Economic Implications of Declining Oil Prices on OPEC Countries Government Subsidies - Case Study Example

Literature Review, Macro & Micro Economics

Lower oil prices have affected both the OPEC countries and Global economy. The effects of the low oil prices on the economy will be stronger if the low oil price is expected to last longer than if the low price is expected to be just for a short period. The reason behind this is the fact that both the consumers and companies show a vigorous reaction if the lower price is permanent (Beredjick, Thomas and Gault 4). However, the effect of the lower oil prices on OPEC countries does not only depend on whether the economists expect the low price to be persistent or temporary, but also on what makes the oil prices to fall (UN.ESCWA 12). If the price of oil falls due to reduced demand, the effects of this situation will be different compared to when an increase in oil supply causes the price to fall. The reason behind this is the fact that if a price is demand-driven, it shows the symptoms of a worsened growth prospects. The extent of the implication of the low oil prices have on the economy of OPEC countries depends on how these nations adjust their monetary and fiscal policies when responding to the falling and fallen oil prices (UN.ESCWA 12).

The OPEC countries have experienced different incidences of change in oil prices, which is caused by a slump or decline in energy prices. Some of the most recent cases are the 1985-96 period, 1998, and 2008-2009 periods. The 1985-1996 oil crises were caused by the slump in the oil prices, which was linked with the changing supply conditions that were recorded as OPEC countries reverted to reaching its target of production, which was 30mb/d (UN.ESCWA 12). The supply conditions were changed despite the unconventional oil that was supplied by both Mexico and the North Sea. The price slump made the American Federal Reserve to embark on several interest rates that aimed at reducing the fund by slowing down activity and declining the inflation (World Bank Group 161). Despite the supportive conditions given by America, the global activity failed to improve. This lack of improvement was caused by significant debt problems and weak growth in some countries in the OPEC region. The effect of this oil crisis was a significant downward on the stock markets across the world (World Bank Group 161).

The 1998 oil crisis was caused by the weakening demand for oil. The oil demand went down due to the Asian crisis in 1997. According to World Bank Group, the expansion of oil production by OPEC may have contributed to the sharp decline in the prices. Despite the sharp decline, the recovery of the global economy remains intact in large periods of 1998, which was caused by the financial market stress in major emerging markets and America ((Beredjick, Thomas and Gault 4). The low oil prices only affected the OPEC economy only in the years 1999 and 2000, mostly as the growth of America and the OPEC countries rebounded.

The third significant and historical oil crisis was in 2008-2009, where the Great Recession during this period made all commodity prices to tumble. Government interventions, wide-range central banking, and resilient growth in the OPEC countries stabilized the global activity. Sadly, the recovery remained slow due to constrictions by large asset price losses, restructuring of the financial sector, and deleveraging of pressures in countries with high incomes (Basar and Pau 333). Over the 2010 period, the combined effect of declining interest rates and rapid rebound of product prices created favorable conditions for the OPEC countries to have sufficient capital flows.

Studies show that the recent low oil prices have been caused by an oversupply of oil. According to some economists, this fall will have implications on the development of OPEC countries’ economies (Basar and Pau 333). However, the said implications will be different from different countries, depending on the ability of the government to react to the situation (Basar and Pau 333). The above low oil prices will not only have an effect on the OPEC countries’ economy but also on the GDP. According to history correlations, when the oil prices fall as summer begins, the level of GDP in the world increases by 1 per cent.

Oil prices in OPEC countries impact inflation and growth through several channels such as effects on activity for the exporters and effects on the prices. Other channels are fiscal and monetary policy responses, indirect effects through commodity and trade markets, and investment uncertainty (Gately and Shane 49). The above channels make the oil prices have immediate on external and fiscal balances, even when the discretionary policy responses are absent. As a result, the real income in the countries exporting oil records a shift that have a high saving rates. If the propensity of these countries is higher, the effects of the oil prices should have a strong demand on the global level. It should, however, be noted that the economic effects of these countries can differ over time (Gately and Shane 49). For instance, which some countries exporting the oils may be forced by the low oil prices to adjust the government spending in the short term, the economic benefits for the exporting economies could be offset and diffuse by higher precautionary savings. However, it should be noted that this can only happen if these countries have a subdued confidence about the growth prospects (Gately and Shane 49).

