Essay On Falling Oil Price And Its Impact On Aggregate Supply Curve Of Oil Importing Nations

Causes behind the declining oil price

Discuss about a Essayt on Falling Oil Price and its Impact on AS curve of Oil Importing Nations?

Falling oil price is a critical problem for today’s world economy, and it drastically raises the aggregate supply of countries that import oil from exporting countries. From 2010, oil price had been more or less stable but since November 2014 it has reduced significantly because of its decreasing demand in the world market. As a result, the oil price reduces below the previous level of price. Except the demand factor, there are various causes that play a key role in decreasing oil price such as the rise of US economy as a shale producer in the market.

Organization of Petroleum and Oil Exporting Countries (OPEC), an Organization that controls the world oil price in the global market and established on the 1970s. This organization can produce oil at a minimum cost of production as the countries have plenty of oil resources. So these countries jointly have the monopoly power in the market to control price and supply in the world market. Large scale industries in oil importing countries depend on the petroleum oil that is the important raw material for production. The expense of production of these importing nations depends on the importing oil price and this cost changes with a change in oil price and global market.

The oil price has reduced by near around 36% since June 2014, and the new price is $70 per oil barrel that was near around $115 per barrel in the previous period. Oil price is determined by the market forces that affect the positions of supply and demand for oil in the global market. Inflation in UK has fallen to 1.25% for this decline in the oil price.

It is explained by the experts that the main cause of this decline in oil price is increasing demand for eco-friendly fuel resources as these resources do not create pollutions in the environment. So investments in renewable resources are rising significantly than the non-renewable resources like oil results in a decrease in oil demand in the global market (THE MONTH IN BRIEF, 2015).

The rise of US economy as a producer of shale oil is the important cause of declining oil price. This does not increase the supply of oil in the global market as US economy does not produce oil for export purpose but fulfilling countries' domestic demand for oil. So this effect reduces the significant portion of demand for oil in the world market (SIIRDE, 2015).

The short term effect on the AS curve of importing countries

It is explained by some renowned economists that world’s greatest oil producer, Saudi Arabia, ride out reduced oil prices for not to lose customers to their biggest competitors. This decision can help Saudi for maintaining its customer base in the world market. Saudi Arabia has a lot of oil resources so it can absorb the inverse impacts of declining oil price (FOCUS: Saudi Arabia struggles to defend market share in Asia, 2015). It has accumulated billions of foreign reserves that cause its production expense low.

Some of Oil exporting nations support for the decline in oil price as it believes that low oil price discourages the production of shale oil. Production expense of shale oil is expensive compared to fossil fuel (The IMF Blog, 2014).

During 2014, many Asian countries like India, China, etc. were suffering from a recession that causes the economic downturn. Aggregate demand in those countries has decreased due to this recession that indirectly affects the demand for importing oil from OPEC. This is considered as an important reason for the decline in oil price as these countries create a huge demand for oil in the global market.

Demand for crude oil affected by the increasing value i.e. appreciation of US dollar (Azar, 2015). Oil is mainly imported and exported in US dollar across the globe. So when the value of dollar increases then it will be difficult to trade oil for some countries those have lower valued currency than the dollar. So it pulls down the demand curve of oil, which results in lower oil price (Azar, 2013).

All these reasons indirectly encourage many countries to find better substitutes for oil that affects the oil price in the world market.

Factor productivity in any industry increases due to change in the oil price. When input cost of oil production decreases, it will raise the economies of scale in the production that means more output can be produced at the same cost. Decline in oil price has a positive impact on the production of oil importing nations. The so aggregate supply of those countries increases as a result people of those nations have more commodities to consume (Pierru and Matar, 2014).

Oil base production units have more opportunities to produce products and to supply in the market that result in an increase in aggregate supply in the market

Diagram 1: Effect on the Aggregate Supply Curve of Importing Nations

Other impacts

In the above diagram, AS_old is the previous aggregate supply curve that shifts rightward when there is an increment in the production of those importing nations. As a result, price level decreases from P₀₁ to P₁₁ and real output increases from Q₀₁ to Q₁₁. Whereas AD_old is the aggregate demand curve.

Prices of alternative energy resources are reduced because of substitution effect of the declining oil price otherwise total sale of these resources will decline. The important beneficiaries are agricultural sectors, manufacturing industries, etc. So the total supply of those nations’ increases as a result people have more commodities to consume (Mean et al, 2015).

