How Oil Price Affect Aggregate Supply Of An Economy?

Reasons behind the fluctuation of oil price

How Oil Price Affect Aggregate Supply Of An Economy?

Various economic researches have been done on global oil price shock during the last few decades. To understand the relation between global oil price shock and global economy many empirical and theoretical models has been emerged by an economist. The global economy is suffering from various oil price shocks since 1970. Oil price shock is an event that is unpredicted and unexpected.  The effect of which in an economy may be positive or negative (BBC News, 2015).  It refers to the unexpected changes in exogenous factors that may have an effect on endogenous factors.   Since 1970, the oil price was sharply increasing, but from summer of 2014 the oil price is decreasing. The declining effect of oil price has the impact on oil exporting countries as well as on oil importing countries.  Here Saudi Arabia is considered as the oil exporting country.  The supply side shock is explained by the Aggregate Supply (AS) curve.

There are many reasons that can be blamed for the rise in oil price since 1970. Some of them are as follows:

There was a decline in U.S. productivity as a result of higher inflation and recession.

Stagflation is also a reason that is a situation of higher economic inflation rate along with high unemployment rate followed by slow economic growth.

The main reason behind this oil price shock is the policies of OPEC (Organization of Petroleum Exporting countries, which is an Intergovernmental Organizations, and it was created in Baghdad conference in 1960. The five finding members of this cartel are Venezuela, Kuwait, Iraq, Iran, Saudi Arabia. Later nine more countries joined OPEC.)

From the 1970s that is after the formation of OPEC oil price was rising as the member countries of the OPEC started to control their domestic petroleum industries and crude oil price increased in the world market. Oil price increased steeply in the global market (Saudiembassy.net, 2015).

After reaching a very high price, it began to weaken in the 1980s. The oil price started to fall from summer 2014.

The reasons for fall in oil price may be categorized as supply side reason and demand side reason.

Four main supply side reasons behind the decline in oil price over the last year are as follows:

Strong U.S. dollar:

The main reason for the declination of oil price is the strength of U.S. dollar. This is known to all that global commodity prices are usually quoted in dollars, and it tend to fall when U.S. dollar is strong.

Aggregate Supply (AS) curve

A global oil glut:

This is the phenomenon of higher supply of crude oil when demand is low for it. This is expected that total oil production to rise 9.35 million barrel per day.

OPEC and U.S. output:

Oil production of United States has nearly doubled over the last six years.  The production and exports of oil in Canada and Iraq are increasing year after year. Saudi Arabia, Nigeria, and Algeria that once was competing for U.S. market nowadays they are competing for the Asian market. The producers are forced to reduce the oil price.

These are the supply side problem.

Demand side problem:

If we look at demand side problem, then we can see that the European and Developing Countries are day by day weakening, and as their vehicles are more energy efficient, so demand for fuel is declining. 

It is clear that oil price falls mainly because of increase in production. The increase in production can be explained by Aggregate Supply curve (Krugman and Wells, 2009). 

Aggregate supply or AS curve is defined as the total amount of goods and services that is real output produced by firms in an economy over a period. Components of aggregate supply are consumer goods capital goods, public and merit goods and traded goods.

In this diagram, the price level is measured in the vertical axis, and national income or GDP( Gross Domestic Product) is measured on the horizontal axis.  It is shown that AS curve is upward sloping, and it indicates a positive relation between price levels and national income.  If price level increase (decreases) the national income increases (decreases).

As supply increases, AS curve will shift outward, and the price, will decrease. If supply decreases then, AS curve will shift rightward, and the price will increase. The outward shift of the AS curve is explained by the following diagram.  AS 1 is the previous Aggregate Supply Curve, which is shifted to AS2 when there is an increase in production. Here the downward sloping line represents the Aggregate Demand (AD) Curve (Mankiw, 2007).

Saudi Arabia is the largest producer and exporter in the world. Saudi Arabia has one-fourth of the world’s oil reserves that is more than 260 billion barrels. As Saudi Arabia is the largest producer and exporter of oil, it plays a very important role in the global energy industry and the global economy (Lane et al., 2015).

