Continuous Rise in the Price of Oil Is Likely to Cause Global Economic Meltdown - Coursework Example

CONTINUOUS RISE IN THE PRICE OF OIL IS LIKELY TO CAUSE GLOBAL ECONOMIC MELTDOWN.” Table of Contents Page Executive Summary The Impact of oil prices on industry in UK 2 2. Impact of oil prices and its implications for the UK economy. 4 3. How Virgin Atlantic responded to changes in the rise in price of oil. 6 4. Perfect Competition 7 5. Impact of Human Right laws in different environments 9 6. Conclusion 10 7. References 11 Executive Summary Inter-related question are raised on the subject “continuous rise in the price of oil islikely to cause global economic meltdown.” The impact of this rise is studied in context of UK’s economy and industry, It is observed that the economy has gained by this as reflected in higher GDP and the industry has fared better with rising exports. However the inflationary trend and rising interest rate will be a cause of concern, It is also found that in an industry like aviation the newer entrants like Virgin Atlantic are coping with these rises in a better way than others because of their pragmatic outlook. The theory of Perfect competition is examined and the cause of this price rise is determined through its application and finally the Human Rights angle is viewed and it is found that it becomes inoperative in view of the states taking a monopolistic approach by forming the oil cartel. 1 The impact of oil prices and its implications for the UK economy. Oil price rises have depressed trend output and the economy has little spare capacity. (National Institute Economic Review)1 Ever since the early seventies UK has become a producer and nett exporter of Oil. Normally an increase in oil prices should have spelt a boom for the economy but there are factors that have negated this possibility. While it is true that higher oil prices have meant larger revenue earnings as also larger tax income for the government, yet there are other sectors of the economy, that have affected differently. Exports have been very important to UK and it largest trading partner is the USA who has 15% share of our exports. But the rising oil prices have a different impact on the US. It is a net importer of oil hence pays a huge price and it leads to possible recession. It shores it up by increasing interest rates which make imports attractive to them. But the downside is that UK too increases the interest rates on international trends and this puts pressure on export prices. There is a constant balancing act to maintain export levels and this is not likely to ease in the near term. The upside is that with expanding economies of the Asian countries some outsourcing to them will reduce our costs to give UK the opportunity to maintain its exports or to even improve on it. The sliding dollar in the international market is yet another worry that affects the UK economy. But with expectation that the sterling too will be weakened is going to reduce the impact. There is chance of even a decent growth in exports. Inflation has been above target all the time and it reflects in erosion in value for consumers. It is at the highest level for past decade (3%). But it is still stable enough to go along with. While sales are higher, the income percentages are lesser on lower volumes. Rising interest rates have been taking their toll and industry has been feeling the pinch. All prudent practices come to naught when capital itself becomes costlier. This trend is likely to continue for the short term but will add fuel to fire and really not help the cause of either checking prices or increasing production. Rise in Interest rates has also lead to higher savings but there is an anomaly here too. Deposits have grown but have been utilised more in giving out loans against equity of households. Therefore consumer spending is likely to grow slowly. A disturbing trend has been that due adding of debt by raising equity against homes, and the diversion of these funds to spending rather than investments. The saving grace is that such loans are usually on fixed rates and with interest rates on the rise, most people will be safe by the time their loans reach maturity. The outlook of the UK economy due to rise in price of oil can now be summed up as under. There are four areas of concern that will have the greatest impact. 1. The global economy largely depends on what happens in the US. If they are able to avoid a recession, which is a million dollar question, then stability will rule. Otherwise a slide is expected and tough measure will have to be called for reversing trend, including measures to reduce oil prices by forcing producers to be more considerate. This is more easily said than done. The recently acquired confidence of the oil producing nations does not augur too well for this scenario. 