Oil is one of the most traded commodities in the world, which is why changes in prices will affect the economy on a global scale and will influence us as individuals and our personal finances. If we were to look at any business in the world it becomes clear that without oil (fuel, gas e.t.c) the business would not function and we begin to see the true importance of it. Many countries would just not even be today if it were not for the discovery of oil, for example Saudi Arabia, a country in which the state of the economy is 99% governed by the export of their crude oil. In 1999 people in the UK went on strike because the price of oil trebled to 30$ a barrel, which managed to sway the British economy for that period. Today the price has further risen to almost 50$ a barrel.
Now the importance of oil has been set we can go on to find out what determines the price. Oil has an unlimited number of uses, and it could be said that it makes the world go around. One of the main uses of oil is for heating. In houses in businesses, in factories, heating is needed everywhere and is initially provided by oil. The majority of people using oil for heating would be households, because people want to keep warm in the winter thus causing an increase in oil demand. And on the other side in the summer households will not require any oil for heating and demand will rapidly decrease. Fortunately this is a trend that the market can prepare for and make adjustments to.
Although this is a mainly a monopoly market there are a few substitutes to oil that may pose as a threat in the coming future. Other companies are investing in finding environmentally friendly fuel, and we cant forget that there is natural gas that performs almost like petroleum and if these substitutes are reliable and better priced than oil then we may see a shift to these alternatives.
There is also a correlation between the demand for oil and economic growth because oil is an essential in every industry. So when an industry increases in size and wealth they will want to expand more to generate more profits, and to do so they would require more oil. The demand rises.
A good example of this is the recent growth of the Chinese economy. China has started to expand rapidly due to them exploiting and exporting their resources and produce which has led to a huge increase in oil demand.
From this we can work out that when global demand for oil rises and the short term supply cannot keep up with the rate the price of oil goes up as the consumer begins to higher the price to get their hands on the product.
Finished with demand I will now investigate the other half of the model, the supply. In the long term the supply of oil is in great danger because of the depletion of known oil reserves. The more the demand rises the quicker these oil reserves will drain. A way to overcome this would be to invest in exploration of new reserves to prolong the supply. And although this seems easy to do it requires tremendous amounts of money and needs to be perfectly times as to the current economic state of the market.
In the short term supply is controlled by several factors. Firstly political situations and current events could wound the economy very quickly, for example the war on Iraq put a stop to that country producing oil which lowered the supply for the immediate consumer. Another factor that determines short term supply is the quantity of stocks that major oil refineries have for immediate use. These are kept in case there is a sudden increase in demand so the producers can meet the rate. Finally an organisation called OPEC and other organisations not included in the OPEC countries make guidelines for the amount of oil to be produced daily. This is done with the intention of prolonging the use of oil, whilst taking into account the current demand.
The Organisation of Petroleum Exporting Countries (OPEC) looks after 40% of the worlds supply of oil. With that much oil to control it gives them a governing position in directing the whole market including oil prices. NON-OPEC countries and Russia control the remaining oil.
OPEC regulates how much oil they want to produce with the target of keeping the economy of the market stable. Although, recently all OPEC countries have exceeded their set targets by up to 10 million barrels a day. And even after this current oil prices are still rising!
The answer to why prices rise is simple, because this market (like many other markets) follow the supply demand model. If we are to look at the global economy since 9/11 we can see that it has done a good job at recovering, and now the global GDP growth is fuelling an increase in business expansion and thus oil demand rises because petroleum is the fuel that keeps businesses running and getting bigger.
Investors are buying stocks of oil for themselves to save for a rainy day. Adding to the ever-decreasing supply driving the prices even higher. This also strikes fear about the future supply so consumers are trying to guarantee their supply with producers by making forward contracts and reserving oil. Once again the supply goes down and demand goes up and we see the market in a downward spiral with a catastrophic destiny.
The rise in oil prices comes with many consequences. For industries in which oil is a major input into their production process, a rise in petrol will mean that many adjustments in the finances of the company need to be made in order to maximise profits. To achieve this a firm needs to increase price and reduce the equilibrium level of output. The extent to which a company can increase their product costs e.t.c, depends on the level of demand for their products. An example of such a situation is an air cargo company that had to cut the costs of running the business, i.e. fly their crew in 2nd class instead of business class, and lower their daily allowances. And by doing this they are able to keep prices to the consumer competitive and keep running the business.
There are also many macroeconomic consequences of higher oil prices that depend on several factors. In the last 30 years there have been 3 global recessions and all were due to the rise in crude oil. Firstly global impact will depend on the time period over which oil price inflates. Say if it only grew for a week then this would have little effect. But if it lasts for longer (like it has been recently) then all businesses are affected and as a follow up the economy crumbles.
Countries that have many industries will greatly rely on oil so when the price changes then the whole economy of the country changes with it either for the good or for the bad. Other countries with small industry are less oil dependent so do not suffer as much to any changes in the oil market.
And to finish off I will look at how oil prices affect the UK economy. Higher oil prices slow down the growth of an economy. This is because higher prices affect people’s real income and real buying power. And because producers are selling less it will mean there is a reduction in overall capital. And the affects of negative output have even more reaching effects like increased unemployment not just in oil industries but across the whole economy. Also company shares ill decrease in value so nobody will want to buy them until the economy has settled, and the companies are loosing on potential extra money (for investment) because people aren’t buying shares.
The recent rise in oil prices seems like a big deal but if e ere to compare it with the inflation of 1972 then we see that this surplus is substantially lower in real terms. And with today’s modern technology we are less reliant on oil than e ere back in 1973.