This paper, hereby being presented, intends, as the headline suggests, the impact of falling global oil prices on the Eurozone inflation level. It has been lately observed, through different forms of media leading to worldwide speculation, over the falling oil prices from around $145 per barrel in the year 2008 until a little less than $70 a barrel in the current year, 2014. This has come as good news for many countries, such as South Asia, India and China, which heavily rely upon the import of oil as this has given these countries an incentive to generate welfare funds against cheap oil price. However, this fall in oil prices has also caused a sudden shift in wealthfrom the oil producing nations such as Russia, United States of America, Venezuela, OPEC (Oil Producing and Exporting Countries) and Libya to the oil importing countries, examples such as mentioned above.
The primary focus on this paper will be upon a couple of factors.
First, the intent of the paper is to explain why the global oil prices are falling and would continue to do so in the near future. It will try to mention the factors which are governing the oil prices in the world and the reasons behind why such a drastic fall will continue to take place which threatens to ruin not only the future of the producers but also the interests of the investors in relation with the producers.
Second, this paper will try to analyze how the global oil price fall is really impacting the economy and the Eurozone inflation level through an analysis on the Macroeconomic Factors such as Aggregate Demand and Aggregate Supply, Consumer Price Index (CPI), Real Fiscal Debt, Gross Domestic Product (GDP) and Unemployment Rate. It will also try to take each factor into consideration so as to verify which factors are benefitting from the price fall and which are highly affected by it.
Third, there would be a further analysis upon what kind of steps the European Central Bank and European Commission is broadly apt to take so as to control the effects of Eurozone inflation level.However, the repercussions of taking these steps will also not be easy on the decision-making and European governing body.
Finally, in the conclusion, this paper will try to highlight the points discussed in the entire paper and the results of the decisions that may have been taken by various figureheads in the world and the decisions yet to be taken which might perhaps change the scenario in the Eurozone.
Reasons for falling Oil Prices:
Oil prices in the international market are governed by the supply and demand for the commodity. The producers and the distributers of oil represent the supplier side while the consumers such as businesses and individual people for heatingand transport purposes, govern the demand side. Oil as a commodity is exchanged for money in dollars in the financial markets thus its price index and its troughs and crests along a time series is severely important for stock investors so as to decide when to buy shares and when to sell them. The governments producing oil mainly govern its prices in the stock exchange. They are the known as the key players in the oil commodity market which completely control the price or are the price makers in the market like a monopoly in a single sub-variant case or an oligopoly in the multiple producer index, examples being the OPEC (Oil Producing and Exporting Companies) as a multiple producer index and United States of America, Russia, Libya and Venezuela being the single sub-variant case each producing their own quantities of oil without collaborating on fixing the oil price with other oil producing nations. Each country is trying to the key player as a producer keeping an eye on Europe represented by Germany as the major source of the oil Demand sector.
However, lately, there have been several emerging countries that are coming out of age with new abundant production of oil due to the advancement of technology availability of new oil fields adopted in the countries such as Iraq, Syria and Libya. There had been a speculation that these three nations, that is Syria (Governing along a civil Strife), Libya (Another hot bed of Civil war) and Iraq (Terrorized by some Active Group) are under continuous threat that their oil fields are or will be under their siege or danger and thus it would cut down the production spree that had started a few months earlier. However, to an utter disbelief to many, production levels in these countries reached new records thus offsetting the key control on the prices these cartels or oligopolistic nations have been governing over six years since the last financial crisis.
Supply of oil gyrated to record levels; emerging countries added more oil into the industry than expected; concurrent oil producing countries continued in their expedition to higher levels in order to match or even surpass these unexpected levels of production with their own reserved capacity cumulated by shortage in demand for the same oil in Eurozone and many other countries struggling with their growth rate.
Bottom-line: Unprecedented supply followed by weak demand – fall in Oil Prices.
However, since the price of Brent Crude has gone down below the production cost of $100 a barrel which is the break even point for countries producing oil such as Russia and USA (Shale Gas Production), these producers have become jittery over the fall and are expecting other nations to cut down their production so as to control the oil back to its original price. However, recently in one of the conferences, OPEC, against all expectations, has decided to continue its current level of production without paying any heed towards the falling oil prices unlike its decision in the 80’s where they had cut down their production. When asked about the decision, it was revealed that the cost of production of oil is less than $2 a barrel unlike its competitors who produce at a price of $100 a barrel. This is a classic case of Nash Equilibrium where each party could have held their production so as to help the oil prices increase and thus benefitting them all. However, they chose to keep their production levels high in order to compete with each other thus putting a downward pressure on the oil prices thus keeping each of the player more in a monopolistic competition where their revenue is equal to or less than the average total cost thus giving them either no gain or further losses rather than any profit. This oversupply could have been counteracted in order to reach the breakeven point if there would have been a surge in demand in parallel with the supply in the European market where they are major consumers of oil. However, over the years, since the financial crisis, there has been very sluggish growth; the latest GDP growth estimate in the third quarter of 2014 being up by 0.2% in the Euro Area and 0.3% in EU28. (Eurostat Data).
