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Global Oil Price and its impact

Explain Forensic Accounting?

The global oil prices have always been of concern for the functioning of any economy.  The fluctuations in the price of the oil have significant impact on the macroeconomic variables of an economy. It has been evident for the past few years that the global price of the oil has declined sharply. This fall in the price has led to the decreased revenue in the oil exporting countries and on the other hands, the oil importing countries have been benefitted by the cheap oil. The consumers of the oil will derive the benefit of the low oil price as they will now pay less for driving cars or heating up their houses. The global oil prices have been fairly stable from 2010 till the mid 2014 which was around $110 per barrel. But from mid 2014, June the world prices of oil have fallen sharply. The Brent crude oil has declined below $50 per barrel whereas the US crude oil has fallen below $48 per barrel. The situation is full of tension for the oil exporting countries. In this paper, the winners and the losers of the fall in the oil prices will be evaluated along with the assessment of the oil exporting countries. In this analysis the AD-AS model is considered for the understanding of the fall in the oil price.

The global oil prices had been considerably stable for the past few years which were recorded to be around $110 per barrel until mid June. Thereafter the oil price more than halved and amounted to be about $50 per barrel. The fall in the global oil prices can be attributed to two-fold reasons behind such drastic change. The oil market has been characterized as an oligopolistic market structure as there were few sellers of oil and many buyers of oil, but with time, the number of oil producers and exporters increased driving the economy towards a competitive framework. Thus, the increased competitiveness in the market has caused due to five features:

  • The market of oil contains many sellers and many buyers.

  • The oil is homogeneous commodity that is exported by the oil producers.

  • The producers of oil are price taker as there is only one price in the market.

  • There is free entry and exit in the oil market.

  • There is little or no market power in the oil market.

  • Producers of oil follow profit maximizing behaviour.

 The demand and supply of the oil are relatively inelastic in the short run which means that changes in the price causes little influence on the demand and supply of oil (Carollo, 2012).

The demand and supply curves are shown in the form of diagram attached in the appendix 1.

 The first reason behind the fall is the weak demand in most of the countries which mainly because of the unexciting economic growth. This situation was aggravated by the surging oil production by the US. The second reason behind the sharp fall in the oil price is due to the issues related to the oil cartel OPEC.  The fall in the oil price is due to the situation of excess supply within the economy (Cordesman and Al-Rodhan, 2006) as shown in appendix 2. As the OPEC has refused to cut down its production in order to increase the price, it has caused rather an opposite situation which is the situation of excess supply. Now from the basic concept of demand and supply it is known in an excess supply situation the price of the commodity will fall which is in this case where the oil price has sharply fallen due to the over production of oil by the OPEC countries. This has slowed down the economic activities of Europe, Japan and China as shown in appendix 3. So it is important to analyze who are benefitted as well as harmed from the fall in the oil prices (Forbes, 2015).

Global oil price and AD-AS framework

The winners due to the sharp decline in the oil prices are the net importers of oil. According to the IMF this fall in the oil prices have been impacting most of the advanced economies as the 30% declined in the oil prices have likely to increase the 0.8% economic growth as they importers of oil. As India has accelerated the disinflationary process it will derive positive impact from the fall in oil prices. The losers on the other hand are the oil exporting countries as by selling oil they are earning less revenue. For example, Venezuela is reported to decrease its public expenditure by 20% to contain the deficit and increase the confidence. Russia on the other hand depends on its export of oil. The fall in the price has deteriorated the economic status of the country by devaluing its currency, increase in the commodity prices leading to inflation and finally there will be a situation when Russia would slip into recession.

The consumer price index (CPI) has fallen to 1.3% in the US which is an impact of the fall in the crude oil price which serves as an input of several products which form the basis of the core inflation. There is also a fall in the unemployment rate to 5.6% and is predicted to fall even further. This trend of economic growth along with the declining inflation rate paved the way for expansionary disinflation which is expected to remain if oil price continue to decrease which sometimes the economist call it a “positive supply shock”. Some economists have difficulty in absorbing this contradictory notion. It is generally the case that the inflation and the employment move in the same direction as conceptualized through the Phillips curve.

