Oil Price Shock: Cause and Effect - Essay Example

Oil Price Shock: Cause and Effect Since 1998, the world price for crude oil has spiked from a historic low of $15.70 per barrel to see a 1000 percent increase to near $150 per barrel in the summer of 2008. This sharp and rapid increase has often been explained in terms of supply and demand and blamed on the US overuse and the rising demand in the developing countries. Still, the rate of increase and the historic highs cannot be explained in strict terms of market economics. War in the Mideast, fear, speculation, and market psychology have all played a part in the escalating cost of crude oil. The results of the high price of oil affects the consumer at the gas pump as well as the grocery store. Industries are forced to scale back production to keep costs in line. Worldwide inflationary pressures push prices higher around the globe. These actions and reactions fundamentally change the way the world works, plays and lives. The necessity of oil drives prices at the margins and the resulting shock pushes consumers and industry to scale back use, limit the demand, and create alternatives for petroleum products. Oil is a commodity that has a demand driven by necessity, is of limited supply, and can therefore be priced at the cost that the last, and highest bidder is willing to pay. This aspect of oil makes it a commodity that is naturally volatile in price. While the news and fear mongers warn of a worldwide oil shortage and a bottleneck in refinery capacity, this alone cannot explain the sharp increase in prices. In 2007, the world demand for oil was 85.7 million barrels per day and a refinery capacity of 85.4 million barrels per day (Doggett 2008, World crude oil refining capacity 2007). In addition, the modest increases in demand have been linear and not a reflection of the volatile spikes in price. Saudi oil minister Ali al-Naimi recently stated that there were no discrepancies in supply and demand and said, "There is no justification for the current rise in prices" beyond psychological and speculative (qtd. in Roberts 2008). Though demand closely approximates supply, small disruptions, or threats to the supply in the system, can lead to the creation of an artificial demand on the supply. Hurricanes, wars, and natural disasters all contribute to a climate of fear. Because oil is a necessity priced at the margins, it requires a relatively large increase in price to decrease the demand significantly. This allows oil prices to fluctuate wildly in a volatile market. Oil futures markets have allowed speculators to create an artificially high demand for petroleum. Futures contracts were originally designed to stabilize prices by guaranteeing a producer a price and insuring a given level of production. However, oil futures traders have used the system to speculate on pricing and have a self-interest in driving prices higher. According to Roberts (2008), "In an effort to forestall a serious recession and further crises in derivative instruments, the Federal Reserve [US] is pouring out liquidity that is financing speculation in oil futures contracts". Hedge funds and investors are financing falling profits through highly leveraged futures contracts in the same way that the housing bubble was built upon the practice of flipping homes (Roberts 2008). Engdahl (2008) contends that, "As much as 60% of today’s crude oil price is pure speculation driven by large trader banks and hedge funds". These futures contracts, largely unregulated, add to an artificial demand in the marketplace and force prices higher. However, as long as there are some market forces at work, this oil bubble will collapse the same way the real estate market has. In fact, as of this writing in October 2008, oil has fallen to 60 percent of its record high. The major effect of the escalating price of oil is the inflationary pressure that it places on the consumer, and the resulting economic slowdown. The most apparent and direct result of the high cost of oil is the rapid rise in the price of gasoline at the pump. Yet, there are many other and more indirect price increases associated with the cost of crude. Food prices have seen a worldwide price increase as it is a commodity that is closely related to the cost of the energy needed for fertilizer, production, processing, and transportation (Capehart and Richardson 2008 p.3). In addition, the high price of gasoline has spurred the demand for ethanol and reduced the available acreage for planting food crops. According to Rosegrant (2008 p.2), "The increased biofuel demand during the period, compared with previous historical rates of growth, is estimated to have accounted for 30 percent of the increase in weighted