Custom «Oil Prices and Inflation» Essay Paper Sample

Introduction

The prices of crude oil like the prices of many commodities experience constant wide price swings due to factors affecting demand and supply. The cycle of oil prices extends over several years in response of the demand and supply of oil globally. During the early 20^th century, the US petroleum industry was heavily regulated in terms of production and price control. During the II World war, the average price of oil was $26.64 per barrel. In the absence of price controls, the average price of oil would be $ 28.68 per barrel during the same period. This price was later adjusted due to inflation to $ 19.50 implying that form 1947 to 2008, only 50% have oil prices exceeded $ 19.60.

History of oil prices

Before the adoption of the $22-$28 price band for crude oil by the OPEC, the only time that oil prices exceeded $24 per barrel was in response to the Middle East crisis. Despite this price band, the OPEC abandoned this price band hence rendered powerless in stemming the surge in oil prices.

Long-term view

Since 1869, the prices of crude oil which have been adjusted for inflation several times have always averaged $22.52 per barrel as it was the prices in 2008 compared to the global prices of $23.42 per barrel world prices. If by the use of post-1970 data, oil prices at $32.36 per barrel would be more relevant to the global world prices of $35.50.

Post World War II (Pre Embargo Period)

The regular and most occurring price of crude oil from the year 1948 all the way to 1950 ranged from $2.50 to $3.00. In respect to recent times particularly in the year 2008, the prices of crude oil fluctuated from $17 to $19 (Bloomberg.com).  This 20% increase in nominal prices just kept up with inflation. The period between 1958 and 1970 was characterized by stability in oil prices that was near $3.00 per barrel. The establishment of OPEC which comprised of 5 member states that are; Iran, Kuwait, Iraq, Saudi Arabia and Venezuela was to reduce the effects of oil producers suffering the effects to the weakening dollar.

The establishment of OPEC established an influence in oil prices in the global market. By the end of 1971, the membership of OPEC had increased to 11 by the joining of Qatar, Indonesia, UAE, Nigeria, Libya and Algeria. The member states of OPEC experienced a steady decline in the purchasing power of oil during the period after the formation of OPEC. The period after the World War II was characterized by a decline in the purchasing power of oil exporting countries but an increase in the demand of crude oil.

In 1971, the Texas Railroad Commission set the oil proration at 100% implying that Texas oil producers were no longer limited in their oil production. This also implied that the US no longer controlled he prices of crude oil but the control of crude oil prices was taken over by the OPEC. Perhaps the best probable explanation for the actions by the Texas Railroad Commission was that the US had no more spare capacity and therefore incapable of fixing  a maximum price for oil. OPEC realized the extent of control it possessed with regards to oil prices through an unprecedented war with other oil producers two years later after its formation.

Middle East Supply Interruptions

In the year 1972, the price of crude oil was about $3.00 by the price went up to four times higher in a period of two years. The Arab Oil Embargo commenced as a result of an attack on Syria by Israel. Most of the western countries as well as the US showed their support on Israel which led to several Arab region oil exporting countries impose an embargo on the allies of Israel. This period eliminated any doubts that the control of oil prices was now under the OPEC. The extreme sensitivity of prices was exhibited during this period when prices increased up to 400% in a period of six months.

Crises in Iran and Iraq

The events happening in both Iran and Iraq which are both major producers of oil led to another round of price increase. The Iranian revolution led to a loss of an estimated 2.5 million barrels daily and at one point oil production in the country almost came to an abrupt end. In the historic context, the Iranian revolution is responsible for one of the highest oil prices in the post World War II era. The impact of the revolution on oil prices would have been short lived had it not been for the subsequent happening that followed in the country. The period after the revolution saw the oil production increase to up to 4 million barrels daily.

The subsequent occurrences were that already weakened by the revolution, Iran was invaded by Iraq. What followed was a sharp decline in oil production from both countries with the combined production of oil from both countries falling to a record 1 million barrels daily. The combined effects from both the Iranian revolution and the Iraq invasion on Iraq led to a double increment in oil prices with oil prices increasing from $14 in 1978 to $35 in 1981. Currently, Iran's oil production is at a million barrels below the peak reached before the war with Iraq.

