Effects of an oil price shock on importing and exporting countries

From the middle of twentieth century, due to exceptional importance of the crude oil in the supply of the world’s energy demands, it has become one of the major indicators of economic activities of the world. Even after the appearance of alternate forms of energy like solar power, water and wind, the importance of crude oil as the main source of energy still cannot be denied.

This sharp increase in the world oil prices and the volatile exchange rates are generally regarded as the factors of discouraging economic growth. Particularly, the very recent highs, recorded in the world oil market bring apprehension about possible slump in the economic growth in both developed and developing countries.

A large number of researchers proposed that exchange rate volatility and oil price fluctuations have considerable consequences on real economic activities. The impact of oil price fluctuation is expected to be different between in oil exporting and in oil importing countries. An oil price increase should be considered as bad news for oil importing countries and good news for oil exporting countries, while the reverse should be expected when the oil price decreases. Through demand and supply transmission mechanism, oil prices impacts the real economic activity. The supply side effects are associated with the fact that crude oil is a basic input to production, and an increase in oil price leads to a rise in production costs ultimately that result in firms’ lower output. Oil prices changes also entail demand-side effects on investment and consumption. Consumption is also affected indirectly through its positive relation with disposable income. Moreover, oil prices have an adverse impact on investment by increasing firms’ costs. On the other hand it is generally recognized that the depreciation of exchange rate would reduce imports and expand exports, while the appreciation of exchange rate would encourage imports and discourage exports. Especially a depreciation of the exchange rate leads to income transfer to exporting countries from importing countries through a shift in the terms of trade.

Since 2003, oil prices increased continuously, even touched the peak of $137 per barrel in July 2008, but after that a declining trend was observed. After 1970s, many negative oil shocks hit the world economies. The first one was during 1973-74 caused by OPEC oil prohibition, and secondly in 1978-79 when the OPEC put restraints on its oil production. This rising trend in oil prices continued until mid 1980s, subsequently, Iraq-Iran war in early 1980s further shoot up the prices. However in 1986, when Saudi Arabia increased its crude oil production, oil price tend to decreased. In 1990s, Iraq-Kuwait war was a major factor of oil price increase but it was ended in a year because of Asian financial crisis. In 1999-2000 the OPEC again narrow its production leading to another price shock. The latest and last oil price shock was started in the year 2003 which continued till July 2008. In other words, oil prices have always remained quite volatile.

According to report of IEA (2004) , these price shocks have raised serious concerns among the policy makers all over the world. The adverse economic impact of higher oil prices on oil-importing developing countries is generally considered as more worse than for the developed countries because of their more reliance on imported oil and are more energy-intensive. Malik. A (2007) also mentioned in her research that, the recent surge in the oil prices especially after 2000 has worried many economists about its possible adverse impacts. This increasing trend in the oil prices has hurt many of the economies worldwide including that of Pakistan, in terms of creating inflationary pressures, increasing budget deficit and balance of payment problems.

According to ADB (2005) report, supply, demand, and speculative factors, and their interrelationships, all leads towards the steady rise in oil prices. From the last many years, all over the world, the demand for oil grew due to economic strength and growth in the US, as well as strong economic performance in developing Asian countries specially China and India. From 1990’s to 2003 global demand for oil grew at the rate of 1.3 % whereas for the People Republic of China and India the combined rates is at 7 % and accounted for almost 40 percent of the demand growth.

There are various empirical literatures, investigating the relationship between oil price variations and economic growth. The existence of a negative relationship between macro-economic activities and oil prices has become widely accepted especially after Hamilton’s 1983 work. He pointed out that increase in oil prices, reduced US output growth from 1948 to 1980. Hamilton’s findings have been confirmed and extended by many authors and researcher. Hooker (1996) confirmed and extended Hamilton’s work for the period 1948 to 1972 and demonstrated that the oil price level and its changes do reflect the influence on GDP growth. This is shown in the third and fourth quarters after the shock that rise of 10% in oil prices lead to a GDP growth decrease of approximately 0.6 %. Accordingly, Lee et al. (1995) Mork (1989), and Hamilton (1996) presented the non-linear transformations of oil prices to re-establish the negative association between oil prices increases and economic decline, as well as these researchers also analyzed Granger causality between both variables. The result of Granger causality test proved that oil prices Granger cause U.S. economy before 1973 but no longer Granger cause was found from 1973 to 1994. Recently, Hamilton (2003) and Jimenez and Rodríguez (2004) also confirms the non-linear relationship between the economic growth of U.S. economy and increases of oil prices

