Table of Contents
This paper covers areas dealing with how the cost of oil affects the economy globally, and in a few countries. It explores the existing relationship between the supply and demand of oil and economic activity. Some analyses show that the high cost of energy has caused little economic damage; hence, this paper looks at which factors affect the supply and demand. Moreover, it assesses the effects of oil price on the economic activity of the industrialized countries. On a global scale, there has been an increase in demand for oil especially in countries such as India and China, which have been experiencing rapid economic growth. There economies are increasingly being urbanized and industrialized. This forces the world demand of oil to increase. Moreover, there has been political unrest in oil producing countries. There exists a paradoxical relationship between oil and economy.
Until recently, oil was cheap and long-run supplies seemed to be in abundance. A spike in the price of oil can end in a recession; however, a long period of economic growth can also end in an increase in the price of oil. When a change in the prices of oil affects the economy, it is usually asymmetrical and nonlinear. The question to ask is whether a reduction in the oil price would benefit the economy. The answer is that there is no clarity on whether declines in oil prices are beneficial to the economy. Until there is an extreme jump in the price of oil, there would always be a huge demand for oil through economic expansion. In fact, growth will always be positive. This paper looks at why there is a global economic expansion despite the fact that oil is very costly nowadays.
To explore the supply and demand relationship between oil and economic activity, and which factors affect the supply and demand.
Projections reveal that the fears of supply disruptions and an increase in demand could be the main factor behind an increase in the oil prices (Brown, 8-9). Globally, the demand for oil has ever been on the increase. Countries like India and China have been experiencing rapid economic growth lately (Dargay & Dermot, 6272). The fact that their economies have been urbanized and industrialized has made it worse; the world demand of oil has increased tremendously. Moreover, there has been political unrest in oil producing countries. However, it is essential to note that the supply and demand for oil do react slowly to the changes in the price. This means that a large shift in price results to equilibrium if the demand should be out of line with supply.
Essentially, an increase in the oil prices increases inflation; oil prices affect the prices of petroleum made goods in a direct manner. An increase in the oil price can stifle economic growth by affecting the demand and supply for goods other than oil (Robert & Kjell, 2271). The increase in oil prices is capable of depressing the supply of other goods. However, despite the effects on demand and supply, the relationship between economic downturn and oil price increase cannot be perfect. It is significant to note that, not every surge in oil price has led to a recession.
The last oil shocks experienced in the 1970s led to high unemployment, low growth, and high inflation (Mufson, 14-6). This could be the reason why a change in the oil price is looked as the source of economic fluctuation. However, research has it that this existing relationship is not stable. The late 1990s and 2000s experienced large oil shocks similar to those in the 90s (Blanchard & Jordi, 56-9). The result was that, there were no huge fluctuations in inflation, the unemployment rate, or real GDP growth. Recent studies have it that, the link between macro-economy and oil price has deteriorated over time. This concerns the fact that there is an increase in energy efficiency; energy prices no longer matter these days. Moreover, monetary policy improvements, good luck, increased flexibility in labor markets have all made sure that the economy is not much affected by oil shocks (Clarida & Mark, 147-80). Monetary policymakers have handled the economic shocks in a different way, which has helped in reducing the impact of oil shocks on the growth of economy.
There exists a paradoxical relationship between oil and economy. In the past, oil was cheap and long-run supplies seemed to be in abundance. This relationship could have causalities on either side. A spike in the price of oil can end in a recession; however, a long period of economic growth can also end in an increase in the price of oil. When a change in the prices of oil influences the economy, it is usually asymmetrical and nonlinear. The question asked is whether a reduction in the oil price would benefit the economy. The answer is that there is no clarity on whether declines in oil prices are beneficial to the economy. Until there is an extreme jump in the price of oil, there would always be a huge demand for oil through economic expansion. In fact, growth will always be positive. Moreover, there is a global economic expansion despite the fact that oil is very costly nowadays.