US Oil Price Controls

The US post embargo period energy policy only led to a further increase in crude oil prices. The US introduced an energy policy imposing price controls on domestically produced oil. This implied that US consumers of oil paid a 50% more on imported oil and oil products while the US oil producers received less returns for their oil in the world market. The question remains whether this policy achieved its intended goal. The recession that accompanied the crude oil price spike was less severe on the US economy as well as consumers as consumers paid relatively lower prices for oil than the rest of the world but this had other effects.

Without price control, it is projected that the exploration as well as the production of oil would have been significantly higher. The higher petroleum prices on the consumers' part would eventually lead to a decrease in consumption.

OPEC Fails to Control Crude Oil Prices

OPEC responsibility in controlling oil prices was put to task when the oil group was often referred to as a cartel. There was a certain occurrence when Saudi Arabia threatened to increase production enough to crash the oil prices. The period between 1979 and 1980 experienced a sharp increase in oil prices. During this period, the Saudi Arabia's oil minister repeatedly warned the OPEC members that an increase in oil prices would undoubtedly lead to a reduction in demand. However, most of the OPEC members did not take these warning into consideration.

The increasing oil prices led to a series of reactions from the consumers. This led to increased efficiency in industrial processes as well as the use of automobiles with higher efficiencies. A combination of these factors coupled with the global recession being experienced led to a reduction in demand of crude oil.  An increase in oil prices also led to an increase in exploration and production of oil outside the OPEC region. Between 1980 and 1986, oil production outside the OPEC region increased to over 10 million barrels daily. This implies that OPEC was faced with a problem of an imbalance between demand and supply.

One of the first attempts by OPEC to stabilize oil prices was by setting production quotas to a record low. The failure of this attempt was as a result of the OPEC members producing beyond their quotas. During this period, Saudi was the swing producer cutting its oil production a move that was aimed at stemming the free fall of oil prices (OPEC Press Release). However, the Saudi government relinquished its role and resulted to linking its oil prices to the spot market prices. This led to an increase in production despite a reduction in prices hence the country was able to compensate for the low prices with increased volumes.

The crude oil prices spiked in the early 90s a situation brought about by a decline in production particularly after the Iraq invasion of Kuwait. During the Gulf War which was carried out to liberate Kuwait from the Iraqi government, the prices of crude oil showed some stability but characterized by a steady decline until in 1994 when the prices a record low level since 1973. This marked the beginning of the incline of the oil prices. This was driven by the US economy and the strengthening of the dollar. This period was characterized by an increase in the global consumption of oil to up to 6.2 barrels daily with Asia recording the highest consumption margin of over 300,000 barrels daily.

The price control strategies by the OPEC continued to experience mixed reactions with regards to the application and effectiveness. The main challenge faced by OPEC was the maintenance of the production discipline among the member states. However, the price increase came to an end in the late 90s as a result of the economic crisis being experienced in the Asian continent. The crisis led to a slowed growth in most economies in the continent which had previously experienced a steady growth in the previous years. One of the reasons why oil prices started declining was as a result of low consumption levels coupled with OPEC production set prices.

The recovery of oil prices started in late 90s up to date. One of the factors that have led to the continued high prices of oil is the weakening dollar as well as the rapid growth of the Asian economy. The rapid growth of the Asian economies has increased the demand for oil and oil products up thereby pushing the prices. Refinery problems in the US which are associated with the conversion of MTBE as an addictive to ethanol have further led to the increment of oil prices. Another important factor supporting the high prices of oil are the high level of US inventories as well as oil consuming countries. The inventories have always been known to provide short term price predictions of oil. OPEC despite not publicly disclosing has always relied on the world inventory management in the oil prices determination. This is one of the key factors that contributed to the recent cutback on production brought about by the growing concern over OECD inventory levels.

