MACROECONOMIC EFFECTS OF OIL PRICE INCREASE AND MEANS OF EXERTING INFLUENCE ON THEM

LYUDMIL NESTOROV
2011 / 5 / 15



Subjects of research in the present article are the causes for variations in oil prices in Bulgaria as well as in the world and their effect on major macroeconomic indicators such as gross domestic product, inflation, unemployment, household income, etc.
The object of the research is not only to determine certain macroeconomic effects, influenced by the growth of oil prices, but also to give some feasible measures for securing macroeconomic stability and economic growth in short and middle term.
Oil prices have been climbing in recent years putting an end to almost two decades of relative stability. The biggest leap of oil price against the preceding year is of Brent Crude, produced primarily in Northern Europe, by 55,7% in the year 2000. During the following years its price continued to rise considerably, by 36,2% in 2003 and 33,9% in 2006 respectively. Just for the last six months of 2008 its price vastly increased by 32,6% /see graph 1/.

Graph 1: Oil price variation

Oil price exceeded the psychological boundary of 100$ per barrel in March 2008 and at the beginning of July /the same year/ it reached its highest so-far value of 146,2$ per barrel. Except for 1990, the price of oil produced by OPEC member countries is comparatively lower than the one of Brent Crude, though the rate of increase compared to the preceding year is higher. For example, in 2000 the leap is by 57.1%, in 2006 by 37.5% and in the first six months of 2008 – by 41.1% /see graph 1/. The trend as per foreign observers is for oil price to continue to rise and it will reach a new psychological boundary of 200$ per barrel, if not by the end of the year, then in the near future.
What is important to analyzing the rate of price rise are the shifts of its relative prices since they do not reflect the impact of nominal monetary units and rates of exchange. Equalized to current dollars the real price of oil abruptly began to increase after the year 2000. In 2007 it exceeded its latest climax of 1981 – 3.5$ per gallon and in mid 2008 it is already over 4$ /see graph 2/.