average grain prices". Rising prices for necessities translates to a lower disposable income and results in a downturn of spending and an economic slowdown. The Royal Bank of Scotland notes that, "Previous episodes of rapid oil price inflation in 1974, 1979 and 1990 preceded global recession" (Fenton 2004 p.1). Indeed we may already be experiencing the effects of a worldwide slowdown as the result of the recent oil shock. The convergence of high inflation and an economic slowdown combine to further slow down industrial output and decrease profitability. Almost all industries are affected from small manufacturing concerns to the airlines and transportation. Industry depends on oil for lubricants, raw materials, energy, and transportation. As oil spikes, producers raise prices. According to Jones, Leiby, and Paik (2004 p.4), "collusive capacity throughout the entire economy permits producers to raise mark-ups beyond what perfect competition would permit. An oil price shock lets them further increase mark-ups, depressing output". Transportation is hit especially hard and at $120 US per barrel, fuel represents 50 percent of the airline's expenses, threatening cancelled routes, laid off employees, cancelled orders for new planes, and possible bankruptcies (Wescott 2006 p.5). The effect of higher fuel surcharges for passengers would decrease tourism and a slowdown in the hotel and restaurant business, which combine to create 10 percent of the global GDP (Wescott 2006 p.5). The ripple effect of high oil prices affects producers, suppliers, and the service sector that relies on transportation and consumer spending. While there are many direct economic impacts that result from the high cost of oil, the large spike in prices drives down consumption, lowers demand, and creates alternative markets. In Australia, transportation is undergoing a fundamental change due to the rising cost of oil. "EcoTransit Sydney believes that the future of transport in NSW will be renewable electricity-driven" and are preparing for a transition from petroleum to renewable resources (EcoTransit Sydney Policy 2007). The high cost will also invite competition from alternative energy sources such as solar and wind. The transportation system may reduce our dependence on personal vehicles and begin to promote and plan large-scale public transportation systems. As long as the price of oil remains high, the world will continue to see major shifts in our buying and spending patterns. In conclusion, the high price of oil is the result of a largely artificial demand from speculators and futures trading that ripples through the economy causing an economic slowdown and a restructuring of society. The immediate effects are felt through industrial slowdowns based on cost increases. Food prices rise as the price of production escalates and acreage is diverted for biofuels. Transportation sectors face slowdown or bankruptcy. Tourism falls off sharply and results in laid off workers in the service sector. Less disposable income in the hands of consumers impacts all of manufacturing. A sustained increase in the price of oil will result in a worldwide recession, and possibly a depression. Still, the market economy creates opportunities for new materials, alternative fuels, and social changes to compensate for the high cost. References Capehart, T. & Richardson J 2008, 'Food price inflation: Causes and impacts', CSR Report for Congress, Washington DC, pp.1-6 Doggett T 2008, World '09 oil demand growth cut by 140,000 bpd – EIA, viewed 8 October 2008, < http://www.bloggingstocks.com/2007/12/14/iea-increases-2008-global-oil-demand-forecast/> EcoTransit Sydney Policy 2007, EcoTransit Sydney, viewed 8 October 2008, < http://www.ecotransit.org.au/ets/files/ETS_policy_2007_final_final.pdf> Engdahl FW 2008, Perhaps 60% of today's oil price is pure speculation, James J. Puplava Financial Sense, viewed 8 October 2008, Fenton D 2004, 'The economic impact of high oil prices', The Royal Bank of Scotland Group, London UK Jones DW, Leiby PN, & Paik IK 2004, 'Oil price shocks and the macroeconomy: What has been learned since 1996'. The Energy Journal, vol.25 no.2, pp.1-32 Roberts PC 2008, Why oil prices are so high; A weak dollar, bad Fed policies, and hedge fund speculators, viewed 8 October 2008, < http://www.globalresearch.ca/index.php?context=va&aid=9300> Rosegrant MW 2008, ' Biofuels and grain prices: Impacts and policy responses', International Food Policy Research Institute, Washington DC Wescott RF 2006, 'What would $120 oil mean for the global economy', Securing America's Future Energy, Washington DC, pp.1-7 World crude oil refining capacity 1970-2007 2007, International Energy Agency, viewed 8 October 2008,   Read More