Oil Prices and Their Effect on the Global Market - Term Paper Example

? Topic: Oil prices and its effect on the global market Introduction: Crude oil in treated as a commodity in the whole world and its trading is done on the International Petroleum Exchange. Just like all commodities from agricultural products such as rice and maize, to precious metals, such as gold and silver, oil is bought and sold on the world market. Crude oil is the primary raw material for other refined petroleum products such as gasoline and kerosene. Oil prices tend to fluctuate greatly and have far-reaching effects on the global market. Crude oil is so important a commodity that its price fluctuations in the international market may lead to rise or fall of economies, especially of the developing countries. The developing countries are heavily dependent on oil exporting countries for their import of petroleum products. So if there is a rise in oil prices only the oil exporting countries benefit while bringing a destructive effect on the developing nations. What really affects the oil prices is the demand and supply of oil which we are going to look into detail later. The global market saw a recent surge in oil prices since the last two years with the most recent rate of today being $124 per barrel (forex.com). It was predicted that the production of crude oil must be increased by the oil producing countries to bring the prices down. The Arab oil exporters held a meeting in early 2011 in Cairo to discuss this issue but refused to increase oil production as they believe that the supply is sufficient in the market. The oil prices rose to $ 94.74 per barrel this year since October 2008 when oil prices were record breaking high. The forecasted trend is an increase in oil prices in the coming weeks touching up to $ 100 a barrel. After the financial crisis of 2008, OPEC or Oil Producing and Exporting Countries decreased their level of output in order to deliberately create a shortage so that prices go up. In 2010, the demand for oil increased and is expected to increase more in 2011. OPEC must release some of their stock and raise the supply of oil or else the prices can rise to unprecedented level of $ 150 per barrel. These unfavorable conditions can lead the world into another crisis. Body: The trading of oil is one of the most significant trading done in the world. Crude oil is a primary ingredient in many energy manufacturing and services industries. I certainly believe that oil should not be treated on the commodity exchange because it can have significant impact on the world economy. So if there is a fluctuation in oil prices it affects oil producers and exporters both. The market price for any product is determined by the demand and supply of it in the market. The desire to want something is defined as demand or when you realize that you want a product, can afford it, and have made a definite plan to buy it. The law of demand means that other things remaining the same, the higher the price of the good, the smaller is the quantity demanded The higher price of any product will reduce the quantity demanded for two reasons. A notable economist, Kotler has found that one of the reason is the substitution effect, that is, when the price of a product rises, other things remaining the same, its opportunity cost rises. Although each good is unique but has its substitutes, for example the substitute of oil in an energy producing plant could be water or solar energy to produce electricity. As the opportunity cost of a product rises, people have a tendency to buy less of that and more of its substitute. Another reason for change in quantity demanded is the income effect. When a price changes and all other influences on buying plans remaining the same, the price rises relative to people’s incomes. So faces with a higher price and an unchanged income, people cannot afford all the things they previously bought. Subsequently, the demanded quantity reduces. Price has an inverse relationship with demand (Kotler, 2006). A supply is more than just having the resources and the technology to produce something but the firm also has to see whether a firm can make profit from it and has made a definite plan to produce and sell it. In accordance with the law of supply, other factors not changing, a higher price associated to a good implies higher supply of the quantity. Price has a parallel relationship with supply. A higher price increases the quantity supplied because of increasing marginal cost. For example, if the quantity produced of oil increases, the marginal cost of producing it also increases. I have noticed that it is never worth producing a good if the price received for it does not at least cover marginal cost. So when the price of oil increases, other things remaining the same, producers are willing to incur the higher marginal cost and increase production. The higher price brings forth an increase in supply. The short-run supply of crude oil depends on the production and consumption decisions of OPEC and Non-OPEC countries. They aim for profit motive. The supply of oil will greatly depend on the current level of stocks and spare capacity to store it so that they are available for supply when there is a sudden increase in demand. Natural disasters like floods and earthquakes and man-made disasters such as wars decrease the output. While in the long-run, supply depends on the scarcity of natural reserves and the fact that they can deplete over time. When oil producers foresee that the oil prices will rise in the near future, they will start investing money and resources in the exploration of new oil reserves, although it can be expensive and time taking just like the cost of extractions due to technological change. So I agree with the research prepared by the IMF Research Department and approved by Michael Mussa, that market oil prices become higher when the demand of oil increases against an inelastic short-run supply of oil. This increase in demand causes oil stocks to fall bringing the price level higher. Once the concept of demand and supply and their effects on the market price is clear, we will now