Analysis Of Historical Trends Through The Energy Coefficient Approach

Describe about the Analysis of Historical Trends Through The Energy Coefficient Approach?

A critical problem of falling oil prices is faced by today's world economy that significantly increases the aggregate supply of oil importing countries. The price of oil decreased enormously since June 2014 because of weaker demand for the crude oil in the market. The price of oil is set up by the interaction of both supply and demand curve of oil in the market.

 In recent periods, the oil price has decreased 50% that have a huge impact on business costs and transport cost reduction. So it is a good news for oil importing nations. The demand shock in the market automatically reduced oil price in global market. Except this demand factor, other factors are there, that affect the price of crude oil in global market. The rise of US economy as an effectively shale oil producer is another factor that affect the price of crude oil in global market. In June 2014, the price of oil has reduced by more than 32%. The price of oil was reduced from $115 per barrel to $70 per barrel during mid-2014(Al-Rashed and León, 2015).

An intergovernmental organization, OPEC, tried to fix oil prices since 1960. In 1970, OPEC was established that is the organization of oil exporting nations as they have substantial oil resources and extract it at a low cost of production. Crude oil is important raw material. Nations those have the insufficient amount of natural resources especially crude oil, it is better for those nations to import oil from OPEC countries. These oil importing nations (like UK) use imported oil to build large scale industries. So the cost of production in UK partially depends on the imported oil price(Geise and Piłatowska, 2015). If there is any change in the oil price, that will affect the cost and so as the profits of these industries. The falling oil price has two types of effects in exporting and importing nations.

There are many reasons for the decline in oil price in the global market. The supply and demand condition of crude oil determines the short-term fluctuations in prices as well as a long-term trend in prices(Holt, 2015). It is found that prices often fluctuates quickly to surprises even before real changes occur. The reasons for the sharp decline in oil price are-

 Saudi Arabia often uses its capacity to increase or decrease oil supply of OPEC as earlier it acted as the swing producer of the cartel. In late November, 2014 OPEC decided to keep its production at 30mb/d that indicated a change in cartel's previous objective. It has changed its objective to maintaining a significant share of the market ((THE MONTH IN BRIEF: Prices continue falling, no oil policy change from new Saudi king, and EU considers sanctions on Libya, 2015).

Short-term Impact on AS curve of importing nations

The growing demand for alternative energy sources is the another reason behind the falling oil prices. Energy resources are more efficient and eco-friendly than fossil fuel resources, so investment in those resources increases result in a decrease in the fossil fuel investment. US shale oil production has constantly increased that affects the global demand for oil. So the rise of the US economy as a producer of energy resources does not increase the total supply of oil because US economy does not export these resources to other nations. It only decreases the portion of demand for oil in the market that was coming from US economy.

 In November 2014, the value of US dollar increases that affects the oil demand in the market. Oil is exported and imported in US dollars across the globe so when the dollar appreciates in 2014 it indirectly affects the demand for oil and make oil more expensive for less developed countries(networkideas, 2015). This causes a downward shift of the demand for oil curve(The National Interest, 2015).

During this period, many Asian countries face a recession that affects the demand for oil in those countries. It is also found that supply disruptions caused by the conflict in Ukraine, Middle East countries have had an effect on the natural gas and oil markets.

The falling oil price has direct effects on the production costs of various industries through reduced input costs. Prices of other energy resources are declined due to the substitution effect of falling oil price. As a result, many sectors including paper, aluminum, and petrochemical face a reduction in input cost where oil is the main raw material. The major beneficiaries are manufacturing industries; agricultural sectors, etc. produce more output in the market. The so aggregate supply of importing nations increases. So people of that country have more products to consume.

