Escalating oil prices and the global economy

¶ … Oil Prices & Global Economy

Due to the increasing worldwide use of and dependence on oil, it naturally follows that its price greatly affects the global economy. An examination of general and historical effects of oil shocks; present global, regional, and national circumstances; and future presumptions affords a better understanding of the bi-directional relationship between oil prices and the global economy. Of particular interest are the macro-economic consequences that escalating oil prices present.

As stated, global economic performance is largely determined by oil prices. It is not surprising that oil price surges affect various economies differently. Escalating oil prices lead to a general redistribution of income in that it is transferred from importing oil countries to exporting oil nations (Birol, 2004, 3). It is important to note, however, that although economic growth in importing oil countries during oil price hikes takes place, it has historically 'been less than the loss of economic growth in importing countries' (Birol, 2004, p.4). In other words, during oil price hikes, global net growth has always been negative.

For importing oil countries, the effects of rising oil prices on economic growth depend on several factors. First, 'the size of the shock, both in terms of the new real price of oil and the percentage increase in oil prices' (Roubini & Setser, 2004, p. 1) is an important determinant of the economic impact on these countries. Second, the speed with which oil prices rise greatly impacts importing oil economies; they better adjusted to slowly rising prices than those that escalate sharply. A third factor is the longevity of an oil shock; the longer the prices remain high, the more likely such conditions will negatively affect economic growth in importing oil nations. Naturally, an economy's dependency on oil has great influence over the effects of a price hike. Lastly, fiscal and monetary responses shape the course of an economy's growth during periods of mounting oil prices. Domestic policy reactions establish the degree of success with which a nation manages changes in oil prices.

While importing oil countries typically undergo declining economic growth during oil price hikes, exporting oil countries generally experience robust economic growth. 'For net oil-exporting countries, a price increase directly increases real national income through higher export earnings' (Birol, 2004, p.3). It is reasonable that during times of escalating oil prices, oil-exporting countries are able to spend more freely than during oil price slumps. However, 'the impact of higher oil prices on growth and activity in oil producing countries will depend on a variety of factors, most importantly how these windfall oil revenues are spent' (IMF, 2000, p. 24). Some nations may elect to replenish their caches while others may utilize the additional income to curb spending restraints in the future -- for example, during periods of waning oil prices (IMF, 2000, p. 26). Moreover, exporting oil nations may capitalize on 'lower external borrowing costs' (IMF, 2000, p. 26) during periods of rising oil prices.

Macro-economic history clearly illustrates the transfer of income during oil shocks. The above said effects on importing oil countries were evident with the 1973 oil price increase as 'direct terms of trade loss...[were] equivalent to around 2 1/2% of GDP in the OECD [Organization for Economic Cooperation and Development] area' (IMF, 2000, p. 37). Conversely, OPEC countries experienced an economic boom during this period. The oil shock of 1979, during which the price of oil doubled within 2 quarters, also contributed to a global recession; the GDP of advanced countries fell 3 1/2% (IMF, 2000, p. 42) while affording exporting oil countries another period of economic growth. Per the EIA (2005), 'OPEC net oil export revenues (in constant $2,005) [were] $3.0 trillion in the 1970s' (p. 7). 'The experience from the earlier large oil price hikes has shown that such increases, particularly when they turn out to be persistent, can significantly increase global inflationary pressures and reduce global demand and output growth, as the fall in aggregate demand in oil importers exceeds the rise in demand from oil exporters' (IMF, 2000, p.43).

While the first two oil shocks created acute and persistent economic effects, the third and fourth oil shocks produced milder consequences. Two reasons for this change were more efficient oil use by developed countries and a reduction of their oil dependency. In fact, 'developed countries [currently] use half as much oil per real dollar of GDP as in the mid-1970s' (The Economist, 2005, p. 56). What's more, importing oil countries now possess substantial reserves in order to cushion themselves from volatile oil markets. Another variable during this period was a lower level of existing inflation than what was present during the first oil shocks. As a result of these factors, there was a slighter setback in output for these countries during the second wave of oil price spikes. Hence, the 1990 and 2000 oil shocks led to a mild global recession, the former with a -.5% of GNP of OECD (OECD Economic Outlook, 1990, p.1). While importing oil countries' growth was receding during this period, 'OPEC net oil export revenues (in constant $2,005) were $1.7 trillion' (EIA, 2005, p. 7). Despite the softer global effects during this era, incidents of climbing oil prices are never inconsequential and may wreak economic havoc at any given moment. In fact, Roubini & Setser (2004) claim 'oil shocks have caused and/or contributed to each one of the...global recessions of the last thirty years' (p.1).

As outlined, rising oil prices have been an important determinant of economic performance, with a typically inverse relationship between oil prices and global growth. The 'global price of oil has tripled since late 2001, closing last week at $68 per barrel' (Wehrfritz, 2005, p.1). However, currently rising oil prices are impacting the global economy in an interesting manner. Despite escalating oil prices, global demand has actually increased 'from 70 million barrels per day (bpd) to above 82 million bpd in the past 10 years' (Grewal, 2005, p.1). In fact, 'last year's increase in global oil consumption was the biggest for almost 30 years' (The Economist, 2005, p. 57). The reasons for an increased oil demand in conjunction with expensive oil are manifold and vary by region and nation. Most notable, however, are the striking differences between developed and developing nations' abilities to handle the current situation.

