Free Economics Essays - Price Economy Oil
Petroleum Price and the Economy Summary
The susceptibility of oil-importing countries to increase oil prices varies noticeably depending on the extent to which they are net importers and the oil concentration of their economies. According to the results of a quantitative exercise carried out by the IEA in cooperation with the OECD Economics Department and with the assistance of the International Monetary Fund Research Department.
Euro-zone countries, which are highly reliant on oil imports, endured the most in the short term, their GDP dropping by 0.5% and inflation rising by 0.5% in 2007. The United States suffered the least, with GDP falling by 0.3%, mostly because local production meets a bigger share of its oil needs. Japan’s GDP fell 0.4%, with its comparatively low oil concentration compensating to some extent for its almost total reliance on imported oil. In all OECD regions, these losses should start to lessen in the following three years as global trade in non-oil goods and services rebounds. This analysis assumes constant exchange rates.
Oil prices impact the vigor of the world economy. Higher oil prices since 1999 – partly the result of OPEC supply-management policies – contributed to the global economic decline in 2000-2001 and are slowing the current cyclical upturn. World GDP growth may have been at least half a percentage point higher in the last two or three years had prices remained at mid-2001 levels. Current suspicions of OPEC supply cuts, political tensions in Venezuela and tight stock prices have driven up international crude oil and product prices even further.
The unfavorable economic impact of higher oil prices on oil-importing developing countries is generally even harsher than OECD countries. This is because their economies are more reliant on imported oil are more energy-intensive, and energy is used less efficiently. On average, oil-importing developing countries use more than twice the amount of oil to produce a unit of economic yield as do OECD countries.
Developing countries are also less able to weather the financial disorder wrought by higher oil-import costs. India spent $15 billion, comparable to 3% of its GDP, on oil imports in 2003. This is 16% higher than its 2001 oil-import bill. It is estimated that the loss of GDP averages 0.8% in Asia and 1.6% in very deprived highly indebted countries in the year following. The loss of GDP in the Sub-Saharan African countries would be more than 3%.
The impact of higher oil prices on economic growth in OPEC countries would depend on a variety of factors, particularly how the windfall revenues are spent. In the long term, however, OPEC oil revenues and GDP are likely to be lower, as higher prices would not fully compensate for lower production.
In the IEA’s recent World Energy Investment Outlook, cumulative OPEC revenues are $400 billion lower over the period 2001-2030 under a Restricted Middle East Investment Scenario, in which policies to limit the growth in production in that region lead to on average 20% higher prices, compared to the Reference Scenario.
This paper reviews how oil prices affect the macro-economy and assesses quantitatively the extent to which the economies of OECD and developing countries remain vulnerable to a sustained period of higher oil prices. It summarizes the findings of a quantitative exercise carried out by the IEA in association with the OECD Economics Department and with the assistance of the International Monetary Fund (IMF) Research Department. That work, which made use of the large-scale economic models of all three organizations, constitutes the most up-to-date examination of the impact of higher oil prices on the global economy.
Oil prices have been climbing higher in recent months: the prices of Brent and WTI – the leading benchmark physical crude oils. These price increases and the chance of further increases in the future have grabbed attention again to the threat they front to the global economy. The next section describes the general mechanism by which higher oil prices affect the global economy. This is followed by a quantitative assessment of the impact of a sustained rise in the oil price on, first, the OECD countries and then on the developing countries and transition economies. Finally the net effect on the global economy is summarized.
Oil Price and the Global Economy
Oil prices remain a significant determinant of global economic performance. Overall, an oil-price advance leads to a transfer of income from importing to exporting countries through a shift in the terms of trade. The enormity of the direct effect of a given price boost depends on the share of the cost of oil in national income, the degree of dependence on imported oil and the ability of end-users to lessen their consumption and switch away from oil.
It also depends on the degree to which gas prices rise in response to an oil-price increase, the gas-concentration of the economy and the impact of higher prices on other forms of energy that compete with or, in the case of electricity, are generated from oil and gas. Naturally, the larger the oil-price increase and the longer higher prices are sustained, the larger the macroeconomic impact.
For net oil-exporting countries, a price raise directly increases real national income through elevated export earnings, though part of this gain would be later make up for by losses from lower demand for exports normally due to the economic recession suffered by trading partners.