Impact of Falling Oil Price on Inflation:
So we come back to our prevailing question about how the falling oil prices is impacting the Eurozone Inflation level.
“80% of the decline in the commodity prices between the year 2011 and 2014 has been caused by LOWER PRICES IN OIL and food.” Quoted by Mr. Mario Draghi, Head of the European Central Bank on May 26th, 2014.
It is hard to believe that most of the business and consumers who are partly or even wholly depended upon oil will create the reason in the decline in the commodity prices. It is assumed that the consumer price index (CPI) would go down with the fall in oil prices because oil, in the form of energy, constitutes around 0.9% in liquid fuels, 0.1% in solid fuels and 0.6% in heating fuels in the Harmonized Index of Consumer Prices (HICP). This percentage is yet too small to figure out how the fall in oil prices will impact the Eurozone inflation level. However, sources and studies conducted by the Bureau of Labor Statistics, Haver Analytics though year to year CPI correlation have found out that the fall in oil prices do have a direct effect of the fall in other domestic commodity prices thus decreasing the entire CPI. (https://www.clevelandfed.org/inflation-central/201411-trends-oil-and-consumer-prices.cfm).
Mr. Mario Draghi, in his May Speech, (http://www.ecb.europa.eu/press/key/date/2014/html/sp140526.en.html) also tried to state that the falling oil prices are having a combined effect of rise in the euro exchange rate making internationally traded commodities less competitive and local factors such as the process of relative price adjustments in certain euro area pulling down aggregate inflation. The former has led to trade commodities in the international market more expensive thus making it less competitive and difficult to sell. However, the latter reason is leading the state towards sovereign debt crisis simply because the lower inflation is causing the real debt to rise and nominal debt to fall, which in turn, is increasing the value of money causing the demand for the quantity of money in order to purchase goods to fall which has a downward pressure on the consumer price index. States, due to the fall in inflation, will actually require more money to repay the debt, the quantity, which is simply going down due to shortage in demand. It is a classic case of cause and effect, which spiraled to another cause leading to other disastrous effects.
There are other factors as well, which needs to be discussed that are causing the disinflation or the fall in inflation inside the Eurozone due to the fall in oil prices. One such criteria is the consumers’ tight leash upon its liquid money by refraining itself from making a purchase on commodities that are being affected by the fall in oil prices. The reason, speculated widely, is that the consumers are actually skeptical about the extent of the fall in oil prices which is giving them enough incentives to hold on their purchases until the price reaches at the bottom of the pit from where there would be a upward swing. The consumers simply want to benefit in a maximum possible manner from the fall, a concept, which, according to some analysts, has generated after the crisis had occurred over the globe in the year 2008.
In the month of July of the year 2008, during the financial crisis, the price of oil globally had peaked to $147.30 a barrel. This sudden rise in oil prices followed by unprecedented widespread loss in jobs or surge in unemployment, almost in every sector, had made their living conditions very difficult, sometimes rendering many people homeless. Those were the turbulent times and getting over it was not only difficult but deemed next to impossible. General mass, in order to survive, started to live on their savings or equivalent to whatever they had been left with. The sudden surge in oil price had almost squeezed their pockets off their savings leaving very little to nothing to purchase other commodities. Over a certain period, the price of oil started to drop and unemployment began to reduce. However, the pace of growth, which is governed by the unemployment rate, was sluggish, in comparison to the fall in oil prices. This change didn’t deter the consumers from holding a tight leash on their earnings, savings and expenditure. The crisis had taught them a hard lesson: Always be Prepared for the worst with the best available, sometimes limited resources.
Another factor, which is governing low inflation rate, is that the Gross Domestic Product (GDP) growth, which has also remained sluggish (http://epp.eurostat.ec.europa.eu/cache/ITY_PUBLIC/2-05122014-AP/EN/2-05122014-AP-EN.pdf). From the data given, it is observed that a growth in GDP of 0.2% in the Euro area and 0.3% in the Euro 28 in the third quarter of 2014, as published on December 5th, 2014. Gross Domestic Product of a state or a nation is defined as the number of finished goods and services produced within a time period by a state or a nation, which shall be available to the consumer for purchase. GDP deflator is defined as the ratio of Nominal GDP to that of Real GDP. It is always measured in percentage.