A recent U.N. report states that developed nations are better 'able to absorb rising oil prices' (Schlein, 2005, p. 1). Not surprisingly, this is due partially to less dependency on oil coupled with more efficient energy use. In addition, oil price increases have occurred gradually -- over a year and a half, 'giving households and firms more time to adjust...doing less damage to their confidence and finances and hence to economic activity' (The Economist, 2005, p.56). Another explanation for the current phenomenon is that 'in real terms oil is not terribly expensive' (The Economist, 2005, p.56). Worldwide inflation, which generally tends to rise along with oil prices, is currently subdued, 'thanks partly to global competitive pressures from China and elsewhere' (The Economist, 2005, p. 59). However, 'the economic impact of higher oil prices varies considerably across OECD countries, largely according to the degree to which they are net importers of oil' (Birol, 2004, p.6).

The current consequences of escalating oil prices are less severe in North America than in other regions. The United States, which, according to Huber & Mills (2005), 'consumes about 7 billion barrels of oil a year' (p.53) and which, per Grewel (2005), translates into '25% of total global oil demand' (p.1) is the most vulnerable of all countries in this region to feel the shock of escalating oil prices. Furthermore, Ellson states that 'American economists estimate that Katrina will result in a loss of activity of 0.25 to.50 per cent of GDP in the second half of the year' (p.1). Despite this, the effects of escalating oil prices on the U.S. are presumed to be minimal, even in the wake of Katrina, which 'will have only a temporary impact on oil prices' (Schlein, 2005, p. 1). Factoring in the effects of Katrina, 'the OECD predicted that the American economy would grow by' (Ellson, 2005, p. 1) over 3% in 2005.

Rising oil prices are jeopardizing the economic growth of some developed countries. Euro-zone countries, which are large net importers of oil, will suffer the most of OECD countries in the short-term (Birol, 2004, p.6). Wielaard (2005), quoting the European Commission, indicates 'the surge in oil prices threatens growth in Europe and could be a blow to already faltering efforts to reform Europe's economy and make it more dynamic in the years ahead' (p.1). This situation poses an immediate concern for those countries of the European Union, which rely heavily on imported oil. In particular, the U.K. is believed to suffer an economic downturn this year bearing significant repercussions as 'the OECD downgraded its prediction for 2005 UK growth to 1.9 per cent form 2.4 per cent' (Ellson, 2005, p.1). What's more, high oil prices expect to stunt growth in Italy and Germany. The implications of this vulnerability to volatile oil prices is simple; 'high crude prices must encourage European governments to make investments in energy sources other than oil' (Wielaard, 2005, p.1).

The negative economic impact of rising oil prices is typically more severe for developing countries than for OECD (Birol, 2004, p.2). This is currently the case as high oil prices 'are badly affecting many developing countries' (Schlein, 2005, p. 1). The U.N. Conference on Trade and Development (UNCTAD) recently stated that 'the high cost of oil is placing a heavy burden on poorer nations that spend around five-percent of their gross domestic product on oil. This, compared with the two-to-four percent that wealthier nations pay' (Schlein, 2005, p.1).

There are several reasons why oil-importing developing countries struggle more over high oil prices than their developed counterparts. Energy dependency and intensity is greater in developing nations than developed ones; this is due to a high level of industrialization and urbanization. Furthermore, energy is used less efficiently in these nations than in developed ones. 'On average, oil-importing developing countries use more than twice as much oil to produce a unit of economic output as do OECD countries' (Birol, 2004, p.2). The amount of debt a developing country carries also profoundly affects its ability to effectively manage rising oil prices. Lastly, developing countries are not able to promptly switch to alternative fuels in order to relieve the burden of escalating oil prices. Essentially, all of the energy resources and mechanisms that developed countries have in place are lacking in developing nations, thereby crippling their ability to surmount oil shocks. In light of the stress high oil prices put on developing countries, the UNCTAD advises them 'to use recent windfall gains from higher commodity earnings as an opportunity to step up investment in infrastructure and manufacturing capacity' (Schlein, 2005, p.2), which are deemed crucial for continued development.

Adverse effects are readily evident in developing nations' economies. There is already a slowdown in China's economy, largely due to domestic policy that renders energy artificially cheap. 'Petrochemicals are a critical raw material across the spectrum of manufacturing, so costlier oil would have an immediate inflationary impact' (Wehrfritz, 2005, p.23). India is in a similar predicament. Currently, it 'relies on imports for 70% of its crude, and unless the global price falls, the cost that subsidies impose on Indian oil companies is forecast to hit $9.15 billion this year' (Wehrfritz, 2005, p.23). The cost of subsidized oil 'is expected to reach $14 billion, or 2.4% of GDP this year' (Wehrfritz, 2005, p.24). In South Korea, higher energy prices may take the nation into a recession (Wehrfritz, 2005, p.24).

Considering the recent increases in oil prices and its varying consequences on individual nations, it is not surprising that the global economy has reflected such changes. In April, IMF stated 'world growth would slip to 4.3% from last year's 5.1%' (MSNBC, 2005, p.1). More recently, however, the UNCTAD found 'the world economy grew by almost four percent last year, the best performance since 2000. But, this is expected to drop to three percent in 2005' (Schlein, 2005, p. 2). Furthermore, 'according to the IMF's model, an increase of $10 a barrel in oil prices should knock three-fifths of a percentage point off the world's output in the following year' (The Economist, 2005, p. 57). Others view the situation more severely: 'the OECD has compared the soaring cost of oil to the price spikes that shook the world economy in the 1970s and warned that today's high energy costs could derail global growth' (Ellson, 2005, p.1).