As we saw in Part 1 of this blog, oil prices have fallen by some 46% in the past five months. In that blog we looked at the implications for fuel prices. Here we look at the broader implications for the global economy? Is it good or bad news – or both?
First we’ll look at the oil-importing countries. To some extent the lower oil price is a reflection of weak global demand as many countries still struggle to recover from recession. If the lower price boosts demand, this may then cause the oil price to rise again. At first sight, this might seem merely to return the world economy to the position before the oil price started falling: a leftward shift in the demand for oil curve, followed by a rightward shift back to where it was. However, the boost to demand in the short term may act as a ‘pump primer’. 
The higher aggregate demand may result in a multiplier effect and cause a sustained increase in output, especially if it stimulates a rise in investment through rising confidence and the accelerator, and thereby increases capacity and hence potential GDP.
But the fall in the oil price is only partly the result of weak demand. It is mainly the result of increased supply as new sources of oil come on stream, and especially shale oil from the USA. Given that OPEC has stated that it will not cut its production, even if the crude price falls to $40 per barrel, the effect has been a shift in the oil supply curve to the right that will remain for some time.
So even if the leftward shift in demand is soon reversed so that there is then some rise in oil prices again, it is unlikely that prices will rise back to where they were. Perhaps, as the diagram illustrates, the price will rise to around $70 per barrel. It could be higher if world demand grows very rapidly, or if some sources of supply go off stream because at such prices they are unprofitable.
The effect on oil exporting countries has been negative. The most extreme case is Russia, where for each $10 fall in the price of oil, its growth rate falls by around 1.4 percentage points (see). Although the overall effect on global growth is still likely to be positive, the lower oil price could lead to a significant cut in investment in new oil wells. North sea producers are predicting a substantial cut in investment. Even shale oil producers in the USA, where the marginal cost of extracting oil from existing sources is only around $10 to £20 per barrel, need a price of around $70 or more to make investment in new sources profitable. What is more, typical shale wells have a life of only two or three years and so lack of investment would relatively quickly lead to shale oil production drying up.
The implication of this is that although there has been a rightward shift in the short-run supply curve, if price remains low the curve could shift back again, meaning that the long-run supply curve is much more elastic. This could push prices back up towards $100 if global demand continues to expand.
This can be illustrated in the diagram. The starting point is mid-2014. Global demand and supply are D1 and S1; price is $112 per barrel and output is Q1. Demand now shifts to the left and supply to the right to D2 and S2 respectively. Price falls to $60 per barrel and, given the bigger shift in supply than demand, output rises to Q2. At $60 per barrel, however, output of Q2 cannot be sustained. Thus at $60, long-run supply (shown by SL) is only Q4.
But assuming the global economy grows over the coming months, demand shifts to the right: say, to D3. Assume that it pushes price up to $100 per barrel. This gives a short-run output of Q3, but at that price it is likely that supply will be sustainable in the long run as it makes investment sufficiently profitable. Thus curve D3 intersects with both S2 and SL at this price and quantity.
The articles below look at the gainers and losers and at the longer-term effects.
Articles
Where will the oil price settle? BBC News, Robert Peston (22/12/14)
Falling oil prices: Who are the winners and losers? BBC News, Tim Bowler (16/12/14)
Why the oil price is falling The Economist (8/12/14)
The new economics of oil: Sheikhs v shale The Economist (6/12/14)
Shale oil: In a bind The Economist (6/12/14)
Falling Oil Price slows US Fracking Oil-price.net, Steve Austin (8/12/14)
Oil Price Drop Highlights Need for Diversity in Gulf Economies IMF Survey (23/12/14)
Lower oil prices boosting global economy: IMF Argus Media (23/12/14)
Collapse in oil prices: producers howl, consumers cheer, economists fret The Guardian (16/12/14)
North Sea oilfields ‘near collapse’ after price nosedive The Telegraph, Andrew Critchlow (18/12/14)
How oil price fall will affect crude exporters – and the rest of us The Observer, Phillip Inman (21/12/14)
Cheaper oil could damage renewable energies, says Richard Branson The Guardian,
Richard Branson: ‘Governments are going to have to think hard how to adapt to low oil prices.’ John Vidal (16/12/14)
Data
Brent crude prices U.S. Energy Information Administration (select daily, weekly, monthly or annual data and then download to Excel)
Brent Oil Historical Data Investing.com (select daily, weekly, or monthly data and time period)
Questions
- What would determine the size of the global multiplier effect from the cut in oil prices?
- Where is the oil price likely to settle in (a) six months’ time; (b) two years’ time? What factors are you taking into account in deciding your answer?
- Why, if the average cost of producing oil from a given well is $70, might it still be worth pumping oil and selling it at a price of $30?
