The Connection between Oil and Business, and Its Effects on International Trade - Term Paper Example

The Connection between Oil and Business, and Its Effects on International Trade Background Since the past couple of years, the world economy has been on a delicate stage, and growth has been pretty slow. In fact, America and the rest of the world has faced a severe recession and financial turmoil, which has left many unemployed and struggling to live. One of the main reasons for a global recession is oil prices, which has seen wobbly fluctuations. The world is having increased dependence on oil, although many countries are trying to find alternatives to it. Introduction According to the publication, "International Trade Statistics 2008" of the World Trade Organization, global trade was on the rise, but slowed down in 2007 due to weakening demand from developed economies (World Trade Organization). International trade slowed, but still rose because of emerging economies, particularly China and India. However, trade has been affected by the recent hike in oil prices. Furthermore, the publication states that fuel products (oil) saw a relatively lower growth than in previous years, which was due to the high prices of oil in the world market. However, Organization of Petroleum Exporting Countries (OPEC) has increased oil demand growth for 2010 (Brock). Oil is a major commodity in international trade and is one of the most influential commodity to impact business, trade and hence, economies. Today, we will analyze the economics of oil, which would include a detailed analysis into oil prices, and its effects on business and international trade. Oil Price Setting a) Market Forces (Demand and Supply) In the international market, price for every good is determined by market forces. The capitalistic system gives freedom to the market forces, and prices are determined by demand and supply. Demand is the willingness of the consumer to buy at a particular price, whereas supply is the willingness of the producer to produce at a given price. For instance, an increase in demand for oil would increase prices, and an increase in supply of oil would contain or reduce prices. Significant growth in countries like China and Brazil has increased recovery prospects, and hence increased demand. Thus, oil prices have been rising. Oil prices have declined since July of 2008 because of a slump in demand due to a severe global recession. This was also one of the reasons why developed economies consumed less fuel than usual. b) Relationship between Oil and the U.S. Dollar Although the price of oil in the international market is determined by market forces, it is also affected by the U.S. dollar. Oil and the greenback share a negative relationship. Traditionally, an increase in dollar value causes a decrease in crude price, and vice versa. People might wonder as to why oil affects the dollar and the other way round, but how come other currencies and oil price are not related. Commodities such as Oil and Gold are traded in the international market in U.S. dollars, and this has been agreed upon by the Organization of Oil-Exporting Countries (OPEC). Before 1971, the U.S. dollar was backed by gold, and changes in price of oil didn't have an effect on producer profits, as gold had intrinsic value. The U.S. Dollar could be liquidated into gold almost immediately. However, after 1971, dollar was made a fiat currency, and was printed without gold backing. This made it easy for the American government to print money, and hence increase supply. In the last 35-40 years, dollar value has declined significantly amid ever-increasing money supply in the U.S. economy. Therefore, when dollar falls (real value decreases), producers ask for more money to compensate the loss in their real value assets, which are based on U.S. dollars. Thus, a decrease in the dollar has pushed oil prices up in the past decade or so. c) The role of the OPEC Besides these factors, the OPEC, which holds two-thirds of the world's fuel reserves, plays a vital role. Refining is done on a large scale in these countries, and they contribute a lot to the world's oil production. For instance, Iraq is an oil rich country, but the war in Iraq has closed many refineries. Therefore, supply has been disrupted and prices increase as a result of supply shortfall. Growing tensions in the Middle East is one of the most apparent reasons for oil supply disruption. Also, refineries across the world keep a pre-determined inventory level to cope with emergencies, such as strikes. The level of inventory that is kept at refineries in the Middle-East and the U.S. is an important price setter, owing to production stoppages. d) The role of the government Finally, the government has not done enough on its part to control oil prices. Although the U.S. government has no direct control over oil price, it should offer tax breaks to investors who invest in oil exploration and development. Exploration is a very expensive process, and the top investors would only be attracted if they are given tax incentives such as exemption on a pre-determined level of oil development. Since America is the largest oil consumer, it would shift the world's oil supply curve, and definitely have a positive impact on price. Relationship between Oil and International Business People would wonder that oil and business are separate entities, but they are closely tied up and dependent upon each other. When we buy products, we forget about their production processes and how it has reached us. All the products that we, the final consumers buy are manufactured somewhere in the world, and then transported to different markets. Machinery in factories around the world is powered through fuel and is inter-related with the oil. If the price of oil increases, it would cost businesses more to produce, and so they will sell at a higher price. On the other hand, if international businesses stop investing in oil exploration and development, oil supply would plunge, and oil price would increase. Therefore, international business and oil cannot be separated. In short, almost everything that we touch has