Impact of the World Recession on the Oil Market 2008-2010 - Essay Example

Running Head: Impact of Global Recession Impact of Global Recession [Institute’s Impact of Global Recession Introduction The Global Financial Crisis initially started in the United States of America in 2008 and gradually spread all across the world. Initially, there was a failure of financial markets, which led to the recession. Such a recession was experienced for the first time after the Second World War. Various institutions in the financial market had started to fail, which had spiraled a series of event, which led to this whole crisis. On September 2008, Lehman Brothers, one of the largest investment bank in the US failed. This eventually led to lose of confidence and a domino effect was seen when other banks started to fail. After a call of Emergency, AIG insurance was bailed out (2008 Global Financial Crisis and Global Recession, 2011). There had been various factors involved, which had led to the crash. The housing market failure had been one of the reasons. However, there were certain external shocks as well, which contributed to the series of financial failures. The oil shock was one major other factor. It had been an observation that prices had started to rise in 2007, compared to the price level after 9/11. A large amount of this price increase was due to the increase in the price of oil. This large amount of price increase triggered people to default on their borrowings, which had started the housing crash. A figure below shows the sharp increase in oil price from 2007 to 2008. (Mongabay, 2010) The price had been averaging at some 60$ per barrel, while in 2008, they had increased to around $132.8. Therefore, this shows that oil shocks ‘might’ have been one of the reasons for the starting of the Global Financial Crisis. However, one would also notice that after the crisis had started, the prices of oil had suddenly dropped by a gigantic amount in 2009. Prices started to pick up in late 2009, but it was a slow increase. This in effect illustrates that the global recession caused changes in the oil market as well. Therefore, the paper shall attempt to discuss the impact of this crisis and recession on the world oil market (Rainforest-mongabay.com, n.d). Discussion “Oil has always been one of the most heavily traded commodities in the world” (Bouchentouf, 2007). It has large importance for the world economy. The demand of oil is such that it is inelastic, that means even if the price rises, people would continue to buy it. Oil is indispensable and is a raw material for various other products. However, oil has an inelastic supply as well, that means since it is a non-renewable resource, it will eventually run out. This all highlights the significance of this fossil fuel. The world market of oil is such that it is highly controlled by OPEC. In fact, OPEC has been thought to behave like a cartel. It especially behaved like a cartel during the 1970s when an embargo was placed on the Western economies, which plunged their economies into deep recessions (Bouchentouf, 2007). In addition, much of the oil supply is located in highly unstable markets, therefore the market of oil is highly volatile (Behr, 2009). The United States is the third largest producer of oil after Russia and Saudi Arabia (Bouchentouf, 2007). However, it consumes the production of oil drastically to support its huge industrial based economy. The United States also imports much of the oil in the world and Japan and Germany are one of the largest importers of oil. The United States and China are currently the largest consumers of oil (Bouchentouf, 2007). Literature Review The sudden decrease in the price of oil as shown in the figure above was because as the recession hit countries all around the world, demand gradually decreased. Because of the drastic decrease in demand, the OPEC to curb the decreasing prices cut down outputs. World oil demand continuously fell across the period from 2008 to 2009. In 2008, world demand had fallen by 0.2 percent, and in 2009, it had fallen by 0.4 percent. The Economist Intelligence Unit (EIU) had predicted at the beginning of the crash, that the ensuing years would see a decrease in the demand. This contraction in demand was because of fall in consumption as the recession hit incomes’ all around the world. Unemployment had also occurred due to the recession, which had resulted in further decrease in consumption. A loss of confidence in the economy had also discouraged investment; therefore, demand for crude oil as a raw material had gradually decreased. In addition, businesses had shut down because of unavailability of short and long-term credit. Therefore, there was a large contraction in the Aggregate Demand function, leading to a decrease in the demand of oil, in the global oil market (ESCWA, 2009). There was a large reduction in trade and industrial activity. This contributed towards a decrease in transportation activities. This had a huge impact on energy demand. Gasoline, diesel, and petrol amount to almost 60 percent of the oil demand. All of these factors contributed to the massive shift in the demand of oil to the left. The reduction in demand has been most prominent in countries of “the Organization for Economic Cooperation and Development (OECD)” (UN, 2010). The greatest impact resulted from a decrease in the demand from Japan, followed by United States and Europe (UN, 2010). However, the demand in non-OECD countries, namely developing countries have gradually been increasing. This demand is constituted of mostly in India and China and Arab oil exporting countries (Economics Online, 2011). The demand for oil with respect