2. The declining dollar may help the US but it will have a disastrous effect worldwide. Shoring up the dollar has been a worldwide campaign as it is in the interest of UK that the dollar remains stable 3. The UK bank rate will determine if the industry and exports remain competitive. However it is not the only factor affecting the economy but would be helpful if they do not rise too much. 4. A strong consumer spending will definitely pick up the economy and raise industry spirits. This will lead to larger manufacturing. But if this spending comes out of equity borrowings then it will spell trouble.(RBS)2 On the whole conditions look stable but any skewing in the above four factors could end in disaster. (wordcount-728) 2 Impact of oil prices on industry in UK Fuel cost comprises the major expense in aviation industry. It is estimated to be 30 % to 60 % of the total costs and is more in case of budget airlines as they have relatively less heads of other costs. It is evident that any upward change in oil prices will have a major impact on aviation business. In case of low cost flying companies it forms an even greater part as they have cut down a number of other services to the flying public. Rising fuel costs are eating into profits, forcing many carriers, to impose surcharges on fares. New ways and means are being developed to protect against volatile markets and one of them is Hedging against rises. Some airlines like Ryanair, a low cost flying company, has up to 80-90% of its future needs hedged.(Times Business)3 But hedging does not mean saving. It really helps in smoothing out the high and lows so what one has achieved is a safety net of a smoother cash flow related shock rather than cash saving. Sometimes it can backfire as in the case of Iraq war it was felt in the market that there would be a price fall and hedges were withdrawn resulting in great losses. It is a similar story in the industrial landscape as well. The backbone of any industry is the energy requirement and it can be in any form. The root of most energy is however fuel. It is rare for an industry to consider alternative fuels for want of cost effectiveness and ready availability. Oil is both inexpensive in comparison and available almost instantly. Rising cost affect product costing and eventual price rise of both capital and consumer goods.. Oil prices have dipped back temporarily but not to the older levels, and are very unlikely to remain at these levels too. The impact on industry has been greater awareness leading to conservation of oil as well as seriously trying to develop alternatives for the industry of the future. (Word count 342) 3 How Virgin Atlantic responded to changes in the rise in price of oil. Virgin Atlantic is a classic example of how David picks on Goliath. Ever since it was launched, primarily pitting itself against the mammoth British Airways, Virgin has always defied rules of logic. "In a challenging year, when many leading players in the airline industry continued to struggle to survive, I am very pleased and proud that Virgin Atlantic has recorded healthy increases in both turnover and profit." (Sir Richard Branson)4 Virgin’s recipe to tackle the oil price rise was head on. Instead of cutting costs, like most of the competition did, he added value and charged for it. It was a calculated move. He not only managed to cover this additional expense, he ended up making an eventual profit of 60 million sterling. Flat beds, massages and complimentary cocktails lured extra passengers on to Virgin Atlantics flights last year, helping the airline to achieve a substantial increase in profits despite a £68m hit from higher fuel prices. In yet another brilliant move Virgin decided to expand its services rather than cut down on employee strength. But that is no all. Sir Richard Branson is known for his radical approach on all issues and here is one from him to meet the challenge thrown up by the oil crisis. In an interview with a reporter from Reuters he said, that he was looking for alternative fuel sources and that even he was planning to start building cellulosic ethanol plants (to make) fuel that is derived from the waste product of the plant. He believes that the future of fuel is in this environmentally friendly technology, which over the next 20 or 30 years actually will replace the conventional fuel. (Sir Richard Branson)5 Virgin has set an example and is showing the way like a true leader. (word count 308) 4 Perfect Competition gives an optimal allocation of resources but existence of scale economies may make it impossible. Perfect Competition is the ideal situation where all similar or identical products are available simultaneously to all buyers. This would make it impossible for both buyers and seller to influence prices. Demand and Supply will determine price at any point in time. There are six conditions which determine existence of Perfect Competition. 1. Atomicity – Under this condition all producers or sellers are relatively small in size compared to the total market. 2. Homogeneity – All goods are very similar or can be replaced by each other as they are very similar. 