The Global Economy: The Fall in Oil Prices - Assignment Example

The Global Economy By The of the The of the School The and where it is located The Date 1: Crude oil prices fell from $110/barrel in May 2014 to below $50/barrel in January 2015. Using appropriate economic theory, explain this fall and its implications for the global economy. The fall in oil prices cannot be attributed to one single cause; various factors must be taken into account in order to explain the radical tumbling down of global oil prices in the past seven months. Oil prices are believed to have fallen by “40% since June, when it was $115 a barrel” (What is quantitative easing?, 2014) after remaining fairly stable for about a decade. This drop in oil rates can be explained by taking into account factors like the decrease in global demand and surge in the world’s oil production, the oil “price war” between OPEC and shale oil producers, end of Quantitative Easing (QE) in the US economy which led to the rise in the dollar value and subsequent fall in the oil prices. Oil prices fall when the world produces more oil than it is able to consume in which case there is a production surplus. Vice versa, a production deficit comes about when the demand for oil is greater than the amount of oil that is being manufactured. However, oil prices have plummeted to half of what they used to be since June. Crude oil has now dipped below $50 a barrel for the first time since May 2009 and US crude has also fallen below $50 a barrel” (2015). In the last decade, oil prices were high because of the rising demand for oil in most of the world but this growing demand could not be met and supply remained low due to conflicts in the oil producing Middle Eastern region, for example Iraq. By 2014, oil production increased exponentially and due to surplus oil being produced, the price of oil fell dramatically. This was caused by a significant increase in US oil production. Because of soaring oil prices, multiple American and Canadian companies started drilling for “new, hard-to-extract crude in North Dakotas shale formations and Albertas oil sands” and advanced methods like fracking and horizontal drilling began to be used (Plumer, 2015. The introduction of American shale oil in the market has added “4 million new barrels of crude oil per day” (Plumer, 2015) to the oil market while the global production is “75 million barrels per day” (Plumer, 2015). Iraq emerged as one of the major contributors to the recent boom in oil production. After the US led invasion of Iraq, oil production was disrupted due to constant war, turmoil and sanctions. However, since 2008 due to efforts being made to bring about stability and curb violence, we have seen a boom in Iraqi oil production. “Over the next five to seven years, Iraq could be supplying nearly half of the incremental growth in world oil demand,” said Larry Goldstein, director of the nonprofit Energy Policy Research Foundation” (Heuvelen, 2012). Another major factor that contributed to falling oil prices was OPEC’s unwillingness to decrease production and keep prices high when demand for oil was falling worldwide. By not cutting down on production which has led to a fall in oil price, OPEC nations hoped that US shale oil production could be curbed. Saudi Arabia, one of the largest producer of crude oil, has decided against reducing production in order to protect its market share and has instead significantly cut down on prices. What we now see is a “price war” between OPEC and the US which has recently experienced an oil boom. OPEC hopes that prices will eventually return to normal as the extraction of American shale oil is much more costly than extracting oil in major Middle Eastern oil producing nations such as Kingdom of Saudi Arabia (KSA) and Kuwait. They hope that US companies will shut down due to high costs and diminishing profits. One way to explain plunging prices is to look at OPEC’s reluctance to cut production but another way is to take into account the ending of quantitative easing (QE) which coincided with the surplus production of oil. QE is a process through which the Central Bank injects money into the economy, aiming to “increase private sector spending in the economy and return inflation to target” (Bank of England, 2015). Just like lowered interest rates, QE acts like a stimulant for the economy and encourages banks to loan more. The connection between QE and global oil prices is in turn based on the connection between the value of the U.S. dollar and oil prices. The greater the value of the US dollar, the lower the price of oil will be. It is believed that the value of the US dollar was artificially kept low as large amounts of currency were printed following the Global Financial Crisis of 2008. Although production was high at this time, the effect of surplus oil was curbed due to the low value of the U.S. dollar. With the end of QE in July 2014, the value of the US dollar grew in comparison with other currencies and consequently the price of oil plummeted to an all-time low. The rapid collapse of oil prices