connection with oil. For example, products like plastics, clothes, and toothpaste etc. Recent oil price hike has spread through the global economy and has dampened business activity. In a New York Times article, Jad Mouawad highlights the effects of oil price hike on the aviation and auto industry (Mouawad, J). He points out that because of the expensive gas at the gas station, customers have stopped their use of gas-thirsty cars from General Motors, Ford, Chrysler and the other automakers. Demand for vehicles in these times hasn't been helped, and the top automakers are left on the verge of bankruptcy. They are asking for government help to provide them with loans to produce energy efficient vehicles. Moreover, the aviation industry has been suffering from losses, owing to high oil prices. In the midst of 2008 when prices were high, airlines were entering into hedge agreements with fuel suppliers to be saved from future increases in oil prices. Hedging was thought to be smart business tactic to survive in the uncertain market. However, oil dropped sharply and wobbled so much that hedging resulted in a greater problem for the airlines. This alone signifies the fact both rising and falling oil prices can have a monstrous effect on international business. Effects of Oil on International Trade In a New York Times article, Paul Krugman notes that higher oil prices increases transportation costs (Krugman, P). He gives an example of China, which imports raw materials to produce goods for export. According to Krugman, producers in China would find it expensive to produce because transport costs increases with an oil price hike. Moreover, Chinese producers would have to lower the price to their exports to retain customers who would be put off by higher prices, assuming that Chinese goods are substitutable. Effect on Oil-Exporting Countries' Current Account Oil is a major driving force for the world economy, as many things from production to travel are dependent on it. OPEC Countries account for a lot of the world's fuel reserves, and therefore, supply oil to most of the countries. There are very few oil exporting countries in the world, relative to oil importing countries. Any increase in oil price in response to demand would significantly increase revenue for these countries, since the world buys from few of these oil rich countries. Usually, economic theory suggests that a rise in price reduces demand, but in the case of oil, demand is price inelastic. Price does not affect demand a great deal because oil is a non-renewable resource, supply is limited and there is no clear alternative for it. Hence, a price increase creates a surplus on the accounts of oil-exporting countries. Effect on Oil-Importing Countries' Current Account When one gains, the other loses. Similarly, when the oil-exporting countries record a surplus following an oil price hike, the oil-importing countries experience a current account deficit. This is because developed nations are not self sufficient in oil production, partly because they consume too much, and even increased production will not match their consumption. Thus, they have to import oil from oil rich countries in the Middle East and Africa. According to the U.S. Census Bureau, U.S. imports in terms of quantity have declined over the past few years since peaking in 2006. However, U.S. imports in nominal terms have increased from $17 billion to $38 billion in a one year from early 2007 to April 2008 (Jackson, J). This has been caused by the rapid price rise of petroleum products including crude oil. Furthermore, latest data suggests that the U.S. Trade deficit reached a record high in the wake of rising oil prices (Healy, J). Recommendations In a period of such economic chaos and uncertainty, it looks as if an oil crisis is on its way. Even though the global economy might be weak, demand from emerging economies would still be enough to keep oil prices within the prevailing range. Continued rising prices would dissolve the global economy into a prolonged recession. In times like these, the government authorities of the world should enact policies that would ease the process of oil exploration through tax incentives and expertise support to investors. As more oil would be produced throughout the world, supply of oil would reduce the price a bit. Furthermore, tensions in the Middle East have to be solved as soon as possible to let the oil companies and refineries concentrate on oil production. Moreover, the people of the world have to realize that oil is a finite resource, and they have to use it when they need it, otherwise they would be forced to pay extra dollars to consume extra. Conclusion Oil will still be a finite resource, even if we control consumption. Controlling consumption would only delay the demise of fuel, so we need to find alternatives to fuel (oil) to help the world sustain its death. First, the automakers would have to produce energy-efficient cars which use relatively less fuel. Experts say that a large part of oil demanded is used for transportation of goods from factories to outlets, and vice versa. We would need to use alternative fuels such as Compressed Natural Gas (CNG), which is much cheaper than oil and much more environmentally safe than oil. All in all, oil will continue to impact all cylinders of the global economy. Put in simple words, the world has to reduce its dependence on oil. Works Cited 1. International Trade Statistics 2008. World Trade Organization. 2008, 1 2. (Brock, J). Oil Demand May Not Reach Pre-Crisis Levels. Reuters. 11 Nov. 2009 3. (Mouawad, J). Swings in Price of Oil Hobble Forecasting. NY Times Online. 5 Jul. 2009 4. (Krugman, P). Vertical Specialization and the Impact of Oil Prices on Trade. NY Times Online. 21 Jun. 2008 < http://krugman.blogs.nytimes.com/2008/06/21/vertical-specialization-and-the-impact-of-oil-prices-on-trade/> 5. (Jackson, J). U.S. Trade Deficit and the Impact of Rising Oil Prices. Congressional Research Service. 10 Jun. 2008, 3 < http://italy.usembassy.gov/pdf/other/RS22204.pdf> 6. (Healy, J). Oil Imports Swell U.S. Trade Deficit. NY Times Online. 10 Sep. 2009 Read More