Inflation and oil prices

According to the IMF, the soaring oil prices and the inflation levels in emerging economies are a great risk towards the global economic recovery. Some of the economies which have exhibited rapid economic growth are economies such as China, Brazil and India. According to the IMF, emerging economies should be very careful so as to ensure that market conditions like he recent housing boom in the US do not lead t a near collapse of the economy. Despite showing some signs of recovery from the recent economic recession, most economies have not realized full recovery hence demand a lot of attention in the financial context. The prospect of oil at $120 is perceived not enough to indicate a steady global expansion.

Commodity price pain

Most commodity prices have increased a situation which has seen the rising food prices in the relatively developing countries. This increase in commodity prices is seen as the key factor that led to the recent Arab world revolts in Yemen, Saudi Arabia, Egypt and Tunisia. The IMF predicts that the inflations levels in developing countries were much likely to increase accompanied by a push for higher wages.  The recent Arab crisis which was recently experienced in oil producing countries had led to a sharp incline in oil prices in recent days but these prices retreated signaling a progress in the Libyan peace talks.

Relationship between oil prices and inflation

There is a close connection between oil prices and inflation. Inflation has been found to move in a similar direction with oil prices implying that an increase in oil prices lead to increased global inflation and vice versa. The major reason for this is as a result of oil being a major input in the world economy. Oil is one of the commodities used in almost each and every activity in the modern world. This implies that an increase inputs will undoubtedly lead to increased cost of end products. A practical example of this is that if an increase in oil prices is passed on to the plastic industry which is then passed on to the final consumer.

The direct relationship between oil and inflation became evident in the early 70s when the price of oil historically rose from the nominal price of $3 before the oil crisis of 1973 to $40 in the 1979 oil crisis. This is attributed with the Consumer Price Index which is a key measure of inflation which doubled from 41.20 in 1972 to 86.30 in 19.80. Economists found out that it had previously took almost twenty four years for the CPI to double, it took only eight years for the same to double depicting the effects of oil on global prices.

However, the relationship between oil and inflation deteriorated after the period of the oil crisis. During the Gulf War oil crisis, the prices of crude oil doubled from $20 to $40 in a short period of six months. Despite this increment, the Consumer Price Index experienced some stability growing form 134.6 in January to 137.9 in December. The relationship between oil and inflation became even more apparent between the years 1999 and 2005 when the annual average nominal price of oil increased from $16.56 to $50.04. During the same period, the Consumer Price Index grew from 164.30 to 196.80 by the end of the same period. However, the strong correlation that existed between oil and inflation in the past is seen to be significantly weakened.

Global Inflation and surging oil prices

In recent times, the global oil prices have led to the global inflation amid fears of interest rates increment as well as steep rises in consumer prices. According to the US labor department, the inflation rate in the US posted a record rise of 2.7% while the Euro zone 17 member states posted increased consumer prices to up to 2.7% increase. At the same time, China Bureau of Statistics stated that the Chinese inflation soared to a record three year high by growing to 5.4% in the month of March. India is also experiencing the same situation where consumer prices unexpectedly rose to 8.9% during the same month

Oil prices and inflation effects on the global recovery

According to the International Energy Agency, high oil prices are impacting negatively on the oil demand growth which has seen slowed. The same sentiments were made by the IMF stating that the soaring oil prices and inflation were a risk to the global economic recovery. Oil prices are seen to cause an effect on key inflation indicators such as the consumer price index and consumer sentiments on the economic outlook.

Oil Price Shocks and Inflation

The recent increase in oil prices have raised fears of a repeat of events that happened in the 70s. This period was characterized by rising oil prices accompanied by severe recession and surging inflation. In the historic context, the relationship between inflation and oil prices became apparent specifically during the period between 1962 and 2000. Economists found out that oil prices had a significant impact on inflation. However, in recent times, economists have come up with theories that argue that the effects of oil prices on inflation depend on the economic approach.

