Thesis on "Exogenous Effects of Oil Price Shocks"

Thesis 10 pages (2574 words) Sources: 7 Style: Chicago

[EXCERPT] . . . .

Exogenous Effects of Oil Price Shocks

The destabilizing effects of Oil price hikes in the trade balance of both developed and developing oil-importing economies is very clear. Even for the OPEC nations, the initial gains in their national revenues would be offset by the depressive effects of inflation in the oil importing countries. Sub-Saharan African countries having the lowest per capita income and highest external debts are the worst prepared to absorb the Oil price shocks. Over the next decade energy diversification would be the key strategic focus for countries that are struggling to manage the ever-increasing demands with the limited sources and striving to reduce their dependence on oil.

Introduction

Global economic performance is clearly dependent on the price of Oil. Oil prices affect the macroeconomic stability of a nation. Geopolitical tensions have created a destabilizing effect on the world economy. The 1973 oil embargo caused immediate repercussions causing the collapse of the stock market in the U.S. This was followed by the 1979 Iranian revolution and then the 1990 Iraqi invasion of Kuwait led to another recession. With seven consecutive years of rising Oil prices last year saw prices reach an unprecedented 147$ per barrel. Early this year the price of oil was 63% lower at $54 a barrel. [Jad Muawad, 2009] However, the supply management polices of OPEC countries intervened to hold off any further fall in the prices and the last few weeks witnessed a dramatic upswing. These fluctuations in Oil price adversely impact the OECD countries, oil importing developing economies, as well as the OPEC in the longer term. Particularly in the OECD and developing nations higher Oil prices contribute to greater unemployment, inflation and national budget deficits. Even for the OPEC countries the immediate profits due to rising oil prices are offset by the reduced exports with their trading countries that are experiencing economic recession. Geopolitical uncertainties, OPEC supply management policies and the ever-increasing demand for energy and its limited sources have made oil the single most important commodity that controls the global economy. Let us have a brief overview of the exogenous effects of oil price shocks on the world economy.

Macro economic Effects of Oil price Hikes

Before we discuss the impact of oil price shocks on the different global; economies it is necessary to have an overview of the transmission mechanisms through which fluctuations in oil price affect the macroeconomic variables. There are six transmission channels that are theoretically known to affect the economy due to changes in oil pricing. The most important of these is the 'supply side shock effect' which simply means the changes in production cost ascribed to the oil price changes. Next is the 'Wealth transfer effect' that relates the marginal consumption rate of 'petro-dollar' to normal trading surplus. Thirdly the inflationary effect which is simply the relationship between regional inflation in context of global oil prices. [Tang et.al, 2009]

Oil Prices and the OPEC Economy

OPEC group represents 12 nations that together have almost four fifths of the world's crude oil reserves and produce almost one third of the world's oil output. The steady growing demand for oil implies that OPEC oil GDP will surge with the hike in the oil prices. The recent swelling of oil prices from 54$ a barrel to almost 80$ is worrying economists as the world is slowly recovering from the recent recession. As per the recent data from the U.S. Energy Information Administration, the Oil export earnings of the OPEC countries for 2010 is supposed to increase to $750 billion as opposed to the earlier projection of $503 billion due to the current hike in oil prices. This is a 30% increase in OPEC oil revenues compared to the current year. The record high prices of 2008 (oil was $147 a barrel) earned the OPEC nations a whooping $966 million in oil revenues. [Tom Doggett, 2009]

In fact, all the OPEC nations enjoyed current account surpluses in 2008 when oil prices went skyrocketing. Together, the OPEC group enjoyed an account surplus of $467 billion, which translates to a 28% increase of current account balance. Saudi Arabia, one of the major members of the OPEC group made $283 billion in oil revenues in 2008 compared to $206 billion in 2007. The increase in oil revenues boosted the country's productivity that can be inferred from the GDP at $482 billion for 2008 up from $381 billion in 2007. In fact, the OPEC group's combined GDP witnessed a distinct increase from $2.27 trillion in 2007 to $2.88 trillion in 2008. [Christopher Johnson] On the flip side, the economic recession of the trading partners would result in lower export levels in the future.

Impact on OECD Countries

As per a recent OECD report, the demand for oil in the OECD countries peaked in 2005 and over the next two decades leading to 2030 the demand is slated to show a slow decline. This is attributed to many different factors. Firstly, the demand for vehicle ownership is already at saturation point and with almost negative population growth there are little prospects of a boom in this sector. Secondly, developed nations have greatly improved their fuel efficiency compared to the developing nations. Also, as a result of the improved fuel efficiency practices that are followed in these countries the amount of oil consumed in the production of one unit of GDP was literally halved from 1972 to 2002. The net imports of OECD countries declined by 14% in 2002 [IEA]. However, despite these favorable trends the OECD countries remain vulnerable to the fluctuations in the Oil market. A graphical comparison of the inflation rates with the oil price changes over the last 16 years clearly reveals that the OECD countries have shown marked changes in inflation rates corresponding to the hikes in oil prices. Among the countries in the group the most affected are the big oil importers. Japan though it has relatively lower oil intensity compared to the European zone experiences a significant impact, as it is a major importer of oil and as its budget deficit is already huge at 7% of its GDP. Also, the European zone is relatively safer due to the strength of the euro when compared to the weakness of the dollar. [IEA]

Among the OECD countries, the oil exporting countries experience an increase in GDP growth in the first year of price hike. However, this growth is not sustained, as over the next few years there is a decline in trade exports to other oil importing countries where recession reduces the demand for products and services. One of the direct consequences of rising oil prices in the OECD zone is the alarming rise in unemployment rates. The U.S. has experienced slowdown in economic growth and increased unemployment due to the rising oil price shocks. In tune with the current increase in oil prices the OECD projects an increase in unemployment in its member countries from 7.8% in July this year to 10% in 2010. According to estimates more than 57 million people will be unemployed in the OECD countries, which is a record high, even exceeding the 1970's peak of 9.8%. [OECD]

Developing and Transition Economies

The impact of oil price hikes is more pronounced for developing economies. As per the IMF data, the poorest countries suffer up to 1.5% loss in their GDP if oil price is increases by 10$ over a sustained period. For instance India and China are two of the important and fast developing economies of this decade. In India and China a sustained $10 increase in oil price would negatively impact the GDP by 1% and .8% respectively. OECD secretary Angel Gurria mentioned China and India would be two main drivers of economy in this period of global recession. However, since India and China import majority of their oil requirements a sudden surge in oil prices has inflationary consequences.

One of the reasons for such immediate impact is the poor energy efficiency in China and India. Oil importing developing countries are more oil intensive economies. Statistics indicate that oil intensive developing countries spend twice as much energy to produce one unit of economic output compared to developed economies. [IEA] India for instance utilizes two and a half times the energy compared to U.S. per unit of GDP. Similarly the energy consumption of China per U.S. $1,000 GDP is .56 tones of oil. This again is far higher than Germany (.09), U.S. (.17), Japan (.12) etc. Also China's oil imports rose to 52% by the end of 2007. However, between 2000 and 2007 when the oil prices were steadily rising China's economy averaged around 9.78% per year. In general increased oil prices would imply industrial production below maximum capacity and passing over of the burden to the consumer. So production output is directly related to consumer price index (CPI ) and the oil price. However, in China low domestic demand, price regulations and stiff competitions in the export sector have not allowed the direct transmission… READ MORE

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