concentrate on just changes in oil prices and their resulting effects. Crude oil is such a vital input in many industries, it is more like a necessity or basic good for everyone (heating, cooking, burning purposes), thus creating an identifiable link between the demand for oil and the pace of economic growth globally. Economic growth occurs when the GDP of any country increases compared to the GDP of last year. When an economy is flourishing, its demand for oil rises. Recently, China experienced a boom in their economy with extreme economic growth and national output in energy-intensive sectors. Therefore, the Chinese economy increased their demand for crude oil with almost 6 m barrels a day in 2004 which was comparatively 15% more than the previous year. 7.1% of world oil demand is now made by China. World’s leading industrialized nations usually come under the Economic Union which accounts for nearly one-fifth of the global oil demand (Khan Mushtaq, 2008). Natural gas and coal are relatively cheaper substitutes for oil. Gas and coal are less expensive in terms of per unit of energy and also transportation cost. They can be internationally traded without limitations, unlike petroleum. Even environmentalists support the consumption of natural gas due to its less deleterious effects because oil spills and carbon dioxide emissions from coal, all add up to environmental degradation. Even though economists insist on the use of these less expensive substitutes for oil, I believe that these emerging sources have their own limitation which is why they are not used so often. The cost of infrastructure for the transportation of gas through gas pipelines can be a little higher depending on the source country to the user country. In international trade, a lower proportion of world market enters. There is a fear that this limited natural resource might become extinct. The changing prices of oil can have major consequences on the microeconomics of some oil-using sectors of the economy. We know that crude oil is refined and then used in many industries and homes for various purposes. Petrol is very important for industries and general public as a main source of means of transportation. Gasoline is used by everyone in cars, buses and bikes. It can be further divided into diesel and jet fuel. Kerosene is used for heating and cooking purposes. Heating oil is used in burning wood and cooking food. Fuel oil is used as boiler fuel for power and shipping industries. The more an industry relies on oil for these innumerable uses, the greater will be the affect of fluctuating oil prices on its costs and profitability. In the long run, a greater fall or rise in its production will be seen. In industries where oil is a primary raw material in the production process, if there is an increase in price of oil, it comes as a supply shock increasing their variable costs of production. Such an increase in cost will drive a profit-maximizing firm to increase its prices to reduce their level equilibrium level of output. The impact will depend on the price elasticity of demand for their product as to how much the effect of increasing cost can they pass onto the final consumer from themselves. (Husain A, 2008) I have observed that the greater effects of the changing oil prices will also depend on the extent to which prices are going high are for a few months or for a few years. Subsequently, the longer the period of high prices the impact will be greater. Exporting and importing countries of oil will be affected differently in the short-run and in the long run both. OPEC countries which include Bahrain, Saudi Arabia, Oman, Iraq, Iran, UAE and America, to name a few, will most definitely benefit from an increase in oil prices. As they export oil, it will boost their revenues and profitability. If a country’s national output has a large dependency on high-energy using industries, then they are more vulnerable to changing oil prices than those countries which have a much smaller manufacturing base and less dependency on energy-using industries. Oil will still be bought and sold regardless of the change in prices. An economy’s monetary and fiscal policy will respond to oil prices accordingly. Countries change their quantity demanded and supplied with the effects of the changing exchange rate. It is also important to note that how flexible the labor market and their real wages are because businesses respond to higher oil costs differently. Generally, higher oil prices per barrel as observed recently in the last 3 or 4 years can bring a halt to economies of a country. It gives rise to inflation, provoking higher interest rates, reducing people’s real income and spending. Economic growth can be defined as the constant rise in potential GDP. Economic growth occurs when over time, the quantity of labor grows, capital is accumulated and technology advances. Higher oil prices slower economic growth and the rate of real GDP. People’s real income and their purchasing power are cut down with an increase in oil prices. And when oil producing company’s profitability reduces because of higher costs, their planned capital investment also reduces. Both consumption and investment are affected negatively. Unemployment can occur in industries that depend on oil but in nearly all industries. Business confidence is eroded. Businesses start hesitating to invest and improve output. Consumer confidence will also be hit when share prices and equities decrease because of a company’s reduction in profits. The firms will not issue new shares due to falling share valuation. While inflation, is the persistent rise in price level. Inflation occurs when, over time aggregate demand increases by more than aggregate supply. Some level of inflation is always present in economies at some time or the other but when it grows beyond a certain point; it becomes detrimental for an economy. It is preferred to pay importance to a recent research that was carried out by IEA or the International Energy Agency which concluded that if world oil prices continue to increase by 10% in the following years then this would bring about a 0.4% increase in inflation