The role of monetary policy

The role of monetary policies on oil and inflation can best be described if we assumed that we lived in a world where oil is the basic substantial input of most economies. This implies that an increase in oil prices would undoubtedly lead to an increase in the cost of living. According to a recent economic outlook by Fed, oil shocks no longer have any significant impact on inflation. A large number of studies have found out that Fed now reacts more vigorously to inflation than it did in previous years. The change in expectations with reference to Fed's response to inflation has led to the containment of inflation fears. The changes in the inflation levels is seen as the key factor that has led oil shocks not to have similar impact like what they did in earlier years.

Events in the 1970s

There exists a close relationship between oil prices, inflation and commodity prices where the events that led to the recession of the 1970s still appears plausibly large in modern economies. According to one economist, a 1% increase in relative prices of oil leads to almost 3% in the core PCEPI. Given the size of the energy sector, these statistics are hard to go by. It is universally known that commodity prices are always sensitive to inflation expectations. The 70s period was dominated by volatile inflation expectations which explains why most economies were able to predict the inflation levels at the time. There are some suggestions that policy makers previously thought that higher inflation levels led to higher output. This led to most policy makers over stimulating the economy but changed their earlier approach of ignoring inflation.

However over the years, policy makers have become more conscious regarding the inflation levels a situation which has led to the containment of global inflation levels. Commodity prices are now seen to reflect the situation in the commodity market rather than the previous inflation concerns. The behavior of oil prices is depended on the actions of OPEC. However, OPEC is very sensitive when it comes to economic developments such as the fluctuating dollar value and the monetary policies not only in the US but other influential economies.

Current global inflation

The Euro zone is one region which raised its interest rates in a bid to counter mounting price pressures. However, the US has shown no intentions of raising its interest rates in a period characterized by a decline in unemployment and a positive economic outlook (World Economic Outlook). The Fed is said to be directly or indirectly responsible for the commodity boom affecting majority of the economies globally. China and India reported inflation rates which were relatively higher than the projected levels. The main reason for the increase in oil and commodity prices is as a result of the strong economic growth in developing countries which has led to outstripped demand since the recent global economic crisis.

During recent months, crude oil was currently running at $120 which is a record high figure stirring inflation concerns. This increase is driven by the mounting price pressure on commodity goods. The consumer price inflation in China quickened in March at the fastest rate since July 2008. In India, the main inflation gauge which is the wholesale price index rose to 8.98% from 8.31% in a period of 12 months beating the earlier projection of 8.36%.

Most economists predict that the Central bank of India and the Central Bank of China will tighten their individual monetary policies hence reduce the inflationary pressures. The highest inflation in China was core inflation with the exclusion of food and energy while in India, a sharp increment of figures led most economists to conclude that the underlying price pressures were higher than they had estimated.

Euro zone and the US

According to recent figures, the Euro zone's inflation figures jumped to 2.7% up from 2.4% which was slightly more than the preliminary forecast. The European Central bank was among the first banks to increase the rate of interest although the move may create an impending damage on economies such as Portugal and Ireland who are struggling with debt.

Surging oil prices jeopardize global economic recovery

According to the recent India warnings, the soaring oil prices may jeopardize the global oil recovery. This is with the fact that the global recovery is still vulnerable to a variety of risks especially after the recent economic recession. The combination of political, social and economic factors combined with natural disasters is a great threat towards economic recovery. RBI governor, Dr. Subbarao in his agrees to the International Monetary Fund stated that unless oil prices stabilize, apart from inflationary pressures, emerging trends from developing economies has led to a global economic slowdown. 

Impact of oil price increase on the global economy

Over the past two years, oil prices have experienced a sharp increase with oil prices rising from $11 to $35 per barrel. In 2000, oil prices seemed to ease but later increased towards the end of the year. The global impact of oil prices on has transferred the oil income from oil consumers to oil producers. In the global context, a fall in demand maybe be experienced in countries that allow higher prices to feed to the final consumers tend to have a lower propensity to consume than energy consumers.