The quantitative exercise conducted by the IEA in alliance with the OECD (Organization for Economic Co-operation and development) department of Economics and with the assistance of IMF Research department in 2004, indicated that a continued $10 per barrel increase in oil price would result in the decrease of about 0.4 % OECD as a whole, in the first and second years of higher prices. Inflation would increase by half a percentage and unemployment would also increase in this case. The OECD imported the oil at a cost of over $260 billion in 2003 which is 20% more than its 2001 oil need. European countries, which are highly dependent on oil imports, would suffer most in the short term, their GDP dropping by 0.5% and inflation rising by 0.5% in 2004. The U.S would suffer the least, with GDP falling by 0.3%, because its indigenous production meets a bigger share of its oil needs. Japan’s GDP would fall 0.4%, This analysis assumes constant exchange rates and economic growth for the US economy.

The present paper is the extension of the existing empirical literature in two directions. First, we have not focused on the oil importing US economy only , rather we analyzed the effects of an oil price shock in two different type of countries which include five oil exporting countries i.e. Saudi Arabia, Norway, Venezuela, Kuwait , Nigeria and five oil importing country i.e. Pakistan, India , China, Japan , Germany. Secondly, we will not only demonstrate the relationship between oil prices and real economic growth but we will also analyze the role of the real exchange rate for real economic growth.

Oil Importing Countries

China

China’s real GDP has increased continuously at surprising rate of 10% per year in recent years. Simultaneously with strong economic growth, its demand for energy is also surging rapidly. The figure 1 clearly shows about the oil consumption and production behavior of the country which tends the country to import from different countries. China produces 3798 thousand barrels per day and consumes 8200 thousand barrels per day of oil in 2009. This means that China has to import roughly 4402 thousand barrels per day to meet its consumption needs per day. In the year 2007, China was declared as the world’s third largest net importer of oil behind the U.S and Japan. In July 2005, the reform of the exchange rate system was introduced by the central bank of China. After the reforms, the exchange rate of yuan was set according to a basket of other currencies. At the end of 2007, the yuan was appreciated by 7.5% approx. against the dollar, in consequence of these reforms.

India

According to the Oil & Gas Journal (OGJ), India had second-largest amount of proven oil reserves i.e. 5.6 billion barrels in the Asia-Pacific region after China as of January 2009. With the high rates of economic growth and over 15 % of the world’s population, India has become one of the important consumer of energy resources. In 2006, India was the sixth largest oil consumption country of the world. The global financial and credit crises have slowed India’s significant economic growth particularly in its manufacturing sector. Due to this crunch, the GDP growth rates have turn down from 9.3 percent in 2007 to 5.3 % in the last quarter of 2008. Despite of this slow economic growth, India’s energy demand continues to rise. India is developing into an open-market economy now but traces of its past autarkic policies remain. The accelerated country growth was averaged at 7% since 1997 and the main factor behind this was economic liberalization, including reduced controls on foreign trade and investment, began in the early 1990s. An industrial slowdown early in 2008, followed by the global financial crisis, led annual GDP growth to slow to 6.5% in 2009, still the second highest growth in the world among major economies. The government abandoned its deficit target and allowed the deficit to reach 6.8% of GDP in FY10. Nevertheless, as shares of GDP, both government spending and taxation are among the lowest in the world. From the figure 2 it can easily be observed that the production of crude oil is not upto that level to meet consumer demand which tends the country to import from outsiders. From 1996 onward India is producing oil approximately with the same trend but consumption is increasing day by day. India produced 680.4 thousand bbl/d of total oil in 2009, of which approximately 650 thousand bbl/d was crude oil, with the rest of production resulting from other liquids and refinery gain. India has over 3,600 operating oil wells, according to OGJ. Although oil production in India has slightly trended upwards in recent years, it has failed to keep pace with demand and is expected by the EIA to decline slightly in 2009. India’s oil consumption has continued to be robust in recent years. In 2007, India consumed approximately 2.8 million bbl/d, making it the fifth largest consumer of oil in the world. In 2006, India was the seventh largest net importer of oil in the world. The EIA expects India to become the fourth largest net importer of oil in the world by 2025, behind the United States, China, and Japan.

On the other hand the Govt of India control its exchange rate and after 2002 reforms , it tends to decrease and Indian currency tends to appreciate.