Variation effects, which result from real wage, price and structural inflexibility in the economy, add to the unswerving income effect. Elevated oil prices lead to inflation increased input costs, reduced non-oil demand and lower investment in net oil importing countries. Tax revenues fall and the budget deficit enlarges, due to rigidities in government expenses, which drives interest rates up.
Because of clash to real declines in wages, an oil price increase typically leads to upward stress on nominal wage levels. Wage pressures together with lessened demand tend to lead to higher short term unemployment. These effects are greater the more abrupt and the more definite the price increase and are magnified by the force of higher prices on consumer and business confidence.
An oil-price increase also changes the stability of trade between countries and exchange rates. Net oil-importing countries normally experience wear and tear in their balance of payments and putting descending pressure on exchange rates. As a result, imports become more expensive and exports less valuable, leading to a drop in real national income. Without a change in central bank and government monetary policies, the dollar may tend to rise as oil-producing countries’ demand for dollar-denominated international reserve assets raise.
The economic and energy-policy response to a mixture of higher inflation, higher unemployment, lower exchange rates and lower real output also affects the overall force on the economy over the longer term. Government policy cannot eradicate the adverse impacts described above but it can minimize them. Similarly, unsuitable policies can worsen them.
Overly contractionary monetary and fiscal policies to contain inflationary pressures could worsen the recessionary income and unemployment effects. On the other hand, expansionary monetary and fiscal policies may delay the fall in real income demand by the increases in oil prices, stoke up inflationary pressures and degenerate the impact of higher prices in the long run.
Impact on OECD Countries
OECD countries remain vulnerable to oil-price increases, despite a drop in the region’s net oil imports and an even more marked decline in oil intensity since the first oil shock. Net imports fell by 14% while the amount of oil the OECD used to produce one dollar of real GDP halved between 1973 and 2006. Nonetheless, the region remains heavily dependent on imports to meet its oil needs, amounting to 56% in 2006. Only Canada, Denmark, Mexico, Norway and the United Kingdom are currently net exporting countries. Oil imports are estimated to have cost the region as a whole over $360 billion in 2006 – equivalent to around 1% of GDP. The annual import bill has increased by about 30 % since 2005.
Higher oil prices have a significant adverse impact on OECD economic performance in the short term in this case, though their impact in the longer term is more limited (Table 1). The impact on the rate of GDP growth is felt mostly in the first two years as the deterioration in the terms of trade drives down income, which immediately undermines domestic consumption and investment. OECD GDP is 0.4% lower in 2005 and 2006 compared to the base case. In all OECD regions, these losses start to diminish in the following years as global trade in non-oil goods and services make progress. Throughout the whole five-year projection period, GDP is 0.3% lower on average.
Table 1: OECD Macro-economic Indicators in Sustained Higher Oil Prices
2005 2006 GDP -0.4 -0.4 Consumer price index 0.5 0.6 Unemployment rate 0.1 0.1 Current account ($ billion) -32 -42
The shock of higher oil prices on the rate of inflation is more marked. The consumer price index is on average 0.5% higher than in the base case over the five year projection period. The impact on the rate of inflation was felt mostly in 2006 – the second year of higher prices. Recent trends show a clear correlation between oil price movements and short-term changes in the inflation rate.
The economic impact of higher oil prices varies considerably across OECD countries, largely according to the extent to which they are net importers of oil. Euro-zone countries, which are highly reliant on oil imports, suffer most in the short term. GDP losses in both Europe and Japan would also exacerbate budget deficits, which are already large (close to 3% on average in the euro-zone and 7% in Japan). The United States suffers the least, largely because indigenous production still meets over 40% of its oil needs.
The Impact on Developing Countries
The adverse economic impact of higher oil prices on oil-importing developing countries is generally more pronounced than for OECD countries. The economic impact on the poorest and most indebted countries is most severe. On the basis of IMF estimates, the drop in GDP would amount to more than 1.5% after one year in those countries. The Sub-Saharan African countries within this combination, with more oil intensive and delicate economies, would endure an even bigger loss of GDP, of more than 3%. As with OECD countries, dollar exchange rates are understood to be the same as in the base case.