Thus, it can be said that the downfall in the inflation rate is a supply side effect which is attributed to the fall in the oil price. So this can be explained through the mechanism Aggregate Demand (AD) and Aggregate Supply (AS). The aggregate demand curve is shows the changes in the price level that impacts the equilibrium level of real GDP. The aggregate supply on the other hand shows the changes in the level of output that impacts the price level. The equilibrium is achieved where the AD curve meets the AS curve. Now due to the positive supply shock in the economy due to the fall in the oil price, the AS curve will shift to the right as shown in the diagram attached in the Appendix 4.

Impact of fall in global oil price on oil exporters

The fall in the oil price has hampered the oil exporting countries as they receive less revenue from the export of the oil. Oil exporters like Russia, Iran, Nigeria, Venezuela and Ecuador depends on the oil market to generate revenue through which they plan to fund infrastructure projects and other social programmes and other financing adventures. With the fall in the oil price, the revenue decreased and hence the funding for projects programmes and plans are affected the most. Another impact of the falling oil prices have on the government budgets, foreign debts and stabilization of the currencies. As the price of the oil has fallen it is not beneficial for the oil exporting countries to export oil so they would withdraw their supply and thus, the aggregate supply of the oil exporting countries will shift to the left which is shown in the diagram attached in the appendix 5.

Saudi Arabia is the second largest oil exporting country. This country completely relied on the oil industry for their revenue generation so the fall in the global oil price will have adverse impact on this oil exporting countries. Some economists are worried about the crash down of the economy of Saudi Arabia as they heavily rely on the oil revenue for the survival. The fall in the oil revenue implies that the GDP growth rate has fallen from 6.4% in the beginning of the year 2014 to 2% at the end of the year 2014. The charts are attached in the appendix. It can be seen that as the global oil price declined and the gasoline price remained stable but the GDP had fallen in the same year (BBC News, 2015). Thus, it can be understood that the oil revenue plays an important role in the GDP of Saudi Arabia. If the oil prices remained as low as $40 per barrel then there will be a government deficit which will be around 14% of the GDP. Also if the oil prices remain low then the Saudi Arabia have t cut down their high cost projects and other social programs after the Arab Spring. The current budget deficit of the country is $39 billion and about 90% of the budgeted income comes from the oil market. it has been suggested by the financial analysts that due to the fluctuating movements of oil price, Saudi Arabia must diversify their revenue source to avoid total crash down. The declining oil price had impacted the national income of the country as it has decreased it by more than $88 billion. As the economy may face instability, the impact of the low oil price revenue will enable the government to cut down expenses in order to combat the deficit and the debts of the country. So in order to decrease the expenses, the government has to decrease the wages and salaries of the employees and also cut down the basic operational expenses. The oil minister of Saudi Arabia has been positive about the fall in the oil price to which he states that the country already posses $750 billion worth foreign exchange which will be utilized in this crisis and this may get depleted. The decrease in the government expense in economics is termed as a policy that can be incorporated by the government which is the contractionary fiscal policy (Forbes, 2015). The government of Saudi Arabia can implement this policy to cut the government spending and thereby reduce the budget deficit. In this regard the government can also increase the tax and social insurance which will fetch additional revenue and increase the revenue after the failure of the oil market to do so. This can benefit the largest oil exporting country. This is shown with the help of the diagram attached at appendix 6 and appendix 7.

Impact of fall in global oil price on Saudi Arabia with respect to aggregate demand

As the recent fall in the oil price is due to the supply component so this is like the positive supply shock and is treated as a simple cost or price level shock which affects the price level permanently but the effects are temporary. Thus, the monetary policy in this case should be accommodating in nature to the shocks. The fall in the oil price has a devastating impact on the price of other commodities and causes a situation of decreasing inflation in Saudi Arabia where the inflation rate has declined after June 2014 from 2.8% to 2.4% (Financial Times, 2015). The inflation rate chart is attached in appendix 8.