Japan

In the years following World War II, government-industry cooperation, a strong work ethic, mastery of high technology, and a comparatively small defense allocation (1% of GDP) helped Japan develop a technologically advanced economy. Today, measured on a purchasing power parity basis, Japan is the third-largest economy in the world after the US and China; measured by official exchange rates, however, Japan is the second largest economy in the world behind the US. Japan has virtually no domestic oil or natural gas reserves and is the second-largest net importer of crude oil and largest net importer of liquefied natural gas in the world. Including nuclear power, Japan is still only 16 percent energy self-sufficient. Japan remains one of the major exporters of energy-sector capital equipment and Japanese companies provide engineering, construction, and project management services for energy projects around the world. Japan has a strong energy research and development program that is supported by the government. Oil is the most consumed energy resource in Japan, although its share of total energy consumption has declined by about 30 percent since the 1970s. The figure 3 clearly shows about the oil consumption and production behavior of the country which tends the country to depends heavily on imports from different countries. Japan Oil production is very low and in 2009 it produces only 5.3 thousand barrels per day which is very low as compare to its consumption demand i.e. 4362.9 thousands barrel per day in 2009. This means that Japan has to import roughly 4357.02 thousand barrels per day to meet its consumption needs per day. Due to its gap between domestic consumption and production, Japan remains the second-largest net importer of oil after the United States. After 1970’s Japan shows the declining trend in its exchange rate with dollar which means that dollar depreciate against Japanese yen. Growth slowed markedly in the 1990s, averaging just 1.7%, largely because of the after effects of inefficient investment and an asset price bubble in the late 1980s that required a protracted period of time for firms to reduce excess debt, capital, and labor. In October 2007 Japan’s longest post-war period of economic expansion ended after 69 months and Japan entered into recession in 2008, with 2009 marking a return to near 0% interest rates.

Germany

The German economy – the fifth largest economy in the world in PPP terms and Europe’s largest – is a leading exporter of machinery, vehicles, chemicals, and household equipment and benefits from a highly skilled labor force. GDP grew just over 1% in 2008 and contracted roughly 5% in 2009. Germany crept out of recession in the second and third quarters of 2009, thanks largely to rebounding manufacturing orders and exports – primarily outside the Euro Zone – and relatively steady consumer demand. The German economy probably will recover to about 1.5% growth for the year 2010. Because of Germany’s monetary dilemma, and because the German government as well as the nation’s bankers and industrialists have recognized German limitations and vulnerabilities, the exchange rate of the country remain very stable from the last many years against dollar. However, If we see the Figure 4, we can easily judge the oil consumption and production behavior of the German economy. In the year 2009 the total oil production was 30.8 thousand barrels per day while the consumption was 2,437 Thousand barrel per day. This means that roughly country had to imported 2406.2 thousand barrel per day of oil from other nations. As with the passage of time it reduces its consumption of oil due to environmental reforms but to fill the gap of Oil production and consumption, country have to rely heavily on oil imports.

Pakistan

Pakistan, an impoverished and underdeveloped country, has suffered from decades of internal political disputes and low levels of foreign investment. Between 2001-07, however, poverty levels decreased by 10%, as Islamabad steadily raised development spending. Between 2004-07, GDP growth in the 5-8% range was spurred by gains in the industrial and service sectors – despite severe electricity shortfalls – but growth slowed in 2008-09 and unemployment rose. Inflation remains the top concern among the public, jumping from 7.7% in 2007 to 20.3% in 2008, and 14.2% in 2009. In addition, the Pakistani rupee has depreciated since 2007 as a result of political and economic instability. The government agreed to an International Monetary Fund Standby Arrangement in November 2008 in response to a balance of payments crisis, but during 2009 its current account strengthened and foreign exchange reserves stabilized – largely because of lower oil prices and record remittances from workers abroad. Figure 5 of oil consumption and production shows that Pakistan is not reach in oil production however, the ratio is quite good than other advanced economies. The consumption of oil in the year 2009 was 373 thousand barrel per day which was less as compare to 2008 i.e.396 thousand barrels per day.

Oil Exporting Countries

Kuwait

Kuwait is one of the world’s top exporters of oil, with about 2.4 million barrels per day exported in 2008. Kuwait’s economy is heavily dependent on oil export revenues which account for roughly 90 percent of total export earnings. Kuwait channels around 10 percent of its oil revenues into the “Future Generations Fund” for the day when oil income runs out.

