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Asymmetric Effect of Oil Price on Economic Growth

Introduction to Oil Prices Plunge

Coronavirus pandemic which was initiated as a health crisis in no time turned into an economic crisis. The necessary caution method as well as lockdown measures to reduce the pace of transmission has adversely impacted the global economy. The oil market was highly impacted by the reduced demand for oil and the rapid drop in oil prices which became negative in no time. The reduced consumption of oil which resulted in reduced demand for oil and the price war in Saudi Arabia as well as Russia resulted in a huge supply of oil. The producers had no storage capacity as a result the oil inventories surged. This was coupled with the crash in financial markets and global economic depression. As a result, the oil price dipped sharply. The aim of this study is to analyze why the price of oil went beyond negative prices. In addition to this, the effect of dipping of oil price on global demand and supply both in the short-term and long-term is discussed in detail. 

The Collapse in Oil Prices Is Caused by The Shocks in The Supply and Demand Mechanism of Oil

This is the result of factors affecting the demand and supply for oil, these are discussed in detail in the following sections:

Factors Affecting the Demand for Oil

Oil is mainly demanded for transportation and industrial purposes. In the first quarter of this year, the total oil demand plunged by 5% and anticipated to reduce by 20% in the second quarter of 2020 (World Bank, 2020). Coronavirus crisis has resulted in reduced demand for oil this is caused by the implementation of measures taken by the government to curtail the transmission of the virus, these include; quarantine, domestic and international restrictions on travel, closure of non-essential factories and industries (World Bank, 2020). There was a sharp dip in domestic consumption of oil as a result of these measures.

Moreover, the pandemic has caused economic contractions of activities as a result, thereby leading to a recession; this has further led to a decline in the demand for oil. The income elasticity of demand for oil is highly elastic (World Bank, 2020), this suggests that a minor change in income will lead to larger changes in the demand for oil. Income elasticity of demand specifies a change in demand due to a proportionate change in income (Mankiw, 2019). Consequently, a decline in income caused by contractions in economic growth will have more than a proportionate impact on the demand for oil.

Factors Affecting the Supply of Oil

The United States shale oil production has augmented over the years as a consequence of it, the Organization of the Petroleum Exporting Countries (OPEC) and its partners decided to increase the oil production in previous years, however, till March the production decision was not altered (World Bank, 2020).

Saudi Arabia and Russia had been working together from 2016 to administer the output and price of oil (World Bank, 2020). In the month of March, the OPEC as well as non-OPEC allies did not agree on a decision to reduce the supply of oil. OPEC suggested deeper production cuts of oil but OPEC allied Russia rejected the proposal of additional cuts in the production of oil (World Bank, 2020). This price war between OPEC and Russia resulted in no significant change in the production of oil. This led to an increase in the inventories of oil. However, in April, the production decision was changed and it was decided that the oil production would be curtailed but 9.7% in May and June (World Bank, 2020).

Effect of Changes in Demand and Supply on Oil Price

The European Brent spot price for crude oil witnessed an 85% decline between the 22nd January and 21st April 2020 (World Bank, 2020). The reduction in the demand for oil could not be compensated by the changes in the supply of the oil, the supply increased initially. As a result, the 2/3 of the downfall in prices of oil can be attributed to the demand-driven shock (World Bank, 2020). On Monday 9, 2020 the Brent Oil price dipped by 24.59% and WTI price by 30% and reached $31.33 per barrel (Kingsly & Kouam, 2020).

COVID-19 has increased the fluctuations in the stock markets across the globe (RFE, 2020). The traders of the futures contracts of oil in the United States wanted others to take the physical delivery of oil due to increased inventories of oil and lack of storage facility (RFE, 2020). The May-dated future contracts for WTI that expire in April necessitate that the buyer of the contract to either take delivery of oil that it specifies in the contract or sell the contract so as to avoid taking the physical delivery (RFE, 2020). Since storage was a challenge that was faced by the companies, this led to the dumping of May-dated contracts. As a consequence of it, the prices became negative and reached a negative $37 per barrel (RFE, 2020).

