Home ›› 29 Jul 2022 ›› Editorial
How have oil prices behaved in recent decades?
Crude oil price stability was observed from 1950 to 1970. In fact, the crude oil price was interrupted first in 1973, when the then king of Saudi Arabia, King Faisal raised the oil price to fight against Israel using oil as a war weapon. This action of raising oil prices was in the aftermath of Arab Israel War in 1973. That was the beginning. Since then raising oil price has become a regular phenomenon.
The second distinct jump in oil prices was seen after the Iranian Revolution in 1979 when Ayatollah Khomeini led the revolution to oust Iranian King Reza Shah Pahlavi. If we want to see the ‘real’ oil price, then it is to be calculated by dividing the price of oil by the GDP deflator. This removes the effect of inflation and thus gives a more accurate sense of what was happening to the price of the commodity itself. In essence, the ‘real’ measure allowed us to compare oil prices over time in a way that we could not when inflation was also part of the price change. Real oil prices have varied a lot over time and large fluctuations tend to be concentrated over some short periods. We have seen that by the spring of 2008 the real prices of oil have exceeded that of the late 1970s.
Now a question naturally may arise as to why are oil prices rising? Both increases in demand and fear of supply disruptions have likely exerted upward pressure on oil prices. Global oil demand has been increasing, outpacing any gains in oil production and excess capacity. A major reason is that developing countries especially China and India have been growing rapidly. These economies have become increasingly industrialized and urbanized, which has contributed to an increase in the world’s demand for oil. Besides, in recent year fear of supply disruptions have been spurred by turmoil in oil-producing countries such as Nigeria, Venezuela, Iraq and Iran. OPEC members at the time cut down production levels to drastically reduce supply against demand, resulting in rising prices.
A sharp increase in the price of oil in the last half of 2007 and the first half of 2008 has led many countries to argue that increased speculation in the commodity market has played a role and indeed there is evidence of increased activity in these markets. However, whether speculation is playing a role in higher oil prices is open to debate. It is also useful to remember that both the demand for and the supply of oil react sluggishly to changes in the prices in a short period, so a very large change in prices can be required to restore equilibrium if demand should move even modestly out of line with supply.
As a consumer, we have seen the impact of high oil prices at the household level. When oil prices are rising, most of us are likely to think about the prices of electricity and gasoline. When gasoline prices increase, a large part of our household budget is likely to be spent on it, which leaves less to spend on other goods and services. When oil prices are up and electricity is produced by diesel the price of electricity is up and goods produced using electricity, the cost of manufacturing is up. As such consumers are indirectly taxed and it curtails the consumption of goods. This impacts a business negatively. Business suffers as exports become costly and uncompetitive in the global markets. Essential commodities in the domestic markets become dearer. Therefore, demand for goods and services falls and negatively impacts the economy and business. Growth in GDP fails to achieve the target. A longer period of high prices of oil may at times lead to recession. It turns out that oil and gasoline prices are closely related. So when oil prices spike, gasoline prices also spike and manufacturing becomes costly as gasoline and oil are used for the production of electricity for industries and households.
Oil prices hike also negatively impact the macro-economy. Oil price increases are generally thought to increase inflation and reduce economic growth. In terms of inflation, oil prices directly affect the prices of goods made using petroleum products. Oil prices directly affect the cost of transportation, manufacturing and heating. The increase in these costs can in turn affect the prices of a variety of goods and services, as producers may pass production costs to consumers in the form of higher prices of commodities. The extent to which oil price increases lead to consumption price increases depends on how important oil is for the production of given types of goods and services. Oil price increases can also stifle the growth of the economy through their effect on the supply and demand for goods. Increases in the oil prices depress the supply thereby laying off workers and increasing unemployment. A decrease in supply occurs due to the high cost of production. In economics terminology, high oil prices can shift the supply curve for goods and services for which oil is an input.
High oil prices also can reduce demand for other goods because they reduce wealth, as well as induce uncertainty about the future. High oil prices appear to be a tax on consumers. This generally occurs in the case of imported oil. The extra payment that consumers are made to pay to foreign oil-producing companies can no longer be spent on other kinds of consumption goods. Despite these effects on supply and demand, the correlation between oil price increases and economic downturns is not perfect. Not every sizeable oil price increase has been followed by a recession.
