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Impact of oil prices on economic growth

Published on 26th Dec, Edition 52, 2016

 

Oil prices are always debatable and remain an important variable in determining the economic activity of any country. Over the past few months, the price of oil has declined by greater than 30 percent and is hovering almost the $55 to 60 mark for a barrel.

More significant breakthrough recorded in the oil industry which after two years ago, global oil prices crashed after the world started pumping out far more crude that anyone needed. That plunge, from $100 per barrel down to $40 tip up the global economy. And now oil producers have had enough, recently Organization of Petroleum Exporting Countries (OPEC) have decided to cut their oil production by 1.2 million barrels per day in order to raise global oil prices. If the price of oil remains fixed at the level it is now or declines more, it would have important implications for the world’s politics and economy.
Going by the principle of economics, oil price depends on supply and demand, as is being taught by economics. In the oil market, the participants’ predictions about the future of oil also affect prices. If oil producers predict a decline 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 risen if it is expected that future prices will increase.
The current decline in oil prices is attributed to a fall in demand and increase/stable future supply. Lower demand is because of the moribund economies of Europe and the west, chiefly after the economic crisis of 2008.

Also, BRICS (Brazil, Russia, India, China and South Africa) economies are on the fall. The growth rate of China has fallen by two points of GDP, for example.

Russia is facing hostility from the West over the Ukrainian crisis, further disturbing the oil market. More significantly, the foreign focus, amidst global warming and problems of climate change, is on shifting to ‘green’ technologies. Such changes in technologies would rise fuel efficiency, thereby affecting oil demand. The prediction of a rise 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 predictions. Nevertheless, focus on energy based on solar, wind and other renewable sources is causing a further fall in oil demand.

The oil price is also linked to interest rates. If the present interest rates on long-term bonds continue over the next eras, producers would find it more attractive to rise the oil supply and invest the resulting income at a higher rate. So, the increase in the interest rate would affect the price of oil in the future.
The decline in oil prices is good for the global economic recovery. Since most of the states import oil, which makes their balance of payments unfavorable, a decline in the price of oil meant an improvement in the balance of payments and an increase in the currency rate.

 

In the case of the US economy, a decline in oil prices implies higher incomes for US consumers. A rise in the consumers’ income, in turn, means rise in demand. This is true in the case of Europe as well, which has been experiencing economic recession since 2008. A rise in the aggregate demand means the pumping of the economy’s heart.

Even developing states would get benefit from the decline in oil prices. The oil bills constitute the biggest item in the import list of Pakistan, thereby disturbing the balance of payments. Also, growing oil prices over the previous few eras have emptied Pakistan’s foreign reserves and are also impacting the price of the rupee, which has been falling against the dollar. Now, a decline in the oil price would decline the import bills of Pakistan, thereby enhancing the balance of payments, foreign reserves and, of course, the value of the rupee. Also, the price fall would 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 Pakistan. The same will be the case in India, which has also been experiencing a decline 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 decline in oil prices does not mean that all states stand to gain.

The losers will include Venezuela, Iran and Russia. The last two states 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 decline in oil prices. These states are heavily dependent on their oil revenues to support their governments. Oil prices below $ 70 a barrel will make it tough for Putin to maintain the transfer programs that bring him popular support. Similar results will be felt in Iran and Venezuela. It is to be seen whether the regimes in these states would be able to survive any future fall in oil prices.

This logic may not apply to Saudi Arabia and other Gulf states. Being major oil exporters, the decline in oil prices will not affect their economies much as prices at $70 a barrel are still profitable for these states. Their cost of extracting oil is much lower. Also, the decline in oil prices would discourage investment in shale gas whose cost of extraction is almost $ 45 a barrel.

So, OPEC states would 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 statescan rise oil prices in the future. Whatever may be oil politics, oil importing states will be the winners.

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