Will the Oil Price Surge Make Us Go Broke?
"The Energy Crisis"
The global oil price benchmark has breached $120 since the beginning of 2022 (Sheppard 2022). The mass outbreak of bullishness has put the world in a frenzy, questioning the same thing: will we be able to afford gas down the road? The energy crisis began with Russia squeezing natural gas supplies to Europe before the invasion of Ukraine and it is more likely to worsen (Sheppard 2022). The key issue at play here is obviously, the scarcity of crude oil. There is not enough oil going around. The lack of supply has enticed fear among us, as reflected by the sanctions-hit oil output in Russia and the heavily discounted cargoes in India and China (Sheppard 2022). As we deal with immense terror over the sustainability of gas purchases, the question of “What’s next?” poses as an even greater challenge. How did crude oil supply reach its state of scarcity? What does this mean economically?
History of Oil Crises
Since the large oil price shocks in the 1970s, changes in the price of oil have been widely seen as an important source of macroeconomic fluctuations (Aastveit 2014). Historically, oil crises have been characterized by widespread concern over the price and availability of energy. The prevalence of such concern has had the influence to cause permanent investment decisions to be postponed. Upon evaluating responses of macroeconomic variables to oil price changes, it is deduced that oil price innovations result from supply shocks (Aastveit 2014) and that a positive correlation exists between oil shocks and recessions (Hamilton 1996). In addition, political and military actions leading up to oil crises are directly responsible for price hikes. For instance, oil price shock was one of the reasons for the economic recession in the United States following the Second World War (Li 2021).
Oil price developments since World War II up to the 2000s can roughly be divided into three stages. Before the 1970s, nominal oil prices were stable, while real oil prices slightly fell (Schneider 2004). The 1970s and early 1980s were characterized by the two oil price shocks, during 1973-74 and 1979-80 with skyrocketing oil prices (Schneider 2004). After the 1980s, nominal oil prices fluctuated until the 1990s, where prices stayed at a stable value of USD 15 to USD 20, with some temporary deviations (Schneider 2004).
It is proven that international oil price changes have a spillover effect on domestic inflation (Li 2021). Focusing solely on the US economy, it is indicated that significant oil prices effects on the macroeconomy have been transferred through inflation and interest rates historically (Li 2021).
Geology & Economics: Statement of connection
As we explore the sciences behind our natural resources on Earth, it is worth investigating why crude oil has become the scarcity that it is and how its scarcity can affect the globe economically. It is thought-provoking how the lack of a geological resource could carry over to the economy around the globe. On top of which, it is concerning how oil crises could severely impact our quality of life. The scope of the issue makes every aspect of the crisis worth investigating. Factors such as the sustainability of crude oil and the reality of the oil trade all contribute to the curiosity around oil price crises and its economical impacts. Is oil still a realistically sustainable resource? What are the reasons for intermittent price hikes and who is the authority behind the scene?
Oil Supply Shortage
Some may say that oil is the life-blood of our modern civilization. Truly, world economic development would not have had its amplification without the help of world oil production. Giant oil fields are responsible for over 60% of world conventional oil production, and they act as an important benchmark when considering the old decline scenario worldwide (Robelius, 2007).
As of 2022, commercial oil stocks in rich countries are rapidly declining as supplies fall short of demand, according to the IEA. For the record, western countries have released oil from emergency reserves in hopes of temporarily cooling oil prices that are currently more than twice as high as their long-term historical average (Brower 2022). In reference to economic analytics, Goldman Sachs has forecasted the oil price to rise up to $135 per barrel this year (Brower 2022). While analysts have suggested that a price jump caused by an increasing supply shock could in turn destroy oil demand and drive down prices, the Ukraine crisis has severely cut back on Russian oil exports, resulting in the failure to match post-pandemic oil demand (Brower 2022).
On the basis of economic theory, in the competitive market of crude oil, a surge in demand and a shrinkage of supply entices the increase of price as it strains the productive apparatus heavily. To counter the effects of a shrinkage, additional output needs to be produced, which requires even higher costs (Adelman 1972).
The Oil Trade
Is the oil shortage real? One question we cannot help but wonder, as we scour through the historical numbers. The reality of the oil trade remains consistent over the years: oil and gas have always been the main provider of our energy and domestic reserves supply our demands at excessive costs, which is projected to only multiply over the next decades (Adelman 1972). While oil supply is predicted to be constantly on the rise, the price is independently monitored by multinational companies in the trade.
Foreign Policies
With the success of OPEC oil cartels, companies are able to produce oil at a monopoly price, but foreign policies have created an imbalanced dynamic between the producers and consumers. Multinational companies are agencies in disguise, taxing consumers regardless of income class, to transfer the proceeds to the governments of oil-producing countries. The transnational system is the eternal motivator behind the inflating prices. To illustrate, the greatest monopoly in oil trade history had transferred approximately $15 billion USD from the consuming countries to their governments (Adelman 1972). On top of the insecure oil supply, the Organization of Petroleum Exporting Countries (OPEC) cartel leads the way for monopoly to obtain authority in the trade. As monopolies, the economic advantage transforms multinational oil companies into agents of foreign power. Additionally, political dynamics across countries would only worsen and is unlikely to be beneficial to the lopsided industry. For example, the recent oil crisis in 2022 was mostly contributed by the invasion of Ukraine into Russia (Sheppard 2022).
Impacts on the Economy
Oil price shocks impact the economy through three dimensions: the supply, the demand and the terms of trade (Schneider 2004). Oil supply takes a hit as production costs rise in reaction to an oil price shock. Relocation of factors eventually contributes to an increase in adjustment costs and the implications of uncertainties for spending on consumer durables and investment, which aggravates the issue of supply shortage. In terms of demand, oil price shocks inflate the general level of prices, which results in lower real disposable incomes and thus reduces demand. Consequently, higher wage pressures and weaker demand depresses employment. As well, a degradation of confidence in the market and stock market reactions can expand the impact of a shock (Schneider 2004).
