Oil Price Effects on the Macro-economy - Literature review Example

Literature review: Оil рriсе еffесts оn thе mасrо-есоnоmy Introduction This section focuses on identifying the impacts of oil price fluctuation on the macro-economy in general. The purpose of the review of literature is to a conduct research on the impacts of oil price variation on countries in general and oil-producing nations in particular. In doing so, the review will touch on the effects of oil price variation on countries such as Kuwait and others which produce oil. This will be based on assessment of research papers and other sources of information that have been written about oil prices and macroeconomic performance. The structure of the review is as outlined next. The first part will provide an overview of the sources of oil price fluctuation in order to have a broad understanding of the concept and its significance. This will be followed a section that will trace the history of oil price fluctuation in various countries have been producing the commodity and the world in general. The next section will discuss the consequences of fluctuations in oil prices on the macro-economy in countries in general – that is regardless of whether they produce oil or not. This will be followed by an examination of the impacts of variations in oil prices on the economies of countries that produce the commodity. That is, this section will specifically look at how countries that produce oil are affected by variations in world oil prices. This section also has a subsection that will review examples of how oil-producing countries are affected by oil price fluctuation. Meaning of oil price fluctuation and overview of its causes Numerous studies have been conducted on what causes changes in the price of oil (for example Kilian, 2008; Kilian, 2009). Notably, Kilian (2009, p. 1054) is of the view that oil price fluctuations are caused by three main factors: changes in oil supply or shocks in availability of oil, shocks in the total global demand for oil, and variations in precautionary demand for the commodity because of doubts regarding oil supply prospects. The first two points can be analysed in relation to how the supply and demand of any commodity affects the commodity’s price. Basically, the prices of commodities, oil included, do not always remain constant – they keep on changing with time (Mweti & van Wyk, 2009, p. 40). When the value of any commodity in the market rises and falls in the world market, its price is understood to be fluctuating. These changes in price are affected by demand and supply. If a commodity such as oil is in high supply, its price will go down; but when the supply becomes scanty, the price of the commodity will rise. Similarly, a rise in the demand for a product causes the price of the commodity to increase. On the other hand, if a commodity is not in high demand, then it follows that its price will go down so as to attract buyers. Economic theory suggests that the cost of a commodity is defined by the laws of supply and demand and that, consequently, prices of commodities are always changing (Mweti & van Wyk, 2009, p. 40). It has also been hypothesised that the price elasticity of oil demand and supply over a short period is very low that the price of oil changes significantly when either demand or supply suddenly changes (Bohi & Toman, 1996, p. 74). According to Rapaport (2010), oil supply and demand variations or shocks often occur as a result of factors such as changes in present oil production flows, changes to the future production of oil, uncertainties regarding the supply of oil, and speculations about the commodity in the international market, which spurs precautionary demands for oil. As noted above, the argument that variations in precautionary oil demand because of uncertainty regarding future supply of the commodity cause oil price fluctuation also applies in the same way as the laws of demand and supply. Precautionary demand is a concept relating to speculation that the demand or supply of oil may change in the near future (Unalmis, Unalmis & Unsal, 2009). For instance, when dealers realise that there may be an interruption in the supply of oil in the following period due to various factors such as political instability in the oil-producing countries or poor weather conditions, the prices of oil are likely to increase in anticipation of the expected shortage and high demand (Unalmis et al., 2009, p. 16). This is because the impulse responses that are taken by players in the oil industry (such as firms holding oil inventories) due to the prospects about future supply of oil reduce the level of supply and thus cause a rise in the cost of the commodity (Unalmis et al., 2009, p. 17; Anzuini, Pagano & Pisani, 2013; Fattouh, Kilian & Mahadeva, 2013, p. 9). When oil firms to engage in speculation, which for purposes of this paper can be defined as the process of purchasing crude oil for future use rather than current consumption (Kilian & Murphy, 2014, p. 455), they cause an increase precautionary demand for the commodity, which consequently results in an increment of its price. History of oil