Introduction
Sharp fluctuation in oil price since the 1970s and its impact on the economy, both macro and micro, have gained huge attention from scholars. Speculative factors alongside immense instability in demand and supply have caused an aggressive increase in oil prices, especially in the previous decades (Hacioglu & Dincer, 2013). Thus, research on this issue intensified and a number of studies tried to explain the core relationship between oil prices and price levels in the economy. In relation to this, researchers have analysed the correlation between oil prices and manufacturing or industrial production, oil prices and balance of trade, oil prices and inflation, oil prices and economic growth, and oil prices and stock prices. This paper critically analyses the impact of fluctuations in oil price on the various sectors of the economy, specifically, agriculture (commodities), stock market, the energy sector, transport, manufacturing, inflation, and exchange rate.
Overview
The effect of oil price changes on the economy can be basically explained in two ways due to the diversification of industries. Increased prices of oil can stimulate investment and boost employment opportunities as it becomes financially feasible for oil firms to take advantage of costlier shale oil reserves. Nevertheless, increased oil prices also adversely affect consumers and businesses with greater manufacturing and transportation costs (Miles, Scott, & Breedon, 2012). On the other hand, decreased oil prices harm atypical oil activities, yet generate advantages for sectors (e.g. manufacturing) where the price of fuel is a major consideration. Oil prices affect inflation and economic growth primarily via three ways-- (1) monetary and fiscal policies, (2) real income changes, and (3) input costs. First, in countries that import oil where dropping oil prices could scale down medium-term inflation probabilities below mark, central banks will have the ability to execute further relaxation of monetary policy, which, consequently, can contribute to economic development (World Bank, 2015, p. 159). Greater output plus reduced inflation indicates a positive short-term policy implication. In contrast, in countries that export oil, reduced oil prices could bring about 'contractionary' fiscal policy strategies, which is a form of policy implemented by the finance administration or central bank to reduce the pace of the economy (World Bank, 2015; Natal, 2010). Contractionary fiscal policy approaches are executed by a government to cut down the money supply and, finally, national expenditures or spending.
Second, a reduction in oil prices causes fluctuations in real income generating higher profit for oil importers, and disadvantages for oil exporters. The transfer of income from oil-exporting countries with greater average rates of saving to oil-importing economies with a greater tendency to spend must largely lead to bigger global demand (Natal, 2010). Nevertheless, as further explained by Tazhibayeva and colleagues (2011), the impact may differ considerably across space and time-- several oil-exporting countries may be driven by financial pressures to regulate both imports and government expenditure drastically for a short time, whereas advantages for importing economies could be distributed and balanced by greater preventative savings if recovery probability continues to be low.
And, third, reduced oil prices lower energy prices on the whole, as prices of various energy products are pushed down as well, and oil-driven electricity is less costly to generate. Furthermore, because oil is a staple resource for different sectors or industries, such as aluminium, paper, and petrochemicals, the drop in price significantly influences a broad array of semi-processed or processed goods (Unalmis, Unalmis, & Unsal, 2012). Several manufacturing industries, agricultural, petrochemical, and transportation sectors would be the main recipients from reduced prices.
Impact of Oil Price Fluctuations on Price Levels
Agricultural economists have been examining forces that affect prices of commodity, and one of these major factors is the value of oil. Different theoretical perspectives can be applied to explain the impact of oil price on commodity prices. Basically, the increase in oil prices brings about a rise in commodity prices by pushing production costs through its effect on input resources (Miles et al., 2012). More specifically, crude oil is a key input resource in the processing of virtually all agricultural goods, such as fertilizers and fuel for machines. Fluctuations in oil price result in an increase in the price level of the commodity. Furthermore, because of concerns for environmental conservation and energy independence, commodities, especially food, are continuously utilised to generate biofuels. This created a new substitution link between oil price and commodity prices which was not present in the past (Hacioglu & Dincer, 2013). As the price of fuel increases, producing biofuel becomes more appealing. Biodiesel and ethanol are alternatives for diesel and gasoline, thus raising the demand for agricultural commodities in biofuel companies alongside high prices of oil. In other words, higher oil prices affect commodity prices by means of the usual cost-push processes and substitution mechanism. The boost in the biofuel industry has possibly created a stronger connection between oil prices and prices of oil seeds and grains (e.g. wheat, soybeans) (Isard, Hunt, & Laxton, 2001). The high demand for grains in the biofuel industry is mostly caused by increase crude oil prices. In addition, the indirect impact of oil price on the prices of agricultural commodities through exchange rate fluctuations leads to a rise in agricultural prices.