The cost-driven inflation permeates the economy in ways beyond an oil price hike. As a significant contributor to all economic activities, crude oil price inflations have an authoritative role in the global economy. There are five economic mechanisms through which oil price changes influence inflation: discretionary income effect, uncertainty effect, precautionary savings effect, operating cost effect and reallocation effects (Li 2021). As a result, virtually every empirical study finds dramatic short-run asymmetric effects between oil price and inflation.
Effects on the 3 Major Economies
How does an economy respond to an oil price shock? The simulation results shown in table 1 are the average deviations of GDP growth rates and inflation in the first three years following an oil price shock. The relative effect on the three major economies varies. The extent to which various countries or economies are impacted depends on several characteristics, namely energy intensity (oil consumption relative to GDP), the sectoral structure of the economy, disposable stocks, the mineral oil tax system (specific or ad-valorem tax), citizens preferences, economic policy responses, the existence and amount of oil reserves and the structure of the labor market and the labor market institutions (Schneider 2004).
While scholars have a symmetric assumption of the two variables, deviation exists, especially in the long-run effects. Mixed results exist in regards to the long-term permeability of oil price shocks into inflation. The reason is that oil prices have behaved radically differently after 1986 than before (Hamilton 1996). The discrepancy indicates that while asymmetry exists in the short run, no constant economic effect can be concluded in the long run. Furthermore, geographical regions respond differently to oil market shocks, with Europe and North America being more negatively impacted than countries in Asia and South America (Aastveit 2015). Most importantly, oil price shocks may have a greater influence in the short run, since oil price change has its direct inflationary effect in the low oil dependency group but its impact is indirect on affecting the inflation in the high oil dependency group through changes on the exporter's production cost (Aastveit 2015).
Using the NARDL system, an asymmetric relationship between oil and food prices is estimated, meaning in the long run, there is a significant relation when the oil price increases, but said relation is absent for an oil price decline (Li 2021). To explain, when oil prices are low, energy related consumption is enticed due to a reduction in operating costs. On the contrary, when oil prices are sharply increasing, the uncertainty and concern about precautionary saving are all necessary to convey an effect on depressed economic activities and joblessness, and consequently cause deflation (Li 2021).
In conclusion, oil demand shocks appear to be more influential than oil supply shocks in fluctuations of the price of oil. Results have stated that oil demand shocks directly cause macroeconomic fluctuations, while oil supply shocks have less of an impact. Nonetheless, the causes behind the changes of demand for oil are critical. For instance, the U.S. economy responds differently to price-sensitive global demand shocks than to demand shocks that are not (Aastveit 2014). It is suggested that monetary policy should respond differently to movements in the real price of oil, depending on the respective causes (Aastveit 2014).
Conclusion / Your Evaluation of the Connections
It is fascinating how geology and economics may intersect, despite not being the most relevant disciplines. The recent oil price surges makes it hard to overlook the economic impacts of the natural resources supply. Hence, looking into this aspect of oil production may provide insights as to how we could possibly minimize the effects of oil crises.
As mentioned previously, the multinational dynamics play a huge role in taxing consumers of the trade. It might be helpful to solve the issue from its root and prevent ulterior motives as such, in order to sustain the supply of our natural resources. By permitting and encouraging tax benefits, it offers a motivation to monopolize oil businesses, which limits the scope of oil production. It is of utmost importance that we bear in mind the purpose of sustainability and put aside the greed for financial gratification, so as to ensure a fair ground for economic development and coincidentally a realistic ground for environmental protection.
References
- Aastveit, K. A. (2014). Oil price shocks in a data-rich environment. Energy Economics, 45, 268–279. https://doi.org/10.1016/j.eneco.2014.07.006
- Aastveit, K. A., Bjørnland, H. C., & Thorsrud, L. A. (2015). What drives oil prices? Emerging versus developed economies. Journal of Applied Econometrics, 30(7), 1013-1028.
- Adelman, M. A. (1972). Is the oil shortage real? oil companies as OPEC tax-collectors. Foreign Policy, (9), 69. https://doi.org/10.2307/1148086
- Brower, D. (2022, March 19). Oil supply shortage fears add to price volatility. Subscribe to read | Financial Times. Retrieved June 24, 2022, from https://www.ft.com/content/4b10002a-d17a-42c6-b558-f1dfdbc9cc7b
- Hamilton, J. D. (1996). This is what happened to the oil price-macroeconomy relationship. Journal of Monetary Economics, 38(2), 215–220. https://doi.org/10.1016/s0304-3932(96)01282-2
- Robelius, F., 2007. Giant oil fields—the highway to oil, Uppsala University, March.
- Li, Y., & Guo, J. (2021). The asymmetric impacts of oil price and shocks on inflation in BRICS: A multiple threshold nonlinear ARDL model. Applied Economics, 54(12), 1377–1395. https://doi.org/10.1080/00036846.2021.1976386
- Schneider, M. (2004). The impact of oil price changes on growth and inflation. Monetary Policy & the Economy, 2, 27-36.
- Sek, S. K., Teo, X. Q., & Wong, Y. N. (2015). A comparative study on the effects of oil price changes on inflation. Procedia Economics and Finance, 26, 630–636. https://doi.org/10.1016/s2212-5671(15)00800-x
- Sheppard, D. (2022, June 10). The world must brace itself for a further surge in oil prices. Subscribe to read | Financial Times. Retrieved June 23, 2022, from https://www.ft.com/content/99cac5d0-bf6e-45ac-8e18-14267dab85f4