The Falling Price of Oil Is Shown Through the Demand and Supply Mechanism (Mankiw, 2016).

In the diagram above, the x-axis represents the quantity of oil while the y-axis represents the price of oil. The market is in equilibrium as indicated by point E where the initial demand curve as indicated by the curve DD intersects the initial supply curve SS. Due to the pandemic and resultant economic depression, the demand for oil declined sharply. In the diagram above, this change is shown by the leftward shift of the demand curve. The new demand curve is shown by DD 1. There is a decrease in demand and no change in the supply of good till March 2020; this is a situation of a surplus of oil. As a consequence of it, the oil prices as well as quantity fell. This is shown by the dip in prices from Price P to P 1 as well as quantity from Q to Q 1.

Short Run Effect of Fall in Prices on Global Demand and Global Supply

The declining oil price is a cause of concern for the oil-producing countries. When the oil prices became negative, the countries are putting pressure to cut back on the supply as well as the production of oil. The Oil producing countries are cutting the production of the oil at a rapid pace than expected. According to IEA (2020) report, the United States will be the country that is expected to reduce production largely. Furthermore, in the same study, IEA has specified that the oil market will flourish as countries are practicing production cuts and recovery of demand as the lockdown measures have lifted, however, the recovery will be gradual but uncertain (IEA, 2020).

The supply is declining as a result, the supply curve is shifted upwards as indicated by SS’’, along with it the demand is recovering as a result, the demand curve will shift to its right as indicated by the curve DD''. The extension of quantity demanded with simultaneous contractions of quantity supplied will lead to an increase in the price of the oil and reduced the quantity of oil.

Effect of Fall in Oil Price on Global Demand and Supply in The Long Run

According to the theory of the invisible hand by Adam Smith, the free market will adjust itself without any intervention in the market when individuals, households, and firms pursue their self-interest (Basu, 2016). The market will correct itself in the long run, the fall in the price of oil has led the oil-producing countries to reduce the supply of oil as a result, the supply curve will shift upwards and as the demand is gradually improving the demand will increase, gradually the price of oil will start to rise and will reach the equilibrium level.

The fluctuations in the oil prices have impacted the financial markets, as a result, the expectations have changed. According to the study by Sharif, Aloui, and Yarovaya (2020), the rise in the case of COVID-19 will not have a significant impact on the prices of oil in the long run. The global economy witnessed a downfall as a result; the market traders will sell their investments while the long-term trader will perceive this situation as transitory (Sharif, Aloui & Yarovaya, 2020). Their anticipation is based on the fact that the government will interfere and take the necessary steps to fix this problem and will stimulate liquidity in the market. The expansionary fiscal policy measures taken by the government will be seen as a positive signal for the trader, thereby, encouraging investment in the market (Sharif, Aloui & Yarovaya, 2020). A rise in investment will lead to an increase in aggregate demand, thereby leading to an increase in aggregate output, thus positively contributing to economic growth (Mankiw, 2016).

As per a study by Kingsly and Henri (2020), the initial decline in the price of oil has been corrected by reducing the production of oil, thereby, leading to a slight recovery in oil prices. However, the rise in the price of oil will be seen over the medium –term when the OPEC and associated countries and Russia modify their agreements. As a result, the Brent crude oil price will converge to $56 per barrel in the medium term (Kingsly & Henri, 2020). Moreover, the global demand forecast for oil suggests that demand for oil will decline as the major importers' China and European countries will curtail their demand for oil (Kingsly & Henri, 2020).

