War and Oil Prices in World Macroeconomics

Lately the crude oil prices have been volatile, reaching an all time high at over 96 dollars a barrel in November 2007. This can be perceived to be brought about by the war on terror. Due to this high prices and pressures from other factors such as environmental issues; energy sustainability is a currently highly discussed topic among governments, Medias, and businesses. However the issue of Peak oil has not been given much attention.

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The global Peak oil model is recognized but the time of the Peak oil occurrence is extensively debated. Peaking in this context indicates that oil production has reached its climax and that half of the worlds oil has been consumed, not that the world oil wells are running dry and most of the remaining oil is in the war ravished regions. This also implies that total oil consumption will decrease, but it does not clarify oil consumption changes on a nation level. Inexpensive oil is vital for the world’s energy demand but its availability is finite, therefore volatility in production volumes will have substantial economic impact (ASPO, 2007).

Due to the wars on terror in the Middle East, during the year of 2007, the world has experienced historically high oil prices both in nominal and in real terms. It will come to no surprise to know that most of the world’s remaining oil lies in the Middle East, with Saudi Arabia being the largest single holder of reserves, followed by Iran and Iraq. In total a little over 60% of the world’s proved reserves are in the Middle East, 11.7 % in Europe including Russia, 9.3% in Africa including Nigeria, 8.5% in South America including Venezuela, 5% in North America, including the US, Canada and Mexico and a paltry 3.5% in the whole of Asia and the Pacific.

OPEC embargo in 1974, in retaliation for Israel attacking Egypt, and by shortages in 1979 brought about by the revolution in Iran and the following Iran-Iraq war. During the intervening years world consumption increase actually went negative for a while before resuming a slower growth rate of between 2% and 3 % per annum for the rest of the 20century. The real prices of oil rose to a higher level in the 1973 and 1979 shocks than in the 1990 and 2000 shocks.

Real oil prices (in today’s real dollars) peaked above $43 per barrel in 1974 and to $82 in 1980, relative to $30 in 1990 and to $32 in 2000. Even at close to $43 (on July 30), oil remains below it 1980 earlier peak when adjusted for inflation. The speed of the change in oil prices (IEA, 2004).

By that standard the increases in 1973-74 and 1979-80 were larger (about 210% and 135%) than in 1990 and 2000 (40% and 60%). Also, in the two latter shocks, the shock occurred from very low initial real prices; for example, in 1997-98 real oil prices had fallen to about $15; thus, the subsequent sharp increase through 2000 was from a very low level. Recently, prices have increased by about 65% (relative to 2002 average prices) – a substantial, but by historical standards, more modest increase.

Early shocks were more persistent. It took about four/five years until the real prices of oil fell back significantly. The 1990 and 2000 shocks were temporary (lasting about 3 quarters). The oil prices shock in early 2003 was moderate in size. But the latest shock, starting in 2002 has been quite sharp and persistent so far (lasting about 9 quarters) (ASPO, 2007)

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Different countries have different levels of oil dependencies, determined by such factors as their economic structure, level of development, access to alternative energy sources, and geographical characteristics. A country’s response to a Peak oil event depends on their level of oil dependency, all else equal. Peak oil is simplified as the point of maximum world oil production and following this Peak oil point or plateau is a decline of oil production leading to an inevitable decline in oil consumption. The logic of Peak oil comes from the well established behavior that the output of individual oil fields rises after discovery, reaches a peak and declines thereafter (ASPO, 2007).

Oil prices are set in US dollars. This helps the US, but the US dollar prices of oil are not independent of the value of the US dollar relative to other currencies. When the US dollar weakens, the purchasing power of OPEC and other oil producers’ dollar revenues in terms of other currencies is reduced and the producers tend to increase the dollar prices of oil. A supply shock that increases oil prices often has an impact on the relative value of major currencies (US $, yen and euro).

The currencies of countries that are more oil dependent tend to weaken. Japan and Europe were more dependent on oil imports than the US in the 70s and 80s, so oil prices shocks led to a strengthening of the US $ and a weakening of the euro and yen. This resulted in a double-whammy for Europe and Japan when oil prices go up because of supply shocks, they lose twice: once because oil prices in dollars are higher; a second time, because their currency weakens relative to the US $. An example of this was in 2000 in Europe when the oil shock hit while the euro was weakening relative to the US $ (Lynch, 2002).

This historical relationship, though, may be changing: the US has a large current account deficit that is worsened by an oil shock, and the US now imports more oil (on net) than Europe (the US imported 12.2 mbd in 2003; OECD Europe imported 8.9 mbd). For the first time, a surging global economy outside the United States is largely driving the oil market. Demand is increasing right now in large part because of booming demand in Asia.

