Oil Prices and their Impact on the Economy
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Published: Thu, 15 Mar 2018
The subject of this study is oil prices and their impact on the economy as a whole. Oil plays a crucial role in the world’s economy and has a big influence on it. It affects the world’s economy and economies of different countries not only through consumption, but also through prices of other goods and import and export.
The aim of this study is to examine what determines oil prices and to analyze how do oil prices affect the economy. Recent analyses show that the problem of explaining oil prices hasn’t been solved yet. There are different approaches to this problem, and it isn’t still clear which of them, or maybe the combination of different approaches, is the most appropriate. Moreover, the problem of oil prices changes was brought forefront before the global economic crisis, when prices of oil rocketed to about $140 a barrel, and during the crisis, when the oil prices fell to less than the fourth of the peak price.
But oil prices wouldn’t be so interesting for analysis if they affect the economy, so the second problem that is brought forefront is how do oil prices affect the economy: do they have positive or negative impact on growth and do they cause higher inflation? Some researchers argue that high oil prices lead to the slowing of economic growth, others believe that they cause acceleration in growth. Some analyses show that high oil prices are significant determinant of inflation while others conclude that oil prices have no impact on inflation.
In my research I will review the existing literature considering oil prices and their impact on the economy and will try to do empirical research on Russian data. It is very interesting to analyze how do oil prices affect Russian economy because oil (especially oil export) plays crucial role in Russian economy, Russia is the second-largest oil exporter in the world and it is often said that our country is very oil-dependent.
The remainder of this paper is organized as follows. Firstly, I will review the literature, then present the theoretical framework, then describe data, then reveal the expected empirical results and then draw a conclusion.
Hamilton (2008) provided a very deep analysis of factors that affect oil prices. He made an overview of existing methods to model oil price and tried to determine which factors are the most significant. Firstly, he discussed statistical predictability if oil prices. He made a conclusion that it isn’t possible to predict oil price changes using lagged values of real oil prices, U.S. nominal interest rates or U.S. GDP growth rates. He also claimed that the real price of oil seems to follow a random walk without drift. So the author argues that it isn’t an easy task to predict the real oil price and that the best forecast of the real oil price in the future may be its current price.
Secondly, Hamilton tried to make some predictions based on economic theory. He asserted that three conditions should hold in equilibrium. The first is about returns to storage and says that the expectation today of the oil price one period ahead should equal the oil price today plus the cost of carry:
The second is about future markets and asserts that the futures price should equal the expectation of the oil price one period ahead plus risk premium or complications induced by margin requirements:
The third follows from the fact that oil is a depletable resource and is called Hotelling’s principle. It was introduced by Hotelling (1931) and states that in the case of exhaustible resource even on the perfectly competitive market price should exceed marginal cost, and in the case of oil prices the scarcity rent should increase at the rate of interest:
But many analyses show that economists think that oil prices haven’t been influenced by the issue of exhaustibility. Before 1997 this scarcity rent didn’t play significant role in oil prices, but then new information about demand growth and production limits lead to a shift to a regime with rather big scarcity rent. It is also important that in many countries governments, not private firms, control most of petroleum reserves, so the intertemporal calculation now plays its role in production decisions, because governments tend to think not only about well-being of current citizens of their countries, but also about that of the next generations.
Another factor which plays significant role in oil prices is speculation.
Thirdly, Hamilton analyzes petroleum demand. He considers its two main characteristics: price elasticity and income elasticity. The demand price elasticity is the percentage change in quantity demanded divided by the percentage change in price other things equal. Hamilton presents results from the literature that show that the short-run elasticity of gasoline demand is about -0.25 and the long-run elasticity is about -0.5 to -0.75. As we move to crude oil, its short-run elasticity is below -0.1 and the long-run elasticity is about -0.2 to -0.3. These figures can’t be very precise because almost every year shifts in demand and supply occur so ceteris paribus principle doesn’t hold and therefore we can’t look only at how prices and quantities behave to make a conclusion about the slope of demand or supply curves.
But even given the fact that we don’t know the elasticity exactly, it can be shown that it must be a small number. Hamilton presents calculations that show that in 1978 – 1981 the price elasticity of crude oil was -0.26, and in 2002 – 2007 it was even smaller. According to Hughes, Knittel, and Sperling (2008) she short-run gasoline demand elasticity was between -0.21 and -0.34 in 1975 – 1980 but only between -0.034 and -0.077 in 2001 – 2006.
As for income elasticity, it was estimated in a number of studies and their results show that it is close to unity. Hamilton states that in fact the income elasticity was greater than unity in 1950s – 1960s, then, in 1970s, there were two significant adjustments to oil shocks, and the income elasticity has decreased to about 0.5. According to Hamilton, the income elasticity decreases as GDP per person rises, and this fact is confirmed not only in the US data, but also in the data from a number of different countries. In developing countries it is still greater than unity, and it is these countries, especially China, which account for petroleum growth now.
Oil demand rises, so the question is if the world can produce oil in such volumes. So now it’s time to consider petroleum supply. Hamilton postulates that there was stagnation in oil production in 2004 – 2007, so given the demand growth a big increase in prices was required to restore equilibrium. So he tries to analyze why supply failed to increase.
Hamilton outlines several important factors. The first is the role is OPEC. Nowadays it is countries rather than private companies who play the main role on the oil market. For example, the market share of the 5 biggest companies was less than 12% in 2007, while Saudi Arabia alone produced 12.1% of world liquids production, and the OPEC-10 produced more than 36%.
The question is whether OPEC is operating as an effective cartel. Economic theory states that in the absence of a scarcity rent the optimal strategy is to set the marginal revenue equal to the marginal cost. The marginal revenue for a member of the group is higher than for a group, so for individual members it would be better to produce more than the cartel production decision suggests. So there is an incentive to cheat by producing more than it was agreed by the group, and an effective cartel should have some mechanism to prevent such behavior.
It’s rather hard to determine the quotas and actual production levels for the OPEC members, but figures seems to show that some OPEC countries have systematically produced more than their quotas were, some have produced less. From these facts Hamilton made a conclusion that it was the quotas that had moved to much production.
Moreover, according to Hamilton, it is difficult to find any clear mechanism used to control whether the OPEC members follow their quotas or not and, if not, to enforce them follow their quotas. And OPEC announcements seem to be based on collecting each country decisions how much to produce rather than on a decision of the cartel as a whole, and these announcements play mainly political role.
Another possible explanation is that Saudi Arabia, which produces a third of the OPEC production, behaves like a monopolist, and other countries make decisions on a more competitive basis. It is difficult to support this hypothesis because the results of calculations are ambiguous, but the decrease in Saudi Arabia oil production in 2006 and 2007 definitely was one of the causes of 2008 price rise. If it is so, why couldn’t other countries increase their production to cut the possible Saudi Arabia monopoly price?
To answer this question, Hamilton analyzed world prospects for increasing oil production.
Ito (2008) provided an empirical investigation of oil price impact on the economy. He examined how oil prices affected the Russian economy. He built a VEC model to analyze the effect of oil price and monetary shocks on the Russian economy in 1997 – 2007. His findings show that a 1% increase in oil prices lead to 0.25% real GDP growth over the next 12 quarters and to 0.36% inflation increase over the same periods. Ito states that the monetary shock affects real GDP and inflation through interest rates. It leads to a 0.52% fall of real GDP over 12 quarters and to 1.04% decrease in inflation. So the impact of the monetary shock is two to three times greater than the impact of the oil price shock.
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