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Oil Production and Price

Introduction

In this paper I analyze how oil price shocks affect macroeconomic performance in an oil exporting country. My interest in understanding the impact of oil prices shocks on Norway's economy stems starts from the fact that volatility in oil prices has significantly impacted the world's economy to a great extent and almost has jeopardised endangered many established economies worldwide. The reason of this devastating impact is simple: oil plays a backbone role in the economy of every country and most of the oil producing countries rely on their oil to bargain with the oil purchasing countries. Rise in oil prices directly impacts the currency value. That is why; the price of dollar has strong relationship with the fluctuating oil prices. Hence, it is imperative to understand the reasons, causes and effects of rising oil prices and its impact on world economy in general and on the Norwegian economy in particular. Studying the impact of oil prices on Norwegian economy is significant as Norway is the third largest oil exporter in the world. Its economy is highly dependent on the offshore oil and natural gas sector, which represents the biggest contribution to GDP (about a quarter), and provides the government its largest single source of revenue (30 percent).

Oil price shocks, defined as unexpected changes in the price of oil, have additional effects on oil-producing EMEs compared to their impact on developed economies. The economic implications of an increase in the price of oil in a developed economy are, mainly, the creation of inflationary pressures due to increases in production costs, a decrease in productivity levels, and a contractionary effect on output due to a reduction in aggregate demand. In contrast, in an oil-producing EME, an oil price shock carries an additional effect. Specifically, the economy as a whole receives a positive wealth effect through better terms of trade and an increase in oil revenues.

The contractionary and cost-push effects have been studied for the case of developed economies, but the wealth effect has not. Potentially, because of the nature of this second channel of transmission, additional inflationary pressures may be present due to the effects on marginal cost and aggregate demand. Naturally, the question of whether there is a positive or negative effect on output and consumption also arises. This line of reasoning implies that the role of monetary policy in these economies may be different compared to the cases when only the standard channels of shock transmission are considered.

The oil sector sells part of its production to the .final goods producing firms and the remaining oil production is sold abroad. This formulation allows for an illustration of the effects of an oil price shock on the relevant economic variables and shows that, depending on the elasticity of labor supply, the effect of an increase in the price of oil can have either a contractionary or an expansionary effect on output. An oil price shock seems to affect economics of oil exporting countries differently from that of oil importing countries. According economics logic we expect oil price increases to have a positive effect for oil exporting countries but a negative result for oil importing countries. The reverse will expect if oil price decreases. As a result of high oil price, oil importing countries might face with higher production cost which decreases output. Therefore it will lower disposable income which leads them to lower consumption level

This study extends the research to other oil producing countries in order to have a broader review of the oil prices shock.

Comparison Between oil producing countries

Of the top fourteen world oil producers of 2004, only four of them (United States, Canada, Norway and United Kingdom) are considered developed economies as catalogued by the World Bank, the International Monetary Fund, and the Central Intelligence Agency. Even high income countries such as Saudi Arabia are not considered developed economies because of their tight dependence on oil revenues. Table 1 illustrates this point. It shows the top world oil net exporters of 2004. The shares of net oil exports and oil production on GDP depict the fact that these economies rely on the performance of their oil sector for economic stability. Furthermore, compared to the shares shown in Table 1, the shares of oil revenues on .fiscal revenues tend to be even greater in these economies.

Table 1: Oil shares of net exports

Country

Net Oil Exports*

Net Oil Exports (% of GDP)

Oil production (% of GDP)

Saudi Arabia

8.73

43.1

52.3

Russia

6.67

14.3

19.9

Norway

2.91

16.2

17.7

Venezuela

2.36

29.3

36.9

United Arab Emirates

2.33

27.4

31.2

Kuwait

2.2

47.0

53.0

Nigeria

2.19

46.6

53.2

Mexico

1.8

3.0

6.5

Algeria

1.68

30.7

35.6

Iraq

1.48

53.0

72.0

Libya

1.34

59.0

70.8

Kazakhstan

1.06

32.5

39.8

Qatar

1.02

47.0

45.6

*Million barrels per day

Source:

British Petroleum Economist Intelligence Unit, CIA, EIA

As specific examples of this fiscal dependence, according to the Energy Information Administration, between 75%-80% of Venezuela's exports rely on oil and contribute up to 45%-50% of government revenues. For Mexico, the average contribution of oil revenues on .scale revenues for the period of 1998-2004 was approximately 30%. Therefore, oil prices play a critical role in the stability of government accounts in these economies and so condition .fiscal policy, which in turn conditions monetary policy.

