Question from my student: Could you
write something about oil prices?
Oil prices have plunged
over the last couple of months and economists predict that they could even go
much lower than this. What are the possible reasons for this? What are the
microeconomic and macroeconomic effects, both good and bad? Is there a lesson
to be learnt from here?
First, let us look at
the most fundamental reasons for dwindling oil prices- market demand and market
supply. If the overall demand is greater than the supply, then there will be a
shortage which is responsible for driving the price up. By contrast, if the
overall supply is greater than demand, then there will be a production glut and
prices will be adjusted downward. The latter explains what is actually
happening behind the global oil market. Demand side is softening but the world
supply remains stubbornly high. There is more than enough for everyone
In better details:
a. Bleak economic outlook
in the Europe and China. The euro-zone economies as a whole is not performing.
There is no sign that the economic malaise will subdue soon. In fact, the
latest statistics by Eurostat are putting more pressures onto policymakers.
Germany which is traditionally known as the euro-zone growth driver recorded
the biggest ever fall in retail sales of 3.2%, a sign that the worse events are
yet to come in 2015. The same can be said about the Chinese economy. Slowdown
can be seen in both the manufacturing sector as well as consumption. Faltering
growth is the prime reason why demand for oil falls. Fewer people buy car,
those who did may opt to travel less, uncertainty means less likely to travel
abroad for holidays and most importantly fewer plastic/ rubber goods were made
which in fact covers almost everything-your gadget, car tyres, basic furniture,
all the toys you see in Toys ‘R’ Us, consumer goods and others
b. Oversupply. Perhaps,
countries like South Sudan, Nigeria, Angola, Libya and Iraq are slow to react
to market responses. According to the law of supply, the higher is the price,
the greater will be the incentive to produce more output. The same goes here.
Earlier on, when prices were at record high level, these countries must have
made too much investment thus resulting in oversupply concurrently when the
demand is not even there
c. Sanction against
Russia. There is also a possibility that the largest oil producer, Saudi Arabia
is working closely together with the Washington to put more pressure onto the
sanctioned Russia. It is an established fact that Russian economy is highly
oil-dependent. About 70% of its revenue is fully derived from oil production.
With every $1 fall in world oil price, it loses $2.1 billion and with the
current trend, it may lose as much as $30 to $40 billion. If this continues,
there is a possibility that its economy will go into recession-unless it has a
deep pocket. This justifies why in the recent OPEC oil cartel meeting, Saudi
Arabia being the most influential producer refused to cut its supply further to
push up prices when it can easily do so in its position
d. Pressuring USA. Once
the usage of shale gas is to be more commercialised, the demand for oil from
the OPEC will continue to dwindle. Saudi Arabia and other influential members
are not going to benefit from this, not into the long term. This is why they
brilliantly allow the market supply to remain high so that its price continue
to stay low. The intention is to rival the production and sale of shale gas.
They are well aware that shale gas is very expensive to extract. By putting
pressure on both prices, the margin for shale extractors will remain low and
hopefully there won’t be much incentive to continue investing
e. Emergence of
substitute. In the study of economics, we always say that one of the
determinants of PED is time period. In the short run, PED may be inelastic but
in the long run, the development of substitutes may cause PED to appear
elastic. True enough in this case. Shale gas is a potential substitute. Thanks
to innovative drilling, the USA has successfully discover unlocked oil and
natural gas trapped in shale rock. Interestingly, for the first time in 30
years, the States has stopped importing oil from Nigeria. If the recent
development continues, there is a possibility that the demand for oil from OPEC
will also continue to fall
f. Strong dollar. It is
also worth noting that oil is traded in dollar around the globe. When the
dollar appreciates, it makes oil artificially more expensive to countries
outside the US. Basically, this lowers the demand from those nations that are
affected. Perhaps, this is also the reason why cheaper oil prices are not
reflected at the petrol pump stations in Malaysia (my country). While global
prices have dwindled from about $110 to $62 per barrel, our MYR (Malaysian
Ringgit) continues to slide further against the greenback. Therefore, we are
unable to enjoy the full benefits of falling oil prices
Possible positive
economic effects
a. Lower cost-push
inflation. Oil is used in almost everything. In fact, it is the ‘mother’ of all
commodities. You can name it- every single thing that you have ever touched is
related to oil like tyres, erasers, toys for kids, plastic kettle, car, basic
furniture, clothes hanger and many more consumer items. Besides, it also
affects the operating costs of airline and shipping firms. Theoretically, when
the costs of production fall, prices fall too. This may be passed on in the
form of lower price and hence lesser cost-push inflation
b. Possible improvement in
the standard of living. Global economic slowdown is far from over. With
stagnating wages growth rate, a fall in inflation is something to cheer about
as this translates into higher real wages. It may not be very large, but, every
dollar saved is a dollar earned. There is lesser opportunity cost for everyone.