Graph 2
Though exceeding these levels, the portion of oil in the production and consumer baskets of developed countries has vastly dropped, since their industry has become less power-consuming. However, this does not affect China, India, the emerging market economies and developing countries` economies which in recent years have marked a high rate of economic growth and are of the greatest need for oil since their economies are still highly power-consuming. This means that demand will climb and along with that will oil price.
According to the Energy Information Agency at the Government of the USA, in the future, oil prices will continue rising, in spite of their high level at present, to reach and even exceed 130 dollars per barrel in 2014. The prognosis is based on the strong economic growth in the Asian countries until 2035 which will cause a 28.5% increase in the demand for petrol and also a growth in its price by 80%, reaching the level of 160-170 dollars per barrel.
1. Main reasons for oil price increase
There have been dynamic shifts in oil price on several occasions during the last decades. As every commodity petroleum is subject to the laws of supply and demand and its price varies depending on economic and political conditions and production capacities. The importance we attribute to oil price is based on its extensive usage throughout the world. The warnings of geologists regarding the depletion of conventional oil fields /within the forth-coming 50 years/ do not arouse optimism since it is difficult for us to envision the world without it. Petroleum as a basic raw material and an end product has a significant and versatile impact on countries` economic development. In order to analyze the outcomes of oil price increase it is necessary for us to determine the reasons for this price dynamics.
Market price is just a signal which fulfills the subjective preferences, evaluations and anticipations of economic agents concerning the respective commodity. In 1973, 1979, 1989 and 2004 oil price recorded a considerable increase as a result of the harsh drop in supply on the part of OPEC. At the basis of these petroleum shocks there have almost always been political crises on a global level. These are, for example, the Arab oil embargo ion 1973, the Iraq-Iran war of 1979, the Persian Gulf war of 1989, and the war in Iraq in 2004. Furthermore, the stable and strong dollar was the reason for increasing the price of oil in the past. The dollar`s impact on oil price is felt through its expression in the current monetary units of the respective countries, compared to the dollar`s exchange rate against them. In case of a strong dollar these monetary units get depreciated which results in oil price increase in the corresponding countries.
Despite differences in the past the lessons that can be learnt today are primarily related to unsolicited intervention on the part of the state in the oil market. We have in mind mostly the intervention of the USA and the Arab petroleum exporting countries, which in one way or another - by political and economic means, influence its price defending their own interests.
Apart from the above-mentioned reasons at the basis of the harsh oil price increase today is the strong impact of increased demand against its limited supply. Bearing in mind the thriving of world economy and particularly in China and India, as well as the current and anticipated branch and product structures, and production and public service technologies, by far larger quantities of oil will be needed in the next 5-10-15 years.
The capacities of OPEC and the other oil-producing countries to boost output are constrained, with the exception of Saudi Arabia and Venezuela. However, Saudi petroleum belongs to heavy oil fractions. Substantial increase of production requires huge new investments and a lot of time. The prolonged maintaining of low prices /10-11 dollars per barrel until the end of 1998/ did not stimulate oil companies to increase funds for developing new output capacities. Moreover, it is necessary that new investments be made for delivering oil /new petroleum- and gas pipelines, tankers, etc…/. However, those are possible only in case of higher oil prices.
The weak dollar at present additionally increases oil price. The fact that this is the monetary unit whereby raw materials in world markets are quoted results in the oil traders` pursuit to offset the exchange margin of low dollar rates, which leads to its nominal rise and thence to oil price increase.
Currently there are also certain geopolitical factors leading to decreasing oil production and supplies which contributes to the strong increase of its cost. Such factors are the political contradictions and the armed conflicts which recently took place on three continents – South America, Africa and Asia.
Petroleum is intensely traded on capital markets in the form of futures, options and other derivative instruments. They are extremely sensitive and incorporate in themselves investors` future anticipations. This makes oil price highly sensitive, reflecting rate fluctuations of securities, currencies, interest rates as well as the slightest fluctuations in world economy development. However, stock exchanges are just a barometer regarding businesses` and investors` anticipations and they cannot have a durable impact on commodity prices provided economic reality does not correspond to price dynamics. We are of the opinion that what underlies those anticipations and at the same time influences oil price rise is the political instability in the world, particularly after September 11th, 2001.
As per Heritage International Research Agency more than half of the petroleum volume in the world is produced in countries exerting strong governmental control over its production and over three-thirds of oil reserves are in countries which the Agency rates as predominantly non-free or even worse with regard to state intervention in the production and trade of the precious raw material. The lack of sufficient economic freedom in most countries producing petroleum would result in its shortage in the future, which would incessantly generate preconditions for world economy crisis and economic development detention.
The low price flexibility of petroleum as a power source additionally raises its demand and stimulates its price increase. This means that as a priority huge funds must be invested in searching, detecting and commissioning of its substitutes.
The large degree of relatedness in world economy also stimulates oil price increase. This is grounded in the fact that even a local disruption of oil production or supplies results in a crucial speculative impact on the market and in economic destabilization in world economy for a long-drawn-out period of time. A cause for oil price increase is also the pursuit of a bigger profit for national petroleum companies, international petroleum concerns, stock markets alternative power-source producers.
As a whole, oil price increase is recently due to raw material price increase in general /including the one of agricultural raw materials/. A critical increase is recorded by the prices of wheat and corn which are not only a source of subsistence and development of stock-breeding, but also a raw material for the production of bio-fuels.
The natural disasters recently /hurricanes “Katrina” and “Rita” in the Mexican Gulf and the USA/, the drought seizing large areas of the world and the global warming have also contributed to oil production decrease and increase of its demand and price.
On the basis of mentioned above we can conclude that the reason for the rising price of “black gold” has its roots in the decreasing of oil reserves, growing petrol demand and expenses for its extracting, transportation and transfer, and also in the increasing risk connected with these activities.
II. Global implications of oil price increase