3. Perfect and complete information – Every seller and every buyer is aware of each others price and terms and conditions and no preference can really be set by them. 4. Equal access - All sellers have access to productions facilities technology and other resources to manufacture and market their products. 5. Free Entry – Any supplier can enter or exit the market at will. 6. Individual buyers and sellers act independently – meaning that no groups will be formed to advantage of each other. (The New Palgrave: A Dictionary of Economics 1987)6 When these conditions prevail we observe a standard behavioural pattern, that the buyers objective is to get the maximum utility out of the product and the seller’s aim is to get maximum profit. In such a scenario we see optimal use of resources where all producers are using similar resources in technology and marketing in a level playing field. In the real world such Perfect competition is impossible but a close resemblance can be observed in the Oil markets. This is the clash with this theory. Some producers have got together and have made an Oil Cartel called OPEC and they together have become much larger that others. This breaks the equilibrium and causes monopolistic trends that spoil the Perfect conditions. The other suppliers who are independent of this cartel, like North Sea Oil of UK also do not oppose this cartel’s ruling as this is in their favour and they too make a hefty profit under Pareto efficiency factor. . Fudenberg, D. and Tirole, J. (1983). Game Theory. MIT Press, Chapter 1, Section 2.4.)7 (Word count 372) 5 Impact of Human Right laws in different environments. Human Right Laws are those enactments that protect and or promote human rights. They are universally accepted but are enforced by local governments and differ in execution as perceptions differ with different environments. Amongst the many faces of such laws is one called “unjust enrichment”. This is a legal expression under English Law that denotes a particular type of causative event that enriches one party as against the other. In plain language an event or “cause” is (artificially) made up and it contributes to making one party, or set of parties, to have undue or unjust advantage or effect over other parties. Cause and effect have a logical relation ship (Lewis, David) 8 and in their nature and content there are four types of causes. Material cause – the raw material, in this case oil, is the cause that is the first constituent. Formal cause – this covers that part of the cause that depends on the need for such material cause. In this case the need for oil as cheap energy source is the formal cause. Efficient cause – This covers the fact that oil has limited supply and will be exhausted after some lapse of time and that it is neither replaceable nor replenishable. Final cause – this covers the fact that the final owners of the oil, the nations that ultimately benefit out of it, will loose this potential earning and therefore are guided by need to get the highest possible price while the commodity will last. This then is the cause of forming the oil cartel called OPEC, but the effect is most alarming on the oil consuming nations and their economies. As consumers they have a right to fair prices determined by demand and supply which is denied to them. Clearly this is a violation of Human Rights, but it is largely ignored due to the peculiar circumstances. (word count 321) Conclusion On thoughtful examination of all issues it is concluded that the economy of UK has indeed fared better by the rise in oil prices. It has benefited the oil industry in particular and the general industry, by and large, have coped up. The stable and growing GDP bears testimony to this fact. However the two concerns of rising inflation, though moderate at this stage, and rising interest rates are areas that will need constant monitoring and corrections. Another redeeming factor is the that the rising oil prices has brought the issue of alternate fuels to the fore and serious attempts are now being made in this direction, This is a sound move and would not have taken place if oil prices were not rising alarmingly. (Total Word count 2101) Reference: 1. National Institute Economic Review, number 194, October 2005 2. The Royal Bank of Scotland Group, Available at: http//www.rbs.com/economics 3. Times Business, 1 June 2004, Available at: http// www.energybulletin.net 4. Sir Richard Branson, The Guardian, May 2005 Available at: http://www.guardian.co.uk/airlines/story/0,1371,1494420,00.html 5. Sir Richard Branson, Abu Dhabi World Leadership summit, November 2005 Available at: http://www.planetark.com/dailynewsstory.cfm/newsid/33519/story.htm 6. The New Palgrave: A Dictionary of Economics (1987) 7. Fudenberg, D. and Tirole, J. (1983). Game Theory. MIT Press, Chapter 1, Section 2.4. 8. Lewis, David. (1973) "Causality." The Journal of Philosophy 70:556-567. Read More