Effects of Expected Future Increase in Oil Prices on the Market for Oil and Other Fuels - Essay Example

Due: EFFECTS OF EXPECTED FUTURE INCREASE IN OIL PRICES ON THE MARKET FOR OIL AND OTHER FUELS INTRODUCTION The Economic Problem. Oil prices are generally considered to be very volatile and are hard to predict with certainty how the outcome will be in the future. The future increases in the price of oil pose a serious economic problem to countries that immensely rely on oil for its economic growth. Nations must now come to terms with the harsh reality that dependence on oil is as short-term solution and the other sources of renewable as well as green energy must be considered. Hubbert (1956) had predicted that the production of oil in America followed a bell shaped graph trend. He stipulated that the peak of oil production was to be attained in 1970 after which production will assume a downward trend. His prediction reigned despite sharp criticisms. He then predicted a global peak to be witnessed in the year 2000. Michael Lynch fronted that the production of oil must be closely tied to oil prices. He argued that Hubbert committed a mistake in assuming that geology is the motivating factor to the discovery, production and depletion of oil. He advocated for supply and demand as the key determinants in the oil industry. "To an economist, the drop in exploration reflects optimal behavior: they do not waste money exploring for something they will not use for decades.” he added. Factors that influence the price of oil. Economic growth is one of the key factors that affect oil prices. A steadfast economic growth will result in an increase in the demand for oil and its byproducts. It thus exhibits a direct relationship with the price of oil. Even as countries seek to experience a rapid economic growth, they need to focus on other sources of energy so that their increased demand for energy can be met adequately. Another factor according to Watson (1987) that affects the price of oil is the seasonal changes. It has been observed that during winter oil prices increases rapidly in Europe and the U.S.A due to the increased demand. Before the beginning of winter, consumers tend to buy excess of oil and its products due to fear of possible. However during summer, demand tends to decrease especially that of domestic use. Energy substitutes such as coal, natural gas and nuclear energy that can replace oil will also determine its price. If more alternative sources of energy are discovered, overreliance on oil will decline and the prices will tend to decline. Foreign exchange affects oil prices since oil is traded internationally and the U.S dollar is the main currency used. Therefore appreciation or depreciation of the local currencies against the U.S dollar will significantly affect the price of oil. When the dollar weakens, the prices of oil will escalate. Increase in oil prices will also lead to high export bill resulting in trade deficits and a further weakening of the dollar. Policies of Organization of the Petroleum Exporting Countries (O.P.E.C) also affect the demand and supply of oil. This further affects prices. Being one of the largest oil regulatory body, their actions will greatly affect production levels as well as international prices. Countries with high production capacity as well as high oil reserves have got high bargaining power in terms of prices. Causes of high oil prices. Instability in the Middle East is a key factor that has led to increase in oil prices. Middle East countries such as Iran, Saudi Arabia and United Arab Emirates form major producers as well as exporters of oil. Iran has not had cordial relationship with the west especially the U.S.A. At times they have threatened to hoard their oil so as to frustrate them. A decline in the exportation of oil by these countries will create a serious shortage thus increasing the prices. Political unrest being witnessed in other oil producing counties in Africa has also affected greatly the production of oil thus resulting in an increase in prices. The recent political turmoil witnessed in Libya, led to a decline in the country’s production capacity. Nigerian which is another major producer has also experienced challenges which affected its oil production. According to Bervan (2007), low interest rates are among the key factors that have led to increase in the prices of oil. “Low interest rates actually induce businesses and individuals to invest in durable goods, production of these goods will require more oil as well as other types of commodities. “he added. Fluctuations in the foreign exchange market have led to increase in the prices of oil especially when the monetary value of the importing countries depreciates against the dollar. The exporting countries will also increase their prices for oil so as to strengthen their economies. The oil market structure. The oil market can be classified as both monopolistic and oligopolistic market structures depending on the producer. Monopoly is a market structure in which there is a single producer or a supplier of a particular good or service with no close substitute. It does not allow for free entry of other players in the same market. The barriers are due to the high cost of production, government regulations as well as other economic reasons. Copyright and patents