ceteris paribus...
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It is quite ironic that this essay title was given in the same week as oil prices hit a six month low but it is arguable that lower oil prices are not here to stay. The recent fall has been caused by short term reasons such as the easing of political tensions in Iran and Nigeria and the International Monetary Fund’s decision to cut its US growth forecast from 3.3% to 2.9%. Nevertheless, proof that traders believe that prices will remain high comes from the futures market, where the price of oil for 2007 and 2008 remain at around $70 per barrel. Rising
demand Emerging economies are having an effect and will continue to leave a lasting impression on oil prices in the future. As the average incomes of 5.5 billion people who live in emerging economies rise, there will be a noticeable rise in demand for cars, household appliances, etc. Inevitably, this will mean that more energy will be demanded, keeping oil prices high. 85% of the increase in world energy demand since the year 2000 has come from emerging economies. Large players include China, India, Indonesia and Brazil. Nevertheless, China’s oil consumption is only one thirteenth of America’s but Deutsche Bank predicts that China’s oil imports will rise from a modest 91m tonnes to 1,860m tonnes by 2020. Its oil consumption has doubled since 2000 and it shows no sign of easing down as China becomes ever more dependent on capital intensive business. Increased
car ownership in emerging economies will greatly influence demand
for oil. Currently, there are 50 cars per 100 people in America
compared to 2 cars for every 100 in China. Goldman Sachs predicts
that the combined rise in car ownership in China and India may
rise from the present 30m to 750m by 2040 - 750m cars would be
more than all the cars on the world’s road today. Limited
supply? Refining capacity and adhering to environmental regulations, which especially applies to the US is one of the reasons for rising oil prices. In some areas, only certain grades of gasoline are allowed to be used, which are more expensive. Insufficient refining capacity has been compounded by new stringent measures to combat global warming. The oil industry also lacks investment into exploration of new reserves. Apart from the modest case in India, the last time a major oilfield was discovered was 30 years ago. The oil which is being supplied to emerging economies is however being used up very inefficiently. Countries such as China and India use twice as much oil as developed countries use to produce $1 of GDP. Their governments have also subsidized the price of oil, meaning that consumers are cushioned from the real prices, resulting in the use of more oil than if they had been paying full market prices. The final product – higher oil prices for the rest of the world. We
can also point the finger at OPEC (Organisation for Petroleum
Exporting Countries), whose members supply 40% of world production
and have 75% of the world’s oil reserves. OPEC is a producer
cartel which aims to “fix” the price of oil by controlling
supplies. They usually wait for prices to lower before cutting
output. OPEC has changed their strategy, adopting a more aggressive
stance towards cutting supplies. Now, they pre-empt dips in oil
prices and cut output. However, this change of strategy means
that oil companies that would normally use the time between the
dip and OPEC reducing supplies to stock up, cannot do this. Saudi Arabia, by far is the world’s biggest crude oil producer, with 13.5% of the market. Al-Qaeda terrorists in Saudi Arabia are stepping up their attacks on foreign workers there, which have added to the mounting pressure. Any substantial attack on oil refineries in Saudi Arabia could affect oil prices. As seen by Hurricane Katrina (although natural), Brent Crude Oil Prices were sent over $65 from the original $55 before it struck proving that supply shocks can shoot prices up, albeit temporarily. However, the situation we face now is one of rising demand which is fuelling higher oil and energy prices rather than tighter supply, which is more controllable. Further tensions in places such as Nigeria and Venezuela can also have an impact, although smaller, on the world oil prices, which could drive up energy prices. The battle between the Russian government and Yukos, Russia’s giant oil producer could spell bad news yet again and result in the closing of some production of oil in Russia. Speculators Even though oil prices are clearly going through the roof, much of it has been affected by inflation. By looking at the commodity prices in real terms, it is clear that there is a downward trend despite the fact that oil is the most heavily traded commodity in the world economy. What many fail to realise is that oil prices are in fact considerably lower in real terms than what they were in the 19th century. Costs and benefits if oil prices remain high for a sustained period of time Benefits Oil exporting countries would hugely gain from higher oil prices. Between 