price fluctuation and current trends A clear analysis of oil price fluctuation can only be traced back to the years after 1945. This is because prior to 1945, the oil industry was still in a nascent stage (Yan, 2012, p. 39). As well, the levels of technology and mining capacity at the time were still far from developed. Additionally, the level of consumption of oil in the world was still low given that many countries relied on coal as a source of energy and thus any fluctuation in oil prices did not have a notable influence on the balance of payment in the countries that were using the commodity. Also, before the Second World War, the world oil market was dominated by western multinational oil companies and as such, there was some level of stability in the price of oil (Yan, 2012, p. 39). Yan (2012, p. 39) also argues that the consumption of oil increased significantly after the Second World War. By 1967, the proportion of world oil consumption had surpassed that of coal as oil increasingly became the major source of energy in many countries. But even with the formation of the Organisation of the Petroleum Exporting Countries (OPEC), international oil companies still controlled the oil market and thus held the oil pricing power. As such, the price of oil still remained relatively stable. However, as oil producing countries started exerting more influence on the international crude oil market, many of the multinational oil companies that were in operation became nationalised by the oil exporting countries and thus lost some of their influence in the world oil marketplace, especially in the oil-producing countries. The adoption of the dollar as the standard pricing system for oil also meant that international oil prices were subject to the fluctuation of the dollar exchange rate. Outbreaks of conflicts in some countries that were producing oil, such as the Middle East War of 1973 led to major oil crises and offered OPEC countries an opportunity to influence the pricing of oil. The aftermath of the 1973 war was that oil-producing countries in the Middle East imposed a crude oil embargo on countries that were supporting Israel and reduced their production of oil (Yan, 2012, p. 39; Baffes, Kose, Ohnsorge & Stocker, 2015, p. 17). Such action, which involved supply shocks, caused a rise in precautionary behaviour and thus led to a considerable rise in the cost of crude oil – a “quadrupling of oil prices” (Baffes, Kose, Ohnsorge & Stocker, 2015, p. 17) to be precise. A similar scenario was experienced in 1979 with the Iranian Revolution (Blanchard & Gali, 2007, p. 2; Yan, 2012, p. 39). Such occasions, which cause changes in the demand and supply of oil, have continued to influence the price of the commodity over time. Overall, the volatility of oil prices, which can be described as the rate and extent of changes in oil prices, has increased over time (Yetiv, 2004, p. 6). The reason for these changes is partly because oil is regarded as a commodity that is subject to impulses in the markets. The relatively stable prices that were witnessed in the past have been replaced by considerable fluctuations, for the most part because OPEC countries did away with price controls and referenced their sales to prices in the international market (Yetiv, 2004, p. 6). Recent causes of changes in oil prices are however different from the causes that were prevalent in the past. Cleveland (2009, p. 248) supports the view that past fluctuations were mainly caused by changes occurring on the supply side of the market (that is factors affecting oil-producing countries) such as wars as described above. However, the recent fluctuation of energy prices stems from aggregate demand shocks caused by a rise in the needs for crude oil in less developed countries such as India and China (pp. 248-249). The increased demand for oil causes as a significant increment in the cost of the commodity. Impacts of oil price fluctuation on the macro-economy of countries in general Many authors (such as Yan, 2012; Ekmekcioglu, 2012; Ebrahim, Inderwildi & King, 2014 and Ftiti, Guesmi & Teulon, 2014) agree that oil makes a key contribution to the growth of the economies of countries across the world, and that as such, the macroeconomic condition of countries is inevitably affected by oil prices. Ebrahim et al. (2014, p. 1) in particular argue that dependency on fuels derived from oil in various industry sectors, such as the transport industry, has exposed the world economy to several macroeconomic side effects. The point here is that many countries rely on oil for transportation, production of other forms of energy such as electricity, and the manufacturing and services sectors, which makes them vulnerable to any variations in the cost of oil. Oil price fluctuation affects the elements that relate to a country’s macro-economy such as rate of growth, price levels, inflation, national income, interest rates, unemployment and growth domestic product (GDP). Various studies have been conducted to establish the consequence of oil price fluctuation on the macro-economic environments of countries. The vector auto regression (VAR) tool has been