year in developed economies. The increased rate of inflation would be even greater for those countries that buy oil from these leading oil producing economies. The effect can be reduced if there is a consequent rise in wages too which will secure real incomes. However, it is not always the scenario. (Woertz, E. 2008) If I take the example of my own country, Pakistan, we import oil from developed nations for our different uses a rise in oil prices will increase the price of petrol thus increasing transportation costs giving a boost to prices of all goods and services. Cement and sugar industries use oil in their roller machineries to make and refine sugar. Apparently, sugar producers will increase sugar prices. Now sugar is a basic necessity, poor people will be most affected by this price increase. It will become difficult for them to even afford a necessity like sugar. Likewise, in Pakistan electricity is generated through oil instead of coal or water. Increase in oil prices would make electricity expensive and unaffordable. The terms of trade for a country worsen or improve with an increase or decrease in oil prices. Terms of trade is the relative price of imports compared to the price of those imports in the exporting country for selling their output abroad. There will be a transfer of income from importing to exporting countries with an oil price increase. For oil importing countries, the terms of trade worsen because they will now have to pay more amount of money per barrel for the same quantity of oil imported previously with lower oil prices. Alternatively, for oil exporting countries, the terms of trade will be beneficial. Their oil is much more the amount of money in the world market. Their export revenues increase with an infusion of income and demand into their circular flow. Balance of payments is the difference between the amount of goods imported and exported. Exporters of non-oil products will face a balance of payment deficit with an oil price shock. Higher oil prices diminish the real income of oil consumers across the globe. There will be a drop in demand for oil in the domestic market but also in international market. A fall in exports will reduce aggregate demand and GDP growth. Higher current account surplus would be provoked by higher oil prices because high oil prices would impact oil exports positively. The value of imports will fall due to reduced international commodity prices. Conclusion: We have clearly seen that an increase in oil prices brings a shift in income from oil consumers to oil producers. The cost of production of goods and services increases when the relative price of energy inputs increase. This puts a pressure on the profit margins. We have seen the likely effects on the rate of inflation. The response of oil prices to inflation can create a wage/price spiral. Financial markets are affected directly and indirectly. An oil price increase will affect equity valuations and exchange rate of currency. It brings about changes in economic activity, rate of inflation, monetary and fiscal policy and corporate earnings. Since the year 2008, oil prices have increased over the years. This oil price increase can shift the GDP from oil importers to oil exporters by 0.4% globally. This is affected through demand and supply effects thus bringing second-hand effects on inflation in terms of higher wage claims. Due to this central banks can raise interest rates to counteract inflationary pressures. Asset prices and financial markets are also affected. Consumer and business confidence decline bring adverse affects on economic growth globally. It is therefore important to minimize budgetary costs by oil importing countries because the access into international capital markets is reduced further constraining foreign borrowing. As oil prices are highly volatile, it is significant to make sure that the government spending is not increased greatly if oil prices fall in the future. I certainly feel that crude oil shall not be treated as a commodity like agricultural products and metals because it is such important a commodity that it is more like a basic good and a vital ingredient for almost every industry and economy. Fluctuations in oil prices have far-reaching effects on both developed and under developed economies with third world nations being affected on a much larger scale. Oil producing countries are not that affected or it doesn’t make much of a difference to them because they have sufficient sources of this valuable resource. Even an oil increases in price would not harm their economies to a greater extent. It must not be traded on the commodity exchange like Forex because of the huge trading and bidding worldwide, its rate changes every minute. References: Arab Petroleum Research Center. (2009 March 16). Arab Oil & Gas Bulletin, Vol. Xxxviii-No 900. Economic Intelligence Unit. (2008, December.). Country Forecast Middle East and North Africa Regional Overview, Energy Information Administration. (2009, March). Short-Term Energy Outlook, Husain A., Tazhibayeva K. and Ter-Martirosyan A. (2008, November). Fiscal Policy and Economic Cycles in Oil-Exporting Countries. IMF Working Paper (WP/08/253). Institute of International Finance. (2008, November 6 and December 4). Regional Report: Gulf Cooperation Council Countries. Institute of Development Studies (IDS). (2008, November). Voices from the South: The Impact of the Financial Crisis on Developing Countries. IDS Report. Voices from the South: The Impact of the Financial Crisis on Developing Countries. IDS Report, November. 2008 International Monetary Fund. (2004). the Implications of the Global Financial Crisis for Low-Income Countries, March. Khan Mushtaq. (2008, November 17). Managing Domestic and Global Expectations, Citi Economic & Market Analysis, Michael Parkin. (2006) Economics, university of Western Ontario, fifth edition. Naude, W. (2009). The Financial Crisis of 2008 and the Developing Countries. UNU-Wider, World Institute for Development, Economic Research, Discussion Paper No. 2009/01. Woertz, E. (2008, October) Impact of the US Financial Crisis on GCC Countries, GRC Report. Read More