China and other emerging Asia accounted for 17% of total world oil demand in 2003, but China and other emerging Asian economies are expected to account for 59% of the growth in demand for oil in 2004 (the U.S. accounts for 26% of overall demand, but only 16% of the expected increase in demand). China accounts for 7% of total world demand for oil, but its rapid growth means that it alone will account for nearly 40% of the expected increase in demand in 2004. China’s net oil imports are expected to nearly double – rising by 80% — between 2002 and 2004 (IEA data). From the point of view of the United States, a prices increase triggered by rising Asian and Chinese demand is much like a prices increase triggered by a fall in supply – the U.S. has to pay more for its oil imports, even though growing U.S. demand is not the core reason for higher prices (Lynch, 2002)

We can predict the effect of latest oil prices shock on the macro economy. Even with oil prices being above $40 per barrel, the real prices of oil remains well below its prices in previous oil shocks, and the percentage increase is less than in 1973-74 and 1979-80. On the other hand, a 65% plus percentage increase in oil since 2002 is still steep enough to have an impact. Current oil dependence on oil imports (as measured by net imports as a share of GDP) is as high as in the 1970s.

Net oil imports have increased from 0.9% of GDP in 1970 to 1.2% in 2003 as domestic production has fallen relative to domestic consumption, and the pace of improvements in energy efficiency has moderated. Net oil imports are more relevant than the economy’s overall energy efficiency in assessing the growth effect of an oil shock. If net imports were zero, an oil prices increase would not affect real GDP and would only redistribute income from domestic consumers to domestic producers of oil. Thus, the real GDP effect of an oil shock depends on the size of net imports. The magnitude of the negative effect on disposable income of the latest oil shock is similar to that of the 1990 and 2000 shocks, about 0.6% of disposable income this is about half the hit on disposable income of the 1973-74 and 1979-80 shocks (Dargay & Gately, 1995).

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Whether the current shock will be transitory or permanent is a harder question to answer. It depends on factors that are as much political as economic. It also depends on the pace of China’s continued growth, and on the pace at which new supply can be brought on line to meet growing oil demand. The inflationary effect of the shock will be moderated by the fact that the inflation rate is quite low compared to the 1970s cases. On the other hand, the monetary policy response is trickier today than in 2000-2001. In early 2001 when the effect of the 2000 oil shocks were starting to kick in, inflation was low and falling (and there were concerns about deflation) and the dollar was strong. (Dargay & Gately, 1995).

Statistical analysis on macroeconomic variables was used as well as the modified Nerlove’s partial adjustment equation to calculate prices and income elasticities both in the short and long-run. Regression results have shown that short-run prices elasticities were low in all countries; in addition income elasticities were also inelastic but more elastic in relation to oil prices elasticities. This indicates that oil consumption is more sensitive to changes in income than to changes in oil prices.

It was concluded that oil dependencies among nations differ and the trend is that developing countries are increasing their oil dependency while developed countries tend to decrease their oil dependency over time. Peak oil will lead to higher oil prices, which in the short-run will change developing countries oil consumption to a greater extent than developed countries, but in the long-run their response are more similar. It was also noticed, that when GDP decreases in net- oil -importing countries, oil consumption will decrease even further. However, for the U.S., higher oil prices stemming from an Asian boom act much like higher oil prices from a reduced supply (Nerlove, 1956 & Awerbuch & Sauter, 2004)

Private sector estimates generally suggest that a persistent 10% increase in the prices of oil – say from an average $30 to $35 – would reduce the US and G7 growth rate by about 0.3%-0.4% within a year. Some are more pessimistic, and calculate that if oil prices were to increase further to levels closer to $45, the reduction in the G7 growth rate may be closer to 1% of GDP. Thus, private estimates of the negative effect of an oil shock currently range between 0.3% to 1% of US and G7 GDP growth.

This means that the US economy, which was growing at about a 4.3% average rate in Q4:2003 and Q1:2004) may see a slowdown of its growth to a level between 4.0% and 3.3%. Indeed, the first estimate for Q2:2004 U.S. GDP growth was 3.0%, a slowdown driven in part by the effect of high oil prices in the first half of 2004 on real consumer demand due to the war on terror ( Awerbuch & Sauter, 2004),

Bibliography

Awerbuch, S., Sauter, R., (2004), Exploiting the Oil-GDP Effect to Support Renewables World Oil Project.

Association for the study of Peak Oil and Gas, (ASPO). Webpage. Web.

Cooper, John C.B., (2003), Price elasticity of demand for crude oil: estimates for 23 countries, Organization for Petroleum Exporting Countries, OPEC.

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Cavallo, A.J., (2002), Predicting the Peak in World Oil Production, Natural Resources Research, Vol.11, No. 3.

Dargay, J. & Gately, D., (1995), The response of World energy and oil demand to income growth and changes in oil price, Annual Review of Energy and the Environment, Vol. 20, p. 132.

International Energy Agency, IEA, (2004), Analysis of the Impact of High Oil Prices on the Global Economy.

Lynch, M.C., (2002), Forecasting oil supply: theory and practice, The Quarterly Review of Economic and Finance 42, p. 373-389.

Mitigation, AIChE Journal Vol. 52, No.1.Horn, M., (2004), OPEC’s optimal crude oil price, Energy Policy 32, p. 269-280.

Nerlove, M., (1956), Estimates of the Elasticities of Supply of Selected Agricultural Commodities, J. Farm Econ. 38; p. 496-509.

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