The low oil prices can have a huge effect on the commodity markets of OPEC countries. For instance, it can generate additional trade terms for exporters of different commodities. The oil-exporting countries that record falling oil prices may be forced to cut their expectations of medium-term inflation and plan on reducing external financing pressures. As such, the central banks can respond to these problems with more monetary policy loosening that can support the economic development of these countries. According to the International Monetary Fund, Research Department (66), lower oil prices in countries exporting oils might result in sharp currency adjustments, contractionary fiscal policy measures, and the re-pricing of sovereign and credit risk. The only way that this can be avoided is through the availability of buffers that can be used to protect expenditures from declining the revenues from the fuel department.

When the oil prices change abruptly, especially by increasing uncertainty, it can result in the reduction of consumption of durable goods and investment opportunities. The investment opportunities reduce because the oil prices determine the return of an investor from a physical investment that cannot be reversed. As a result, the increased uncertainty about the fuel prices results in organizations reducing capital expenditures and delaying investments. The sharp movements in the prices of oil create uncertainty that hinders the consumption of goods. Additionally, the oil prices rise without having a certainty of the future, which leads to a precautionary oil demand, which hinders economic activities (International Monetary Fund, Research Department 66). The falling or reducing oil prices cut the overall costs of energy as the prices of products that compete against oil are forced down.

Sectors that need high intensive energy in the OPEC countries are thus capable of making high profits, which creates more friendly conditions for employment and investment. Additionally, since oil feeds various sectors with energy, including paper, aluminum, and petrochemicals, the fall in oil prices directly affects many semi-processed or processed inputs (International Monetary Fund, Research Department 66). Some industries such as the agricultural sectors, petrochemicals, and transportation benefit from the lower oil prices. For the consumers, declining inflation and lower oil costs increase the support consumption and real disposable income.

The reducing oil prices also have several indirect effects on OPEC countries. In most of these countries, the finances of the ruling government rely on the taxes from the oil sector. The fiscal revenues of these countries are mostly from the oil-based revenues account. The corporate sector weakness amplifies the fiscal strains in countries exporting oil. According to Smith (2009), most of the largest oil firms in these countries are state-owned. The companies that are public traded have raised the debt-to-asset ratios. An important thing to note is that such countries are at a risk of having a sharp fiscal consolidation that can be caused by significant loss revenue. However, this can be avoided if the governments have enough buffers to safeguard their spending (International Monetary Fund, Research Department 66). Additionally, if the oil prices reduce, they negatively affect the current account of the government and precipitate the depreciations of the currency.

The declining oil prices have made the oil exporters experience fiscal balances. The movements in oil prices impact energy and oil-related revenues, which at times affect the government budgets of the OPEC countries. The oil exporters in OPEC countries collect enough revenue from the oil sector that accounts for 50 percent of the government’s income. The break-even of the fiscal process that ranges between $184 per barrel for Libya and $54 for Kuwait exceeds the current energy prices for most countries (World Bank Group 30). If the government loses oil revenues due to the decreasing periods, it can have many financial strains that require it to cut the spending, unless it has fiscal buffers for use. Some OPEC countries such as Kuwait can mitigate the fiscal pressures through the use of reserve assets or sovereign wealth fund. This is a contrast to fragile oil exporters like Yemen that lack significant buffers (World Bank Group 30). As a result, a decline in oil prices may need external and substantial fiscal adjustment, which includes import compression or depreciation.

The falling of the oil prices usually affects the inflation and activity by shifting the supply and aggregate demand and triggering policy responses. According to Shojai (44), the low oil prices on the supply side results in low production costs. When industries are able to produce commodities at lower costs, it is likely to pass the commodities consumers at good prices, which reduces inflation indirectly (Shojai 44). The lower production costs also result in a higher investment. When the oil prices decline due to demand, it reduces the energy bills, which in return raises the real income of the consumer, and at the same time leading to increased production. The fall of oil price eases the inflation, especially the inflation expectations and core inflation. The central banks can help to rectify such a situation by responding with monetary loosening that helps in boosting activity.