More money can be allocated elsewhere say, food, healthcare, child’s education,
holiday, Christmas gifts and others
c. Jobs creation. Falling
oil prices may boost the competitiveness of manufacturing industry especially
for some uncompetitive euro zone economies as well as the UK. Lower costs
should be reflected in the final price of output. An improvement in price
competitiveness should be able to increase exports. Factory orders will
gradually improve and more jobs should be created over the time. The same can
be said domestically. As people are more able to spend, jobs should be created
everywhere, from factories to banks
d. Higher potential
growth. Theoretically, falling oil prices shall reduce the operational costs of
a firm and hence more funds are available for investment. They may consider
this as the right time to invest e.g. replacing old machines with newer and
better ones, build new factories and others. Investment is one of the
components of AD and hence AD may shift rightward. In the long run, it also
improves the supply-side of an economy by raising its potential capacity. A
boost of (X-M) as mentioned earlier can also contribute to the rightward shift
of AD and hence an increase in the real GDP
e. Reducing the current
account deficit. Inflation back at home may be lower than elsewhere and after
making price comparisons, people decide to shop domestically. This may
contribute to lower overall imports. At the same time, price competitiveness
may help to boost exports and considering both simultaneously, inflows of money
may be greater than outflows. This should be able to reduce the size of current
account deficit
Possible negative
economic effects
a. Prices are sticky
upwards. Most of us don’t actually realise one thing. When oil prices increase,
the retailers almost instantly increase the prices of all their goods and
services. However, the same cannot be said when oil prices fall. In fact, prices
remain stubbornly high. Business owners are reluctant to do so on many excuses
such as suppliers are not willing to reduce their price, having need to
‘wait-and-see’ and others. Cost-push inflation may not necessarily eased in
this case
b. Jobs cut. While jobs are created somewhere, the oil and gas industry is most likely to shed workers. Oil producing and oil dependent nations are the worst affected. A plunge in oil prices makes investment relatively uninteresting and there is no point to keep so many workers as before. Someone just have to leave their job. Unemployment in the economy will probably increase
c. Economic crisis.
Venezuela, Iran, Nigeria and Russia will be in huge economic mess in near
future if oil price is not restored to at least $100 per barrel. As mentioned
earlier, bulk of the state revenue comes from oil extraction and with a
continuous free fall, budget/ fiscal deficit will worsen and this may lead to
more problems e.g. rising unemployment from the public sector, negative
multiplier effect and hence an economic recession, more expensive to borrow/
issue bonds and others
d. Deflationary threat.
Countries in the euro zone are already struggling with falling AD and most of
them are experiencing price disinflation- a case where prices are increasing
but at a much slower rate. If this is not curb, then it may turn into a full
blown deflation, which is the worse evil between the two. As people expect
prices to fall, they will cut spending/ consumption into the economy with the
hope that they can purchase it at a lower price in the future. However, if
everyone thinks a like, then AD will fall further (Consumption is one of the
components of AD) thus triggering another round of price deflation. Again,
consumption will fall and the vicious cycle repeats itself. It is the least
that ECB would expect because there is already not much room to cut interest
rate to boost spending and investment
e. More emissions. When
oil prices are really cheap, people tend to care less about travelling and
conserving. In fact, driving will increase, people will buy large gas-guzzler
vehicles, incentives to use or conduct research on renewable energy will slow
down and many more