applied on several occasions to study the implication of oil cost fluctuation on the economy. Based on this model, Hamilton (1983) suggested that 7 out of the eight economic recessions in the US which followed a period of war were heralded by a steep increase in the cost of fuel. The same view is supported by Kilian and Vigfusson (2014, p. 6), who argue that most recessions experienced in the US after 1973 were heralded by increases in oil price, and that it can therefore be said that recessions are caused by increases in oil prices. The same view can be supported by the argument that the Gulf War, which involved invasion of Kuwait by Iraq and later intervention by the US between 1990 and 1991, led a twofold rise in the cost of oil and was succeeded by the US’s 9th economic recession (Hamilton, 2010; Kilian & Vigfusson, 2014). Thus, Hamilton’s (2010) conclusion based on the previous work (Hamilton, 1983) and further studies is that shocks in oil prices can have an effect on the economy through their influence on both demand and supply. The findings by Hamilton (1983, 2010) are also supported in a study conducted by Anzuini et al. (2013), who also used the VAR model and noted that factors that cause oil market shocks result in an increase in consumer price index (CPI) and instantaneously reduce the US’s economic activity with a six month period lag (p. 15). A review of literature by Hamilton (2010) also shows that oil cost fluctuations have a bearing on countries’ GDP. Specifically, it is indicated that oil price volatility is a precursor of reduced economic growth, and that oil price reductions have some contractionary ramifications for a country’s GDP (p. 5). More importantly, it has been found that there exists a nonlinear correlation between the cost of oil and consequent real GDP expansion (Hamilton, 2003; Hamilton, 2010, p. 5). Cologni and Manera (2005) also utilised the VAR approach to investigate the effect of oil price variations on interest rates and inflation. The two authors point out that the increases in oil prices that were being recorded in world oil market at the time of the study were causing apprehension regarding potential reductions in the economic activity of the most advanced economies in the world. According to the paper by Cologni and Manera (2005), there are various reasons as to why oil price fluctuation affects economic variables and why shifts in oil prices are inversely related to collective economic activity. The first explanation is that a scenario such an oil supply shock, which is associated with increasing oil prices, is suggestive of the growing shortage of energy. Since a key requirement in production (oil) is obtainable in less than the required quantity, labour productivity and output are reduced. In milder cases of oil supply shock, the oil shortfall leads to a reduction in the speed of growth in labour productivity and output. In addition, Cologni and Manera (2005) argue that if consumers anticipate a temporary increase in prices of energy, they can choose to save little or borrow more, a situation that causes a decline in the real balance as well as an additional rise in the price level. The other way in which oil price fluctuation can affect economic functions is based on the shift of income from countries that import oil to those that export the commodity. According to this point of view, increasing oil prices can be regarded as a tax that is charged by countries that export oil on oil consumers. Even though the decrease in domestic demand needs to be offset, at least partly, by demand for exports from foreign receivers of the income that is transferred, the real implication is that in net terms, an unconstructive effect results on the consumer need for commodities that are manufactured in the countries that import oil (Cologni & Manera, 2005, p. 2). The third way in which oil price fluctuation can affect the macro-economy as described by Cologni and Manera (2005) is in terms of the aggregate economic effect through the real balance effect. This concept proposes that following a rise in the price of oil, as the population makes attempts to find an equilibrium towards liquidity, a rise in the demand for money occurs. Therefore, if the authorities that are concerned with monetary regulations fail to fulfil the increasing demand for money by an increasing the supply of money in the economy, in which case the price level rises with no concomitant increment in the liquidity supply, a reduction in the real balances occurs, which consequently boosts interest rates. There are some differences between the experiences of countries that export oil and those that import the commodity in regard to price oil price fluctuation. Notably, the consensus seems to be that countries that import oil face negative effects such as reduced economic growth, reduced GDP and high unemployment. An example of such situations was given above of the US economy’s several recessions due to high oil prices experienced after wars in oil-producing countries. This finding is relatively undisputed since even more recent studies have suggested that a rise in the cost of oil has a