International
IMF considers impact of oil price above $80
By Finfacts Team
Apr 8, 2005, 06:35

The International Monetary Fund (IMF) released a report on Thursday on the oil market, which considers the impact of a surge in oil prices past $80 per barrel.

The recent oil price increases have been substantial, but should be kept in perspective. The average price of crude oil has risen by more than 40 percent since the  beginning of 2004 to $44.95 in January 2005, surpassing the record nominal high set during  the Iraq invasion of Kuwait in 1990. In real terms, however, the price is still well below the real price of $90 in today's prices that was reached in 1990 $39.50 per barrel in nominal terms).

The price increase is relatively small compared to the 1970s. While oil prices more than tripled in the two oil shocks in the 1970s, the WEO projection for the 2005 oil price is 55 percent above its 2001.03 average.

Moreover, the oil intensity of consumption and production particularly for advanced economies.is now significantly lower than in the 1970s. Finally, the durability of the price increase is uncertain, given uncertainties about medium- and long-term supply and demand behavior.

Saudi Arabian oil facility

• The recent surge in oil prices seems to be the result of a secular increase in demand from North America and Asia, combined with historically low excess capacity and heightened concerns about supply disruptions. While the higher oil price appears to contain a significant risk premium, there is no firm evidence that increased speculation has contributed to that.
• The oil market is likely to remain tight over the medium term. Demand is projected to grow rapidly, but prospects for increased production are uncertain. Although higher oil prices, if they persist, should encourage investment in the oil sector, impediments remain. These include the experience with the large capacity overhang in the 1980s, the high cost and long gestation periods of investment in the sector, and uncertainties about the long-run demand response to higher prices.
• The impact of the higher oil price on the global economy is likely to be limited. Staff estimates suggest that, on present oil price projections, global activity could be ¼-½ percentage points lower than otherwise in 2005. Even in the highly improbable event that oil prices rise to as high as $80 per barrel, the lower oil intensity and improved policy credibility over the past few decades should prevent the world economy from suffering a recession comparable to that following the oil shocks in the 1970s.
• While most oil-importing developing countries should be able to manage, the oil shock will leave some countries even more vulnerable. The incremental financing needs of oil-importing developing countries are large, but the bulk of the resulting financing gap is expected to be offset by policy adjustments, endogenous changes (for example, in the exchange rate), and reserve drawdown. The Fund stands ready to deal with residual country-specific financing needs as they arise.
• Oil-exporting countries saved most of their estimated $200 billion in higher oil export revenues in 2004. This was reflected in higher current account balances,  reduced external debt, and higher international reserves. The fiscal revenue windfall was about half the size of the export revenue windfall, and governments saved about two-thirds of the extra revenues on average.
• Fund staff has advised member countries to respond prudently, given the uncertain outlook for prices. It has identified general principles that should guide policy responses, although each country.s response will need to take into account its specific circumstances, including its degree of access to international capital, strength of underlying monetary and fiscal regimes, exchange rate regimes, and levels of external debt and other financial vulnerabilities. For example, exporters should smooth their public spending response to higher prices and attempt to find a judicious balance between spending and saving the windfall. Some oil importers will be in a position to finance the higher cost of petroleum imports in the short run, while others will have to adjust more rapidly.
• Consuming and producing countries can contribute to stability in oil markets by strengthening policies to promote energy sustainability and efficiency and working to reduce unnecessary obstacles to oil sector investment. Dialogue between consumers and producers could also help promote stability, including through adequate exchange of information on future supply and demand trends.

The recent increase in oil prices seems to be the result of a secular increase indemand from North America and Asia, combined with historically low excess capacity and heightened concerns about supply disruptions.

The world economic recovery has been the main factor underpinning the rapidincrease in oil demand.4 Global demand grew 3.3 percent or 2.7 mbd in 2004, the highest growth rate since 1976. While demand from the United States and other OECD countries has been strong, demand from Emerging Asia has been growing about three times as fast as in the OECD countries since the fall of 2003. In particular, oil demand by China has been surging, outstripping real GDP growth. This demand growth was largely unanticipated, as typically oil demand has lagged output growth. Notwithstanding the higher oil prices, demand will continue to grow strongly, reflecting global expansion and rapid economic development in Asia (especially China and India). The bulk of this growth will most likelycome from the transportation sector, which remains highly dependent on oil.