On the other hand, the significant drops in oil prices since 2014 have surprised numerous experts. They are astonishing in terms of rapidity and magnitude, considering that global supply of oil has been steady over the last decade (Oster, 2016). Because energy comprises 50 per cent of the cost of production of various commodities, a reduction in oil price cuts down the production cost of numerous other commodities (Oster, 2016). For instance, corn is significantly influenced by reduce oil prices as reduced energy costs trim down the production cost, stimulate more agricultural activities, and enhance margins. Corn is also one of the key components in bio-ethanol production and thus reduced corn prices could sustain greater demand. Another complex problem is the interplay between lower oil prices and other commodity prices. For instance, in Australia, a significant reduction in oil prices results in massive negative income outcomes. However, for bigger economies, like Europe, India, and China, lower oil prices contribute to lower input costs (Oster, 2016), which generate additional feedback loops through more favourable export prospects.
Fluctuations in crude oil prices are generally regarded as a key variable for explaining changes in stock prices. For instance, in 2006, The Financial Times claimed that the slump of the U.S. stock market is brought about by an escalation in the prices of crude oil triggered by uncertainties about the political order in the Middle East (Kilian & Park, 2007). It is widely believed that changes in oil prices and the outcome of primary stock market indicators are strongly correlated. Traditional knowledge claims that a rise in prices of oil will increase input costs for almost all businesses and compel consumers to pay more for gasoline, thus trimming down the corporate income of other enterprises. In theory, changes in oil price influence stock prices via their impact on discount rate (i.e. interest rate) and expected earnings (Pokhlebkin, 2016). However, Federal Reserve Bank of Cleveland researchers found almost no correlation between changes in oil prices and stock prices (Ross, 2016). Their findings do not automatically confirm that oil prices have little effect on stock prices; nevertheless, it does show that experts cannot truly forecast how stock prices respond to fluctuating oil prices.
However, these conflicting assumptions must also be taken into full consideration: higher oil prices raise energy cost and thus trim down the purchasing power of consumers and corporate earnings, hence pulling down stock prices. In contrast, as stated in another perspective, as the economy starts to progress, businesses recover, hence stock prices go up; and as businesses recover, demand for oil and other energy resources goes up as businesses expand and intensify their operations (Beidas-Strom & Pescatori, 2014). The latter explanation implies that oil prices and stock prices escalate at the same time. The process through which a drop in oil prices could bring about a downfall in the stock market depends on the financial instruments or means employed to finance oil operations across the globe. Present-day oil exploration is funded by means of an array of procedures, such as generating debt via bank loans and bonds and distribution of shares to raise capital (Kilian & Park, 2007; Pokhlebkin, 2016). Simply put, at times oil prices and stock prices rise or drop simultaneously, and at times they move contrastingly.
The indefinite correlation between changing oil prices and stock prices can be explained by a number of factors. Primarily, there are numerous forces in the economy (e.g. interest rates, wages) that can counteract fluctuations in oil prices. Moreover, it is likely that companies have become more and more accurate at predicting markets and are more capable of forecasting price changes; a company must adjust its production system to counteract higher fuel prices. Several financial experts claim that average stock prices frequently increase alongside a rise in the volume of money, which takes place exclusive of changes in oil prices (Unalmis et al., 2012). In other words, changes in stock prices are influenced by investor risk resilience, intrinsic factors, future corporate profits, and several other aspects. Although stock prices are generally accrued and drawn together, it is highly likely that changes in oil prices have an impact on some domains much more seriously than others.
Fluctuations in the prices of diesel and gasoline reflect changes in the prices of oil. These fluctuations are established in the global oil market through the global supply and demand for oil. From 2008 to 2009 poor economic circumstances in the U.S. resulted in lower demand which contributed to the lowering of prices (Arouri, Boubaker, & Nguyen, 2013). Crude oil prices significantly affect petroleum prices in the long term. On the contrary, in the short term, petroleum prices are determined by the marketplace dynamics of competition and demand and supply. Crude oil is processed to generate diesel and petrol and crude oil prices are usually the key variable influencing fuel prices (Macalister, 2016). When prices of oil increase substantially, it often results in higher demand for alternative energy products, like natural gas and coal. In fact, higher oil prices tend to push the price of other fossil fuels up.
Oil prices have dropped substantially recently. The costs of other energy products have also dropped considerably. For instance, the drop in oil prices has resulted in a decrease in the prices of liquefied natural gas (LNG) and thermal coal due to the intensifying production of coal over the past decade (Hacioglu & Dincer, 2013). However, it has been observed recently that a drop in the price of crude oil does not automatically result in lower fuel prices. The drop to the price of oil to $10 did not result in the drop of fuel prices due to the tax levied (Macalister, 2016). Taxes occupy a considerable portion of fuel prices. In addition, even though the price of crude oil has the greatest effect on the average prices of petroleum, local market forces (e.g. regulatory mechanisms, competition, demand and supply) can also have a considerable effect on the costs of petroleum (Macalister, 2016; Miles et al., 2012). For instance, refineries convert crude oil into gasoline and even though the demand for gasoline should theoretically push the cost up, the refineries can screw up the costs of both gasoline and crude oil.
