Why does the world economy tank when oil prices goes down? Should it not go up as more people willbe able to travel more, products involving oil, like plastics should become cheaper, so should airtravel, shipping etc. So why does the world economy rumble when oil prices does the same?
In: Economics
Oil prices rise when economic output is strong. When business aren’t producing as much across the whole world then they don’t need to buy as much oil. That means that the oil that has already been produced doesn’t sell so the price lowers. So a low price for oil is sometimes related to a low demand for oil which is due to shrinking economic activity. It’s a little more complicated because oil isn’t freely traded. A large number of oil producing countries have banded together into a group called OPEC+ which can artificially set oil prices. Russia has recently had a disagreement with the group and has left the group. That made Saudi Arabia, one of the largest oil producers, increase production to extremely high rates in an attempt to flood the market with oil so the price will drop. This is designed to hurt Russia because the Russian economy is essentially little more than production of oil and other raw materials. This is extreme action that is a sign of high tension and instability. Stock markets tend to sell in times of uncertainty or when tensions may risk conflict. In the current situation there are worries that reduced travel and increased numbers of people sick from the COVID19 virus will reduce economic output/demand for oil. So the surplus of cheap oil on the market isn’t as likely to have a stimulatory effect.
Oil Prices are like human body temperature.
Things go bad is if it’s too high or too low.
Like it or not, oil companies are a big part of the economy.
When these companies suffer they bring down the rest.
They make a lot of money, so they invest a lot in other companies.
When they do badly they don’t invest as much, so there’s less money until everyone adjusts.
They also employ a lot of people to find oil, take oil out of the ground, and make oil usable, so these people might get fired and have to find other jobs.
Global financial output is roughly proportional to global energy used. When OPEC posturing suggests a sharp decline in demand it’s a leading indicator of declining industrial output to come.
The economy is not tanking because oil prices are down. Oil prices are down due to slowdown in economic activity – people use less of it, so the price goes down.
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Oil is the commodity that backs all currency since 1974. As a result oil drops immediately both on demand (as is happening now) and economic downturn (which may come as a result of the turmoil over a relatively low risk virus). Oil is a trailing indicator, not a leading one. Ie oil tumbles when the economy tanks, not the other way around. But because it is so close to the money supply it is a “close” trailing indicator meaning it responds rapidly.
Because it’s also affected by Geo political crisis, violence, supply worries etc. It can also send false signals not related to the economy which is why it’s such a dangerous commodity to base currencies upon. This is why the US in the early 1980s developed the war for oil doctrine and actively goes to war to ensure the oil supply stays relatively constant and. O one power here too much control (ie Saddam Hussein in the 1990s)
It can also go up if central banks are printing money and inflating the money supply thus lowering the value of every dollar. This is what happened in the 1970s. The price of oil stayed the same versus gold, and oil production increased not decreased but because the US defaulted and the federal reserve resorted to massive money printing the price of oil went way up. The US government blamed OPEC nations but it was monetary policy that caused it. (And oil went way up in all other currencies too because all world trade is done in USD because of the Breton woods Accord this pegging most currencies to the USD either strongly like China where they act to keep it in a small window, or loosely like Canada where it stays in a window based on Canadian monetary policy and commodity output.)
Rich people like to say they are “losing money” when, in fact, their profit margins went down. The world market tanked because less people are buying gas due to the coronovirus.
You have the causality backward. Oil prices go down when the economy is weak and people can’t afford to do as much. Consumers buy less, stores sell more slowly and need fewer trucks and trains and ships to keep good in stock. People travel less and put off large purchases until they have more certainty about the economic future.
Demand goes up when the economy is strong, price goes down when the economy is weak, and right now it’s on life support. The price of oil is the indicator, not the driver, of economic health. That said, when it gets too high, it can act as an anchor on the global economy dragging it down.
Price is the thermometer, not the sickness.
When people talk about the economy they are typically talking about the stock market. This means companies’ profits (more specifically its future profits) are a focal point. Oil is a huge industry, making up a large part of the stock market. If a big industry takes a hit without other industries making up for it the market tends to suffer. However, there is more the story of why the market is currently down. Consumer spending makes up the largest part of the economy. In turn, consumer confidence is a significant economic indicator as well. If consumers are confident in the economy and the stability of their jobs, they are more likely to buy things that they don’t merely need.
Oil being a gigantic industry also translates to a lot of jobs (most of which have often been higher paying than comparable jobs in a different industry). Oil production methods such as fracking aren’t profitable at current oil prices, and companies will not operate meaning no work to be done. Fewer jobs = fewer dollars to spend by the consumer = lower company profits.
The market has been tanking for several reasons mostly due to fear/uncertainty. The corona virus first dropped the market due to fear of supplies coming from China and Asia being held abroad until the disease stops spreading, which is unknown. This would make companies unable to sell its products to consumers who want them, for an unknown period of time. There was an interest rate cut by the US Fed of 50 basis points (1 bp = .01%) or half a percent. News of this lifted the economy briefly (interest rate cuts explained below). As more cases are being reported all over the world and huge events are being canceled or under threat of cancellation, there is fear that many money producing things will come to a halt. Fear of wide level quarantines exacerbates the problem as the worker/consumer will be stuck at home, neither making nor spending (nearly as much) money, resulting in lower company profits.
Cutting interest rates is one of the ways a central bank can stimulate the economy by making borrowing money, specifically business loans, more enticing – you don’t have to pay as much back due to the lower interest rate. This theoretically turns into more jobs and more consumer spending. Interest rates are super low currently meaning the Fed is left with its other tool known as quantitative easing, essentially buying bonds and pumping money into the economy. However, with interest rates at long-term historic lows and very close to 0% and the use of quantitive easing, the risk of inflation is high.
Hope this helps and stays within the ELI5 guidelines :).
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