GDP DEFLATOR=(Nominal GDP/Real GDP)*100
Nominal GDP= Product of Current Year prices with the Current Year Number of Goods and Services Produced.
Real GDP=Product of Base Year prices with the Current Year Number of Goods and Services Produced.
As per the Eurostat data of 2014 (http://epp.eurostat.ec.europa.eu/tgm/table.do?tab=table&init=1&language=en&pcode=teina110&plugin=1), the second quarter of 2014 shows a GDP deflator for Euro 28 shows around 123.7. It means that Nominal GDP is 1.237 times that of the Real GDP. The interpretation of this equation is that the product of prices of the current year and the Number of goods and Services produced in the current year is 1.237 times that of the product of the goods and services produced and the prices in the base year. Hence it can be assumed that the prices and the quantity of goods and services produced are increasing by 23.7 %. However, this figure is relatively low, the reason being that producing companies are ready to manufacture more goods if only they get the best price for the desired product. However, as mentioned earlier, the consumers, due to the falling inflation, are not ready to spend immediately, which further has a downward pressure on the demand of goods. This downward pressure or weak demand, spiraled with incoming production has the same effect of fall in consumer price index, which in turn causes the producing facilities or manufacturing units to either reduce, or completely halt their production. This effect, in turn, has a negative effect on the employment scale in the nation due to the less demand in labor due to the less demand in consumer products.
Unemployed people (EUR Area 28 Countries – 10.5%,http://epp.eurostat.ec.europa.eu/tgm/table.do?tab=table&language=en&pcode=teilm020&tableSelection=1&plugin=1) especially the youth, not having a fixed or variable income, are forced to curb their own spending which leads to further downward pressure in the consumer price index. This added fall in consumer price index leads to weak demand of money in the form of currency notes leading to the downward pressure of disinflation. If only, growth in the European Union could have been steady, more demand for skilled and unskilled workers would have gained leading to further lessening of unemployment. This surge in employment would instigate an upward pressure towards renewed spending which would incentivize the government to supply more money thus causing rise in inflation level to a sustainable level by keeping the velocity of money high or the quick exchange of money from one hand to another thus keeping the inflation higher from the current state.
Future Effects of Falling Oil Prices on Eurozone Inflation Level (Possible Remedies):
It is being widely speculated that the falling oil prices will have future repercussions caused due to disinflation such as fall in other asset prices catapulted with bankruptcies and debt crisis of certain institutions, which are grilling under huge amount of debt, leading to horrendous financial instability. The scenario in Europe doesn’t look good although certain remedies are being proposed through monetary and fiscal policies such as Increase in Government Spending and reducing Interest Rates in bank savings so as to harness the consumers to be available with more money in order to enhance spending, with the hope that the extra money would not only help the consumers give more purchasing capacity but also the incentive to spend more thus increasing demand for goods and services which would in turn boost the producers to commence the production and distribution which in turn would require labor so as to meet the demand finally checking or reducing unemployment to earlier sustainable levels bringing upon a win-win situation to all. However, in order to boost the monetary policy, certain number of Investments is also required in infrastructure and research in other related technologies which is actually difficult to attract, keeping in mind, that, the investors currently are too skeptical to carry out any such investments where there wouldn’t be high risk, low return relationship. The risk of huge government spending, on the other hand, if ill-perceived by the people, might have reverse effects, such as a situation of stagflation; a term where there is stagnation of growth due to weak consumer demand followed by unsustainable inflation due to huge, unprecedented money supply which instead of spending, if used to save in banks thus damaging the intended money flow which could have otherwise harnessed growth in the ailing economy.
At present, the situation in Europe doesn’t look rosy. Oil prices are low which should come as a good sign for incentivized spending due to the lower Consumer Price Index. However, the financial crisis has trained the consumers to save more than ever reducing the demand for goods in a macroeconomic level, leading to stunted growth in manufacturing and production leading to huge lay-offs and widespread unemployment finally leading to a black hole from where, hedging a safe way out seems next to impossible, unless, the European Central Bank, and other commissionaires take active part in addressing the aggressive situation by making easy inroads in order to attract private and public investors from domestic and foreign countries with real confidence of real rate of return to the investment about to be made.