world’s oil reserves. The mechanism through which it affects oil prices is in its setting of production levels subject to global demand and can, therefore, influence oil prices by either increasing or decreasing production level, thereby influencing the supply of oil. Another mechanism through which OPEC influences fluctuations in global oil prices is in setting the price for oil produced in its member countries (Venezuela, Qatar, United Arab Emirates, Kuwait, Iran, Indonesia, Ecuador, Algeria, Nigeria Angola and Libya), which ultimately influences global oil prices by tilting the demand-supply equilibrium which has the spiral effect of changing global oil prices. For instance, in 2014, OPEC set the oil price at $100, but it fell to below $50 a barrel, creating a global fall in oil prices. The diagram below provides a conceptual framework of the mechanisms through which OPEC influences international oil prices. Figure 1.0: Mechanisms through which OPEC influences global oil prices Source: Yan (2012). p. 41 Natural disasters are as much a cause of fluctuations in oil prices. Such disasters either disrupt the supply or demand of oil leading to a change in oil prices. For instance, in 2005, after Hurricane Katrina struck southern U. S. 19% of the U.S. oil reserves was affected leading to a rise in the price of a barrel by about $3. In essence, natural disasters are a serious cause of fluctuations in oil price owing to the supply and demand shocks they that lead to a shift in equilibrium oil prices. For instance, the Hurricane Katrina destroyed a lot of oil reserves in the United States, and this created a shortage in the oil supply and increased demand since there was an increased need for energy. In such a circumstance, the price of oil shoots up sharply since the laws of supply and demand posits that an increase in demand results in a higher price if the supply is not adjusted. According to Yan (2012), the imbalance between supply and demand of oil, caused by different factors such as natural disasters is the most obvious and the most direct factor that has the single largest impact on the international oil prices. Moreover, he noted that the situation is fueled by the oil production capacity that includes the capacity for exploration, transportation, refining, development and marketing does not match the consumption capacity for oil (p. 42). Political stability causes fluctuations in oil prices by affecting production and distribution costs and sometimes directly influencing oil prices (Stevens & Hulbert, 2012, p. 3-6). Political stability in the Middle East, for instances, greatly affects the oil prices especially given that the region accounts for almost half of the world’s oil prices. According to Oil Price (2009), political stability in the Middle East is the most significant determinant of global oil price fluctuations drawing from the instances of war in Iraq and Afghanistan in 2008 in which the price of a barrel of oil rose to $136. During instances of political stability, oil price rises due to skepticism because it is often difficult for suppliers to assure consumers that they will maintain the oil supply (Balke et al., 2011, n.p). Changes in the business cycle lead to a fluctuation in oil prices through the mechanisms that it influences supply and demand of oil (DeHaemer, 2015, n.p). For instance, during economic recessions, buyers cut back on their spending especially driving cars, which directly reduce the demand for fuel leading to a drop in oil prices (Kilian, 2014, p. 137). Additionally, the reduced consumption during economic recessions decreases oil prices due to the low level of economic activities in which fewer goods are shipped. In essence, it can also be deduced that the business cycle influences the global oil price through different mechanisms that alter the demand and supply of oil leading to a global imbalance. Speculation by industry players on price increase or a price fall in future influences the price of oil because alterations in relative prices create incentives for oil suppliers to increase production while the buyers cut back on their purchases of oil (IMF, 2000, n.p: Kilian, 2014, p. 138). According to Balke et al (2011), speculation affects oil prices because the expectations of an increase in the real price of oil in future has an incentive to store oil to take advantage of oil prices in future the effect of which is an increased demand and by extension, increased oil prices in the short run. In essence expectations of future rise or fall in the international oil prices leads industry players to engage in certain behaviours that only work to make the current international oil prices more volatile, even if there is no substantive cause for alarm. Speculation can result in both supply and demand shocks. Speculative demand shocks that manifest in the form of mispricing in the future oil market and global real interest shocks usually have the largest impact on international oil prices, albeit in the short run (Beidas-Strom & Pescatori, 2014, p. 23-24). Macroeconomic variables like inflation and exchange rate complications have also been found to affect the global fluctuations in oil prices significantly. For instance, the appreciation of the U.S. Dollar has been cited by researchers as a major cause of sharp fluctuations in the price of oil in the world. A broad-based appreciation of the U.S. Dollar is found to raise the local cost of oil currencies in countries that have currencies not linked to the U.S.D. More aptly, a stronger Dollar reduces the demand for oil in such countries whose currencies are not linked to the U.S.D. and results in a stronger supply in non-U.S. dollar producers (Baffes et al., 2015, p. 14). World inflation resulting from a multiplicity of causes also leads to fluctuations in oil prices especially during the business cycle as it alters demand and supply of oil. The dollar exchange rate is also found to impact the international oil prices greatly. According to Yan (2012), fluctuations in dollar exchange rates