The Kuwaiti constitution forbids foreign ownership of Kuwait’s mineral resources. The Kuwaiti Parliament passed the “Foreign Direct Investment Act” in 2001, aimed at promoting foreign investment in Kuwait’s oil and gas sectors, which facilitated some development in those sectors. Kuwait has a geographically small, but wealthy, relatively open economy with self-reported crude oil reserves of about 102 billion barrels – about 9% of world reserves. Petroleum accounts for nearly half of GDP, 95% of export revenues, and 95% of government income. Kuwaiti officials have committed to increasing oil production to 4 million barrels per day by 2020. Kuwait survived the economic crisis on the strength of budget surpluses generated by high oil prices, posting its tenth consecutive budget surplus in 2008, before slipping into deficit territory in 2009. Foreign exchange rates of Kuwaiti dinar are quite stable if compared with dollar. Figure 6 above shows the production and consumption capacity of the country which clearly depicts the exporting behavior of the country. In the year 2009 the total oil production was 2350 thousand barrels per day where as consumption was only 320 thousand barrels per day which allow the country to export the oil to other nations and increase their income level. From the figure the it can also seen the how Iraq- Kuwait war in 1992 impact the Kuwaiti oil market and its production.

Venezuela

Venezuela is one of the world’s largest exporters of crude oil and the largest in the Western Hemisphere. In 2008, the country was the eighth-largest net oil exporter in the world. The oil sector is of central importance to the Venezuelan economy. Venezuela remains highly dependent on oil revenues, which account for roughly 90% of export earnings, about 50% of the federal budget revenues, and around 30% of GDP. A nationwide strike between December 2002 and February 2003 had far-reaching economic consequences – real GDP declined by around 9% in 2002 and 8% in 2003 – but economic output since then has recovered strongly. President Hugo CHAVEZ in 2008-09 continued efforts to increase the government’s control of the economy by nationalizing firms in the agribusiness, banking, tourism, oil, cement, and steel sectors. In 2007, he nationalized firms in the petroleum, communications, and electricity sectors. In January, 2010, CHAVEZ announced a dual exchange rate system for the fixed rate bolivar. The system offers a 2.6 bolivar per dollar rate for imports of essentials, including food, medicine, and industrial machinery, and a 4.3 bolivar per dollar rate for imports of other products, including cars and telephones.

The nation is also the fifth largest member of the OPEC, in terms of production. As a result of its bountiful natural resources, Venezuela’s economy has been one of the most thriving economies in South America. According to Oil and Gas Journal (OGJ), Venezuela had 99.4 billion barrels of proven oil reserves in 2010, the largest amount in South America. Figure 7 shows that Venezuela’s production of crude oil has fallen, while domestic consumption has risen, causing a decline in net oil exports.

Saudi Arabia

Saudi Arabia is the birthplace of Islam and home to Islam’s two holiest shrines in Mecca and Medina. Saudi Arabia has an oil-based economy with strong government controls over major economic activities. It possesses about 20% of the world’s proven petroleum reserves, ranks as the largest exporter of petroleum, and plays a leading role in OPEC. The petroleum sector accounts for roughly 80% of budget revenues, 45% of GDP, and 90% of export earnings. Roughly 5.5 million foreign workers play an important role in the Saudi economy, particularly in the oil and service sectors, while Riyadh is struggling to reduce unemployment among its own nationals. Five years of high oil prices during 2004-08 gave the Kingdom ample financial reserves to manage the impact of the global financial crisis, but tight international credit, falling oil prices, and the global economic slowdown reduced Saudi economic growth in 2009, prompting the postponement of some economic development projects. Saudi Arabia is the world’s largest producer and exporter of total petroleum liquids, and the world’s second largest crude oil producer behind Russia. Saudi Arabia’s economy remains heavily dependent on oil and petroleum-related industries, including petrochemicals and petroleum refining. Oil export revenues have accounted for around 90 percent of total Saudi export earnings and state revenues and above 40 percent of the country’s gross domestic product (GDP). Figure 8 shows the Suaid Oil production and consumption behavior. It is the largest consumer of petroleum in the Middle East, particularly in the area of transportation fuels. Domestic consumption growth has been spurred by the economic boom due to historically high oil prices and large fuel subsidies. In 2006, Saudi Arabia was the 15th largest consumer of total primary energy, of which 60 percent was petroleum-based. The remainder was made up of natural gas, the growth of which has been limited by supply constraints. The graph also depicts the same behavior of consumption and production Saudi Currency is one of the stable currencies as compared to dollar from the last decade.