has had an impact on almost every country. Saudi Arabia and some other Middle Eastern oil producers like UAE and Kuwait have enough foreign currency reserves which would enable them to survive lower oil prices for a long time. Iran and Russia are likely to be the most affected by the drop but Saudi Arabia can also expect to lose 14 percent of GDP if the price stays low for a long time and will make massive budget cuts on social spending (2015). Low prices could even lead to the shutdown of some high cost producers but that’s a chance that Saudi Arabia is willing to take to preserve its market share in the global oil market. Major budgetary cuts will have to be made by those countries that rely primarily on oil exports. The effect of falling oil prices will have a calamitous effect on those nations which rely primarily on their oil and gas exports, for example Russia. The collapse in oil prices has propelled a series of calamitous changes in the Russian economy as oil exports constitute 4 percent of the GDP. Russia loses about $2bn in revenues for every dollar fall in the oil price, and the World Bank has warned that Russias economy would shrink considerably if prices do not recover (Bowler, 2015). The fall has also led to a collapse in the value of the ruble, rising inflation and increased prices of imports. Banks have also been forced to make major changes including increasing the interest rate from 10.5 percent to 17 percent in order to prevent people from selling off the currency. The plummeting oil prices will have a catastrophic effect on Iran and Venezuela. According to IMF estimates, it was anticipated that there would be a 2.3 percent growth after a long recession but the fall in oil prices will halt this process. Iran needs to keep the price at a minimum of $100 per barrel (Plumer, 2015) to avoid incurring losses. It will have to slash its fuel subsidies if the prices don’t return to normal (Plumer, 2015). Most of the world has been hit hard by the drop in prices but countries like Russia, Nigeria, Iran and Venezuela have been impacted the most. OPEC made a decision to not cut back production so that it wouldn’t lose its market share and it hoped that prices would settle down eventually. Although this unprecedented drop in oil prices has brought benefits to consumers, the economies of most oil producing nations are going through a process of sudden and unprecedented change contributing to the disruption of the global economy. 3) Effective tax rates around the world are generally far below headline rates with many well-known multinationals paying little tax. Explain how: i) these companies are able to reduce their tax liabilities; ii) where tax issues fit within the theory of multinationals; and iii) assess the challenges facing tax authorities in their quest to increase corporate tax revenues and reduce aggressive tax avoidance. Effective tax rates are the tax that corporations are liable to pay divided by their pre-tax incomes. These tax rates are usually different from the headline or base tax rates that are set by the government. The base rates are usually set in brackets of earnings, for example 10% for $100,000-$150,000. However companies within the same brackets can have different effective rates die to different earnings and this method is considered to give a true picture of the taxes being paid. These effective rates are usually lower than the headline rates, usually for the multinationals that operate in various countries. These companies are at an advantage of managing their profits and cash flows in such a way as to affect the tax expenses that can be charged. In the past few years, companies such as Starbucks and Amazon have been accused of these activities. Reducing tax liabilities is a simpler task for multinationals than it is for local companies. There are several ways in which multinationals are able to do so. The main advantage lying with such companies in this arena is the fact that they exist in many locations all around the world. This gives them a huge opportunity in terms of paying lower effective tax rates. In comparison to local companies, they can easily manipulate their earnings and profits while staying under the legal framework and using intelligent tactics. One way that multinationals do so is through transfer pricing. Transfer pricing is the selling and purchasing of products within different departments of a company in order to reap different kinds of benefits, one of which is tax evasion. In the case of multinationals, this buying and selling takes place across different countries. The aim of these corporations is to shift profits to countries where the tax rates are lower, by inflating costs in the high tax countries and inflating revenues in the low tax countries. Goods can be bought at high prices by divisions in the lower tax rates areas from the countries that have higher rates and so evading millions in taxes. An example is that of the controversy that rose Starbucks in the UK. In 2012, Starbucks is reported to have made sales of 400 million pounds with no tax payments (Barford and Holt). One way this was done was through transfer pricing tactics, such as buying coffee beans from its Switzerland subsidiary at very high prices so as to shift costs and revenues so that the benefit of a low 12% tax rate could be availed from Switzerland (Knight) There are other ways through which tax liabilities are reduced by multinationals. Debt is often used to transfer profits. Loans are taken at high interest rates from the subsidiaries located in low tax areas so as to transfer profits through interest income to lower tax countries. This tactic has also been used by Starbucks. Another way is to do the same through selling intangible assets or items such as royalties, patents and other intellectual properties using the same techniques. One way Amazon avoided its taxes in the UK was to transfer all payments made by the UK customers to Luxemburg. Whenever a book is bought, the payment is made not to the UK subsidiary, but to the one present in Luxemburg. This gives a higher sales figure and hence profits for the Luxemburg part of Amazon rather than the UK division, avoiding the higher tax rates prevalent in the UK (Knight). Tax avoidance by these multinationals is also carried out through channeling their investments through countries with low tax rates so as to avoid taxes in the countries where the operations are actually taking place. These tax issues can be explained under the internalization/transaction cost theory of multinationals. The theory focuses on the creation of internal markets, carrying out transactions internally rather than using the external market, in order to reap cost benefits. There are a lot of factors that affect this decision one of which is the political and fiscal issues of the countries involved. The transaction cost idea also puts forward that given a chance to increase profits and lower costs, multinationals will internalize. The benefits of shifting profits here and there and gaining the benefit of lower effective tax rates could well be an incentive to internalize hence the importance of the internalization and transaction cost theory in this arena. According to Teece, "circumventing or minimizing taxes and controls" are possible incentives to internalize markets. (Kusluvan). Examples of these are evident in the supply chain management of Starbucks by purchasing beans by its own subsidiary and reaping other advantages through the location benefits, turning it into tax avoidance benefits. Governments and regulatory authorities have been working rigorously to solve the issue of tax avoidance. Multinationals, specially, constitute a large amount of their sales from countries where they try to avoid taxes and therefore a large portion of income for the government is lost. Tax authorities are usually in the quest to tackle this issue at hand. They have tried different ways to mitigate the tax avoidance. Attempts have been made to establish activities of cooperation between the authorities and companies, to legally try to protect the tax money, and many other actions. However this issue is still highly prevalent because of the intriguing challenges faced by the tax authorities. One of the challenges faced is the politics involved in this issue. Multinationals might be evading taxes legally and through tactful methods, but one highly beneficial point which forces governments to still support these companies is the creation of employment that it brings. When the issue of Amazon and Starbucks was on its peak, tax authorities were disappointed by the reaction of the government, which according to Richard Murphy of the Tax Justice Network, turned a blind eye towards this issue (Pollock). The political players are also reluctant to take extreme moves and rather focus on mild policies when it comes to such companies. The tax authorities in the UK were agitated when the government rejected the General Anti-Avoidance Principle which was supposed to recover billions of pounds (War on Want). When it comes to developing countries, another issue faced by authorities is the lack of enforcement of tax laws. Even if there is careful planning, there is very little implementation. One of the biggest issues however is the fact that all of these activities of profit transferring are one through legal channels. Tax authorities and all other are aware of the avoidance going on but to stop them legally is a big challenge because of the law allowing the companies to legitimately avoid tax because of the loopholes. Effective tax rates have long been below headline rates, especially for multinationals. The biggest multinationals of the world have been involved in the practice of reducing their tax liabilities. Governments of these countries form which profits are being shifted need to take some actions in order to recover the income being lost. However they also need to do a cost benefit analysis as this could lead to tough relationships with multinationals that are providing them other economic benefits such as employment and higher GDP. 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