Oil price reduction increases the real income of oil importing countries. Reduced oil price increases the total supply in the economy, so it reduces the price level. Without an increase in monetary income, people of these countries now feel wealthier because price level falls( Real income is monetary income divided by price) (Finlay and Price, 2015). The marginal propensity to expend increases that affect the total expenditure on products. It is like a tax cut for the people of those countries. People have now more purchasing power than before. Increased real income brings more opportunities to spend rather than to save.

Other effects

Graph 1: Effects of falling oil price on AS curve of oil importing nations

In the above figure, it is clear that a decline in oil price has increased the total supply of the economy by making a rightward shift of the aggregate supply curve. So the total production increases and the price level decreases that results in reduced inflation rate. AS₀ is the previous supply curve that shifts to AS₁. AD₀ is the aggregate demand for the economy. There is an increase in real output from q₀ to q₁ and price level reduces from p₀ to p₁ .

A drop in the oil price causes lower price that means lower inflation and higher cost of living. So the value of imports of importing countries declines that eventually reduces the current account deficits. Falling oil prices reduces expected inflation rate below the targeted level of inflation(Ozdemir and Akgul, 2015).

Depending upon the share of oil imports in GDP, it is found that a 10% reduction in the price of oil increases the growth of oil importing countries by 0.5%. So a price of oil and growth of importing countries are negatively correlated. UK economy is growing at a rate of 2.9% that is more expected in the last November(Economicshelp.org, 2014).

Falling oil prices reduces transportation and oil related business costs as now these countries import more oil at a lower price. Cost of living of oil importing nations increases due to this fluctuation in price. Lower oil price reduces the cost of production of energy-intensive goods that leads to higher investment in the production(Means, Wynveen and Fann, 2015).

The falling oil price has macroeconomic impacts as it raises the cost of living of oil importing nations(Worldbank.org, 2015). Demand and supply of oil are affected by the lower price of oil in the market.

Falling oil prices indirectly reduces the price of other alternative energy saving resources that eventually reduces the profits of those producers.

A drop in oil prices delays the investments into other sources of energy that are more eco-friendly technology-based energy sources like it reduces the use of electric cars(Pierru and Matar, 2014).

As oil prices decreases the use of cars rises that brings environmental costs of petrol use with an increase in traffic congestion.

The long-term picture is different from the short term effects. At recent days, the biggest danger in European countries is 'fear of deflation'. As inflation at the mild rate is healthy for an economy otherwise, production and employment will decrease(Sotoudeh and Worthington, 2014). At recent days, there is a slide towards deflation as a result of falling oil price. This increases the real debt burden to European countries that will be harder to mitigate. So given deflation consumers are likely to save rather than to spend that makes deflation an actual possibility(riksbank, 2015).

Conclusion:

Since 1960 OPEC countries have been trying to stabilize the oil price in the market. In November 2014, the price of oil decreases more than 32% results in an increase in the aggregate supply in the oil importing nations. There are many factors behind the shortfall in the oil price. The rise of the US economy as a producer of shale oil reduces a portion of demand for oil in the global market. Besides this factor, appreciation in US dollar, recession in Asian countries, are important factors that reduce the oil price though falling oil price has positive impacts on the oil importing countries. It reduces the inflation rate, raises the cost of living and output of the economy but, in the long run, the picture is different from the short-term situation. In the long run the fear of deflation arises that is a nightmare of European economies. So it can be concluded that shock in oil price has positive effects in a short term but has negative effects in the long run.

References

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Holt, R. (2015). Falling Behind? Boom, Bust, and the Global Race for Scientific Talent. Phys. Today, 68(3), pp.48-50.

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Pierru, A. and Matar, W. (2014). The Impact of Oil Price Volatility on Welfare in the Kingdom of Saudi Arabia: Implications for Public Investment Decision-making. EJ, 35(2).

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Sotoudeh, M. and Worthington, A. (2014). Long-term effects of global oil price changes on the macroeconomy and financial markets: a comparative panel co-integration approach. Applied Economics Letters, 22(12), pp.960-966.

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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 9 Aug. 2015].