Oil Exporting Country Saudi Arabia

The economy of Saudi Arabia has grown very strongly in recent years. The reasons are mainly:

< >High oil prices and high oil outputIncrease in governmental spendingImplementation of many domestic reform initiatives.Strong private sector activityHow the domestic economy will be recovered from the volatility in the global oil market. How the dependence on oil revenues could be reduced.Response of Saudi Arabia to global decrease of oil price:

The response of Saudi Arabia is important in this case because it will affect the future dynamics of demand and supply of the global market.  As the world’s largest exporter Saudi Arabia, the most influential member of OPEC could help this situation by cutting down its production. But Saudi Arabia did a very little in this matter (Quora.com, 2015). According to some economist Reasons could be that Saudi Arabia can survive in this situation of low oil price because it has large Foreign Exchange Reserve. However, it is easier said than done.  Saudi Arabia is already facing high unemployment. Low oil prices are going to create socio-economic problems in Gulf state. Saudi Arabia’s current strategy is to maintain in market share and sacrifice the price and to force the U.S. shale producers and Canadian oil sand producers out of the market (Macalister, 2015). According to IMF,  the decrease in oil prices leads to the lower export of oil price and lower level of fiscal revenue but the effect on the overall economy is so far been limited. According to Tim Callen who led the IMF mission to Saudi Arabia said that so far been the largest oil producing nation of OPEC less concerned about the fall in oil prices and continued to produce oil in large quantities (International Business Times UK, 2015).

Conclusion:

There are many uncertainties regarding the oil price market.  On one side demand for oil is increasing by the strong growth in emerging economies and on other demand is decreasing because nowadays many European and Developing Countries are using energy saving vehicles which leads to the demand for oil to fall. Supply is also increasing from the U.S.  and the other Non-OPEC countries (Liu, Schultz and Swieringa, 2014). It will be better if the OPEC countries along with non-OPEC countries will solve this problem of volatility in oil price then the stability in oil price will lead the global economy to be stable (Lescaroux, 2010) .

References:

BBC News, (2015). Falling oil prices: Who are the winners and losers? - BBC News. [online] Available at: https://www.bbc.com/news/business-29643612 [Accessed 12 Aug. 2015].

International Business Times UK, (2015). IMF: Oil price decline has limited effect on Saudi Arabian economy. [online] Available at: https://www.ibtimes.co.uk/imf-oil-price-decline-has-limited-effect-saudi-arabian-economy-1503929 [Accessed 12 Aug. 2015].

Krugman, P. and Wells, R. (2009). Macroeconomics. New York, NY: Worth Publishers.

Lane, R., Somaney, J., Robertson, A., Somaney, J., Barder, O., Morgan, J., Fidelman, M., Jensen, K., Velocci, T., Knudson, K., Zaldivar, G., Benjamin, J., Williams, B., Zwilling, M., Auerbach, B. and Nitti, T. (2015). Saudi Arabia - Forbes. [online] Forbes. Available at: https://www.forbes.com/places/saudi-arabia/ [Accessed 12 Aug. 2015].

Lescaroux, F. (2010). The petroleum market: The ongoing oil price “shock” and the next “counter-shock”. International Economics, 121, pp.99-129.

Liu, W., Schultz, E. and Swieringa, J. (2014). Price Dynamics in Global Crude Oil Markets. Journal of Futures Markets, 35(2), pp.148-162.

Macalister, T. (2015). Oil price falls as Saudi Arabia pushes Opec cartel to hold production levels. [online] the Guardian. Available at: https://www.theguardian.com/business/2015/jun/05/oil-price-falls-as-saudi-arabia-pushes-opec-cartel-to-hold-production-levels [Accessed 12 Aug. 2015].

Mankiw, N. (2007). Macroeconomics. New York: Worth Publishers.

Quora.com, (2015). Why is Saudi Arabia lowering the price of crude oil? - Quora. [online] Available at: https://www.quora.com/Why-is-Saudi-Arabia-lowering-the-price-of-crude-oil [Accessed 12 Aug. 2015].

Saudiembassy.net, (2015). Economy & Global Trade. [online] Available at: https://www.saudiembassy.net/about/country-information/economy_global_trade/ [Accessed 12 Aug. 2015].

Tverberg, G. and →, V. (2013). Ten Reasons Why High Oil Prices are a Problem. [online] Our Finite World. Available at: https://ourfiniteworld.com/2013/01/17/ten-reasons-why-high-oil-prices-are-a-problem/ [Accessed 12 Aug. 2015].

Waldman, P. (2015). Saudi Arabia’s Plan to Extend the Age of Oil. [online] Bloomberg.com. Available at: https://www.bloomberg.com/news/articles/2015-04-12/saudi-arabia-s-plan-to-extend-the-age-of-oil [Accessed 12 Aug. 2015].