general impact of reducing economic activity and hence expansion. For example, figures quoted in the The Economist in October 2014 indicated that the conflict imposed in Iraq by the Islamic State (IS) fighters would cause a shock in the oil price and hence result in a 0.5 per cent to 1.5 percent drop in the world GDP and that inflation in rich countries would rise by at least half a point (“Cheaper oil”, 2014). This suggestion is in line with the outcome of a study conducted about the effects oil price fluctuation on Russia’s macroeconomic activity (Ito, 2010). In the research, it was found that a 1 percent decrease or increase in oil prices leads to a rise or depreciation of the exchange rate by 0.17 percent and a GDP growth of -0.46 percent (p. 2). However, currently, there is an overall increase in the supply of oil from other oil-producing countries such as the US and hence a drop in prices (Baffes et al., 2015, p. 160; Silverstein, 2015), the result of which would probably be an increase in the global GDP due to increased production. Ironically, as noted by Baffes et al. (2015, p. 160), the world’s GDP expansion is projected to be much feeble compared to the growth that was experienced in the period between 2003 and 2008 when oil prices increased considerably. This emphasises the fact that the correlation between oil price variations and GDP growth is not linear. According to The Economist, a 10 percent adjustment in the cost of oil is usually connected with about a 0.2 percent shift in the world’s GDP. Hence, a fall in world oil prices leads to an increase in GDP by moving materials from those who produce them to those who consume them, who are likely to have an increased spending capacity (“Cheaper oil”, 2014). In the same dimension, Cologni and Manera (2005) posit that after a rise in the price of fuel, industries are likely to shift from energy intensive areas to those that are more energy efficient. However, since it is not possible to achieve such realignments quickly, there tends to be a rise in lack of employment as well as an underutilisation of materials (Cologni & Manera, 2005; Hamilton, 2003, p. 365). In most cases, oil price fluctuation causes uncertainty in the economy since firms are not sure in regard to the movement of oil prices in the future, which gives them an incentive to put off their investment decisions. The scenario in oil-producing countries however is that a rise in the cost of oil results in a rise in GDP. For instance, in Nigeria, a rise in world crude oil prices translates to GDP growth (Gunu & Kilishi, 2010, p. 44). According to Gunu and Kilishi (2010) the implication of this is that Nigeria’s economic growth is likely to decline if crude oil prices fall in the world market. Another difference is in terms of the connection between changes in the price of oil and shifts in unemployment. As it has already been discussed, a rise in oil prices possibly increases unemployment as industries tend to focus on energy-efficient sectors and practices. However, for oil exporting countries such as Nigeria, a rise in the cost of crude oil results in a reduction in unemployment (Gunu & Kilishi, 2010, p. 44). This is likely to be because of the increased money supply in the oil exporting countries as a result of increased earnings from the oil resource, which spurs firms in the oil exporting country to employ more people. However, it is not necessarily true that increases in oil prices favour the oil-producing countries, since such countries are also subject to other macroeconomic factors. For instance, such countries also import other commodities and services, whose prices are affected by the increases in the price of oil. The next section discusses the effects of oil price fluctuation on oil-producing countries in more detail. Impacts of fluctuating prices of oil on oil-producing countries The effects of oil price fluctuation on countries that produce oil are also mixed. This review looks at the impact of oil price variations on countries whose economies largely depend on exporting oil. Such countries include the members of OPEC, which comprises Nigeria, Algeria, Saudi Arabia, Ecuador, Angola, Libya, Kuwait, Venezuela, the United Arab Emirates (UAE), Qatar, Iraq and Iran (OPEC, 2015). It is important to note there are also countries like the US which produce oil but only export a small portion of it and thus still import a significant amount of the commodity from other countries (US Energy Information Administration, 2015). According to Omojolaibi (2013, p. 143), for most countries that are net exporters of oil such as Nigeria, the economy depends on oil exports. Hence, fluctuations in the price of the commodity have a major impact on the economy. Most such economies tend to have government structures that are considerably large compared to the underdeveloped private sector. Spending the revenue earned from the oil exports is thus the most important feature of such economies, implying that monetary and fiscal policies are pegged on earnings from oil. Therefore, in the event of oil price fluctuation, elements of the macro-economy like the real exchange rate are