The primary implication of increasing the price of oil as a basic power-source for the economy is that it results in the spiral price increase of a number of commodities
and services along the production chain, and this leads to a consumption slump in general. According to a report of IMF on the status of world economy as of July, 2008 the average crude oil price has increased in the last year and a half by 83% and the prices of other raw materials have risen by 0.5% on the average. Therefore, oil price increase is at the basis of the overall increase of consumer prices for the same lapse of time. As a result, consumer prices have climbed by 1.2% in developed countries, and by 2.7% in emerging market economies and developing countries.
The high prices of consumer goods result in a decrease in their demand by households, which on its part leads to a drop in firms` production, a decrease in their profit margins owing to the more expensive raw materials and their withdrawal from investment projects. All of this leads to the shrinkage of overall production, unemployment rise, decrease in households` earnings and budget revenues, i.e., conditions are created for an economic crisis with all the ensuing negative economic and social implications. From a mathematical perspective under the above conditions the countries` GDP would inevitably diminish in its actual expression owing to the decrease of its biggest expenditure components – consumption and investments.
According to a report of the IMF of July 2008 regarding the implications of oil price and inflation increase, it reads that there is a pending slump in world economy and there will be a particularly strong and negative impact on emerging market economies as well as on developing countries` economies.
The reason lies in the fact that they are insufficiently effective, highly power-consuming and most of them are oil importers. Furthermore, along with oil price, natural gas price is rising as well. In this fashion the inflation stimulated by the prices of these basic power sources results in the price increase of primary foodstuffs, water, fuels and transport which most strongly impacts on people in countries with low average earnings.
Based on the assessment of the IMF, in countries with average household earnings such as China, India, Turkey, the South-African Republic and the Central and East European countries /including Bulgaria/ it is projected that prices of foods, water and oil increase between 25-40% in the coming 1-2 years. Oil price rise will have a worse impact on countries with earnings lower than the world`s average ones where Egypt, Mongolia and the Middle East countries belong. In the latter countries the impact of oil price on the price increase of primary consumer goods is projected to be over 50%. Oil price increase will have the least impact on developed countries such as the USA, the old member countries of EU, and Australia – between 10-20%. Therefore, oil price increase will deepen world poverty and the need for new techniques for its containment and the abolishment of its implications.
The problem has another aspect as well: as a result of oil price increase a number of companies from developed countries are beginning to re-orientate their production capacities towards China, India or the emerging market economies, seeking opportunities to diminish the cost price of the commodities they produce, and to preserve their current retail prices. This results in unemployment rise in these countries and in the emergence of a number of other economic and social problems.
The co-relationship between the oil price and the price increase of basic raw materials for production given a low economic growth and diminished capabilities for an active monetary and fiscal policy is turning into a real precondition for slowing down economic growth within a short time-line, and for a new economic crisis in a long-term perspective.
It is possible that there be armed conflicts in the future owing to constraining oil reserves and increasing its demand. This would further boost political and economic instability and would result in a new price rise of the precious raw material and thence the emergence of new negative economic and social processes in the world.
I²². The impact of oil prices on Bulgarian economy
Bulgarian economy is one of the most power-consuming economies in Europe. Data on the relative power consumption of petroleum in the country indicate that power usage is some 9 times as much compared to the EU member countries, over 60% of the country`s energy carriers are imported. This results in low labor productivity in Bulgarian economy, low payrolls, low competitiveness and low negative balance on the payment sheet.
It is hard to foresee accurately the impact of petrol prices on the economic growth of Bulgaria. Data provided by the National Statistical Institute for 2008 display that growth in GDP is above estimated level - 6% higher than previous year. Consumption rose by 3.9%. Import also increased by 4.9% and most of it being due to high oil prices. Mostly as a result of the growing price of fuel by 15.5%, inflation in the year 2008 marks a record-breaking growth by 12.3% compared to 2007 . It’s been the highest rate of inflation for the last ten years.
Bulgarian companies are redirecting their focus on energy effectiveness and are not prone to making investments for optimizing their power consumption expenditures. These are negative signals indicating that Bulgarian economy is not flexible enough and oil prices in the future may turn out to be a critical problem economy-wise for our country.
Bulgaria is a small-size open economy and the impact of world economic trends is direct. Various branch and specialized organizations have already stated that they will raise the prices of offered goods and services. Since the beginning of 2008 the prices of gasoline and gas have already risen by 20.5% and 26.1% respectively, followed by diesel and propane-butane prices. Entrepreneurs and consumers will not be able to adapt swiftly to the new market conditions and prices. The indexing of salaries and pensions as of July 1st, 2008 by 10% did not succeed in compensating the consequences of inflation. These conditions led to a drop in real income and a lower real growth in GDP by 5% in 2009 compared to the previous year.
²V. Conclusion
World oil reserves are limited and its demand is continually on the rise, which means that its price will continue to increase. This gives us reason to generalize that we are undergoing a consecutive oil shock which faces us with a new world economic crisis. To avoid this dire scenario for the future development of world economy we can and must seek a way out predominantly in the opportunities for increasing oil price flexibility and in decreasing our dependence on it. This means it is necessary that more funds be invested in finding its substitutes – water, wind, sun, bio-fuels, and geothermal energy; further liberalization of the energy sector, stimulating competition and boosting economic freedom on producing and freighting energy resources, improving production structure, introducing new, more effective energy-conserving technologies, designing and employing hybrid automobiles, etc…
Within a short-term period one can counteract to oil price rise via lowering income and indirect taxes, lowering interest rate, indemnifications and indexations of low incomes, improving foreign economic relations, etc…From a long-term perspective a strong positive impact on oil and gas prices will be accomplished by the joint effort of all countries towards more political wisdom, understanding and foresight, which would guarantee economic and political stability in the world. Should the above not be accomplished, market mechanisms, as flexible as they are, would not be able to ultimately meet the new economic trends and oil prices may turn out to be a threat to universal peace and progress.




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