In general, emerging market economies and developing economies are more vulnerable to increases in oil prices than developed nations. According to a 2004 analysis by the International Energy Agency (IEA) based on IMF estimations, for a sample of developing economies, a $10 permanent increase in the price per barrel of oil would imply a 1.5% reduction in GDP. The analogous effect on OECD countries amounts to only a .3%-.4% GDP reduction. Similarly, the cost-push pressures of a $10 increase in oil prices would imply an increase in inflation of 1%-2% for the non-OECD sample and a .5% increase for the OECD countries. Moreover, the IEA study mentions three facts that explain why the impact of higher oil prices on emerging market economies is more severe than on developed nations. First, non-OECD countries are not able to switch rapidly and efficiently to other forms of energy. Second, these countries tend to be more energy intensive and less efficient in their energy usage. And third, non-OECD countries require twice as much energy input for a unit of output than do OECD countries.

LITRETURE REVIEW

The correlation between increases in oil prices and contractions in the GDP has been extensively documented for the US and other developed economies.[1] However, Hamilton and Herrera (2004) have pointed out that there is no general consensus as to what this correlation means. An exception is Bjørnland (2000) who, for a group of developed economies that includes the US, finds that oil price shocks have a significant negative effect on output.

Turning our attention to the relevant literature concerning monetary policy in oil-producing economies, DeLong (1997), Barsky and Kilian (1999), Hooker (1999), and Clarida, Galí and Gertler (2000), are among those who suggest that there is a stabilization role for monetary policy when dealing with oil price shocks. Hunt, Isard and Laxton (2001) use the IMF multicountry model to suggest that the effects of oil price shocks on economic activity can be limited if appropriate monetary rules are chosen. There has been considerable debate as to whether monetary policy, and not oil price shocks has been responsible for US recessions that have followed significant oil price increases. Among those who have attributed the source of these recessions to the Federal Reserve's response are Bohi (1989) and Bernanke, Gertler and Watson (1997). In contrast, Hamilton and Herrera (2001, 2004), among others, potential of monetary policy to counteract these shocks is minimal. Aguiar-Conraria and Wen (2005) specify that in order to explain the sharp US recession of 1974-75, as well as the revival of 1976-78, with oil price movements, it is necessary to take into account a multiplier-accelerator mechanism that arises in a model characterized by monopolistic competition with increasing returns to scale. Rotemberg and Woodford (1996) show that a model with imperfect competition can explain the effects of oil price shocks on output and real wages much better than a model that considers perfectly competitive markets. In contrast, Finn (2000) argues that perfect competition is enough to explain these effects.

Hamilton (1983) 1948-1980, Shows that significant association amid oil price increases and economic recessions is not a statistical fluke. Oil price augment was followed 3-4 quarters by slower output expansion by means of a revival commencement subsequent to 6-7 quarters. Supposed oil price augment could be probable to lead to a small output outcome through inflationary times than in non inflationary period if compared to Gisser, Goodwin (1986) Demonstrate that oil price effects on financial output cannot be explained only by financial as well as fiscal strategy. The connection flanked by oil price shocks and United States economy did not change much after 1973. Confirm Hamilton's study (1983) concerning a parallel association by and after 1973. While Loungani (1986) using Quarterly employment data for 28 industries, Assumes that disturbances in the world oil market create noteworthy joblessness throughout sectored shifts. Oil price boosts in the 1950s as well as 1970s emerge to version for troubling the work reallocation process. Comparing with Mork (1989) Study if Hamilton's consequences stay accurate when the oil markets crumple of the 1980s in addition to the genuine oil prices are measured as well; Shows an even stronger unhelpful relationship flanked by oil price augment as well as output expansion than Hamilton. Regardless of oil price declines in the 1980s, monetary production increase is slowed down by oil price changes irregularity in effects. Corroborates Hamilton's (1983) study of a negative association linking productivity development plus oil price increases and extends facts until 1988.

Lee et al. (1995) 1950-1992 intention: Examination causality of actual oil price to the macro economy throughout 1992 in an extensive era of constancy, oil price shocks (= shock) have a superior collision than in a volatile setting. For production increase in a 24-quarter prospect the major negative desire appears 4 digs after the oil price shock, revival begins concerning 6 quarters after the upset.