- How does speculation affect oil prices?
- Why has OPEC decided not to cut oil production even though this is likely to drive the price lower?
- With Brent crude at around $60 per barrel, what should North Sea oil producers do?
- If falling oil prices lead some oil-importing countries into deflation, what will be the likely macroeconomic impacts?
Oil prices have been plummeting in recent months. Indeed, many commentators are saying that this is the major economics news story of 2014. In June 2014 Brent crude was around $112 per barrel. By December the price has fallen to around $60 – a fall of 46%. But what are the implications for fuel prices?
Just because the crude oil price has fallen by 46%, this does not mean that prices at the pump should do the same. Oil is priced in dollars and the pound has depreciated against the dollar by just over 7% since June, from around £1 = $1.69 to around £1 = $1.57. Thus in sterling terms, crude oil has fallen by only 42%.
More significantly, the cost of crude is a relatively small percentage of the price of a litre of petrol. At a price of 132p per litre (the July average price), crude accounted for around 27% of the price, or around 36p per litre. At a price of 114p per litre, the price in late December, crude accounts for around 19% of the price, or around 21.5p per litre. The largest element of price is fuel duty, which is charged at a flat rate of 57.95p per litre. In addition there is VAT at 20% of the pre-VAT price (or 16.67% of the retail price). Finally there are the refining, distribution and retail costs and margins, but these together account for only around 16p per litre.
What this means is that the 46% cut in oil prices has led to a cut in petrol prices of only around 14%. If petrol prices were to reach £1 per litre, as some commentators have forecast, crude oil prices would have to fall to under $40 per barrel.
Although petrol and diesel prices have fallen by a smaller percentage than oil prices, this still represents a significant cut in motoring and transport costs. It also represents a significant cut in costs for the petrochemical industry and other industries using large amounts of oil.
For oil-importing countries this is good news as the fall in the oil price represents an increase in real incomes. For oil importing countries, and especially those such as Russia and some OPEC countries where oil constitutes a large proportion of their exports, it is bad news. We explore these effects in Part 2.
Videos
UK petrol prices hit four-year low BBC News, John Moyland (10/12/14)
Petrol prices plunge ahead of Christmas holidays Belfast Telegraph (19/12/14)
Petrol price plummet – could fuel drop to below a pound a litre in the New Year? Channel 5 News on YouTube (17/12/14)
Articles
UK motorists benefit from petrol price drop Financial Times, Michael Kavanagh (23/12/14)
Petrol to drop to £1 a litre, says Goldman Sachs The Telegraph, Szu Ping Chan (9/12/14)
Oil prices: How low will they go in 2015? International Business Times, Shane Croucher (22/12/14)
Plummeting oil price may lead to petrol falling below £1 a litre RAC news (17/12/14)
Pump Prices: Cheap Petrol Comes With A Warning Sky News (19/12/14)
Data and information
Fuel prices in Europe Drive Alive (20/12/14)
Weekly road fuel prices Department of Energy & Climate Change (23/12/14)
Prices at the pump – why are they falling and will this continue? ONS (18/12/14)
Fuel Prices Explained RAC
UKPIA Statistical Review 2014 United Kingdom Petroleum Industry Association
Questions
- Why does the price of petrol fluctuate less in percentage terms than the price of crude oil?
- What factors will affect whether UK petrol prices fall to £1 per litre?
- If crude oil prices fell by 20%, in which of these two cases would there be a bigger percentage fall in petrol prices: (a) petrol price currently 140p; (b) petrol price currently 110p? Explain.
- Distinguish between a specific tax and an ad valorem tax. Which of these is (a) fuel duty; (b) VAT? Illustrate your answer with a supply and demand diagram.
- What determines the price elasticity of demand for petrol and diesel? Is the long-run elasticity likely to be higher or lower than the short-run elasticity? Explain.
- Distinguish between demand-pull and cost-push inflation. Given that oil price changes are correlated to inflation, would you characterise recent falls in inflation as reductions in demand-pull or cost-push pressures, or both: (a) in a specific oil-importing country; (b) globally?
A big expenditure for many households is petrol. The price of petrol is affected by various factors, but the key determinant is what happens in the oil market. When oil prices rise, this pushes up the price of petrol at the pumps. But, when they fall, do petrol prices also fall? That is the question the government is asking.
