Answer to Question #55682 in Microeconomics for chris mastropietro

Question

Since Fall of 2013, the price of oil has shown a steady decline as continued increase of global oil production that has far exceeded the rising demand for oil. Accordingly, many analysts in the energy field have had predicted the likelihood of further decline in oil price in the US market as the US continues to expand its domestic oil production with a long term objective of becoming even net exporter of oil by Y2030. Given that prediction of falling global demand for petroleum oil and rising supply of oil caused significant decline of oil price to come down to as low as $40 per barrel in Aug 2015 from its price of o $90 in Aug 2014. The most recent price of oil has further declined even below $40 per barrel, with a modest rate of volatility.

Finally, explain why sharp decline in oil prices might not necessarily have positive or negative impact on the US equity markets (stock market) even at the current trend of declining but volatile oil prices.

Answer 1

Currencies would adjust to changes in trade balances. Since oil contracts are settled in US dollar and oil exporters invest part of their windfall earnings in US dollar dominated assets, higher oil prices would lead to raise the value of US dollar by increasing the transactions demand for it. A stronger dollar would raise the cost of servicing the external debt of oil-importing developing countries, as that debt is usually denominated in dollars, exacerbating the economic damage caused by higher oil prices. Past oil shocks provoked debt-management crisis in many developing countries. In other hand, to the extent that changes in oil prices have impact on economic activity, corporate earnings and inflation, financial markets would be affected – notably equity values and exchange rates– even, as assumed here, if there are no changes in monetary policies. In fact, higher oil prices would be revised downwards the international capital market valuations of equity and debt in oil-importing countries and upwards those in oil-exporting countries. To the extent that the creditworthiness of some importing countries that are already running large current account deficits is called into question, there would be upward pressure on interest rates. Tighter monetary policies to contain inflation would add to this pressure but would also increase the value of domestic currencies. Throughout the world, the countries dependencies of oil products are diverse and fluctuations in oil prices can have different effects. Thus, the following section overviews the economic background of some different countries and group of countries. A short history of each countries relationship to oil will also be presented to clarify the status of the today’s oil dependency in these countries.