Norway

Norway is the world’s third-largest gas exporter, its position as an oil exporter has slipped to seventh-largest as production has begun to decline. Norway opted to stay out of the EU during a referendum in November 1994; nonetheless, as a member of the European Economic Area, it contributes sizably to the EU budget. In anticipation of eventual declines in oil and gas production, Norway saves almost all state revenue from the petroleum sector in a sovereign wealth fund. After lackluster growth of less than 1.5% in 2002-03, GDP growth picked up to 2.5-6.2% in 2004-07, partly due to higher oil prices. Growth fell to 2.1% in 2008, and the economy contracted by 1% in 2009 as a result of the slowing world economy and the drop in oil prices.

According to the Oil and Gas Journal (OGJ), Norway had 6.7 billion barrels of proven oil reserves as of January 1, 2009, the largest oil reserves in Western Europe. Norway produced about 2067 thousand barrels per day (bbl/d) in 2009 and consumed about 220.2 thousand barrel per day (Figure 9).From 2004 onward the trend shows that Oil production is declining day by day but the good sign is that consumption trend is not showing many fluctuations however, there is hope that new developments in the Barents Sea and increasing the production of existing fields will offset some of the recent declines. In 2008, Norway was the sixth-largest net oil exporter in the world, exporting about 2.25 million bbl/d. According to EIA, Norway exported an estimated 2.25 million bbl/d of crude oil and petroleum products in 2008, down from 2.34 million bbl/d in 2007. According to Statistics Norway, the amount of crude oil alone exported in 2008 was 1.83 million bbl/d. The largest single recipient of Norwegian oil was the United Kingdom, which imported 35 percent of Norway’s total oil exports. Norway currency was also depreciated in 2007-08 but again appreciated in 2009 as compared to dollar.

Nigeria

British influence and control over what would become Nigeria and Africa’s most populous country grew through the 19th century. Following nearly 16 years of military rule, a new constitution was adopted in 1999, and a peaceful transition to civilian government was completed. Oil-rich Nigeria, long hobbled by political instability, corruption, inadequate infrastructure, and poor macroeconomic management, has undertaken several reforms over the past decade. Nigeria’s former military rulers failed to diversify the economy away from its overdependence on the capital-intensive oil sector, which provides 95% of foreign exchange earnings and about 80% of budgetary revenues. Based largely on increased oil exports and high global crude prices, GDP rose strongly in 2007-09. The Nigerian economy is heavily dependent on the oil sector which, according to the International Monetary Fund (IMF), accounts for over 95 percent of export earnings and about 65 percent of government revenues. Figure 10 shows the oil production and consumption of the country. The graph shows the decreasing trend in the production si de, hence less oil will be available to export. In 2009, total oil production in Nigeria was slightly over 2.2 million bbl/d, making it the largest oil producer in Africa. Crude oil production averaged 1.8 million bbl/d for the year. According to the Oil and Gas Journal, Nigeria had an estimated 37.2 billion barrels of proven oil reserves as of January 2010.Since December 2005, Nigeria has experienced increased pipeline vandalism, kidnappings and militant takeovers of oil facilities in the Niger Delta. The Movement for the Emancipation of the Niger Delta (MEND) is the main group attacking oil infrastructure for political objectives, claiming to seek a redistribution of oil wealth and greater local control of the sector. Additionally, kidnappings of oil workers for ransom are common. Security concerns have led some oil services firms to pull out of the country and oil workers unions to threaten strikes over security issues. The instability in the Niger Delta has caused significant amounts of shut-in production and several companies to declare force majeure on oil shipments. Nigeria is an important oil supplier to the United States. Close to 40 percent of the country’s oil production is exported to the United States. Currency of Nigeria is also not as much stable and was highly depreciated in 2009 against dollar.

Despite the general recognition that oil price and real exchange rate plays an important role in economic growth, a comparative analysis on the impact of oil prices and exchange rate on oil export country and oil import country is still few. In this paper we firstly take the natural log to eradicate the problem of after that we have checked the descriptive statistics of the data. After descriptive analysis we then employed ADF test to check the stationarity of data. After checking stationarity of data we employed AIC test and then Co-integration. Granger Casualty test was employed at the end to investigate whether the oil price and real exchange rate Granger cause to the economic growth in all of our oil importing and exporting countries. Moreover, the vector autoregressive (VAR) modeling with co-integration techniques is applied to examine how real GDP in all our sample countries are affected by changes in international oil prices and the real exchange rate of these countries in the long-run. Finally, a vector error correction model (VECM) will be employed to analyze the short-run dynamics of these variables.