The impact of the falling oil price will impact the aggregate demand of the Saudi Arabia. The aggregate demand gives the negative relationship between the price level and the real GDP of the country. With the fall in the oil price, the government expenditure will be reduced which will cut down the wages and reduce the consumption expenditure which will cause a fall in the aggregate demand curve to the left and thus, the real GDP will fall. The diagram is attached in the appendix 9. The typical business cycle represents four phases; Saudi Arabia is in the downturn phase which is characterized by growth moderating, contraction in credit, revenue and national income is under pressure, policies taken are contractionary in nature and there is economic instability (Fidelity.com, 2015). The chart is attached at the appendix 10.

Conclusion:

The fluctuations in the oil market, particularly in the oil prices have significant impact on the economies of the world. In the course of the fall in the oil prices, it is the oil exporters that are the losers whereas the oil importers who have to pay less for the same amount of oil that they purchased earlier will derive the benefit and so they are the winners. Based on this scenario, the fall in the oil prices are explained through the concept of AD-AS. Thus, the fall in the oil prices are considered as a positive supply shock which causes the rise in the real GDP and fall in the price level. On the other hand, this paper highlights the impact of the fall in the oil price on the oil exporting countries. It is the fall in oil price that hampers the economy by suppressing the fund allocation in the projects, programmes and other arenas which undermines the growth within the economy. It can be said that the poor oil exporting countries who depend on the oil revenue for their well being will be affected the most whereas the impact of the declining oil prices will be less severe on the countries who are prepared for the volatility in the oil prices. In this paper, the case of an oil exporting country which is in this case is Saudi Arabia is analyzed. The impact of the oil price fall on the economy of Saudi Arabia has been negative which caused a fall in the GDP rate, decrease in the national income, cut down of government expenses and wages and operational expenses are reduced so there is an economic instability in the economy of Saudi Arabia.

References:

Carollo, S. (2012). Understanding oil prices. Chichester, West Sussex: Wiley.

Cordesman, A. and Al-Rodhan, K. (2006). The global oil market. Washington, D.C.: CSIS Press.

Forbes, (2015). The Economic Impact Of Falling Oil Prices: 'Expansionary Disinflation'. [online] Available at: https://www.forbes.com/sites/jonhartley/2015/01/12/the-economic-impact-of-declining-oil-prices-expansionary-disinflation/ [Accessed 10 Jul. 2015].

Imf.org, (2015). IMF Survey : Falling Oil Prices Hurt Exporters across Mideast, Central Asia. [online] Available at: https://www.imf.org/external/pubs/ft/survey/so/2015/CAR012115A.htm [Accessed 10 Jul. 2015].

Unalmis, D., Unalmis, I. and Unsal, D. (2009). On the sources of oil price fluctuations. [Washington, D.C.]: International Monetary Fund.

Fidelity.com, (2015). Business cycle update: Results of low oil prices. [online] Available at: https://www.fidelity.com/insights/markets-economy/february-business-cycle-update-2015 [Accessed 24 Jul. 2015].

Financial Times, (2015). Saudi Arabia predicted to cut state spending after oil price fall - FT.com. [online] Available at: https://www.ft.com/intl/cms/s/0/e52a434e-9c9f-11e4-a730-00144feabdc0.html#axzz3ghphkZNW [Accessed 24 Jul. 2015].

Forbes, (2015). How Will The 2014 Drop In Oil Prices Affect The World Economy And Geopolitics?. [online] Available at: https://www.forbes.com/sites/quora/2015/01/06/how-will-the-2014-drop-in-oil-prices-affect-the-world-economy-and-geopolitics/ [Accessed 24 Jul. 2015].

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 24 Jul. 2015].

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