The real income of importing nations increases due to this declining oil price. Total supply increases, so AS curve shifts rightward. As a result price level decreases and real output increases. So people of these importing nations feel wealthier because of this falling price, without an increment in money income. Real income is monetary income divided by price level. When denominator (price) reduces, it is obvious that real income decreases. Marginal propensity to expend increases i.e. people are ready to spend more income on their expenditure bundle. This brings opportunities to expend rather than to save. It is just like a tax cut to the consumers of importing nations (Yoshizaki and Hamori, 2013).

Declining oil price causes lower price level that result in higher living standards. The import value of importing nations reduces that eventually decreases the deficits in the current account. Declining oil price decreases the expected inflation level far below the targeted inflation level (Yoshizaki and Hamori, 2013).

It is recognized that 10% decline in oil price raises the growth by 0.5% of the oil importing nations. So there is a negative correlation between the growth of a nation and price of oil in the world market. After the reduction in oil price UK economy is growing more than at a rate of 2.5% that is expected in November (Economicshelp.org, 2014).

Declining oil price has the power to reduce the business-related transportation costs and living standard also increases in these countries. This falling oil price decreases the cost of production that eventually increases the investment in these energy-based resources(Pierru and Matar, 2014).

Other impacts:

Declining oil price decreases the prices of alternative renewable resources by substitution effect that result in a reduction of profits of those producers. These energy saving producers are now unable to supply resources at a lower price and forces them to go out of the business.

A fall in the price of oil discourages other investments in other energy sources that are technology based and more eco-friendly viz. It encourages people for not to use electric cars.

Lower oil price encourages people to use more cars in the market that directly affects the environment by polluting the air with increasing traffic congestions (Critchlow, 2015).

There is a difference between short term and long term effects of falling price of oil. Mild rate of inflation in any economy is healthy for production purpose. At recent years, the alarming danger in EU countries is the attack of deflation that discourages production and employment in any country. It is found that there is a slide towards deflation because of declining oil price. Deflation creates a huge burden of debt to these nations that are difficult to mitigate. So people are ready to save for future rather than to spend that makes it a real possibility (Murthy, 2015).

Conclusion:

In mid-2014, oil price reduces more than 31% that raises the aggregate supply of importing nations. Many reasons are there for this shortfall in the price of oil. The increasing value of US dollar discourages many lower developed countries for a reduction in the consumption of oil. The rise of US economy as a shale oil producer is another factor that plays a major role in the falling price of oil. Declining oil price encourages various producer of oil importing nations to increase production. In the short run, lower oil price encourages lower inflation rate and lower price level. In the long run, the picture is totally different as lower inflation rate may bring fear of deflation that inversely affects the production and employment. So it is clear from the above passage that shortfall in oil price has both negative and positive effects depending on the period.

References:

Azar, S. (2013). Oil prices, US inflation, US money supply and the US dollar. OPEC Energy Review, 37(4), pp.387-415.

Azar, S. (2015). The Relation of the US Dollar with Oil Prices, Gold Prices, and the US Stock Market. RWE, 6(1).

Critchlow, A. (2015). Falling oil price a curse, not a tax cut, for British economy?. [online] Telegraph.co.uk. Available at: https://www.telegraph.co.uk/finance/economics/11373208/Falling-oil-price-a-curse-not-a-tax-cut-for-British-economy.html [Accessed 12 Aug. 2015].

Economicshelp.org, (2014). Impact of falling oil prices |  Economics  Help. [online] Available at: https://www.economicshelp.org/blog/11738/oil/impact-of-falling-oil-prices/ [Accessed 12 Aug. 2015].

FOCUS: Saudi Arabia struggles to defend market share in Asia. (2015). Oil and Energy Trends, 40(3), pp.4-7.

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 12 Aug. 2015].

Means, E., Wynveen, J. and Fann, J. (2015). The Sky is Falling - Again: Oil Price: Biggest Factor Affecting the Industry. The Way Ahead, 11(02), pp.18-20.

Murthy, I. (2015). Macroeconomic Determinants of Crude Oil Price: Evidence of Long-Run Relationship. IIMS Jrnl. Mgmt. Sci., 6(1), p.42.

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).

SIIRDE, A. (2015). EDITOR’S PAGE. OIL SHALE RELATED FUNDAMENTAL RESEARCH AND INDUSTRY DEVELOPMENT. Oil Shale, 32(1), p.1.

THE MONTH IN BRIEF: Prices continue falling, no oil policy change from new Saudi king, and EU considers sanctions on Libya. (2015). Oil and Energy Trends, 40(2), pp.6-6.

Yoshizaki, Y. and Hamori, S. (2013). On the Influence of Oil Price Shocks on Economic Activity, Inflation, and Exchange Rates. International Journal of Financial Research, 4(2).