Dutch disease

oil-field

The Dutch disease refers to the problems associated with a rapid increase in the production of raw materials (like oil and gas) causing a decline in other sectors of the economy. When the raw materials run out, the economy can be in a worse position than before. – Can the discovery of substantial raw materials …

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What factors cause an increase in the price of oil?

The oil price is determined by supply and demand side factors. Rising oil prices are indicative of rising demand and/or shortages of supply. The oil price is also affected by market speculation.

Rising Demand

Increasing demand will push up the price of oil. A short-term rise in demand could lead to a significant increase in price because supply is quite inelastic – at least in the short-term.

A significant cause of rising demand for oil is simply a growing global population. An increasing number of people have greater energy demands causing a steady rise in demand for oil

Secondly, economic growth is a major cause of rising oil demand. With higher economic growth, there is an increase in derived demand for transport, oil and also energy. In recent years, strong economic growth in India and China has led to a significant rise in demand for oil. For example, the growing middle class in China have aspirations to own a car, therefore the increase in income can cause a proportionately bigger % increase in demand.

 

rise-in-demand

Technology. In recent years we have seen new technology which has diminished the need for oil – more fuel-efficient cars, hybrid cars, switch to renewable energy. This has moderated the demand for oil, though greater efficiency has been outweighed by the growing demand – especially from emerging economies in S.E Asia.

Inelastic Demand

With many goods, higher prices lead to lower demand as people switch to alternatives. However, demand for oil is notoriously inelastic because of the lack of available substitutes. Therefore, if the price rises, people are willing to pay the price.

In the long term, demand may become less inelastic because substitutes develop; but, at the moment alternatives are now widely available. This means as price rises, demand doesn’t drop off. People just pay the higher prices.

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Petrol Price Per Litre $ Around the World

price-petrol-per-litre-around-the-world
Source: World Bank

This shows the price of petrol per litre around the world. Varying in price from $0.02 a litre in Venezuela to Eritrea with a price of $3.33. Generally Western European economies have the highest price of petrol due to higher petrol tax.

Out of 217 countries listed by the world bank.

Most expensive place to buy petrol in the world

  1. Eritrea $3.33
  2. Norway $2.27
  3. Netherlands $2.15
  • The UK is the 12th most expensive country at  – $1.92
  • The US is one of the cheapest countries – ranked 199/217 on list – $0.76

The cheapest places to buy petrol

  1. Venezuela – $0.02
  2. Saudi Arabia – 0.16
  3. Kuwait – 0.22

Reasons for variation in the price of petrol around the world

  • Oil producer/importer. Countries which produce oil Saudi Arabia, Venezuela and Kuwait unsurprisingly have the cheapest prices.  The one exception is Norway – which despite being a major oil producer has one of the highest prices. By contrast, countries which import oil and petrol have higher prices.
  • Tax levels. In the UK fuel duty is £0.5795 per litre. In addition, VAT is charged at 20%. Approx 60% of the fuel price motorists pay in the UK is tax. This compares to China which has no fuel tax. Malaysia has even had a fuel subsidy.
  • Wage costs and renting. The other significant cost for petrol is the rent for a petrol station and wages of workers. Wages and costs in Western Europe are higher than in the developing world – explaining part of the price differential.

Petrol consumption per capita

petrol-consumption-per-capita

The US has the highest petrol (gasoline) consumption in the world by quite a long way. This is due to

  • US has one of the world’s highest living standards,
  • A transport system geared towards the motorist, long distance car journeys are more common with extensive highway network and more limited public transport systems.
  • Relatively low price compared to countries with similar living standards.

As China experiences economic growth, its per capita consumption is likely to grow rapidly.

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Effect of Higher Oil Prices

effect-higher-oil-prices

A look into the effect of higher oil prices. Readers Question: With oil prices rising towards $100, what are the economic effects of rising oil prices? Demand for oil is inelastic, therefore the rise in price is good news for producers because they will see an increase in their revenue. Oil importers, however, will experience …

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Impact of falling oil prices

In recent months the price of crude oil has fallen 50%. This fall in the price of oil has a significant impact in reducing transport and other business costs. Falling oil prices is good news for oil importers, such as Western Europe, China, India and Japan; however, it is bad news for oil exporters, such as Venezuela, Kuwait, Iraq and Nigeria.

oil-prices

Impact of lower oil prices on oil consumers

Lower oil prices help to reduce the cost of living. Oil-related transport costs will directly fall, leading to lower cost of living and a lower inflation rate. Falling oil prices is one reason behind the fall in UK inflation to 0%

With stagnant real wages, this fall in the cost of living is important for giving Western consumers more discretionary income (more income to spend). A fall in oil prices is effectively like a free tax cut. In theory, the fall in oil prices could lead to higher spending on other goods and services and add to real GDP.

Macro economic impact of falling oil prices

  1. Lower inflation
  2. Higher output

sras-shift-right

This diagram shows that a fall in oil prices (and a fall in firms costs) will shift the short-run aggregate supply (SRAS) to the right, causing lower inflation and higher real GDP. (Some economists say a 10% fall in oil prices leads to a 0.1% increase in GDP (BBC article on falling oil prices)

3. Balance of payments

Oil importers will benefit from a falling oil price because the value of their oil imports will drop. This will reduce the current account deficit of oil importers; this is important for a country like India who imports 75% of oil consumption and currently has a large current account deficit. However, for oil exporters, a falling oil price will do the opposite reducing the value of their exports and causing lower trade surplus. The UK is currently a small net importer of oil, so will have limited impact on UK current account.