Increasing oil prices have also led to a rise in the cost of production goods. This is because an increase in the relative price of energy inputs has led to increased pressure on profit margins. The magnitude of oil prices on inflation entirely depends on monetary policies in oil producing countries and developing nations which are significantly becoming the greatest oil consumers. The impact on the financial markets will be both direct and indirect. There will be expected changes in economic activities, corporate earnings and inflation. The impact is also seen to affect the equity market where equity and bond valuations are seen to move with respect to oil prices.

The Impact on Industrial Countries

Taken as a group, the industrial nations will experience a fall a decline in the real GDP. However, the greatest impact is felt in the US and the Euro zone where the net exporters of oil that is the UK and Canada are n this group. In an attempt to control the surge in oil prices, the US and the Euro zone are likely to increase the real nominal short term interest rates. In the exchange rates sector, increase in oil prices has led to the stabilizing of exchange rates with the dollar appreciating slightly higher to the yen and the Euro.

Financial Crisis

According to Knittel, the effects of the financial crisis which originally developed form the sub-prime lending is further compounded by worries of global inflation in the broader U.S. economy(Knittel 2007, US Department of Treasury. ). The worries regarding global inflation are the main cause of the ineffectiveness of the stimulus package drawn by Fed in the beginning of the year. The origin of the crisis was as a result of lax lending in the property market which at the time was further fuelled by easy monetary policies in 2001. The speculation in the property market proved to be very disastrous for the U.S. economy. The approach taken by Fed at the time was to encourage low interest rates boosting consumer spending fuelled by low mortgage prices. This enabled a property boom that saw the U.S. register a record surge in house ownership. This in turn increased spending which further pushed housing prices up. This implies that instead of Fed averting one problem, it introduced an even greater problem.

Inflation

Instead of eliminating and reducing undisciplined spending, the Fed encouraged another round of speculative spending. The world's most sophisticated financial tool, the CDO was used to package and securitize mortgage loans and then sold to equity markets across the globe. The predications of Fed were that as long as house prices maintained their stability or kept on rising, the housing bubble could not bursts and that the economy could survive on its indiscriminately spending. Fed was also encouraged by home owners, central bank, speculators, lenders and investors implying that the continued borrowing by these parties would finance their spending.

This trend reached the height characterized by default rates becoming apparent and the wide-spread euphoria of a hike in house prices disappearing. The whole system of the mortgage lending and borrowing to finance spending eventually collapsed leading to an apparent economic crisis. The impact of the collapse of this system is not limited on the household income but spilled over to financial institutions and other government backed mortgage lenders such as Fannie Mae and Freddie Mac.

Recession

Generally, the economy is facing a slowed growth momentum and a possible recession complicated further by global inflation. This is at a time when customers are facing financial difficulties leading them to cut on expenses due to high debt level and a reduction in value of the property assets. The purchasing power of consumers is further undermined by global inflation rates which have been mainly caused by depreciating dollar value. This creates a cycle of crisis leading to further erosion in the purchasing power of consumers as well as imported inflation. This raises the question whether the stimulus package by Fed and the cut of interest rates by central bank will revive the aggregate demand which is the economic engine in current economic times.

What should Congress do?

During this time of economic crisis, the congress should address economic policies that affect near and long term economic performance. One of the areas that the congress can address is the tax policy. The congress should signal today what it expects to do on taxes in some few years to come. Maintaining lower taxes encourage labor and capital leading to increased economic activities. Another area that congress should address is mortgage market regulation by not extending new subsidies in the housing sector. This is because, an efficient mortgage credit industry is central to the country's economic future.

What Fed should do

Right now, the effectiveness of the stimulus package by Fed is dependent to some extent by foreign power. According to Bernanke, easing monetary policies by fed would further cause increased inflation and increased recession (The New York Times). One tool which Fed can use is change the reserve ratio. This will allow banks to lend less reducing the supply of money hence reduce inflation. Fed can also reduce the money supply through open market operations. The interest rates play an influential role in the economy. Fed's signal regarding the rate of interest in the financial market will hence address consumer behavior as well as regulate spending.