The oil shocks of 1973 and 1979 were characterized by low growth, high unemployment and high inflation. It is no wonder that changes in oil prices have been viewed as an important source of economic fluctuations. In the past research has challenged this conventional theory about the relationship between oil prices and the economy. The late 1990s and early 2000s were periods of large oil price fluctuations, which were comparable in magnitude to the oil shocks of the 1970s. However, these later oil shocks did not cause considerable fluctuations in inflation, real GDP growth or the unemployment rate. Simply observing the movements of inflation and growth around oil shocks may be misleading. Keep in mind that oil shocks have often coincided with other economic shocks.
In the 1970s there was a large increase in commodity prices, which intensified the effect on inflation and growth. On the other hand, the early 2000s were a period of high productivity growth, which offset the effect of oil prices on inflation and growth. Therefore, to determine whether the relationship between oil prices and other variables has changed over time, one must go beyond causal observations and appeal to econometric analysis. Researchers observed that the responses of prices, wage inflation, output and employment to oil shocks have become muted since the mid-1980s.
Economists have viewed that increase in energy efficiency has weakened the link between oil prices and inflation. Increased flexibility in labour markets, and monetary policy improvements have contributed to the decline of the impact of oil shocks on the economy. Monetary policymakers believe that the economic shocks caused by rising oil prices may have played a role in the impact of the shocks on economic growth and inflation.
What are the likely effects of the oil price hike on developing countries like Bangladesh? Higher oil prices are generally thought to increase inflation and reduce economic growth. In terms of inflation, oil prices directly affect the prices of goods and services. Higher prices of oil indirectly affect costs of transportation, heating and manufacturing. Oil prices rise negatively affect Bangladesh’s import costs, GDP growth, exchange rate, and Balance of Payments and cause higher inflation. For the last 3 years, Bangladesh is in the grip of the Covid-19 pandemic. Normal economic activities were further hampered by the ongoing war between Ukraine and Russia. Although we are not directly involved in the war, the spillover of the war has hurt our economy. We may have lost our European export market to some extent due to the high cost of export items making those less competitive.
At the same time millions of refugees coming into nearby states putting pressure on the income and wealth of the EU member states’ citizens indirectly due to curtailment or reduction of various welfare facilities. These curtailments of benefits are likely to force citizens to adjust their home budget in terms of purchases, indirectly shrinking our export market. The rise in oil prices impacted our economy directly and indirectly.
Rising oil prices will lead to an escalation of poverty. Poor will become poorer and new poor will add to the total poverty. The poverty eradication programme will be seriously hampered. Implementation of the country’s fiscal policy will have a setback. Imports will fall, thereby custom duties will fall, high cost of export items will impact export markets. So fall in export earnings. This may force us to readjust our export target. Therefore, it may not be possible to achieve our export targets of $67 billion of which $46 billion from RMG, $12 billion from other items and $9 billion from service sectors.
On the domestic front fall in purchases of household and industrial input will reduce VAT and sales tax earnings. On the monetary front, there will be an indirect devaluation of the taka in terms of the US dollar. This will increase import costs thereby making our exportable items costly and uncompetitive. Factories will cut down production due to a fall in sales and will be forced to terminate workers which will aggravate the unemployment situation further.
Resorting to electricity load management could be a temporary solution but unless energy efficiency can be ensured, problems will not be solved. Coal-fired generation of electricity could not be produced as Bangladesh is committed to reducing the use of coal to curtail coal-fired emission of carbon– dioxide. COP26 has put a voluntary restriction on the use of coal.
Increased oil prices will drastically pull down the standard of living of low and middle-income households. Supply-side inputs will be costlier. Budgetary deficits will be seen both at the national and household level. The growth trajectory may experience a downward trend. Prudent policy options have to be taken up to meet the challenges of high prices of oil.
The writer is former Director General of EPB. He can be contacted at hassan.youngconsultants@gmail.com
