Impact of oil prices

Impact of oil prices.


Quite unpredictable international oil prices can be. Over the past few months, the price of oil has fallen by more than 30 percent and is hovering around the $ 55 to $ 60 mark for a barrel. More importantly, oil-producing states in the recent Organisation of Petroleum Exporting Countries (OPEC) meeting have also decided not to cut supply to maintain oil prices. If the price of oil remains fixed at the level it is now or falls further, it will have significant implications for the world’s politics and economy.


Going by the rule of economics, oil price depends on supply and demand, as is being taught by economics. In the oil market, the participants’ expectations about the future of oil also affect prices. If oil producers predict a fall in the prices of oil in the future, they can cut down the supply to adjust it with the market level. And the supply can be increased if it is predicted that future prices will rise.


The current fall in oil prices is attributed to a fall in demand and increase/stable future supply. Lower demand is due to the moribund economies of Europe and the west, particularly after the economic crisis of 2008. Also, BRICS (Brazil, Russia, India, China and South Africa) economies are on the decline. The growth rate of China has declined by two points of GDP, for example. Russia is facing hostility from the west over the Ukrainian crisis, further disturbing the oil market. More importantly, the international focus, amidst global warming and issues of climate change, is on shifting to ‘green’ technologies. Such changes in technologies will increase fuel efficiency, thereby affecting oil demand. The expectation of an increase in supply is based on the discovery of shale gas in the world. The shale gas revolution in the US, the development of Canada’s tar sands and Mexico’s decision to develop the country’s energy resources changed the oil market’s expectations. Nevertheless, focus on energy based on solar, wind and other renewable sources is causing a further decline in oil demand.


The decision by OPEC not to reduce supply is also based on the fear that any cut in oil supply meant giving away market space to new suppliers in the US and Canada. The oil price is also linked to interest rates. If the current interest rates on long-term bonds continue over the next years, producers will find it more attractive to increase the oil supply and invest the resulting income at a higher rate. So, the rise in the interest rate will affect the price of oil in the future.


The fall in oil prices is good for the world’s economic recovery. Since most of the countries import oil, which makes their balance of payments unfavourable, a fall in the price of oil meant an improvement in the balance of payments and a rise in the currency rate. In the case of the US’s economy, a fall in oil prices implies higher incomes for US consumers. An increase in the consumers’ income, in turn, means increase in demand. This is true in the case of Europe as well, which has been experiencing economic recession since 2008. An increase in the aggregate demand means the pumping of the economy’s heart.


Even developing countries will get benefit from the fall in oil prices. The oil bills constitute the biggest item in the import list of Pakistan, thereby disturbing the balance of payments. Also, rising oil prices over the past few years have emptied Pakistan’s foreign reserves and are also impacting the price of the rupee, which has been declining against the dollar. Now, a fall in the oil price will reduce the import bills of Pakistan, thereby improving the balance of payments, foreign reserves and, of course, the value of the rupee. Also, this price fall will reduce the cost of inputs, which will be reflected in the prices of final products. Any reduction in the cost of production means a reduction of inflation in the country. The same will be the case in India, which has also been experiencing a fall in growth rate over the past few years. And let us not forget China, which will benefit the most from the fall in oil prices.


The fall in oil prices does not mean that all countries stand to gain. The losers would include Venezuela, Iran and Russia. The last two countries are already facing economic sanctions that are hurting their economies. Holding the strategic position for being oil suppliers, both Russia and Iran may be hard-hit by the consistent fall in oil prices. These countries are heavily dependent on their oil revenues to support their governments. Oil prices below $ 70 a barrel would make it tough for Putin to maintain the transfer programmes that bring him popular support. Similar consequences would be felt in Iran and Venezuela. It is to be seen whether the regimes in these countries would be able to survive any future decline in oil prices.


This logic may not apply to Saudi Arabia and other Gulf countries. Being major oil exporters, the fall in oil prices will not affect their economies much as prices at $ 70 a barrel are still profitable for these countries. Their cost of extracting oil is much lower. Also, the fall in oil prices will discourage investment in shale gas whose cost of extraction is around $ 45 a barrel. So, OPEC countries will bear temporary losses in terms of lower revenues for the short-term to discourage heavy investments in shale gas and other non-oil energy resources. Once shale gas production ceases to be profitable (oil prices below $ 70 a barrel means no attraction for non-oil energy sources), the Gulf countries can increase oil prices in the future. Whatever may be oil politics, oil importing countries will be the winners.