Many developed nations still forecast impressive economic growth despite the forty percent jump in the price of oil. Some analysts say that ah increase in the oil price increases the world economic growth by the fact that it raises the real resource prices through the revenue effect. The fast-paced increase in the values of world merchandise trade leads to the fast and rapid growth of world liquidity. It is projected that, with the current economic growth despite the high oil prices, it is possible that oil in the future will be more expensive under tight supply constraints, but with minimal economic impact. In the past, it took a massive interest rate to deal with inflation and high oil price or demand after the shocks experienced in the 70s (Hammers & Wills, 501-11). In any case that such level of interest rates were to be used again so as to bring down the oil price, there will be no guarantee to a return to cheap oil, there might be a recession and there might be no chance of recovery once again like in the 80s (Sill, 67).
The continued strong growth in the economy gives analysts enough confidence that the economy is able to withstand the effects of more and more high oil prices relatively unharmed. It seems that the world's economy went into this period of high prices of oil with a strong momentum. Even if the prices go further upwards, the impact would be smaller because economies as the United States' is much more efficient in terms of energy use than some time back. The economy has shifted to a more service-based one and there are traces of improvements in energy efficiency (Andrews, 54).
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With projections such as these, crude oil prices would have to be more that $180 a barrel for the economy to suffer effect on a large scale. Latest economic figures suggest that the global economic growth was excellent and now countries seem to be settling down to a growth that is solid and sustainable. In the United States, Federal Reserve policy makers have raised short-term interest rates to curb inflation, which then makes it difficult for oil prices to undermine growth.
Oil prices respond to changes in supply and demand in addition to various geopolitical factors. The global production of oil runs under OPEC, which tries to keep the price for crude oil at its lowest. However, global events have made it difficult for the prices to go down to $30 per barrel. Extreme weather conditions, recessions, and wars are factors that seem to affect oil prices the most. Political instability in Asia has affected oil prices because they do produce large amounts of the world oil. For example, wars in Afghanistan and Iraq saw the price of oil reach over $136 a barrel in 2008. When there is a surge in oil prices, the consumer will have to cut back on its use, which then reduces the demand. In the end, oil prices begin to go down. These are the basic laws of supply and demand that affect or determine the price of oil.
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If there is a recession, a number of factors will lead to a reduction in the demand for oil, which then ends in price drop. The reduction in use of motor vehicles will save on cash, which then reduces the demand for oil. Another factor that determines the price of oil in a recession is the decrease in demand for products. When consumers decrease their expenditure, the demand for oil goes down because few products will go to consumer countries. This will create a less demand for goods shipped, and hence the demand for oil goes down.
In an economical aspect, if there is a rise in price of oil, consequentially, the supply will rise. It is imperative to note that, the market for oil is unusual due to the fact that supply and demand is very much elastic. This means that any huge change in the price of oil will have minimal impact on its demand.
How was the economic growth and oil price from OPEC established to end of Cold War? (1960-1989)
The Cold War was a protracted ideological and economic struggle between the two global superpowers, the United States and The Soviet Union, supported by their respective alliances. Major clashes were not directly between the two superpowers, but between one of them and an ally of the other. Most of the Cold War concentrated around Asia. The conflict ended in 1991 when the Soviet Union disintegrated, the Soviet and East European Communism had collapsed earlier in 1989. Noteworthy, there was no direct and armed conflict in the Cold War. It occurred through a variety of means including economic pressure and selective aid, propaganda, intimidation, proxy wars in Vietnam and Korea, technological and economic rivalry, and diplomatic maneuvering. It brought about the largest and most expensive arms race. The Soviet Union wanted to spread Communism further into Europe while the United States and Britain vowed to stop Russia's advances.
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The economy of the United States suffered a number of rude shocks in 1970. However, it was because of a number of external events, which then forced a number of reconsiderations in economic priorities. The most felt shock came about when OPEC (a block oil exporting countries) when forced crude oil's price to double, triple and up to quadruple levels in the year 1973 (Mabro, 351). This move caused inflation because oil was essential to almost all of economic activities. There were widespread doubts on whether the United States could control its economy since there was a massive redirection of financial resources to the oil producers. This was the time that the United States released the dollar from being the dominant currency; it let go its main role in the world's economy as a voluntary measure. Results were that there were no longer any concerns on whether little countries decided to be Communist or not (Bodzin, 11). These Communist parties seemed to be independent from Moscow; hence, they no longer seemed threatening. In the end, Russia and China acted as friends; there was no need for aggressive anti-communist foreign policies. Trade between Communist blocs and American allies resumed, and the world seemed multifaceted (Galbraith, 45-6).
