In the last two decades, after the collapse of the oil market in 1998, there have been significant fluctuations in the global oil prices. Oil is a commodity and thus is expected to have changes in price as it is affected by the law of supply and demand. However, the variations in the crude oil prices have been massive which makes it an interesting phenomenon. For example, in January 2007, Oil traded at 49 US dollars per barrel. In July 2008 one barrel traded at 140 US dollars. The price of one barrel later sunk to less than 40 US dollars in the December of the same year. Currently, the price of a barrel of oil trades at approximately 50 US dollars.
Various scholars have tried to explain both the short-term and long-term fluctuations in the oil prices. The price markup is a function of the marginal cost, the price elasticity of demand and the industry market share. Evidently, the oligopolistic theory fails in explaining the short-term fluctuations in crude oil prices (Aastveit, Bjørnland, Thorsrud, p. 1018, 2015). Again, it is widely held that crude oil being an exhaustible resource, the scarcity of crude oil affects the prices of crude oil. Therefore, in this regard, the prices of crude oil can be perceived as being a stochastic variable. In this paper, we examine the fluctuations in the prices of crude oil by conducting a microeconomic analysis. Besides, the welfare implications of the crude oil price fluctuations are examined in detail.
Reasons Behind the Fluctuation of Oil Prices
OPEC (Organization of Petroleum Exporting Countries) is an organisation of 13 oil producing countries. As earlier mentioned oil being a product is affected by the laws of supply and demand. OPEC regulates at least forty percent of global oil production. In a hypothetical situation, the consortium sets the targeted production levels required to meet the global demand for oil. Therefore, OPEC can influence the oil prices by increasing or decreasing the global crude oil production. However, in recent years the OPEC influence on the crude oil prices has been restricted to short-term only. There exists conflicting interest between OPEC and the member countries; which contributes to the enormous fluctuations in crude oil prices (Baumeister and Kilian, p. 139-60, 2016). In 2014, OPEC decided to maintain the prices of a barrel of oil above 100 US dollars. However, in July 2014, the prices fell sharply from a hundred US dollars to below 50 dollars. The reason behind this is because that although OPEC was adamant in reducing crude oil production to meet the reduced demand for oil from Europe and Asia, the member countries still insisted on producing the crude oil. In the end, this created a surplus in demand which resulted in the reduction in the prices. Therefore, it is apparent that the conflicting interests between OPEC and the member countries interfere with the supply of the crude oil which causes massive fluctuations in the oil prices.
Nonrenewable Nature of Crude Oil
Unlike other commodities, the demand and supply of oil are not entirely affected by the price but the valuation mechanism of crude oil prices involving future markets. A typical future contract for oil gives the holder the right to buy the barrel of oil at a fixed price in the future. Thus, in this way, the price of these international futures affects the average price of crude oil. This oil price mechanism leaves the crude oil price vulnerable to opportunistic forces. There have been more significant long opportunistic trades in NYMEX than the short opportunistic trades. Therefore, these oil speculative practices are essential components used in explaining the unstable oil prices and the fluctuations (Kilian and Murphy, p. 468, 2014). The oil future markets provide an investment opportunity to large capital traders. The traders hype the oil futures by either creating an imbalance between price and supply or by using the available market information to purchase oil futures contracts without having real possession of the oil wells. The entrance of the traders in the oil market primarily has led to an added variability in the prices of crude oil. This leads to the considerable fluctuations in the oil prices.
Geopolitical instability
A considerable number of the oil wells are located in the Middle East; an area characterised by widespread political instability. In the last one decade, there has been the Iraq war, the Syria war, and the Afghanistan war. All these wars have occurred in the Middle East a region which contributes to the vast amount of the global oil production. Therefore, people have been engulfed in a continued state of fear. In 2003 the wars in Afghanistan and Iraq led to a state of unrest and an increase in the consumer's fears. The price of a barrel of oil rose to 136 US dollars as a result. The political instability affects the prices of crude oil because political unrest affects the demand and supply of the crude oil. As earlier mentioned the price of commodities is determined by the interaction of demand and supply curves, thus a variable which affects these curves will outrightly affect the price of crude oil (Arezki et al., 2014).