do not only influence the stability of the global economy and by extension, the stability of the international oil prices but also influences the policies pertaining to oil production, processing, marketing and distribution in the oil producing countries. Moreover, the impact of the dollar is that its devaluation increases the international oil price while its appreciation creates a drop in international oil prices and all this happens due to the impact of the U.S. dollar devaluation and appreciation on the purchasing power in the economies of OPEC (p. 43). Another cause of international oil prices that most researchers fail to highlight is the rise in the cost of oil exploration, processing and distribution. The costs of oil exploration machinery and human capital determine the international oil prices as the new prices have to take into account the factor input costs associated with its production. According to the principles of classical economics, the price of a commodity is essentially the cost of producing that specific commodity (which basically is its value) and the implication is that a shift in the cost of producing the commodity directly influences the price of the commodity (Britannica, 2016, n.p). For this reason, it is important to note at this point of the paper that the causes of the volatility in the prices of capital used in oil production also influences the ultimate volatility of international oil prices through interrelated causative mechanisms. According to the succinct analysis of the causes of fluctuations in global oil price, it can be summarized that the following are the major causes of oil price fluctuations in the world i. OPEC Policies: setting of oil price and production limits in member countries ii. Political instability iii. Natural disasters like Hurricane Katrina iv. Economic Variables like Inflation and Exchange rate policies v. Business Cycle Effects vi. Speculation In summary, all the factors that influence either the supply or demand (or both) of oil distort the supply-demand equilibrium thereby shifting the price of oil. Based on the laws of demand and supply, the effect of each factor can, therefore, be analysed based on how it tilts the global oil supply-demand balance. Consequences of Oil Price Fluctuation Oil is a very important commodity on which most economies rely on as a major source of energy and therefore, price fluctuations often result in significant effects on the economy from variations in commodity prices to incomes through channels that are so intricately related in such a manner that one leads to the other in a mutually reinforcing manner. This section discusses some of the major consequences of fluctuations in the price of oil. i. Effects on Aggregate Level of Production Given that most production activities rely on oil-derived energy as a key factor input into the production processes, any change in the price of oil will greatly affect aggregate production especially in the short term by varying demand and supply of oil. More aptly, oil-specific demand and oil supply shock usually reduce industrial production while global demand shock leads to an increase in the production level (Fukunaga et al., 2011, p. 8). Moreover, given that production processes involve a lot of transport costs, increase in oil prices increases transport costs and by extension the costs of production implying that the production levels will have to fall due to increased costs. Analysing the impact of oil price fluctuation on the aggregate level of production reveals that the significance of oil in the transport industry and as a raw material for the production of some capital goods and raw materials used in the production process is much more than can be estimated. Moreover, since fluctuations in the price of oil create volatility in most macroeconomic variables, it influences the GDP growth of different economies by influencing the level of production. ii. Effects on Commodity Prices Fluctuations in oil prices influence the prices of commodities through different mechanisms. First, some oil-produced goods such as cooking oil are likely to increase in price due to increase in oil prices since the price of the commodity has to take into account the increase in the price of raw materials. Secondly, in a bid to meet place utility, transportation of commodities to consumer points will be more expensive due to the increase in fuel costs implying that the transported commodities will have to be priced highly in order to recoup the high transport costs (CEIC, 2015, n.p). The consequences of oil price volatility on the prices of commodities have also been found to be through its impact on aggregate demand in the economy. According to FRSSF (2016), higher oil prices have the impact of reducing demand for other commodities since the high prices reduce the amount of real income and that higher oil prices are essentially taxation to consumers as it reduces income available for other expenditures. Precisely, an increase in the price of oil can influence commodity prices in two ways. Firstly, an increase in oil price leads to increased production costs and, therefore, increased prices of commodities. Alternatively, an increase in oil price decreases the proportion of disposable income available for spending on other commodities other than oil which implies that the demand for such commodities will fall and by extension, result in a fall in prices of that commodity. Therefore, the type of impact that results from price volatility of oil depends on several factors such as the margin of the price increase and the absorptive capacity of different economies. iii. Macroeconomic Effects Fluctuations in oil prices are likely to result in “imported” inflation especially in the economies of oil importing countries if the exporting countries already experience inflation. Precisely, importing oil from an economy experiencing inflation is likely to be expensive and the higher price will be transferred to buyers in the destination economy where the higher prices of