to incomes has always been inelastic. This has been true in the case of OECD advanced economies like Europe and United States. However, with the recession, as incomes of the people decreased, the income elasticity of demand was also under negative effect (Economics Online, 2011). However, in emerging economies such as China and India, the income elasticity of demand has also started increasing. Estimates are suggesting that the YED is now close to one. The pattern was somewhat consistent even after the recession (Economics Online, 2011). However, the demand was so weak that “it drove the prices of oil, which had peaked, at $147 per barrel in July 2008 to $30 barrel in December 2008 recession” (Economics Online, 2011). The sharp decrease in the global demand of oil meant that the producers were left with excess supply of oil. This is shown in the diagram below: (ZIS Economists, 2010). As the graph above shows, the area from QC to QC1 shows excess supply, because of a reduction in the demand. The response of the OPEC was to decrease its oil production to take away the element of excess supply. “Since September 2008, there has been an agreed reduction of almost 4.2 million barrels per day” (UN, 2010). Therefore, the supply curve shifts to the left. However, among the non-OECD countries, China has been building up stocks of crude oil. China is one of the emerging economies; therefore, its oil consumption did not decrease by a massive amount. The prices of oil in the market after the Crisis are also further commenting on. Oil prices have been under negative effect because of two main factors. Many investors liquidated their positions in the commodity markets in order to cover losses and the oil demand had reduced by a large amount, leading to a decrease in price of oil (ESCWA, 2009). “The prices fluctuated from $33.79 to $60 between the periods of 2008-2010” (ESCWA, 2009). However, the governments moved in with different incentives and packages, provided stimulus to the economy, which led to the rise of optimism in the economy (UN, 2010). Oil prices, therefore are the ‘barometer of the world economy’. A ‘recession’ shock created a massive amount of change in the oil market as observed from the demand and supply analysis above. The global financial crisis had a cyclical effect, in the sense that lower demand for oil triggered an even lesser demand for this energy source. This had been the first time that oil demand had fallen by such a large extent after the 1980s. Therefore, the demand and supply of the oil market has been adversely under effect due to the global financial crisis. However, it is important to identify the impact of oil prices on the economy. This is where a macroeconomic analysis plays an important role. Different variables such as economic growth and employment variables also have to be considered. Oil price changes can have significant impacts on the real GDP of a country. This is doable in two ways. One of the ways is through the direct consumption route. The other way is the indirect inflation route. The inflation one regards an increase in the price of the oil, and therefore it is not important to talk about this route since oil prices decreased after the recession hit the economy. The decrease in the price of oil was inevitably a decrease in consumption spending. The major component of aggregate demand is consumer expenditure. As people’s personal incomes fell, the consumption of oil greatly decreased, leading to a shift in the demand curve, pushing the prices down. Consumption of oil had decreased significantly in developed parts of the world. The decrease in national income can be shown in the following diagram. (Macroeconomics Lecture Notes, n.d). As the above diagram shows, the GDP of countries fall when there is a decrease in consumption, if other things remain. The oil market is also very prone to various problems when it comes to new investment. There is obviously considerable uncertainty when it comes to future oil prices and demand, combined with the fact that oil market has this tendency to be jittery. On a whole, it is also difficult to identify consumption and production patterns especially that of the non-OECD countries. There are problems of fixed capital, running costs and uncertainty in the oil market. Therefore, oil investors tend to be more careful before investing. Therefore, oil investment is done in a way that it follows price increases. However, when the prices had suddenly increased before the recession, then people would have invested more in the oil market. A sharp decrease in oil prices would have led to losses for these investors and discourage further investment. Hence, on a whole, investment decreases affecting the economic growth of a country adversely (Behr, 2009). The oil price volatility has important implications for the global economy, especially the exporters of this product. In addition, lower prices would mean lower export revenue. This will affect the countries’ expenditure plans including development projects and welfare services. This would also result in the reduction of imports to offset the negative balance of trade that would arise because of the adverse terms of trade. Therefore, the international trade suffers greatly due to recessions as well (Olowe, 2009). Nigeria is one of the oil exporting countries and its external sector has largely been under influence. There was a large reduction in the value of “Nigeria’s exports from US$28.2 bn from US$76.3 bn in 2008” (Balouga, 2009). In addition, the Gulf Cooperation Council (GCC) was hit the hardest because it is the main exporter of oil (Reinikka, 2009). Secondary effects of the crisis of