Joblessness begins to climb 4 quarters following the oil fright through 8 quarters subsequent to the shock that is not counteracting at soon dates. The significant tip of this revise is the insertion of the changeable oil price fright, that means the gauge of how an altered in the certain oil price differs as of the past pattern. Ferderer (1996) 1970-1990 daily spot market oil prices, to clarify the irregularity in things, instability as well as oil price change has a stronger and more significant crash on economic movement than economic strategy variables. Oil price increases are accompanied by superior instability. Oil price precariousness as well as the Federal funds pace governs the oil value height in terms of explanation fluctuations in business construction. Volatility has a pessimistic and important impact on output expansion straight away and over eleven months later. Oil price changes have an important impact on production increase following on one year. U.S. financial system is exaggerated by oil market disruptions as of the 1970s till the 90s throughout sectarian shocks and indecision as shown by Lee et al. Ferderer finds proof that instability has a better impact than the oil price height! Rotemberg and Woodford (1996) wrongly spirited market models can clarify the big result of oil price changes on production increase plus real wages. A 1% augments in oil prices results in a lessening in production of about -.25 % after 5 - 7 quarters. After an oil price increase of 10%, real wages fall by 1% following 5 - 6 quarters after this increase. The turn down in production in addition to real wages gains significance in the 2nd year following the oil price destabilize. The era chosen seems to decline the qualitative results since oil price declines and instability occur in the 1980s. Hooker (1996) 1948-1994, 1948-1972:

10% augment in oil prices led to GDP expansion approximately 0.6 % inferior in the third as well as fourth quarters after the shock 1973-1994: Neither unemployment nor GDP expansion can be forecast by oil prices levels. Though, GDP expansion could be predicted sometimes by instability. Disproves the linear relation flanked by oil prices plus production (Hamilton 1983) as well as the asymmetric association based on oil price rise (Mork 1989). Hamilton (1996) outstanding to the oil value instability because 1986, the era of the earlier year has to be measured quite than only the previous sector when analyze oil price expansion (net oil price augment (NOPI)), Relation flanked by GDP increase plus NOPI leftovers statistically important for the filled period as of 1948:1 to 1994:2. Hamilton agrees totally by means of Hooker refuting linearity plus asymmetry in the oil price macro economy association. Hamilton (2000) conclude by saying that Oil price increases substance substantially more than oil price decreases. Increases that happen after a long phase of steady prices have a superior collision than those that merely correct previous decreases. Commencing 1949 to 1980 a 10% augment in oil prices resulted four quarters shortly in a level of GDP enlargement that was 1.4% inferior. Except now, there is not sufficient chronological knowledge to choose one particular practical appearance unambiguously over another. Chaudhuri (2000) Valid oil prices have an sway on real product prices, yet if oil is not being used openly in the fabrication of supplies. An oil price modify may influence the prices of most important possessions. Jones, Kaul (1996) analyses différent set of countries: U.S.: 1947-1991Canad.: 1960-1991Japan: 1970-1991 UK: 1962-1991 Objective: To observe if supply prices reasonably reproduce the impact of news on existing as well as prospect actual cash flows in Japan, U.S., Canada, and UK. Oil price tramp had an important, plus (on average) damaging result on the supply market of each country. It is “staged” in the case of Japan plus much weaker for Canada.

For each country -apart from UK - together existing as well as lagged oil value variables affects stock returns pessimistically. The truth that the concluding has a superior negative sway suggests that oil shocks persuade some variation in expected supply returns or the stock market's inadequacy .Sadorsky (1999) , the standard value of a harmful shock is 20% bigger in unqualified worth than the average cost of a activist alarm. Oil price shocks have a pressing important collision on real stock returns; this blow was strongest after 1986. Rising oil prices sadden real store returns.

After 1986 there's somewhat an alter in dynamics than alter in the reply of the classification. Thus, oil price instability shocks play an important asymmetric role. The learning rears up the consequences of Jones and Kaul by using journal data instead of periodical data.

Papapetrou (2001) examines using the data 1989-1999 for Greece In an average- as well as long-term association, oil price shocks explanation for 20% (up to 22%) of alters in business making.

1) belongings of an oil price upset as well as industrial production:

- urgent augment of attention rates

- abrupt diminish of engineering fabrication (peak after 4 months)

- abrupt reduce of real stock returns

2) Belongings of an oil price shock as well as service:

- instant augment of significance rates

- lessen of service (after 4 months)

- reduce of genuine supply returns

Ciner (2001) 1983-2000 Important nonlinear causality as of crude oil futures proceeds to S&P 500 manifestation returns as well as evidence that supply index returns also influence crude oil futures, signifying an advice relation. The relation is yet stronger in the 1990s. Corroborates Sadorsky's (1999) consequences of stronger possessions of oil cost shocks after 1986 Comparing all these theories explains the different impacts of oil prices inflation on the markets in modern age. Reading all those different books and journals proved very useful. As it has helped enabling me to get a thorough understanding of what can be the effects of price in stability of oil on the modern markets.

[1] Relevant research in this direction includes work by Rasche and Tatom (1981), Hamilton (1983, 1985, 1996, 2003), Burbidge and Harrison (1984), Santini (1985), Gisser and Goodwin (1986), Loungani (1986), Tatom (1988) and Mork (1989), among others. For an extensive list of references studying this correlation, see Hamilton and Herrera (2004).

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