Effect of Crude Oil Prices

Effect of Crude Oil Prices

Crude Price Rise May Hamper Global Recovery

With global crude oil prices hitting the roof, the International Monetary Fund (IMF) has warned that rising prices of scarce natural resource could aggravate poverty. Just as the U.S. and global economies are finally strengthening, they face a new danger: Rocketing oil prices, which topped USD120 a barrel. The global economy may face another serious crisis if oil prices keep increasing because of unrest in the Middle East and North Africa.  

The unrest that has swept from Tunisia to Yemen, Algeria, Bahrain and Iran is fanning the advance of oil prices. Libya’s escalating violence represents the biggest threat to global oil supplies since the invasion of Iraq eight years ago as political unrest sweeping the Middle East centers on a member of the Organization of Petroleum Exporting Countries, or OPEC. Oil prices jumped to the highest in more than two years as Libya’s violent uprising threatened to disrupt exports from Africa’s third-biggest supplier and spread to other crude-producing nations in the Middle East.

Impact On Indian Economy

India’s crude oil import bill may cross USD100 billion if the global price stays firm at USD 100-USD 120 a barrel. If that happens, it will upset the delicate fiscal balance, expand deficit, increase the subsidy bill that continues to bloat year after year and fuel in­flationary expectations. Rising crude oil prices will impact inflation whether the government absorbs the burden or passes it to the consumer by increasing prices of petroleum products. If the government acts as a buffer, the oil subsidy bill will rise and affect fiscal deficit. This will indirectly fan inflation. India's oil import bill in the first 11 months of 2010-11 was USD 85 billion. For the whole year, it is reported to have reached USD 90 billion. India, which imports nearly 80 percent of its crude oil re­quirement, spent USD 79.55 billion in 2009-10.

The recent strengthening of crude oil prices could impact economic growth momentum in the country for the current fiscal. The main factors that would be responsible for economic growth moderation in 2011-12 would be crude oil prices and RBI's tightening of monetary policy in response to oil prices. Rising crude price will lead higher inflation and higher inflation attracts monetary tightening. Monetary tightening would lead to a squeeze on aggregate demand, impacting economic growth.

Impact On World Economy

It is estimated that over a year, USD 100 oil would reduce U.S. economic growth by 0.2 or 0.3 of a percentage point. So rather than grow an estimated 3.7 percent this year, the economy would expand 3.4 percent or 3.5 percent. That would likely mean less hiring and higher unemployment. The global economy wouldn't be affected as much. In part, that's because emerging economies consume less oil, per person, than industrialized countries do. In addition, many developing countries regulate or subsidize the cost of gas. Global growth would slip about 0.1 percentage points, economists estimate. But rising oil prices could threaten European economies, many of which are net importers of oil and gas, haven't fully recovered from the financial crisis and face heavy debt loads. Spain and Italy, where gas at the pump already goes for about USD 8 a gallon, face years of a slow, grinding recovery. A spike in oil would deal their economies another setback.

Rising oil price would also push up inflation in Europe, where it already exceeds official targets, and in countries with surging food prices, like China, Brazil and India. Those countries might then have to raise interest rates to cool inflation. Doing so, in turn, would slow growth in Latin America and Asia.

What is the relationship between oil prices and inflation?

The price of oil and inflation are often seen as being connected in a cause and effect relationship. As oil prices move up or down, inflation follows in the same direction. The reason why this happens is that oil is a major input in the economy - it is used in critical activities such as fueling transportation and heating homes - and if input costs rise, so should the cost of end products. For example, if the price of oil rises, then it will cost more to make plastic, and a plastics company will then pass on some or all of this cost to the consumer, which raises prices andthusinflation.

           The direct relationship between oil and inflation was evident in the 1970s, when the cost of oil rose from a nominal price of $3 before the 1973 oil crisis to around $40 during the 1979 oil crisis. This helped cause the consumer price index (CPI), a key measure of inflation, to more than double from 41.20 in early 1972 to 86.30 by the end of 1980. Let's put this into perspective: while it had previously taken 24 years (1947-1971) for the CPI to double, during the 1970s it tookabouteightyears. 

          However, this relationship between oil and inflation started to deteriorate after the 1980s. During the 1990's Gulf War oil crisis, crude prices doubled in six months from around $20 to around $40, but CPI remained relatively stable, growing from 134.6 in January 1991 to 137.9 in December 1991. This detachment in the relationship was even more apparent during the oil price run-up from 1999 to 2005, in which the annual average nominal price of oil rose from $16.56 to $50.04. During this same period, the CPI rose from 164.30 in January 1999 to 196.80 in December 2005. Judging by this data, it appears that the strong correlation between oil prices and inflation that was seen in the 1970s has weakened significantly.

Crude prices traded at USD101.20 pre inventory data release from the U.S. Energy Information Administration.