greatly affected if preventive actions are not taken. However, when the price of oil increases, the government earns more money from oil exports and thus has more money to spend and this translates to positive macroeconomic outcomes (Omojolaibi, 2013, p. 143). Despite the assertions by Omojolaibi (2013) , Gunu and Kilishi (2010, p. 41) argue that previous studies conducted in Nigeria on the effects of volatility oil prices on the economy of the country did not unearth any considerable effect of shocks in oil prices on macroeconomic indicators such as price level, money supply, government spending and productivity. However, studies conducted in the Middle East and North Africa (MENA) countries in terms of the effects of international prices of oil on the GDP of countries such as Kuwait, Jordan, Qatar, the UAE, Syria, Iran, Iran, Algeria and Kuwait suggested that there was a notable effect of oil price variation on the countries’ GDP (Omojolaibi, 2013, p. 145). The impact of fluctuating oil prices can also be analysed by focusing on countries that are members of the Gulf Cooperation Council (GCC), most of which are members of OPEC. These countries are Kuwait, Saudi Arabia, Bahrain, the UAE, Oman and Qatar (Arouri, Lahiani & Bellalah, 2010, p. 132). Arouri et al.’s (2010) review of these countries indicates that following the high prices of oil that were experienced starting 2003, the GCC countries have grown into centres of economic growth. The same countries have also become important investors in the international arena. However, they are limited by factors such as low industry diversification, having relatively small private sectors, and other economic deficiencies (Arouri et al., 2010, p. 132). Therefore, the most probable outcome is that these countries are also susceptible to recessions in case of sustained downwards trends in oil prices. However, in contrast to these countries, Nigeria’s economic development has not been associated with the discovery of oil in spite of the country being a member of OPEC (Ayadi, 2005, p. 205). Berument, Cylan and Dogan (2010) also conducted a study to determine the effect of oil price volatility on the economic expansion of a number of MENA states. The findings of the study, which were based on the use of the structural vector auto regression model, suggested a number of things. The first one is that countries such as Iraq, Iran, Algeria and Kuwait, which are notable oil producers and exporters, exhibit the propensity of being affected by shocks in oil prices only during the time that the shock occurs. This point can be used to explain why the economic growth and GDP growth of many Arab oil-producing countries often shifts with changes in world oil prices. Another important finding from the study by Berument et al. (2010) is that oil-producing countries that also have larger non-oil industries, such as Iran and Iraq, have a higher capacity of overcoming macroeconomic challenges associated with oil price shocks. The following section reviews some examples of how countries that produce oil are affected by oil price fluctuation. Oil price fluctuation effects on selected oil-producing countries Kuwait According to Ramadhan, Hussain and Al-Hajji (2013, p. 412), Kuwait’s economy is greatly dependent on oil exports. Notably, oil revenues account for 50 per centum of the nation’s GDP, 95 per centum of its exports and 90 per centum of revenue earned by the government. The other contributors to the Kuwaiti GDP are personal and financial services (35 percent) and logistics and trade (12 percent). Other economic activities account for the remaining percentage of the GDP. Alzami (2008, p. 65) argues that Kuwait is an example of a small open economy that is greatly affected by occurrences in world markets. Given that the country imports almost everything, and has oil as the only major export, fluctuations in oil prices significantly affect its economy. For instance, Alzami (2008) notes that when oil prices increase and most of the other countries in the world are affected by inflation, Kuwait will also be affected. This arises because Kuwait imports nearly everything that it needs from the other countries, which are affected by inflation due to the high oil prices (p. 65). Indeed, Kuwait is one of the countries whose economies have been adversely affected by world oil shocks, including the 1990-1991 period when the country was attacked by Iraq in what came to known as the Gulf War (Barsky & Kilian, 2004; Zhang, Yu, Wang & Lai, 2009). An analysis by conducted by the International Monetary Fund (IMF) (2014) suggests that the economy of Kuwait is highly reliant on oil revenue and thus exposed to oil price fluctuations. This is particularly so because Kuwait is one of the oil-producing countries that have less diversified economies (El Anshasy, 2009, p. 6). In 2013, some of the macroeconomic factors which showed volatility due to oil price volatility included real revenues, spending, as well as welfare and consumption. Additionally, according to the IMF (2014, p. 4), there was a decline in spending in the 1980s-1990s when oil prices dropped substantially. This could