2003 and 2005, oil producers’ export revenues rose by $400bn. If used correctly, this money could be used to aid further investment and research into the oil market. However, as was the case in Saudi Arabia in 1980, a large spending spree led the balance of payments account to a 13% of GDP deficit from a 26% surplus of GDP. Higher oil prices have boosted BP’s profits over the last three years. Their net profit for the first three months of this year was $5.49bn which is up 29% from a year ago. Governments could also gain from higher oil prices. As oil producing firms earn greater profits, more of that goes towards corporation tax. As prices become higher, the more the government gains, which can be used to fund public spending in the economy. If this extra revenue is used wisely, it can have a positive result on the economy and benefit many consumers who would have lost out due to higher energy prices – but this gain may be minimal. High oil prices have now in effect become a new sort of global economic control, which does not need any government interference. If the world economy overheats as a result of high energy prices, demand will consequently slow down without any interference of government macroeconomic instruments. Costs Quite simply put, consumers pay the final price of oil – it is like a ‘pipeline’ of prices where the costs build up and the final price is paid by the consumer at the end of the pipeline (but this idea is not wholly true as this is a simplification). So an increase in oil prices for a firm that produces goods which require a lot of energy will need to increase the price for the consumer in order to offset the price of oil in the beginning. Higher oil prices may also have adverse effects for the less well-off, as their spending on energy accounts for a larger proportion of their total spending. According to a survey from the Office of National Statistics, 6% of the spending of the poorest fifth in the country is used for energy bills whereas only 2% of total expenditure in the richest fifth goes towards utility bills. Understandably, the 30% rise in energy prices over the last year would have placed a much greater burden on poorer people. Production costs can be very large for producers that use high energy intensive capital. In places like China, where it is evident that they are hugely energy inefficient, this is certainly not welcome news where manufacturing using high energy intensive capital is all too common. For firms that are dependent upon oil, it is clear that they gain less profit. This will affect many smaller businesses greatly and could reduce the production of goods requiring huge amounts of energy. In developed countries, where less emphasis is placed on manufacturing using high energy capital and more on the tertiary sector, higher oil prices will have a slightly dampened effect. More advanced economies are nowadays less sensitive to oil price rises, which could be part of the reason why the world economy has been able to shrug off high oil prices. But this is no consolation to those producers who depend on oil. Money will be lost to foreign oil producers from domestic firms in Britain that import oil. As discussed previously, those foreign companies will gain significantly due to high oil prices. This in turn, on a larger scale will affect the country’s balance of payments as money is withdrawn from the circular flow. Currently, the UK has an oil trade deficit, with a large part of it going towards energy costs. In 2005, Britain entered the red as £11.4 billion worth of oil was imported compared to £10.9 billion worth of exports – this was the first time Britain has collected an oil trade deficit since the premiership of Margaret Thatcher. According to an IMF (International Monetary Fund) model, an increase of $10 per barrel would reduce the world’s output by three fifths of a percent in the next year. If this was the case, then the rising price of oil would not be desirable. However, this model is intended to describe what would happen in supply shocks as witnessed in the 1970’s and in 1990. In those cases, the rise in the price of oil was caused by a decrease in supply which would have caused the GDP to go down. However, this time round, the oil price rise is not the sole result of tighter supply but rather due to higher demand as described earlier. Higher effective demand spells out higher economic growth, showing that consumers and producers are willing and most importantly able to buy oil or oil based products. Therefore, one can conclude that the rise in oil prices this time will not have as large an effect as thought previously but unlike supply shocks which are more temporary, it seems that high oil prices as a result of high demand are here to stay. Despite oil prices easing off a little over the last few days, a new equilibrium of $60 per barrel of oil may have been reached. As demand increases evermore and supply tightens up, who knows what may happen to the price of oil… Sources
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