Low oil prices will negatively impact the prices of other associated commodities such as natural gas, fertilizers as well as food (Baffes, Kose, Ohnsorge & Stocker, 2015). Historically, it has been seen that a 45% reduction in the price of oil will cause a reduction of 10% of food commodities. Lower food prices is an advantage for the economy as it will benefit the poor people as their purchasing power has increased (Baffes et.al., 2015). Oil importing countries are mainly the demanders of oil while the Oil exporting countries are suppliers of oil. Historically seen, that changes in oil prices does not have a short-run impact on the economic growth of the importing countries, however, the positive impact on growth in the long run (Akinsola & Odhiambo, 2020). The reduction in oil prices will lead to a rise in savings as the purchasing power of people will increase in these countries. Moreover, their external, as well as the fiscal balances of these countries, will increase, however, the exporting countries will witness a decline in economic growth. Nevertheless, the decline in oil prices in 1986 did not support the arguments as the economic growth is also impacted by the changes in the global demand, reallocation of factors as well as other structural changes within or outside the domestic territory (Akinsola & Odhiambo, 2020).

The global effect on demand for oil is uncertain since it depends on the global coronavirus cases, easing of lockdown, the fiscal and monetary policies measures taken by the government of the respective countries, inflationary expectations, and the pace of recovery of economies (EIA, 2020).

Conclusion on Oil Prices Plunge

The recent coronavirus pandemic has impacted the economies across the globe. The social, health, political, and economic impact of coronavirus has led to reduced demand for all commodities. The oil industry is highly affected by it as the measures to avoid transmission has curtailed transportation and industrial activities. These were the main drivers of the demand for oil. However, the supply of oil was not curtailed initially as a consequence the price of oil fell and reach beyond negative levels. The market mechanism works in the free market has a property of self-correction as given by the invisible hand. The falling in the price of oil will be corrected by the market forces. When the market price of oil continues to fall, the producers will decrease the supply, also, at lower prices, the quantity demanded will expand. As a result, the price of oil will start to recover. However, it is important to understand that the rise in price will be affected by many factors such as changes in global demand, recovery of economies, market expectations, and structural changes, and it is too soon to say what the net effect would be in the long run.

Reference for Oil Prices Plunge

Akinsola, O.M. & Odhiambo, M.N. (2020). Asymmetric effect of oil price on economic growth: Panel analysis of low-income oil-importing countries. Energy reports (6), 1057-1066. https://doi.org/10.1016/j.egyr.2020.04.023

Baffes, J. Kose, A.M., Ohnsorge, F. & Stocker, S. (2015).The great plunge in oil prices: causes, consequences, and policy responses. Retrieved from http://pubdocs.worldbank.org/en/339801451407117632/PRN01Mar2015OilPrices.pdf

Basu, K. (2016). Beyond the invisible hand: groundwork for a new economics. United States: Princeton University Press.

EIA. (2020).Short term energy outlook. Retrieved from https://www.eia.gov/outlooks/steo/pdf/steo_text.pdf

IEA. (2020). Oil 2020: Analysis and forecast to 2025, IEA, Paris. https://doi.org/10.1787/cf9397c0-en.

Kingsly, K. and Henri, K, (2020). COVID-19 and Oil Prices. SSRN. http://dx.doi.org/10.2139/ssrn.3555880

Mankiw, N. G. (2016). Principles of macroeconomics. United States: Cengage Learning

Mankiw, N. G. (2019). Principles of microeconomics. United States: Cengage Learning.

Pettinger, T. (2017). Cracking Economics. United Kingdom: Octopus Books.

RFE (2020). A negative oil price? What in the world is happening? Retrieved from https://www.rferl.org/a/a-negative-oil-price-what-in-the-world-is-happening-/30568505.html

Riad Ajami (2020) Globalization, the Challenge of COVID-19 and Oil Price Uncertainty, Journal of Asia-Pacific Business, 21(2), 77-79, DOI: 10.1080/10599231.2020.1745046

Sharif, A., Aloui, C. & & Yarovaya, L. (2020). COVID-19 pandemic, oil prices, stock market, geopolitical risk, and policy uncertainty nexus in the US economy: Fresh evidence from the wavelet-based approach. International Review of Financial Analysis, 101496. Doi: 10.1016/j.irfa.2020.101496

World Bank (2020). Adding fuel to fire: Cheap oil during the pandemic. Retrieved from http://pubdocs.worldbank.org/en/372581588788369195/Global-Economic-Prospects-June-2020-Topical-Issue-2.pdf

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