Oil exporters

For oil exporters, a falling oil price is bad news. Many oil exporting countries rely on tax revenue from oil production to fund government spending. For example, Russia gains 70% of all tax revenues from oil and gas. Falling oil prices will lead to a government budget deficit, and will require either higher taxes or government spending cuts. Other oil exporters like Venezuela are relying on oil revenues to fund generous social spending. A fall in oil prices could lead to a significant budget deficit and social problems.

Other oil exporters, such as Saudi Arabia and UAE have built up substantial foreign currency reserves; they can afford temporary falls in oil prices because they have substantial reserves. This is why Saudi Arabia has so far not responded by cutting output.

Why falling oil prices is not enough for Europe

Usually falling oil prices would be welcomed by oil importing countries. However, many are deeply fearful about prospects for the European and global economy.

Firstly, the fall in oil prices is largely a reflection of weak global demand. Continued low growth around the world, is holding back demand. Thus the falling price of oil is a reflection of weak global growth – rather than the harbinger of economic recovery.

oil-deflation

Deflation nightmare. The biggest fear in Europe at the moment is the slide towards deflation and the fear of a ‘Japan-style’ lost decade. EU inflation has fallen to a five-year low (0.4% in August 2014) 31% of Eurozone goods are now falling in price. This is a concern because deflation tends to cause serious macroeconomic problems:

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Are falling oil prices good for the economy?

In recent months, we have seen a dramatic drop in oil prices. For many consumers and business, this fall in the price of oil will be welcome reduction in the cost of living and a reduction in the cost of business. However, is such a steep fall in oil prices good for the economy? Benefits of …

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Russian economic crisis

With economic sanctions and a plummeting price of oil, the Russian economy is seeing a real economic crisis. The value of the rouble is falling – causing inflation and a decline in living standards. Government tax revenues are falling as oil tax revenues decline. On top of a falling Rouble, the economy faces recession due to declining export revenues, falling real incomes, a collapse in confidence and higher interest rates.

Causes of Russian economic crisis

Oil dependent economy. The Russian economy has done well in recent years from high oil and gas prices. This has led to strong export revenues and government tax revenues. In 2012, the oil and gas sector accounted for 52% of federal tax funds and 70% of exports But, the near 50% in oil prices have caused the economy to suffer. Unfortunately, the strength of the oil industry has meant alternative manufacturing industries remain undeveloped – and unable to benefit from more competitive export prices. The Russian oil economy is an example of the Dutch disease.

Falling oil prices. The oil price has collapsed from $115 a barrel in June 2014 to just above $60 in Dec 2014. Falling oil prices have caused a big fall in export revenue, a fall in real GDP and a fall in government tax revenues.

Economic sanctions. Sanctions imposed by the EU and US since the issues around the Ukraine have damaged the ability of some Russian firms to raise finance. On their own, the sanctions are quite limited in effect, but combined with the timing, they are a big blow to confidence in the Russian economy.

Recession. Due to the 50% devaluation in the Rouble, the price of imported goods has increased, leading to imported inflation. With inflation running at 9%, consumers are seeing a fall in real wages. Wages, pensions and benefits are not keeping up with rising cost of living. This is causing lower spending. The Central Bank faces a difficult dilemma – because of the recession it needs to cut interest rates, but the falling Rouble has caused it to increase interest rates to 17% – to try and protect the value of the Rouble – but, this will further reduce spending and lower growth. (See: effect of higher interest rates). With the oil and gas sector hit, big firms are likely to lay off workers, due to the fall in demand and revenue. This rise in unemployment will exacerbate the recession. It’s a tough combination of factors, which give the government and Central Bank little room for manoeuvre.

russia-rouble-independent

Source: Independent

Falling Rouble. Despite high foreign currency reserves, the Rouble has fallen in value, suggesting investors have lost confidence in the Russian Central Bank, the Russian economy and the Rouble. The problem of the falling confidence in the Rouble, is that it is encouraging capital flight – where Russians seek to protect the value of their wealth  by transferring it into other currencies outside Russia. This is a toxic mix – a self-reinforcing cycle of falling Rouble, causing more people to give up on the Rouble.

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Factors affecting Oil Prices in Short Term and Long Term

A look at the different factors affecting the price of oil in both short term and long.

Readers Question: I’m trying to update myself on what’s happening with oil prices at the moment (partly to prepare myself for uni interviews) but I’m finding very conflicting articles, such as:

  • Article warning of oil rising to $150 at BBC
  • Oil drops below $96 on Italian debt fears at Washington Post
  • Oil nears $96 on Italian debt fears at NPC

 Could you possibly explain to me what’s really going on?

It’s an interesting question, and in a way all three articles are sound economics. It is possible to have conflicting predictions for oil prices. Perhaps the easiest explanation is to consider both short term and long term factors.

Oil Prices Since 1987

oil prices
Oil Prices – volatile

Between Jan 1999 and Jan 2008, oil price rose from under $20 a barrel to over $130. However, during this long term price rise, there were still periods where oil prices fell.

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