Microeconomic and Macroeconomic Effects of Falling World Oil Prices

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