Asia, which imports the majority of its oil, would experience a 0.8% fall in economic output and a 1% point weakening in its current account balance (expressed as a share of GDP) one year after the price raise. Some countries would suffer much more: the Philippines would lose 1.6% of its GDP in the year following the price rise, and India 1%. China’s GDP would drop 0.8% and its current account surplus, which amounted to around $45 billion in 2006, would drop by $6 billion in the first year.
Other Asian countries would see weakening in their aggregate current account balance of more than $8 billion. Asia would also see the largest increase in inflation in the first year, on the thought that the increase in international oil price would be quickly moved through into domestic prices. The inflation rate in China and Thailand would go up by almost one percentage point in 2007.
Latin America in general would suffer less from the increase in oil prices than Asia because net oil imports into the region are much less. Economic growth in Latin America would be reduced by only 0.2 percentage points. The GDP of transition economies and Africa in aggregate would increase by 0.2 percentage points, as they are net oil-exporting countries.
The economies of oil-importing developing countries in Asia and Africa would bear most from higher oil prices because their economies are more reliant on imported oil. In addition, energy-intensive manufacturing generally accounts for a larger share of their GDP and energy is used less efficiently. On average, oil importing developing countries use more than twice the oil to produce one unit of economic output as do developed countries.
The IMF estimates suggest that, in the sustained oil-price increase case, the net trade balance of OPEC countries would improve initially by about $120 billion or around 13% of GDP, taking account of lower global economic growth. Venezuela would gain the least and Iraq and Nigeria the most, reflecting the relative importance of oil in the economy. The impact of greater oil prices on economic growth in OPEC countries would depend on a variety of factors, particularly how the windfall revenues are spent.
In the long term, however, OPEC oil revenues and GDP are likely to be lower, as higher prices would not compensate fully for lower production. Higher oil prices in the last four years are in part the result of OPEC’s success in implementing its policy of collectively constraining production. This policy has led to a decline in OPEC’s share of world oil production from 40% in 1999 to 38% in 2003. There is a risk that this policy may be continued in the future, which would limit the extent to which OPEC producers, notably those in the Middle East, contribute to meeting rising world oil demand.
According to the IEA’s latest World Energy Outlook, OPEC’s market share is projected to rebound to 40% in 2010 and 54% in 2030. In the IEA’s recent World Energy Investment Outlook, cumulative OPEC revenues are $400 billion lower over the period 2001-2030 under a Restricted Middle East Investment Scenario, in which policies to limit the growth in production in that region lead to on average 20% higher prices, compared to the Reference Scenario.
Impact on the Global Economy
The results of the sustained higher oil price simulation for both the OECD and non- OECD countries suggest that, as has always been the case in the past, the net effect on the global economy would be negative. That is, the economic stimulus provided by higher oil and gas export income in OPEC and other exporting countries would be outweighed by the dispirited effect of higher prices on economic movement in the importing countries, at least in the first year or two following the price rise.
Combining the results of all world regions yields a net fall of around 0.5% in global GDP – equivalent to $ 255 billion - in the first year of higher prices. The loss of GDP would diminish somewhat by 2008 as increased demand from oil-exporting countries boosts the exports and GDP of oil-importing countries.
The main determinant of the size of the initial net loss of global GDP is how OPEC and other oil-exporting countries spend their windfall oil revenues. The greater the marginal propensity of oil-producing countries to save those revenues, the greater the initial loss of GDP. Both the IMF and OECD simulations assume that oil exporters would spend around 75% of their additional revenues on imported goods and services within three years, which is in line with historical averages.
However, this assumption may be too high, given the current state of fiscal balances and external reserves in many oil-exporting countries. In practice, those countries might take advantage of a sharp price increase now to rebuild reserves and reduce foreign and domestic debt. In this case, the adverse impact of higher prices on global economic growth would be more severe.
Higher oil prices, by affecting economic activity, corporate earnings and inflation, would also have major implications for financial markets – notably equity values, exchange rates and government financing – even, as assumed here, if there are no changes in monetary policies:
International capital market valuations of equity and debt in oil-importing countries would be revised downwards and those in oil-exporting countries upwards. 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.
Currencies would adjust to changes in trade balances. Higher oil prices would lead to a rise in the value of the US dollar, to the extent that oil exporters invest part of their windfall earnings in US dollar dominated assets and that transactions demand for dollars, in which oil is priced, increases. 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.
