Literature Review – The Implication of Falling Oil Prices on the Global Economy

Literature review; the implication of falling oil prices on the global economy

Commodity prices are influenced by market forces of demand and supply. A shift in the demand or supply curve, upwards or downwards, subsequently changes commodity’s price point (Gaur 2016). Numerous studies have been conducted in an effort to explain the causes of oil price fluctuations. Most of the studies have focused on disruption of global oil production because of different exogenous events such as political revolution and wars within major oil producing countries (Baumeister & Kilian 2016).  Increase in consumption demand is one of the factors that have contributed to fluctuations in oil prices (Baumeister & Kilian 2016).

The mid 2000s was characterised by remarkable increase in oil prices due to the huge demand for oil globally. By the end of 2011, the price of oil had increased to $ 100 per barrel (Gaur 2016). However, over the recent past, oil prices have fallen considerably. According to a 2015 Monetary Policy report, the price of oil has declined by approximately 50% (Monetary Policy Report 2015).  The decline began in mid-2014 and reached the lowest point in a period of 10 years in early 2016 (European Central Bank 2016). In addition to increase in oil supply, the decline in oil prices is also attributed to weaker global demand.  For example, emerging economies, especially the energy-intensive economies, have experienced a weaker economic growth hence dampening the oil prices.  Conversely, technological innovation had led to development of effective oil extraction techniques such as shale oil extraction, which has contributed to surge in oil supply (European Central Bank 2016).  In November 2014, the Organisation of the Petroleum Exporting Countries (OPEC) resolved to maintain the production quotas hence increasing the downward pressure on oil prices (Carbaugh 2016). Wald (2016) asserts that ‘OPEC is a formal cartel that often, although not always, institutes production quotas to keep oil prices high’ (par. 1). OPEC may also resolve to stop its ‘cartel like behaviour’ hence providing its members to produce oil according to their capacity. This resolution has provided the oil producing countries to pump oil at will.

Impact of falling oil prices on the global economy

Crude oil is a strong indicator of the performance of the global economic activity because of the outstanding demand for energy (Ghalayini 2011). Despite the presence of alternative sources of energy, the economic importance of oil in the global economy remains strong. Ghalayini (2011) corroborates that ‘there is a strong relationship between the growth rate of a country and oil price changes’ (p. 127).  The impact of falling oil prices on a country’s economic activity varies depending on whether a country is oil exporting and importing country. According to the Monetary Policy Report (2015), a long-lasting low oil price has a strong impact on the economy compared to a temporary low oil price.

Gross Domestic Product

Falling oil prices has a strong positive impact on a country’s economic activity and hence the size of the Gross Domestic Product (GDP) (Jimenez-Rodriguez & Sanchez 2004). Historical correlations indicate that the low oil prices experienced since 2014 will contribute to a 1% increase in the level of global GDP in future if the low oil are maintained (Baumeister & Kilian 2016).  Falling oil prices contributes to a considerable increment in the rate of GDP especially in the net oil importing countries. Due to the low oil prices, the net-oil importing countries experience significant improvement in the balance of payment through reduction in the size of current account deficit (World Bank 2015). However, the effect of the falling oil price on a country depends on the proportion of a country’s oil import.

According to the World Bank (2015), falling oil prices were projected to boost the Chinese economic activity by a margin of 0.1% to 0.2%. The projection is based on the fact that crude oil accounts for only 18% of the country’s energy consumption while coal accounts for 68% of energy consumption (World Bank 2015). For example, India imports approximately 75% of its oil hence creating a substantial current account deficit (Pettinger 2016). Therefore, falling oil prices will contribute to a significant reduction in India’s current account deficit.

The economic growth in the net-oil importing country arises from the resulting multiplier effect (Thomas, Savatgy & Klimovich 2016).  Decline in oil prices increases the level of household consumption. Therefore, businesses experience high profit gains because of the lower energy-input cost such as the cost of transport and production (Bawden 2016). As a result of the high level of profits, businesses are able to increase their level of investment hence creating new jobs.  On the other hand, investment in oil production decreases (World Bank 2015).  In the medium term, a review by the Financial Times (2016) proposes that the fall in oil prices may have a negative effect on the capital-intensive oil extractive industries. Nevertheless, the benefits attained by the households will have a balancing effect. Husain et al. (2015) contends that ‘although oil price gains and losses across producers and consumers sum to zero, the net effect on the global economic activity is positive’ (p.1).

The European Central Bank (2015) emphasises that ‘falling oil prices culminates in income redistribution from the oil-producing or net-exporters to the oil-consuming or net-importing countries’ (p.1). Subsequently, the falling oil prices will translate in substantial real income shifts. This increases the consumers’ purchasing power hence stimulating economic growth further. Unlike the net-importing countries, falling oil prices dampens GDP growth in the net exporting countries. The decline in GDP growth arises from reduction in the volume of export revenues (Baumeister & Kilian 2016).

The OPEC member countries collude in an effort to maintain high oil prices.  However, the strong OPEC members with reference to oil production do not always need to maintain high price in order to benefit (Wald 2016). This arises from fact that the large oil producers are characterised by substantial cash reserves. Unlike the strong OPEC members, the weak OPEC members are characterised by significantly low cash reserves, which means that the low oil prices has a significant negative impact on the countries’ GDP (Wald 2016).

