Oil price rises a sign of a healthy global economy.

Oil prices have been irregular over the last four years with the price of a barrel of oil being over $100 in 2014. This price had been suggested as the new $20 due to scarcity of oil reserves. However by 2016 the price had dropped to $28 a barrel the talk was that there was a global glut. Today the price is around $70 and analysts have been perplexed as to what is behind this increase. According to The Economist three significant questions arise:

1. Why has the oil price more than doubled in the space of two years against all expectations?

The 2016 slump in prices ($28) was in part due to the weak demand and an abundance of supply – simple economics. But demand recovered quickly and in particular the Chinese economy quickly pepped up its economy with fastest growth rates. On the supply side OPEC were able to restrict output and stocks of oil in the US started to fall. This saw D > S = P↑. Usually when there is an increase in price it attracts other sources of oil which are more expensive to extract – eg shale oil in the US and the tar sands in Canada. This is in turn will increase the supply and lower the price. But small suppliers are finding it harder to increase output as the financiers want more focus on profit rather than output. It can take months before oil actually comes on-stream.

Source: The Economist 20th January 2018

2. Why have stockmarkets been pleased with higher oil prices when it is usually associated with economic crisis?

The overall impact of higher oil prices has been to reduce aggregate demand in the global economy. With higher prices one might expect that the profits would be pumped back into the circular flow and therefore stimulating AD. However the Middle East producers tend to be big savers of oil profits at the expense of oil consumers in the West. Also countries have become less reliant on oil – demand peaked in 2005. Oil exporters depended on high oil prices to fund their government spending as well as importing consumers goods – Venezuela is a classic example of an economy that has relied on oil revenue for over 80% of government spending. Most big oil producers in the Middle East need the price of oil to be above $40 a barrel in order to cover their import bill. But a rising price of oil is usually a healthy sign that China is growing as it is the world’s biggest importer of oil.

3. What will be the ‘normal’ price of oil?

The critical change in the oil market from 30 years ago is that there is now an abundance of oil. Back then it was seen as an asset rather than a consumer good – oil in the ground was like money in the bank. But new sources of oil such as shale and tar sands have amounted to the existence of plentiful reserves. It must be added on the demand side the gaining momentum of mass-market for electric cars have reduced the demand for oil. It is being suggested that not all oil will extracted as there will not be enough demand. It makes sense that the five big producers in the Middle East – Saudi Arabia, UAE, Iran, Iraq and Kuwait – which can extract oil for under $10 a barrel, to undercut high-cost producers and capture the market share. So it is better to have money in the bank rather than in the ground. Will oil prices plunge? Unlikely especially when oil exporters are cannot sustain low prices for very long – in order to fund their expenditure they need oil prices of $60 barrel.

Source: The Economist 20th January 2018 – ‘Crude Thinking’


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