It would also amplify the impact of higher oil prices in pushing up the oil-import bill at least in the short-term, given the relatively low price-elasticity of oil demand. Past oil shocks provoked debt-management crisis in many developing countries.
Fiscal imbalances in oil-importing countries caused by lower income would be exacerbated in those developing countries, like India and Indonesia that continue to provide direct subsidies on oil products to protect poor households and domestic industry. The burden of subsidies tends to grow as international prices rise, adding to the pressure on government budgets and increasing political and social tensions.
It is important to bear in mind the limitations of the simulations reported on above. In particular, the results do not take into account the secondary effects of higher oil prices on consumer and business confidence or possible changes in fiscal and monetary policies. The loss of business and consumer confidence resulting from an oil shock could lead to significant shifts in levels and patterns of investment, savings and spending.
A loss of confidence and inappropriate policy responses, especially in the oil-importing countries, could amplify the economic effects in the medium term. In addition, neither the OECD’s estimates for member countries nor the IMF’s estimates for the developing countries and transition economies take explicit account of the direct impact of higher oil prices on natural gas prices and the secondary impact on electricity prices, other than through the general rate of inflation. Higher oil prices would undoubtedly drive up the prices of other fuels, magnifying the overall macroeconomic impact. Rising gas use worldwide will increase this impact.
Nor does this analysis take into account the macroeconomic damage caused by more volatile oil prices. Short-term price volatility, which has worsened in recent years, complicates economic management and reduces the efficiency of capital allocation. Despite these factors, the results of the analysis presented here give an order-of-magnitude indication of the likely minimum economic repercussions of a sustained period of higher oil prices.
Oil prices remain a significant macroeconomic variable. Higher prices can still impose considerable damage on the economies of oil-importing countries and on the global economy as a whole. The surge in prices in 1999-2000 added to the slowdown in global economic motion, international trade and investment in 2000- 2001. The below par pace of recovery since then is at least partly due to increasing oil prices: according to the modeling results, global GDP increase may have been at least half a percentage point higher in the last two or three years had prices stayed at mid-2001 levels.
The results of the models presented in this paper suggest that further increases in oil prices sustained over the medium term would undermine drastically the prospects for continued global economic recuperation. Oil importing emergent countries would generally suffer the most as their economies are more oil-intensive and less able to weather the financial chaos wrought by higher oil-import costs.
The general economic background to the current run-up in prices is considerably dissimilar to previous oil-price shocks, all of which coincided with an economic boom when economies were already overheating. Prices are now increasing in a situation of tentative economic revival, excess room and low inflation. Firms are less able to pass through higher energy-input costs in higher prices of goods and services because of brawny competition in wholesale and retail markets.
As a result, higher oil prices have so far gnarled profits more than they have pushed up inflation. The consumer price index growth has fallen in almost every OECD country in the past year, from 2.3% to 2.0% in the Euro zone and 2.4% to 1.9% in the United States in the 12 months to December 2003. Deflation in Japan has worsened from -0.3% to - 0.4% over the same period.
A weaker dollar since 2002 has also offset partly the contact of higher oil prices in many countries, particularly in the euro-zone and Japan. The squeeze on profits belated the recovery in business investment and employment, which began in earnest in 2003 in many parts of the world. In difference to previous oil shocks, the financial authorities in many countries have so far been able to hold down interest rates without risking an inflationary downturn.
Yet the economic threats posed by upper oil prices stay real. Worries of OPEC supply cuts, political tensions in Venezuela and tight stocks have just driven up international crude oil and product prices even further. Current market conditions are more unbalanced than normal, in part because of geopolitical uncertainties and because stiff product markets – notably for gasoline in the United States – are reinforcing upward pressures on crude prices.
The increase of futures prices during the past several months implies that recent oil price increases could be continual. If that is the case, the macroeconomic consequences for importing countries could be unpleasant, especially in view of the severe budget-deficit problems being experienced in all OECD regions and inflexible high levels of unemployment in many countries.
Fiscal imbalances would worsen, pressure to increase interest rates would expand and the current revival in business and consumer confidence would be cut short, threatening the durability of the current recurring economic growth.