Again, natural disasters can be credited to the fluctuations in price. There have been increased incidences of natural disasters in the last ten years. In 2005, the Katarina hurricane struck the southern part of the USA, affecting at least 19% of the USA oil supply. The flooding of the Mississippi River in 2011 led to the fluctuation in the oil prices. Again, just like political instability, natural disasters affect the demand and supply of oil. Therefore, the uncertain effect of the natural disasters on the demand and supply curves means that this effect is also exalted on the prices of crude oil.
Implications of Crude oil price changes on the Welfare
When examining the welfare implication of the changes in the prices of crude oil, it is imperative to consider how the variations influence the different microeconomic agents. A typical microeconomy is composed of the following agents: households, firms, and the government.
Households
Households are one of the biggest consumers of crude oil prices, and thus the fluctuations in oil prices tend to affect households significantly. Household uses crude oil for cooking, driving among other activities. The variability in the oil prices affects households depending on whether the variance is an increase or decrease. In the events of an increase in price, houses hold will increase the amount spent on the crude oil. Therefore, this means there will be a reduction in the household's savings and other expenditures (Baffes et al., 2015). It is during instances of increases in oil prices when there are numerous complaints about rising costs of living. On the other hand, in the event of a decrease in the oil prices, households reduce the total amount spent on crude oil and this results in an increase in households' savings. Thus, the fluctuations in crude oil significantly affect different household's propensity to both spend and save.
Firms
Firms are the most significant consumers of crude oil. Nearly all the production processes cannot proceed in the absence of crude oil. Crude oil forms a vital part of a firm's daily operations. Therefore, the firm's production activities are significantly affected in the event of wide variations in the prices of crude oil. In the event where there is an increase in the price of crude oil, or the firm anticipates the crude oil prices to increase, the firm may have to cut down on the production process. This affects the households, in that as a result of a cut down in the production process some of the workers of the firms (who form the households) will be laid off. Besides due to a reduction in the production process, low amounts of goods will be produced leading to a rise in the prices of commodities. Reverse results hold for a reduction or an anticipated reduction in the prices of crude oil.
Government
Although the government is not a direct consumer of crude oil, the effect of the fluctuations in crude oil prices on both households and firms significantly affect government operations. Both households and firms pay taxes to the government. The government, on the other hand, is required to provide the social amenities and other related services to the households and the firms. Thus, in the event of a reduction in the crude oil prices or an anticipated rise in the crude oil prices, this means that the households and firms will pay low amounts of taxes to the government. Evidently, this reduces the government resources required for the provision of services to its citizens (Sodeyfi and Katircioglu, pp 980-990, 2016). The opposite also holds. Therefore, it is observed that the fluctuation in the oil prices affect how the different agents in the micro-economy dispense their services which constitute the welfare implications of changes in crude oil prices.
The arguments supporting the variations in the price of crude oil are ingrained on the prevailing impact on both the demand and supply of oil. An increase in demand leads to an increase in prices while a decrease in demand leads to a reduction in the prices. The geopolitical instability, nonrenewable nature of oil, OPEC and its member's countries all affect the demand and supply of oil thereby leading to the fluctuations in the oil prices experienced in the last decade. To understand the welfare implications of the fluctuations of oil prices, it is imperative first to analyze how the different agents in the micro-economy are affected by the variations in the price of crude oil.
References
Aastveit, K.A., Bjørnland, H.C. and Thorsrud, L.A., 2015. What drives oil prices? Emerging versus developed economies. Journal of Applied Econometrics, 30(7), pp.1013-1028.
Arezki, R., Loungani, P., van der Ploeg, R. and Venables, A.J., 2014. Understanding international commodity price fluctuations.
Baffes, J., Kose, M.A., Ohnsorge, F. and Stocker, M., 2015. The great plunge in oil prices: Causes, consequences, and policy responses.
Baumeister, C. and Kilian, L., 2016. Forty years of oil price fluctuations: Why the price of oil may still surprise us. Journal of Economic Perspectives, 30(1), pp.139-60.
Kilian, L. and Murphy, D.P., 2014. The role of inventories and speculative trading in the global market for crude oil. Journal of Applied Econometrics, 29(3), pp.454-478.
Sodeyfi, S. and Katircioglu, S., 2016. Interactions between business conditions, economic growth and crude oil prices. Economic research-Ekonomska istraživanja, 29(1), pp.980-990.