The transport industry is one of the sectors that were greatly affected by the rise in the prices of fuel in 2000. In the case of road transport, the prices of oil only comprise the overall fuel cost to a certain degree, because the other portion is strongly connected to the interplay of different other factors such as the costs of processing and distribution, market factors, shortage in the supply of particular fuels, and so on (Beattie, 2015). Specifically, the cost of fuel for road transport is largely determined by excise taxes that comprise a fixed component of fuel costs for consumers. This implies that fluctuations in oil prices influence only a portion of the final fuel price tied to fuel production, such as the costs of needed unprocessed materials (Martino, Casamassima, & Fiorello, 2009). On the other hand, as far as the aviation and maritime industry is concerned, because of cheaper processing and distribution costs and lack of taxation, the fluctuation in oil prices significantly influences these transport sectors (Martino et al., 2009). In other words, the comparatively low correlation between fuel consumer prices and oil prices somewhat reveals why the steep rise in oil prices has not resulted in a decline in fuel use within the transport industry.
As regards the manufacturing sector, the study of Alper and Torul (2009) shows that increases in oil price do not hamper general production growth. However, they reported that oil price escalations significantly hamper production growth of some manufacturing industries, such as electrical machinery, plastic and rubber products, chemicals, and wood products. Clearly, oil prices affect manufacturing costs. A reduction in fuel prices, for instance, implies reduced costs of transport. As oil becomes a key ingredient in processing industrial chemicals, reduced oil prices generates advantages for the manufacturing sector (Alper & Torul, 2009). Reductions in oil price were generally regarded as favourable because it trimmed down the costs of oil imports and lowered costs for the transport and manufacturing industries. Such lowering of costs could be positively felt by consumers. Better purchasing power for consumers can further benefit the economy (Beattie, 2015). In contrast, increased oil prices raise the costs for the manufacturing sector, and these additional costs are also felt by businesses and consumers. Increased oil prices can lead to increased prices for various services and products.
The findings of empirical studies are also varied to acquire a conclusive explanation of the correlation between changes in oil prices and exchange rate fluctuations. Jawadi and Barnett (2010) have conducted a thorough longitudinal research on the interplay between the value of oil and the U.S. real exchange rate. They applied various nonlinear and linear econometric methods so as to determine whether there is a relationship between the dollar and oil prices. Their key results reveal the following (Jawadi & Barnett, 2010, 140): substantial proof that both the U.S. real exchange rates and real oil prices have a unit root; there is no significant long-term correlation; price of oil and the U.S. exchange rate are significantly correlated in the short-term; and, lastly, there are certain indications of nonlinearity in the interaction between oil price and exchange rate.
The dilemma in explaining the negative correlation between exchange rates and value of oil is that the causality can follow two paths. Two major mediums of transmission by which fluctuations in the prices of oil can impact exchange rates have been extensively discussed in empirical studies (Tazhibayeva et al., 2011). The first medium is, as discussed previously, by means of the terms of trade. For economies that largely depend on oil imports, a rise in oil prices will result in a disruption of the trade balance and consequently in the national currency's depreciation. In view of this, Jawadi and Barnett (2010) demonstrate that the fluctuation in the prices of oil even dictates a great deal of the changes in the terms of trade. Second, the value of oil can influence exchange rates thru wealth outcomes. Economists explain that increased value of oil will redirect wealth from oil-importing economies to oil-exporting countries, which results in an adjustment in the exchange rate of the oil importer by means of portfolio redistribution and current account disparities (Natal, 2010; Arouri et al., 2013). The ultimate effect will be determined by the reliance on oil and the allocation of exports to oil exporters.
Presently, there are steady fluctuations in commodity prices, particularly food, because of the complex relationship between different factors. The value of oil is broadly regarded as a commodity price that has critical repercussions for financial markets and the real economy. As discovered by numerous scholars, in recent years, sharp increases in oil prices greatly contributed to reduced stability and values for stocks and bonds, trade losses, steep inflation, and economic slumps. The decline in the prices of oil has been occurring recently. One of the reasons why oil prices are steadily declining has been an appreciating U.S. dollar. Because the value of oil is expressed in dollars, as the currency grows stronger, the cost of oil decreases for American consumers, all held constant (Macalister, 2016). However, petroleum goods bought by consumers in other countries are not expressed in dollars; hence the drop in dollar-based oil value does not affect them in the same manner as that of the U.S. Even so, this pattern has global repercussions for geopolitics, national budgets, and economic growth (Arouri et al., 2013). On the other hand, although crude oil exporters and oil companies enjoy greater income and revenues, increased prices of gasoline adversely affect business companies and consumers across the globe.
Conclusions
Fluctuations in oil prices tend to affect prices in the economy, particularly commodities, other energy products, stock prices, transport, manufacturing, consumer spending, inflation, and exchange rates. However, the relationship between oil prices and factor prices is not always positive. For instance, a drop in oil prices does not automatically result in a reduction in fuel prices, because the latter is also affected by other factors, particularly taxation. Moreover, further studies are needed to fully ascertain the impact of oil prices on stock market prices. All the same, changes in oil prices affect both the global and national economy.
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