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Relationship among transportations cost, energy cost and economic growth
It is significant to note that, any future transport system's framework is in a close link with general supply of oil. The availability of cheap petroleum oil in the past years has enabled a great expansion of the transport system. The combustion engines that aid to power the transport system exemplify the relationship between the characteristics of the transport system, vehicle technology and energy supplied. However, things have changed nowadays. There is a concern for the availability of oil in the future, its rising cost, the instability in oil producing countries, and the effects they have on the global economy.
In general, oil demand and supply may seem to be inelastic in the short term but end up being elastic in the long term. A disruption in the oil supply cannot change consumer behavior in an instance, but if there is an increase in the long-term expectations in the price of oil, then the demand and supply will be affected. It is vital to note that there is nothing like over or under supply; the price at which the market clears is the only existing thing. Over the long term, a surge in the oil price will see consumers trying to reduce energy consumption or start using other forms of energy. In a similar way, if there is an investment in developing technologies or inhospitable areas, greater quantities of oil will reach the market. With all these, it seems that any boom in the price of oil sows the seeds for its own destruction (Fernald & Bharat, 31).
Factors affecting the supply and demand
It is essential to note that in any market situation, an imbalance in the supply and demand can affect prices in the short and long term. If there is a disruption in the oil supply, the short-term demands for oil may surpass the supply on hand, and hence influence prices to go high. Consumers will end up affected by the prices because of the imbalance between supply and demand.
In the United States, gasoline markets suffered effects when the government took several regulatory measures aimed at reducing air pollution. Moreover, taxes levied upon different sectors by the government also affect the fuel prices. It is significant to note that these taxes vary across the existing different markets. The differences in local and state sales and excise taxes can add up the fuel price.
Another factor that influences the gasoline market is permitting requirements for petroleum infrastructure. It is a fact that there are no new refineries built since the 1970s in the United States despite the fact oil demand has risen. It then follows that the United States has to import huge volumes of oil to meet the demand (Krugman, 35).
The price of heating oil relies on competitive factors including supply and demand. In addition, marketing costs, refining and distribution costs, and the price of crude oil also affect it. Moreover, the prices of crude oil are very essential in determining gasoline prices since crude is the raw material. Notably, crude oil prices can account for more than half of the price of a gallon of gasoline.
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Another factor to consider in gas prices is the transitions in supply. It affects the short-term availability of gas. After been processed, crude oil turns into gasoline then transported to a terminal. It is here that it a wholesaler or retailer, can buy it. The retailer then comes up with the final price known as the street price. Competition among retail outlets does affect pricing. One may notice differences in price of gasoline between two gas stations.
It is imperative to note that crude oil trade happens on the world market. However, recent prices of this commodity have been on the upward scale due to a rise in the global demand, in addition to instability in a number of oil producing countries. The price of crude oil determines the gasoline price because crude oil is the raw material used in the production of gas and other petroleum products. In answering the question on how oil prices are determined, it is significant to note that, commodity traders are the ones responsible for oil prices.
They do this by bidding on oil contracts in the future. However, there are factors considered when developing bids that end up creating oil prices. First is the current supply in terms of output set by OPEC (Barnett, 5). Secondly are the oil reserves, including the capacity at the refineries in the United States and Strategic Petroleum Reserves (Nick & David, 87-9). Lastly is the oil demand especially from the United States. For example, in winter, weather forecasts aid in determining the potential use of oil for heating. During the summer, travel forecasts seem vital in determining potential gasoline use.
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Oil prices are highly dependent on its location, the sulphur content, or its grade. Moreover, the demand for oil depends highly on various global macroeconomic conditions. According to the International Energy Agency, the surge in oil prices generally translates to downward economic growth. In 1985, there was a collapse of the pricing system administered by the OPEC. Moreover, the experimental netback pricing was also short-lived. It is then that oil-exporting countries decided to adopt a market-linked pricing system. Currently, the pricing markers include WTI, Brent, and Dubai or Oman.