The price of oil is a key cost of production for companies providing petrol and so when oil prices rise, it shifts the supply curve up to the left and hence prices begin to increase. We also see supply issues developing with political turmoil, fears of war and disruption and they have a similar effect. As such, it is unsurprising that petrol prices rise with concern of supply and rising costs. But, what happens when the opposite occurs? Oil prices have fallen significantly: by a quarter. Yet, prices at the pump have fallen by around 6%. This has caused anger amongst customers and the government is now urging petrol retailers to pass their cost savings from a lower price of oil onto customers. Danny Alexander, Chief Secretary to the Treasury said:
“I believe it’s called the rocket-and-feather effect. The public have a suspicion that when the price of oil rises, pump prices go up like a rocket. But when the price of oil falls, pump prices drift down like a feather … This has been investigated before and no conclusive evidence was found. But even if there were a suspicion it could be true this time it would be an outrage.”
However, critics suggest that tax policy is partly to blame as 63% of the cost of petrol is in the form taxation through fuel duty and VAT. Therefore even if oil prices do fall, the bulk of the price we pay at the pumps is made up of tax revenue for the government. Professor Stephen Glaister, director of the RAC Foundation said:
“It’s a simple story. Before tax we have just about the cheapest petrol and diesel in Europe. After tax we have just about the most expensive … It’s right to keep the pressure on fuel retailers but if drivers want to know what’s behind the high pump prices of recent years all they have to do is follow the trail back to the Treasury … if ministers are serious about reducing fuel prices further then they should cut duty further.”
(Click here for a PowerPoint of the chart.)
However, even taking out the fuel duty and VAT, Arthur Renshaw, an analyst at Experian has said that the actual price of petrol has fallen by 21% since last year. Still, a much bigger decrease than we have seen at the pumps. One further reason for this may be the fact that dollars is the currency in which oil is traded. The pound has been relatively weak, falling by almost 7% over the past few months and hence even though the price of oil has fallen, the effect on UK consumers has been less pronounced.
The big supermarkets have responded to government calls to cut petrol prices, but how much of this cut was influenced by the government and how much was influenced by the actions of the other supermarkets is another story. A typical oligopoly, where interdependence is key, price wars are a constant feature, so even if one supermarket cut petrol prices, this would force others to respond in kind. If such price wars continue, further price cuts may emerge. Furthermore, with oil production still at such high levels, this market may continue to put downward pressure on petrol prices. Certainly good news for consumers – we now just have to wait to see how long it lasts, with key oil producing countries, such as Russia taking a big hit. The following articles consider this story.
Articles
Supermarkets cut fuel prices again The Telegraph, Nick Collins (6/11/14)
Petrol retailers urged to cut prices in line with falling oil costs The Guardian, Terry Macalister (6/11/14)
Supermarkets cut petrol prices after chancellor’s criticism Financial Times, Michael Kavanagh (6/11/14)
Governent ‘watching petrol firms’ Mail Online (6/11/14)
Our horrendous tax rates are the real reason why petrol is still so expensive The Telegraph, Allister Heath (6/11/14)
Osborne ‘expects’ fuel price drop after fall in oil price BBC News (6/11/14)
Danny Alexander tells fuel suppliers to pass on oil price cuts to drivers The Telegraph, Peter Dominiczak (5/11/14)
Further UK fuel cuts expected as pound strengthens The Scotsman, Alastair Dalton (6/11/14)
Data
Spot oil prices Energy Information Administration
Weekly European Brent Spot Price Energy Information Administration (Note: you can also select daily, monthly or annual.)
Annual Statistical Bulletin OPEC
Questions
- Using a supply and demand diagram, illustrate the impact that a fall in the price of oil should have on the price of petrol.
- What is the impact of a tax on petrol?
- Why is petrol a market that is so heavily taxed? You should think about the incidence of taxation in your answer.
- Why does the strength of the pound have an impact on petrol prices in the UK and how much of the oil price is passed onto customers at the pumps?
- Does the structure of the supermarket industry help customers when it comes to the price of petrol? Explain your answer.
- Militant action in some key oil producing countries has caused fears of oil disruption. Why is that oil prices don’t reflect these very big concerns?
One of the key prices in any economy is that of oil. Whenever oil prices change, it can have a knock-on effect on a range of other markets, as oil, or some variation, is used as an input into the production of countless products. The main products that consumers will see affected are energy prices and petrol prices..
Although on the supply-side, we see a large cartel in the form of OPEC, it is still the case that the forces of demand and supply directly affect the market price. Key things such as the demand for heating, economic growth, fears of war and disruption will change the demand and supply of oil. The possibility of militant strikes in oil producers, such as Syria, would normally reduce supply and push up the market price. However, we have actually seen oil prices drop much faster than we have in two years, dropping below $100 per barrel since September 5th. The slowdown of economic growth in Asia, together with the return of Libyan production at a level greater than expected have helped to push prices down and have offset the fears of global production.
