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  • Writer's pictureThe Financial Literacy Cell

Dependence of Global Economy on Oil Trade Market

The global economy gives crude oil, also referred as the 'Liquid Gold', a considerable significance in today's scenario. Ever wondered why? Well we all must understand the dependency of world trade on the oil market. However, an important step before this to know how oil trading works within the market and analyze its functioning. Oil trading wholly involves buying and selling different kinds of oil and oil-linked assets with the motive of constructing a profit. Oil is a finite resource. It can witness volatility in its price, thanks to the demand and supply of oil, thus making it look attractive to any of the traders. There are majorly three ways during which the market may trade oil. Firstly, within the spot price method, oil spot prices represent the value of buying or selling oil 'on the spot' – rather than at a group date within the future. Secondly, oil futures are a particularly commonly used way of trading oil within the market. Oil futures are contracts wherein you conform to trade the commodity at a collection price on a specified date. They're traded on exchanges and reflect the demand for disparate oil varieties. It locks companies during a beneficial oil price and hedge against extreme price fluctuations within the future. The two major types are Brent Crude and West Texas Intermediate (WTI), which are traded on the Intercontinental Exchange (ICE) and the New York Mercantile Exchange (NYMEX), respectively. Thirdly, oil options is another method of trading. It's just like oil future, but there's no obligation to trade if you don't want to. The two forms of options are call and put. If there's an occasion of market prices rising, then a call option is bought. Conversely, if there's a chance of the price falling, then a put option is purchased.

Crude oil is arguably one of the significant driving forces of the world economy. Changes in oil prices substantially affect the economic process and welfare worldwide. Indeed, the extent of oil dependency of industrialized economies became particularly clear within the 1970s and 1980s, when a series of political incidents within the Middle East disrupted supply protection and had severe effects on the worldwide oil price. Since then, oil price shocks (i.e. sudden changes) have continuously increased in size and frequency because of such exogenous events. While oil demand tends to be slow-moving, mainly driven by economic processes and climate policies, the prospective of oil prices in future is extremely uncertain – not least considering persistent political instability in exporting countries and, therefore, the uncertainty regarding the invention of recent reserves. As a result of such uncertainties, oil prices could undergo further (increasingly) drastic fluctuations within the future.

It is imperative to analyze how the oil price fluctuations affect the economy. Oil prices are determined by the availability and demand for petroleum-based products. During an economic expansion, prices might rise due to increased consumption; they could also fall due to increased production. Oil price increases are generally thought to extend inflation and reduce economic processes. In terms of inflation, oil prices directly affect the costs of products made with petroleum products. In the economic sense, high oil prices can shift up the supply curve for the goods and services that oil is an input. Thus, extreme oil price fluctuations fabricate volatility in share prices of varied sectors (Energy, automobile, paints, tyres, oil marketing companies, aviation, cement and many more) linked directly and indirectly within the stock exchange. When it comes to the impact of crude price on the Indian economy, a high crude price will hurt the economy's fiscal and current account deficits. A rise in these deficits will cause higher inflation and impact monetary policy, consumption, and investment behavior within the economy. A ten per cent increase in oil price will increase the deficit by $7 billion; that is, the deficit will widen by 560bps. Furthermore, energy stocks have 12.5 per cent weightage within the Nifty50 and 15.2 per cent within the Sensex. Hence, the Nifty and the Sensex are sensitive to grease price movements. Recently, in January 2022, the 10-year bond yields rose sharply to shut at 6.64 per cent, from their previous close of 6.58 per cent as high oil prices threatened to derail the fiscal math, necessitating potentially higher or out of turn borrowings. The increased international costs also translated to dearer crude for India, which meets around 85 per cent of its domestic requirement through imports. The Indian Basket of petroleum traded at $84.54 a barrel on 14th January 2022, the highest since the start of the present twelvemonth. Higher oil prices also brought the rupee fraught and closed at 74.25 a dollar.

Therefore, high international crude prices have always been a red flag for India's macro, given its impact on CAD, inflation, fiscal deficit and exchange rates.

Oil price shocks are transmitted into the macro-economy via various channels. A positive oil price shock within the private sector will increase production costs and restrict output – with price increases a minimum of partially passed on to consumers. Moreover, as prices for gasoline and electricity increase, households face higher living costs, with the poor being particularly vulnerable. These impacts can have other significant knock-on effects and repercussions throughout the economy, affecting macro-indicators like employment, visible balance, inflation and public accounts, yet exchange prices and exchange rates. Thereby, the character and extent of such knock-on effects depend upon an economy's structural characteristics; for example, the more a rustic engages in oil trade, the more it's exposed to cost shocks on global commodity markets. Countries looking forward to a high fuel share in their energy mix, or energy-intensive industrial production, are more vulnerable. Moreover, oil price shocks on the international market can be amplified in specific countries, looking at the separate Dollar charge per unit and prevailing inflationary pressures. While a given oil’s price increase could also be perceived positively by oil-exporting countries and negatively by importers, a rise in oil price volatility (i.e. consecutive positive and negative oil price shocks) increases perceived price uncertainty for all countries – irrespective of their visible balance. Such oil price volatility reduces planning horizons, causes firms to postpone investments, and will require expensive reallocation of resources. To cut back price volatility, policymakers should cherish the usage of long run instrumental policies like decreasing the fuel share within the national energy portfolio, increasing energy efficiency, and developing structural and technological alternatives to create production processes that are less fossil fuel-intensive. These long-run instruments must complement short-term risk management instruments, like physical reserves, strategized purchase contracts, and financial instruments. To facilitate the implementation of an integrated risk management framework, it's critical to create institutional arrangements with adequate technical capacity, political independence and skill to coordinate across ministries and sectors.

By - Suyash Bansal

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