The Effect of Oil Prices on the Economy

Abstract

Oil has a strategic nature and is an important commodity that affects the world economy at both micro and macro levels (Mohaddes, 2016). The price of oil which is majorly influenced by market supply, demand and sentiments, the fluctuations in oil prices affect both oil importing and exporting countries differently (Kilian, 2008). According to Knut (2016), the political instability in the Middle East and Venezuela and sanctions against Iran, a major oil producer reduces the supply of oil globally while fracking makes undiscoverable oil reserves known thus increasing the supply though the former outweighs the latter. A one percent disruption in oil production due to an oil supply shock eventually increases the oil price by 5-10 percent.

For oil exporting developing countries like Angola and Nigeria, oil price volatilities can have a big impact on their economies as they rely on oil revenues as their main source of revenue. Raising oil prices produces additional income for oil producing countries which can be used to expand and diversify the domestic economy as well as investing in foreign economies. Lower oil prices affect the economy by reducing on foreign exchange earnings and creating budget deficits which can cause huge crisis including social unrest if the economy is not controlled (Baffes, 2015). Greater impact is felt by developing countries that import oil as compared to the oil producing countries. This is attributed to their high dependency on imported oil, their high energy intensity and high energy inefficient (Hamilton, 2011). On average, oil importing countries use twice as much oil to produce a unit of economic output as compared to OECD. Developing countries are also less able to weather the financial turmoil wrought by higher oil-import costs (Kilian, 2008). According to World Bank (2016), for Uganda, a developing economy whose main drivers of growth were manufacturing and construction activities, it is expected that oil prices have a greater economic impact.