The market forces pushing prices down, while good for consumers and firms that use crude oil or one of its by-products, are clearly bad for oil producers. (Click here for a PowerPoint of the chart.) Countries are urging OPEC to halt its production and thereby shift supply upwards to the left putting a stop to the downward oil price trend. Several countries are concerned about the impact of lower prices, and one country that may be significantly affected is Russia. Some are suggesting that the impact could be as big as 4% of Russia’s GDP, taking into account the ongoing political crisis with Ukraine.
The market for oil is highly susceptible to changes in both demand and supply-side factors. Microeconomic changes will have an impact, but at the same time any global macroeconomic factors can have significant effects on the global price. Expectations are crucial and as countries release information about the size of the oil stocks and inventories, it is adding to the downward pressure on prices. Some oil experts have predicted that prices could get as low as $80 per barrel before OPEC takes significant action, influenced heavily by countries like Saudi Arabia. The following articles consider this global market.
Articles
Iran urges OPEC to halt oil price slide Financial Times, Anjli Raval (26/9/14)
Oil overflow: as prices slump, producers grapple with a new reality The Globe and Mail, Shawn McCarthy and Jeff Lewis (27/9/14)
Weak demand, plentiful supply drive decline in oil prices International Distribution (26/9/14)
Oil prices plunging despite ISIS CNN Money, Paul R La Monica (25/9/14)
Oil prices fall on EIA report of big U.S. crude stocks build Reuters, Robert Gibbons (17/9/14)
Sanctions and weaker oil prices could cost Russia 4% of GDP – official RT (25/9/14)
Data
Spot oil prices Energy Information Administration
Weekly European Brent Spot Price Energy Information Administration (Note: you can also select daily, monthly or annual.)
Annual Statistical Bulletin OPEC
Questions
- What are the key factors on the microeconomic side that affect (a) demand and (b) supply of oil?
- Explain the key macroeconomic factors that are likely to have an impact on global demand and supply of oil.
- Militant action in some key oil producing countries has caused fears of oil disruption. Why is that oil prices don’t reflect these very big concerns?
- Use a demand and supply diagram to explain the answer you gave to question 3.
- What type of intervention could OPEC take to stabilise oil prices?
- Why is the Russian economy likely to be adversely affected by the trend in oil prices?
- Changes in the global macroeconomy will directly affect oil prices. Is there a way that changes in oil prices can also affect the state of the global economy?
The price of road fuel is falling. Petrol and diesel prices in the UK are now at their lowest level since February 2011. The average pump price for a litre of unleaded petrol has fallen to 130.44p in November – down nearly 8p per litre since September.
According to the AA, the reduction in price equates to a fall in the average monthly expenditure on petrol of a two-car family of £14.49 – down from £252.54 to £238.05. This saving can be used for spending on other things and can thus help to boost real aggregate demand. The fall in price has also helped to reduce inflation.
But will lower fuel prices lead to a rise in fuel consumption? In other words, will some of the savings people make when filling up be used for extra journeys? If so, how much extra will people consume? This, of course depends on the price elasticity of demand.
The following articles explain why the price of road fuel has fallen and look at its consequences.
Webcast
Good news for motorists as fuel prices fall in the East ITN (22/11/13)
Articles
November fuel price update Automobile Association (22/11/13)
Finally there is good news for motorists as petrol prices hit lowest level since 2011 The Telegraph, Steve Hawkes (22/11/13)
Petrol prices fall to lowest level for almost three years as strong pound gives motorists relief on the forecourt This is Money, Lee Boyce (22/11/13)
Falling petrol prices boost motorists The Guardian (22/11/13)
Data
Weekly road fuel prices Department of Energy & Climate Change
Europe Brent Spot Price US Energy Information Administration
Spot exchange rate, US $ into Sterling Bank of England
Questions
- Why have the prices of petrol and diesel fallen?
- Illustrate the fall in price of road fuel on a demand and supply diagram.
- How does the size of the fall in price depend on the price elasticity of demand for road fuel?
- If a fall in price results in a fall in expenditure on road fuel, what does this tell us about the price elasticity of demand?
- Why may the price elasticity of demand for road fuel be more elastic in the long run than in the short run?
- If a motorist decides to spend a fixed amount of money each week on petrol, irrespective of the price, what is that person’s price elasticity of demand?
- Using the links to data above, find out what happened to the dollar price of sterling and the Brent crude oil price between September and November 2013.
- How do changes in the exchange rate of the dollar to the pound influence the price of road fuel?
- If the price of oil fell by x per cent, would you expect the price of road fuel to fall by more or less than x per cent? Explain.
- Why do petrol prices vary significantly from one location to another?
As we saw in Part 1 of this blog, oil prices have fallen by some 46% in the past five months. In that blog we looked at the implications for fuel prices. Here we look at the broader implications for the global economy? Is it good or bad news – or both?