be a predictor of what is happening in the country presently due to the low oil prices being experienced. Iran The economy of Iran is also highly vulnerable to fluctuations in the price of oil (Farzanegan & Markwardt, 2009, p. 134). Farzanegan and Markwardt (2009) applied the VAR strategy to examine the dynamic correlation between shocks in oil prices and key indicators of the macro-economy in Iran. The study findings suggested that unbalanced impacts of fluctuations in oil prices, such as negative and positive shocks in oil prices, cause a considerable increase in inflation. The authors also found a positive connection between rises in the price of oil and growth in industrial output. Furthermore, they also noted that there was only a negligible impact of oil price variations on government’s real spending. But more importantly, Farzanegan and Markwardt (2009) noted that Iran was experiencing the “Dutch disease” because of a significant increase in the real effective exchange rate (p. 134). Dutch disease is a negative situation associated with contraction of other tradable sectors of the economy (such as agriculture and manufacturing) because of price booms for a major resource such as oil (Farzanegan & Markwardt, 2009, p. 135; Brahmbhatt, Canuto & Vostroknutova, 2010, p. 1). The result is a rise in the real effective exchange rate, leading to negative effects such as inflation (Farzanegan & Markwardt, 2009, p. 141). In contrast, negative oil price shocks result in substantially negative reactions with regard to the real effective exchange rate, which leads to a rise in the attractiveness of Iran’s tradable goods in international markets (Farzanegan & Markwardt, 2009, p. 135). Another notable point is that as a result of Iran’s economy’s reliance on oil income, there was a co-movement in the country’s GDP per capita and oil price between 1970 and 2003 (Farzanegan & Markwardt, 2009, p. 135). That is, GDP per capita increased when oil prices increased, and it decreased with a drop in oil prices. Qatar According to Al-mulali and Sab (2010, p. 1), oil is a major contributor to Qatar’s economy, accounting for over 60 per centum of the state’s GDP, 70 per centum of the government’s income and 85 per centum of earnings from exports. The country has also had one of the highest GDP per capita among the Arab countries since 2001. However, since Qatar’s economy largely relies on oil, oil price fluctuations result in significant changes in the country’s GDP. In particular, Qatar has been affected by many oil price shocks, from that of 1973-1974 to that of 2003-2008. During all this period, there appears to have been a positive association between the cost of oil and the country’s GDP. This is because a graph of oil price and GDP from 1970 to 2008 shows a co-movement of the two phenomena – an increase in GDP when oil price increases and a contraction in GDP when oil price falls. As well, increases in the cost of oil have been noted to be the cause of the increase in inflation in Qatar. This is because when the price of oil increases, it causes a sudden rise in liquidity. This in turn increases the price levels, leading to a higher level of inflation. Moreover, given that Qatar’s exchange rate is pegged to the dollar, monetary policy interventions by the country seem to be less effective in dealing with sudden liquidity increases (p. 2). Conclusion The review has discussed the effects of fluctuating oil prices on countries in general and those that produce and export oil in particular. The results suggest that the effects of oil price fluctuation on the macroeconomic environments of countries in general are mixed. Notably, effects of increases in oil price include economic recession, increased inflation, reduced economic activity, a reduction in GDP, and reduced labour output and productivity and hence the concomitant effects such as increasing unemployment. The flip side is that low oil prices cause an increase in production since oil is almost always a key input of production in many industry sectors. Thus, countries that do not produce oil are likely to increase their production when oil prices are low. The impacts of oil price fluctuation on countries that produce and export oil are slightly different. To start with, high costs of oil lead to a rise in GDP because of the high revenue earned from oil exports. This means that low oil price translates to a contraction in the GDP. As well, an increase in oil prices leads to elevated economic expansion as seen for the GCC states, Kuwait included. However, there are some oil-exporting countries whose economic growth has not relied on oil exports, such as Nigeria. Finally, even though a rise in the price of oil should result in high GDP for oil-producing countries, the review has also established that high oil prices lead to negative effects such as increased inflation and Dutch disease since most of these countries rely on oil as the major export and have to import almost every other commodity that they need. References Al-mulali, U, & Sab, C. N. C. (2010). The impact of oil shocks on Qatar’s GDP. 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