Level of inflation

The rate of inflation is positively correlated to oil prices (Carbaugh 2016). Thus, falling oil prices leads to reduction in the level of global inflation. A study conducted by the World Bank in 2015 projects that global inflation would decline by 0.4 to 0.9 percentage points due to a 30% decline in oil prices (World Bank 2015). The decline in oil price has a significant effect on the rate of inflation especially in countries whose Consumer Price Index (CPI) is comprised of a significant proportion of oil-based products (Baumeister & Kilian 2016).  The World Bank (2015) postulates that ‘falling oil prices often affects activity and inflation by shifting aggregate demand and supply and triggering policy responses’ (p.162). The low oil price stimulates the volume of production within the energy-intensive industries because of the low cost. These benefits are subsequently passed on to the consumers in terms of low product prices.  The falling oil prices have led to a fall in the UK rate of inflation to 0%, which represents a deflation (Pettinger 2015).

Impact on monetary policy and financial markets

A fall in oil prices as a result of increase in supply may not lead to long-lasting effect on the level of inflation. Subsequently, the Monetary Policy Report (2015) asserts that ‘the monetary policy response should be fairly cautious’ (p.5). Contrary to the view that falling oil prices stimulates consumer spending, the deflationary effect of falling oil price might make consumer less willing to consume the windfall gains accrued from the falling oil prices. In such a situation, consumers might prefer to save (Giles 2014). To deal with such a situation, it is imperative for the central bank to intervene accordingly, for example by loosening the monetary policy. One of the approaches that the central banks can consider entails implementing a flexible exchange rate regime (World Bank 2015).

Falling oil prices are further associated with increase the degree of volatility within the financial markets such as equity and foreign exchange markets (World Bank 2015). For example, investors might reassess the decision to invest in the oil production sector or in the oil producing countries because of the limited growth prospects. Reduction in the volume of investment might increase capital outflow, increase in the rate of currency depreciation and significant reserve losses within the oil exporting countries. The decline in the size of investment in the oil sector or oil exporting countries might increase the losses incurred by financial institutions, for example in terms of increase in non-performing loans by corporate institutions (World Bank 2015).  Considering the fact that falling oil prices might lead to deflation, it is essential for governments of the affected countries to implement monetary policies that will stimulate economic growth.

In summary, falling oil prices has a significant impact on a country’s macroeconomic factors. Nevertheless, the impact varies between the net oil importing and net-exporting countries. The impact on the net oil-importing countries is positive while the net oil-exporting countries are negatively affected because of the income redistribution effect. The two notable impacts of falling oil prices entail stimulation of GDP growth and reduction in the rate of inflation.

References

Baumeister, C & Kilian, L 2016, ‘Forty years of oil price fluctuations; why the price of oil may still surprise US’, Journal of Economic Perspectives, vol. 30, no. 1, pp. 139-160.

Bawden, T 2016, Oil price crash; how the industry’s decline will affect the UK economy. [Online]. Available at:

<http://www.independent.co.uk/news/business/news/oil-price-crash-how-the-industrys-decline-will-affect-the-uk-economy-a6820096.html> (Accessed October 15, 2016).

Carbaugh, R 2016, International economics, Cengage Learning, New York.

European Central Bank: Global implications of low oil prices 2016. [Online]. Available at: <https://www.ecb.europa.eu/pub/pdf/other/eb201604_focus01.en.pdf?48284774d83e30563e8f5c9a50cd0ea2> (Accessed October 14, 2016).

Giles, C 2014, Winners and losers of oil price plunge; inflation and strong dollar could curb global economic impact. [Online]. Available at:

<https://www.ft.com/content/3f5e4914-8490-11e4-ba4f-00144feabdc0>  (Accessed October 17, 2016)

Financial Times: A falling oil price is good for the world economy 2016. [Online]. Available at:

<https://www.ft.com/content/86916314-8776-11e4-bc7c-00144feabdc0>  (Accessed October 15, 2016)

Gaur, A 2016, ‘Impact of falling oil prices on the Indian economy’, International Journal of Multidisciplinary Approach and Studies, vol. 3, no.1, pp. 220-222.

Ghalayini, L 2011, ‘The interaction between oil price and economic growth’, Middle Eastern Finance Economics, vol. 4, no. 13.

Husain, A, Arezki, R, Breuer, P, Haksar, V, Hebling, T, Medas, P  & Sommer, M 2015, Global implications of lower oil prices. [Online]. Available at: http://www.imf.org/external/pubs/ft/sdn/2015/sdn1515.pdf (Accessed October 15, 2016)

Jimenez-Rodriguez, R & Sanchez, M 2004, Oil price shocks and real GDP growth; empirical evidence for some OECD countries. [Online]. Available at: <https://www.ecb.europa.eu/pub/pdf/scpwps/ecbwp362.pdf?b35d2a5fd0bae52378b274ce13a956c4>  (Accessed October 16, 2016)

Monetary Policy Report: Effects of the falling oil price on the global economy 2015. [Online]. Available from. <http://www.riksbank.se/Documents/Rapporter/PPR/2015/150212/rap_ppr_ruta2_150212_eng.pdf>  (Accessed October 15, 2016)

Pettinger, T 2015, Impact of falling oil prices. [Online]. Available at: http://www.economicshelp.org/blog/11738/oil/impact-of-falling-oil-prices/  (Accessed October 14, 2016)

Wald, E 2016, Why low oil prices make OPEC stronger. [Online]. <http://www.forbes.com/sites/ellenrwald/2016/05/09/opec-iran-low-prices-stronger-demise/#657d7d054dfb> Available at: (Accessed October 16, 2016)

World Bank 2015, Global economic prospects, January 2015; having fiscal space and using it, World Bank Publications, Washington, DC.