Oil Price Volatility Its Impact & Consequences

Praveen Jaiswal

The big news in the oil markets is not just lower prices its the return of volatility, and
volatility works in both directions.
-

Michael A. Levi, Senior Fellow for Energy & Environment, Council on Foreign Relations, NY, USA

The downward trend in global oil prices that has garnered so much attention in the recent
past has raised a million dollar question with respect to the return of volatility to global
oil markets that has experienced a period of relative calm. Oil prices traditionally have
been more volatile than any other commodity. Like the fall of the Berlin Wall in 1989 and
the financial crisis of 2008, the current drop in oil prices is sending shockwaves across
the globe. Oil firms are shedding jobs and cancelling exploration projects. Crude oil is
arguably one of the single most important driving forces of the global economy and any
changes in the price of oil, either up or down, has significant effect on economic growth
and welfare around the world. The recent fall in oil prices is first and foremost a natural
response to an abrupt, dramatic change in global economic growth prospects.
During oil price volatility policymakers face contrasting dilemmas ranging from blunting
volatility to helping consumers to cope-up with the consequences. Oil market has always
sprung surprises and unavoidable price swings. Managing volatility requires greater
market transparency as well as engaging and cooperating with the oil market's producer
countries. Various options are being explored by different countries to safeguard oil-price
volatility viz. domestic drilling, investment in alternative-fuels, battery operated vehicles,
public transportation and reducing oil subsidies to name a few.
Oil price shocks are transmitted into the economy via various channels. In the private
sector it increases cost of production and hence restricts output with price increases
which is finally passed on to consumers. Further as prices of oil and electricity increases;
households face higher costs of living. These impacts can have further significant knockon effects and repercussions throughout the economy affecting macro-indicators such as
unemployment, trade imbalance and inflation.
The nature and extent of damage depends on the structural characteristics of an economy;
for instance, the more a country engages in oil trade, the more it is exposed to oil-price
shocks. Countries relying on a high fossil fuel share in their energy mix, or on energy
intensive industrial production are the ones most vulnerable. Oil price shocks on the
international market are amplified in specific countries, depending on the respective
dollar exchange rate and prevailing inflationary pressures.
Before considering interventions to reduce and manage price volatility, it must be
recognized that some price volatility is an inherent characteristic of oil markets. Though
there is a popular myth, mainly among politicians and the public, that high oil-prices are
the greatest economic risk that we face when it comes to energy. They are mostly wrong;
it is the wildly fluctuating prices and not the high ones per say that really does the
damage. Rapidly rising prices drain consumers wallets without giving them time to
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Oil Price Volatility Its Impact & Consequences

Praveen Jaiswal

adapt; frequent change also makes long-term investments more difficult. Though some
volatility is natural and quite tolerable, moreover, modest volatility can prompt
consumers to take steps, like shifting to fuel-efficient cars and adopting energy saving
living practices.
As the general notion says that; that governments should stay away from market
dynamics, however there are exceptions to this rule when oil-prices are concerned.
Markets, in general, are ill-equipped to handle such large oil-price swings that would
result from major geopolitical events and natural catastrophes. In such cases,
governments market interference through oil subsidies and other measures helps in
stabilizing the market, though subsidies turnout to be counterproductive in the longer run.
Oil markets and its inevitable price swings must be accepted as a natural feature of life.
Governments should take active steps to improve market-efficiency and ensure that any
volatility is fundamental and not speculative in nature. Improved transparency both on
physical demand & supply as well as financial positioning may help in reducing needless
volatility. Longer-term dynamics like fuel-conservation and efficiency, substitution into
other forms of energy and new extraction technologies that may transform the energy
balance are few such alternatives which needs to be explored for sustainable
implementation. Governments must build an efficient and proper regulatory framework to
address and support these dynamics. The most effective response to oil price volatility is
simply to allow markets to work. Government restrictions and regulations impede the
market's effectiveness in responding to changes in oil prices.
Owing to the complex snowball effect of volatile prices and its repercussions, its
consequences trickle down from governments level to firms and households. Such oil
price volatility reduces planning horizons and forces industry to postpone investments.
Formulation of realistic national budgets becomes more difficult, as importing countries
face uncertainty regarding import costs and fuel subsidies levels and exporters face
volatile revenues. In order to protect firms and households against such adverse price
volatility on international markets, particularly in developing countries, governments
often allocates large parts of their budgets to subsidizing fuel. These subsidy systems not
only expose governments to significant budgetary risks but result in significantly
compromising on education, health and other investments in social development.

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