Impact Of Falling Oil Prices: Cost Structure, Supply And Demand Relationships, And Outcomes

Reasons behind the Falling Oil Prices

• Identify the nature of resource cost structure and the practical significance of different costs;

• Explain the factors influencing optimum size and the significance of demand and supply relationships;

• Demonstrate an understanding of the relevance and limitations of arning outcomes to be examined in this assessment.

Today’s world economy is facing a critical problem of falling oil prices that significantly increases the aggregate supply of oil importing nations. The price of oil had been stable from 2010, but it has decreased enormously since June 2014 due to the weaker demand for the oil in the market. This demand shock automatically declines the price of oil in the market. Besides the factor of weaker demand for oil, there are many factors responsible for the drop in the oil price in the market. The rise of the US economy as a producer of shale oil has affected the total demand for oil in the market.

The Organization of the Petroleum Countries, an intergovernmental organization, aimed to secure oil prices in the world market since 1960. They have substantial oil resources, so they produce oil at a low cost of production which is a main raw material of any large scale industry. They export oil to those countries that have an insufficient amount of natural resources. With the help of imported oil, these oil importing nations (like UK) can build industries where oil is used as a main raw material. So the cost of production of industries in UK depends on the price of oil, transportation cost, etc. The cost structure of UK totally depends on the price of oil in the world market (Asian Development Bank, 2015).

Now the price of oil has decreased by more than 35% since June and now the price of the oil is $70 per barrel which was $115 per barrel during mid-2014. The price of crude oil is set up in the market depending on the positions of demand and supply of the oil. It is found that UK inflation has fallen to 1.2% due to this falling oil price (Breunig and Chia, 2014).

The main reason for the shortfall in the oil price is the growing demand for the alternative fuel sources. Investment in the renewable energy is increasing rapidly than the fossil fuel sources as these energy resources are more eco-friendly and less expensive. So the demand for the petroleum oil decreases. Another important reason behind the falling prices is the rise of the US economy as the major oil producer though they are not the exporter of oil, but they reduce the demand for the oil drastically. So it is argued by some economists that Saudi Arabia, world’s greatest oil producer, ride out decreased prices to avoid losing consumers to their competitor. It is a strategy to maintain the market share in the world. Saudi Arabia, the largest oil supplier, is expected to absorb the negative impacts of the declined oil price as it has a huge amount of resources. It has accumulated more than US $ 650 billion as foreign reserves, so its production cost is low (iMFdirect – The IMF Blog, 2014).

The Impact on the AS Curve of Importing Countries

The production cost of shale oil is comparatively expensive, so if the price of oil is low, then it will affect the profit of the US oil producers. Some of the OPEC countries like Venezuela do not support this strategy followed by Saudi Arabia, and they cut down their production of oil in the market (Li et al. 2014).

Some of the Asian countries are facing economic downturn due to the recession, so their lower demand has a negative effect on the production of the oil. Demand for oil is also affected by the impact of strong US dollar as oil is exported and imported in US dollars across the world. It makes the oil more expensive for the other countries. This pulls the demand down and a price of oil decreases (Stlouisfed.org, 2015).

The supply of the substitutes of the oil increases because of the rising importance of the renewable resources. This affects the price of the oil in the market as oil is produced from non-renewable resources.

Falling energy price has effects on the productivity of both labour and capital of an economy. So the factor productivity increases for this reason that has posivitive effects on an economy. The total production increases with increase in income. As a result, aggregate supply of that economy increases as a result people of that country now have more products to consume (Husain et al. 2015).

Again oil importing countries import more oil at a lower price and so the cost of production of some industries where oil is used as a major input, falls. So these industries are now ready to supply more output in the market. As a result, he aggregates supply of oil importing country increases with the fall in the production cost (Allen, 2015).

As total supply in the market increases there is an excess supply in that economy at the existing price level p₁. So to meet the excess supply price level has to be decreased in the market (Creti, Ftiti and Guesmi, 2014). As a result inflation also decreases in that economy.

In the above figure AD1 is the aggregate demand of an oil-importing economy (UK) and AS1 is the aggregate supply of an economy that increases to AS2 after falling in oil price. So the price level decreases to p2 from p1 and real output increases from q1 to q2.

This causes lower inflation and higher cost of living in the economy. So oil importers gets benefits from this falling price as the value of imports declined and this eventually decreases the current account deficits of these nations. UK is now a small importer of petroleum oil so this has low effects on the current account of UK. GDP of UK economy is growing ate a rate of 2.9% that is more than expected on last November.In oil importing countries, falling oil price can reduce the expected inflation rate below the targeted level.Before 1980, it is found that there is a positive correlation between inflation and price fluctuations but this impact of oil price fluctuation on inflation has declined over the years (Ozdemir and Akgul, 2015).