oil will have a spiral effect of increasing general prices in the economy (Tverberq, 2013, n.p). Other than “imported inflation,” an increase in the global oil price results in an increase in the general price of commodities since oil price has a positive and significant correlation with the general price level of the economy (FRSSF, 2016, n.p). The implication of this finding is that a rise in prices of oil in an economy is likely to result in inflation and ultimately, changes in interest rates and exchange rates. The impact of volatility of oil prices differs depending on the level of development of an economy and its political and macroeconomic policies. According to Yoshino & Taghizadeh-Hesary (2014), the impact of impact of oil price fluctuations is often larger in developing countries than is the case in developed economies (like Japan and the United States) due to “greater strategic crude oil stocks and government-mandated energy efficiency targets” (p. 15). In essence, there is a consensus in theory and empirical literature materials that oil price fluctuations indeed influence the macroeconomic variables in different ways only that the magnitude of impact depends on the level of development which determines the complexity and quality of political and economic strategies adopted by different economies. Consequently, economies need to develop sound and flexible economic policies to insulate themselves from the harmful effects of oil price fluctuation. iv. Distributional Effects The major distributional effect of oil price changes takes place through the transfer of the wealth of nations from better off to worse off countries depending on the situational terms of trade that characterize a particular transaction. When the aggregate demand for oil falls, the price also falls as prescribed by the laws of demand and supply. The fall in oil prices resulting from a reduction in aggregate demand enables (poor) oil-importing countries to acquire oil at a relatively lower price thereby leading to an increase in real incomes and by extension, wealth (Kpodar, 2006, p. 15-17). This can be seen as a distributional effect of oil courtesy of reduced prices and works in the reverse mechanism when the oil prices rise beyond equilibrium prices. The fluctuations in oil prices can also lead to a distributional effect in the sectors of a particular economy. For instance, a fall in oil prices increases prosperity in the non-oil sector due to increased aggregate demand and supply while an increase in oil prices leads to enhanced growth in the oil-related sector due to higher incomes. Additionally, the spiral effect of increased oil prices that creates inflation is that such increases lead to distributional effects of inflation between borrowers and lenders in the economy as well as between importing and exporting economies at the international level. v. Trends towards diversification This is one of the most significant impacts of fluctuations in international oil prices that have received very little attention in empirical research. Given that the oil forms the backbone of the economy in oil-producing countries in the Gulf Region, fluctuations in international oil prices leads to serious consequences in the economies as well as increasing uncertainty for the future of such economies. Consequently, the fluctuations in oil prices have resulted in diversification of economies to incorporate irrigation agriculture, trade and commerce as a means of stabilizing the economic environment and prospects of such economies. Similarly, the economies of oil-importing countries have also been forced to diversify their sources of energy and the common idea between the two parties globally is to reduce the amount of their economies dependence on oil and oil products. According to a survey done by the International Monetary Fund, the diversification also encompasses diversification in the sources of crude oil on the part of importers and that the United States, for example, had responded to fluctuations in oil prices by increasing the number of sources thereby importing gasoline and oil from 40 countries and jet fuel from more than 25 countries as a deliberate strategy to cushion its economy from the impacts of oil price fluctuations and imbalances in supply and demand (IMF, 2011, n.p). Essentially, price fluctuations have several effects most of which are occasioned through the price mechanism that results in several effects as discussed above. An analysis of the consequences of global oil price fluctuations reveal that the impacts of oil changes on various economies will always differ based on the situational variables that characterize a particular economy relative to the global oil supply and demand conditions. Nonetheless, the greatest impact of oil price fluctuations is in varying commodity prices that occur due to increase in transportation costs or oil-derived inputs into the production process. In analysing the causes and consequences of oil price fluctuations, this paper has established that the causes and the consequences of oil price fluctuations are so intricately related such that one factor leads to the other in a mutually reinforcing cycle. Nonetheless, the intensity of both causes and consequences of oil price fluctuations differ depending on the nature of the different world economies. References Baffes, J., Kose, M. A., Ohnsorge, F., & Stocker, M. (2015). The great plunge in oil prices: Causes, consequences, and policy responses. Consequences, and Policy Responses (June 2015). Balke, N.S., Brown, S.P., and Yücel, M.K., 2011. Oil price shocks: Causes and consequences. Working Paper, Southern Methodist University. 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Analysis of the International Oil Price Fluctuations and Its Influencing Factors. Yoshino, N. and Taghizadeh-Hesary, F., 2014. Economic impacts of oil price fluctuations in developed and emerging economies. IEEJ Energy Journal, 9(3), pp.58-75. Retrieved on March 8, 2016 fromhttps://eneken.ieej.or.jp/data/5734.pdf Read More