trade, remittances, and foreign direct countries hit most of “the Middle East and North African (MENA) countries” (Reinikka, 2009) who imported oil. Growth in these countries sharply declined. In addition, in MENA countries, unemployment always had been an issue. With the recession, industries where oil had been one of the basic raw materials, shut down, unemployment decreased to large levels (Reinikka, 2009). With regard to some specific countries, Venezuela that is one of the largest oil exporters. Oil constitutes almost 92.5% of the country’s exports. Therefore, when oil prices decreased, Venezuela was severely affected (Morss, 2010). Although, eventually oil prices picked up in 2009, the export value of Venezuela did fall by around 46%. The GDP of the country also had a negative impact. In addition, the budget remained in a deficit as well. In addition, such conditions were not viable for foreign investment either and thus it declined. The economy therefore showed a great decrease during and after the recession and its impact on oil market. Ecuador is another Latin American country heavily dependent on oil as its primary export. It therefore faced the same consequences as Venezuela faced. Ecuador, however started to recover after oil prices started to rise (Morss, 2010). Methodology An analysis conducted by Rufus Ayodeji Olowe of Cambridge University in 2009 proved that the oil price always have had high volatility. It also analyzed from the date that Nigeria’s spot price of oil was the most volatile. This can explain why Nigeria lost out so much due to the financial crisis. The study therefore did prove that uncertainty in demand for oil was caused by the volatility in oil price changes. Therefore, it had disastrous consequences for the economy. However, another study also proves that the market fundamentals of demand and supply alone did not control the price of the oil. Since before the financial crisis hit the global economy, there had been a decrease in the decline of the dollar, which triggered a ‘flight to commodities’. There was a large investment in the future oil market. Financial investors had driven up the demand for oil artificially. Expectations about future oil prices increased. Prices were therefore, pushed up higher due to expectations. However, when the recession hit the global economy, the entire process was reversed. There was an investment ‘out’ of the future oil market, which caused an ‘exaggerated price slide’ (Behr, 2009). Conclusion In the past financial crises of the world, oil prices have always played an important role. They played a high role in the financial crisis as well. However, one should generally avoid exaggerated price changes, because it has many negative socio-economic impacts, such as unemployment, negative balance of trade. The oil market is such that there is a great deal of misinformation that clouds the judgments of the investors. Therefore, Behr (2009) expresses his concern that more information should be made available for the oil market, making investment safer. The paper has therefore analyzed the starting of the global financial crisis. It also has looked into the argument whether oil shock was the result of the recession. Afterwards, it has explained how the ‘recession’ shock affected the oil market in terms of demand and supply, causing prices to drop suddenly by the end of 2008 (Behr, 2009); three months after the crash had started. It has also discussed some consequences on the macro economy of the world. Investment and consumption had played a major role in decreasing the economic growth of the country. The concern of many economists and policy makers remain whether an oil spike is expected in the future with economy on recovery mode. Reports by different researchers have concluded that the oil market has always been volatile. Therefore, the constant changes are inevitable. However, such extreme price changes can be moderated from peak to a sudden decrease as seen in the years 2008 and 2009. Investment needs to increase to match the increase in the demand of the emerging economies and the countries, which are on the verge of recovery. References "The Aggregate Expenditure Model Lesson 18." Macroeconomics Lecture Notes. N.p., n.d. Retrieved on May 26, 2011: www.oocities.org/szulczyk/lessons/economics_lesson_18.html 2008 Financial Crisis & Global Recession. (2011). 2008 Financial Crisis & Global Recession. 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Retrieved on May 19, 2011: http://press.ihs.com/press-release/energy-power/%E2%80%9Crecession-shock%E2%80%9D-hits-oil-market-are-future-shocks-and-oil-market-volati Mongabay. (2010). Crude oil price chart, 2000-2010. Retrieved on May 19, 2011: www.mongabay.com/images/commodities/charts/crude_oil.html Morss, E. (2010). "Ecuador: Effects of Global Recession and Future Prospects | Morss Global Finance." Morss Global Finance. Retrieved on May 26, 2011: www.morssglobalfinance.com/ecuador-effects-of-global-recession-and-future-prospects Morss, E. (2011). "Venezuela: Effects of Global Recession and Future Prospects | Morss Global Finance." Morss Global Finance. Retrieved on May 26, 2011: www.morssglobalfinance.com/venezuela-effects-of-global-recession-and-future-prospects Olowe, R. A. (2009). “Methodology, Conclusion.” Oil Price Volatility and the Global Financial Crisis. Lagos: Cambridge. Reinikka, R. (2009). “The Day after Tomorrow.” The Financial Crisis, Recovery, and Long Term Growth in MENA. Springer. UN. (2010). “International Trade.” World Economic Situation and Prospects 2010. UN Press. ZIS Economists. (2010). Welkerwikinomics. Retrieved on May 27, 2011: www.welkerswikinomics.com/students/?paged=3 Read More