Impact on Other Macroeconomic Factors of the Oil-Importing Countries

 Oil importing countries get benefits from this shock in the market as now it is profitable to import more at a lower price. This has the significant impact on the reduction of business costs and transport costs (Worldbank.org, 2015).

Reduction in oil price has macroeconomic impacts on the oil price importing nations as it reduces the cost of living of UK. So transport cost of oil and directly has fallen and leads to lower inflation rate in the economy. It affects the demand and supply of oil in the market, and lower price of oil reduces the cost of production of energy-intensive goods that are produced with the help of oil. This lower cost of production also leads to higher investment in the production (Geise and Piłatowska, 2015).

So with stagnant monetary wages, the fall in oil price has the positive impact on the real wage (it is the monetary wage divided by price). So consumers of UK have more income to spend on other goods, and it is like a tax cut to them. So economists can say that a fall in the oil price effectively increase the spending and so as the real gross domestic product of the economy.

The long-term picture is totally different from this present scenario of UK as well as oil importing countries. Inflation at a certain rate is healthy for an economy but if it decreases at a large pace, then productivity performance of an economy will decrease (Deflation, 2014).

 This deflation has serious effects on the future of the economy.This will raise the domestic risk of UK’s economy. So low oil price may have positive effects in the short run, but it can not radically change the UK economy (Cashin et al. 2014).

Conclusion:

OPEC countries have the aim to stable the oil prices in the market since 1960. Since mid-2014, it is found that price of oil reduces more than 35% that increases the aggregate demand of oil importing countries. This situation brings more income, lower inflation and higher growth to some oil exporting countries. The main reasons behind the shortfall in the price are the rise of US economy as a producer of oil and the weaker demand for oil in the world market. So falling price has the a positive impact on the UK ( oil importing country)economy in the short run. Current account deficits of UK economy decreases and consumers enjoys increasing in real income, but this picture is different after some years. In the long run, there will be an increase in the domestic risk in the UK economy. So it can be concluded that falling oil price has both positive and negative effects on an economy.

References

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Asian Development Bank, (2015). Falling Oil Prices in Asia and the Pacific: Potential Gains for Importers, Opportunities for Exporters. [online] Available at: https://www.adb.org/news/features/falling-oil-prices-asia-and-pacific-potential-gains-importers-opportunities-exporters [Accessed 27 Jul. 2015].

Breunig, R. and Chia, T. (2014). Sovereign Ratings and Oil-Exporting Countries: The Effect of High Oil Prices on Ratings. International Review of Finance, 15(1), pp.113-138.

Cashin, P., Mohaddes, K., Raissi, M., and Raissi, M. (2014). The differential effects of oil demand and supply shocks on the global economy. Energy Economics, 44, 113-134.

Creti, A., Ftiti, Z., and Guesmi, K. (2014). Oil price and financial markets in the main OPEC countries. Energy Studies Review, 20(3).

Deflation, T. (2014). The Economic Consequences of Global Oil Deflation. [online] www.counterpunch.org. Available at: https://www.counterpunch.org/2014/12/08/the-economic-consequences-of-global-oil-deflation/ [Accessed 27 Jul. 2015].

Geise, A. and Piłatowska, M. (2015). Oil Prices, Production and Inflation in the Selected EU Countries: Threshold Cointegration Approach. DEM, 14, p.71.

Husain, M. A. M., Arezki, M. R., Breuer, M. P., Haksar, M. V., Helbling, M. T., Medas, P. A., & Sommer, M. (2015). Global Implications of Lower Oil Prices(No. 15). International Monetary Fund.

iMFdirect – The IMF Blog, (2014). Seven Questions About The Recent Oil Price Slump. [online] Available at: https://blog-imfdirect.imf.org/2014/12/22/seven-questions-about-the-recent-oil-price-slump/ [Accessed 27 Jul. 2015].

Li, J., Tang, L., Sun, X., and Wu, D. (2014). Oil-importing optimal decision considering country risk with extreme events: A multi-objective programming approach. Computers & Operations Research, 42, 108-115.

Ozdemir, S. and Akgul, I. (2015). Inflationary effects of oil prices and domestic gasoline prices: Markov-switching-VAR analysis. Petroleum Science, 12(2), pp.355-365.

Stlouisfed.org, (2015). How Much Do Oil Prices Affect Inflation?. [online] Available at: https://www.stlouisfed.org/on-the-economy/2015/may/how-much-do-oil-prices-affect-inflation [Accessed 27 Jul. 2015].

Worldbank.org, (2015). Most Developing Countries Will Benefit from Oil Price Slump, Says World Bank Group. [online] Available at: https://www.worldbank.org/en/news/press-release/2015/01/07/most-developing-countries-benefit-oil-price-slump-world-bank-group [Accessed 27 Jul. 2015].