given to some firms may also prevent other from entering the market. In Saudi Arabia, the government enjoys full monopoly in the oil industry. Oligopoly on the other hand arises when few firms that deals with identical products join together to dominate the market. Just like monopoly, players in oligopoly market set their own prices and are therefore price makers and not price takers. They are usually interdependent especially when determining their prices. Their pricing policies are very rigid as well as sticky. One firm cannot reduce its price without prior information on the action that will be taken by other firms in the market. It exhibits a kinked-demand curve as a result of the interdependence which creates a lot of uncertainty. Organization of the Petroleum Exporting Countries (O.P.E.C) is an oligopolistic structure in the oil market. International trade theory according to Evanston, G (2007) is concerned with various forms of international trade as opposed to domestic trade. Key factors to consider when developing these theories include time costs, tariffs and other barriers to trade. Costs incurred in meeting legal formalities are also an important factor to be considered. Many scholars have formulated international theories on trade. The Heckscher-Ohlin model that was forwarded by Lescaroux, F. and Rech, O. (2008) lays emphasis on endowment of the factors of production as the main basis for international trade. He argued that nations will export the products which are made using the domestically available factors of production. Goods by factors that are not readily available will not form the basis for exportation. Ricardian Model which was based on comparative advantage affirms that countries will mainly trade those products in which they have comparative advantage. David Ricardo defined comparative advantage as the ability of one country to produce or manufacture a particular product at a lower opportunity coast as well as marginal cost. He farther outlined some assumptions to his theory. These include perfect competition in the factor market and the commodity market, homogenous labor as well as constant technology. Production is also subjected to constant returns to scale. According to gravity model of international trade, economic sizes as well as distance among nations are some of the key condition for international trade. Conclusion One of the major steps towards averting the looming crisis and to save economies that are incurring huge expenditures in importing oil is to adopt other substitutes to fossil fuel. Solar energy is among the key substitutes of oil. Termed as a green source of energy by Kouris, G. (2000) solar energy does not pollute the environment as well as causing global warming. This is the greatest, readily available and most efficient source of energy. Less cost is incurred while using this source of energy. Currently, very few units of this energy is being put into productive use. Adoption of solar energy will greatly reduce overdependence on oil. This will greatly assist in the reduction of oil prices due to decreased demand. Another important substitute for oil is the hydroelectric power. This source of energy relies on water. This ensures a steadfast generation of power which can greatly help in minimizing dependence on oil energy. Many countries have invested heavily on this form of energy. At times it proves unreliable especially during dry seasons when water level in the dams goes down. Wind energy as Harvey, A. C. (1997) puts it, is another free source of energy that can substitute oil energy. Wind forms a safe form of energy with less waste materials as well as harmful byproducts. If wind energy is properly harnessed, nations can secure a non-polluting and cheap form of energy. Generation of wind energy does not interfere with other natural resources such as land since other activities such as farming can still take place. Use of animal waste commonly known as biomass is another important source of energy. This source of energy emits less amount of greenhouse gases however some methane as well as carbon dioxide is released into the atmosphere. It takes advantage of the natural process of fermentation. Therefore as oil prices increase, nations will be forced to discover and exploit these alternative sources of energy. This will also help curb the looming shortage of fossil fuels such as oil. Works Cited Harvey, A. C. (1997) Trends cycles and autoregression. Economic Journal, 107, pp. 192-201. Hunt, L. C. and Ninomiya, Y. (2003) Unravelling trends and seasonality: A structural time series analysis of transport oil demand in the UK and Japan. The Energy Journal, 24, 63-96. Huntington, H. (2006) A note on price asymmetry as induced technical change. The Energy Journal, 27, 1-7. Koopman S. J., A. C. Harvey, J. A. Doornik and N. Shephard (2000) Stamp: structural time series analyser, modeller and predictor. London: Timberlake Consultants Press. Kouris, G. (2000) Fuel consumption for road transport in the USA. Energy Economics, 5, 89–99. Lescaroux, F. and Rech, O. (2008) The impact of automobile diffusion on the income elasticity of motor fuel demand. The Energy Journal, 29. Ryan, D. L. and Plourde, A. (2002) Smaller and smaller? The price responsiveness of nontransport oil demand. Quarterly Review of Economics and Finance. Read More