The price impact of the supply concerns has likely been magnified by historically low spare capacity. At about 2 million barrels per day, end-2003 global spare capacity for  crude oil production was already lower than at any time since 1991. In 2004, sustained strong demand and supply disruptions reduced spare capacity further, despite an increase in OPEC production. Also, in October 2004 inventories of heating oil in industrial countries were some 20 million barrels below their five-year average.

The likely impact of the higher prices so far

• A number of factors suggest that the economic impact of the most recent increase in oil prices will be less severe than in the past if oil prices stabilize or fall in the period ahead.
• Estimates suggest that global activity could be 0.2-0.5 percentage points lower than otherwise in 2005. A number of important developments since the 1970s influence this outcome:
• To date, the magnitude of the shock has been smaller both in terms of the increase in and level of real oil prices. Currency appreciation vis-à-vis the U.S. dollar has also mitigated the impact of higher oil prices in local currency terms for the euro area and a number of other countries.
• In addition, much of the increase in oil prices so far reflects.and to a large extent, its effects have been moderated by.increased global aggregate demand. As a result, its additional impact on world activity is likely to be smaller than if it were caused primarily by an exogenous supply shock (as in the 1970s).
• Oil intensity has fallen significantly in the past two decades in most countries.
• Inflation expectations are more anchored owing to greater monetary policy credibility and cost-push pressures are limited, reflecting mostly negative output gaps worldwide.
• Most industrial economies have become more flexible.particularly labor markets and financial sophistication.including from hedging practices.has increased.
• Owing to the increased role of market forces.including price liberalization in industrial countries.high oil prices are likely to be less persistent with prices more responsive to weakening global growth than in the 1970s. For example, excess capacity seems to be a much stronger factor in determining oil (prices than in the past). 

The impact on financial markets—in particular dollar-denominated assets, which remain the major form in which oil proceeds are held—should also be limited. While information on the composition of asset holdings is sketchy, there have not yet been significant inflows into U.S. securities markets from oil exporters. Oil exporters represented a small share of foreign inflows into U.S. securities last year: of $30 billion in average monthly inflows into U.S. treasury securities during 2004, only $1.5 billion came from OPEC nations.

Of the $76 billion average of total monthly inflows in 2004, approximately $2.5 billion originated from oil-exporting countries.in contrast to around $30 billion originating from Asia. This is an approximation derived from the published data and does not include any transactions through London, for which information on final buyers is not available. Information on other currency holdings is even more limited and drawing conclusions about specific currencies is difficult. However, given that the total increase in the oil exporters. revenues is relatively small (around $10-15 billion per month for oil exports), a sizable effect on currency markets is unlikely. 

What if—the Likely Impact of Much Higher Oil Prices

Simulation results (based on the MULTIMOD model) suggest that a rise in oil prices to about $80—although very unlikely barring a major unforeseen event—would have considerable adverse effects on most countries, but also illustrate that such an increase is unlikely to throw the world economy into a recession comparable to that following the 1970s shocks.

Given the balance of global supply and demand, it would require a large supply shock to drive prices to $80 per barrel.

The impact of higher oil prices on real GDP growth will be greater for increases perceived to be persistent rather than transitory, and may be higher if business and consumer confidence is damaged. Estimates suggest that GDP growth would be  0.3-0.5 percentage points lower for increases seen as persistent. While it is difficult to predict the effects of uncertainty on confidence, based on experience of the 1970s, a severe fall in confidence could reduce U.S. GDP growth by a further 0.8 percentage points (relative to the base case) in the first year.

In the face of a much larger shock, inflationary expectations may increase significantly and credibility may be threatened. For example, if the price of oil were to rise to $120, U.S. CPI inflation could rise above 5 percent in the first year and GDP growth decline by 2.3 percentage points. In that case delaying interest rate hikes could be costly if inflation expectations were to ratchet upwards, and could result in lower output over the medium term to re-anchor inflation expectations at low levels. 

While it is difficult to estimate the final impact on activity of a rise in prices, especially given uncertainties about the policy response and external financing, the near-term impact of a rise in prices to $80 per barrel in emerging market and developing country regions is likely to be larger than for advanced countries. These results are based on very simple models that capture the impact on consumption nd investment of real income losses and the impact on exports of weaker industrial country growth, both owing to higher oil prices. Interest rate and supply-side effects which are likely to take longer to ave an impact.are incorporated only judgmentally.

Download the report.