Vulnerability to Oil Price Increases

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1 Extractive Industries and Development Series #1 August 2008 Vulnerability to Oil Price Increases Public Disclosure Authorized Public Disclosure Authorized Public Disclosure Authorized A Decomposition Public Disclosure Authorized Analysis of 161 Countries Robert Bacon and Masami Kojima

2 The Oil, Gas, and Mining Policy Division series publishes reviews and analyses of sector experience from around the world as well as new findings from analytical work. It places particular emphasis on how the experience and knowledge gained relates to developing country policy makers, communities affected by extractive industries, extractive industry enterprises, and civil society organizations. We hope to see this series inform a wide range of interested parties on the opportunities as well as the risks presented by the sector. World Bank Group s Oil, Gas, and Mining Policy Division Oil, Gas, Mining, and Chemicals Department A joint service of the World Bank Group and the International Finance Corporation The findings, interpretations, and conclusions expressed in this paper are entirely those of the authors and should not be attributed in any manner to the World Bank or its affiliated organizations, or to members of its Board of Executive Directors or the countries they represent. The World Bank does not guarantee the accuracy of the data included in this publication and accepts no responsibility whatsoever for any consequence of their use.

3 Extractive Industries and Development Series #1 August 2008 Vulnerability to Oil Price Increases A Decomposition Analysis of 161 Countries Robert Bacon and Masami Kojima Extractive Industries for Development Series

4 COPYRIGHT (OR /oil OR /gas OR /mining) (OR /oil OR /gas OR /mining) Cover Photos: Oil rig, hematite-banded ironstone, LNG tanker.

5 TABLE OF CONTENTS v vi vii Foreword Acknowledgments Abbreviations Executive Summary Introduction Methodology Vulnerability and Why It Matters Components of Vulnerability to Oil Prices Decomposition of Changes in Vulnerability Data and Sources Results Trends in Contributing Factors Vulnerability Levels and Changes Results of the Decomposition Analysis Conclusions Appendix 1: Refined Laspeyres Index Decomposition Technique Appendix 2: Vulnerability Levels and Decomposition by Country References Extractive Industries for Development Series iii

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7 FOREWORD Between January 2002 and July 2008, world oil prices increased sevenfold. Because countries use oil across all sectors of their economies, rising oil prices have large effects. This study was undertaken as part of a broader program examining the impact of higher oil prices and the policy responses to oil price increases. It looks at the effects of changing oil prices and of net volumes of traded oil on countries vulnerability to rising oil prices defined here as the percentage of gross domestic product spent on importing oil in 161 countries between 1996 and For net oil importers, this percentage generally rose, increasing their vulnerability during the study period. By contrast, net oil exporters benefited from rising prices. Lower-middle-income countries were the most vulnerable to rising oil prices, followed by low-income countries. The study breaks vulnerability down into several contributing factors. Vulnerability is first split into production effects and consumption effects. For countries that do not produce oil, the production effects are zero. Consumption effects are always non-zero, because all countries consume oil. Consumption effects are then broken down to account for the effects of the higher oil prices, the changing share of oil in energy, the changing energy intensity of the economy, and the changing real exchange rate. Everything else being equal, the higher the share of oil in energy, the higher the energy intensity, and the lower the real exchange rate, then the higher the vulnerability to rising oil prices. The study finds that oil intensity (a product of the share of oil in energy and energy intensity) declined in more than 70 percent of the sample countries between 1996 and In 46 countries, however, oil intensity increased, exacerbating the impact of higher oil prices. In both 1996 and 2006, highincome countries that do not belong to the Organisation for Economic Co-operation and Development had the highest oil intensity, followed by lower-middle-income countries. Low-income countries had the lowest oil intensity in 1996, but countries of the Organisation for Economic Co-operation and Development reduced their oil intensity more than low-income countries and showed slightly lower oil intensity by The weakening dollar helped reduce vulnerability in 89 percent of the countries. Government policy instruments can, to varying degrees, influence import dependence, the share of oil in energy, the economy s energy intensity, and the exchange rate. Countries can reduce the share of oil in energy by diversifying away from oil, increasing the efficiency of oil use, and reducing net demand for oil-consuming activities. Similarly, countries can lower energy intensity by improving efficiency, managing demand, and moving the economy toward less energy-intensive sectors. Future work will examine what approaches have been effective in helping to mitigate countries rising vulnerability resulting from oil price increases and what policies have been successful with regard to implementing these measures. Somit Varma Director Oil, Gas, Mining, and Chemicals Department Extractive Industries for Development Series v

8 ACKNOWLEDGMENTS The authors wish to thank Ferdinand Vinuya for providing research assistance. The paper has also benefited from comments by Delfin Sa Go, Donald Laron, and Hassan Zaman, all of the World Bank. Alice Faintich of the Word Doctor edited the document, and Esther Petrilli-Massey of the World Bank oversaw the report production. vi VULNERABILITY TO OIL PRICE INCREASES

9 ABBREVIATIONS Btu EIA ESMAP GDP IEA OECD PPP WTI British thermal units Energy Information Administration Energy Sector Management Assistance Program gross domestic product International Energy Agency Organisation for Economic Co-operation and development purchasing power parity West Texas Intermediate Extractive Industries for Development Series vii

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11 EXECUTIVE SUMMARY This paper examines the levels of and changes in vulnerability to oil price increases between 1996 and 2006 in 161 countries for which data are available. Vulnerability defined here as the ratio of the value of net oil imports to gross domestic product (GDP) rises if oil consumption increases and oil production decreases per unit of GDP. By comparing the level of vulnerability of different economies at a point in time, those that are particularly vulnerable to oil price increases can be highlighted. This enables consideration of the factors (variables) that help determine the magnitude of vulnerability. Over time economies change in ways that may make them more vulnerable to oil price increases or less so, and the change in vulnerability will be related to changes in the underlying variables. The analysis this paper uses is a starting point for linking these factors. To gain an understanding of the relative contributions of different factors influencing vulnerability, the study uses a refined Laspeyres index to decompose the change in a country s vulnerability between any two years into the sum of the effects of changes in seven parameters, four related to oil consumption and three related to oil production. The consumption-related factors are the changes in the price of oil, the share of oil in total commercial energy consumption, the ratio of commercial energy consumed to GDP (referred to as energy intensity), and the proxy real exchange rate (the ratio of the nominal exchange rates in the two years divided by the ratio of local GDP price deflators). The production-related factors are the changes in the price of oil, the level of oil production, and the inverse of GDP. During the period under review, the oil share of energy declined only slightly on average, but energy intensity fell markedly in the 161 countries studied. As a result, the consumption of oil per unit of GDP declined. The proxy real exchange rate appreciated against the U.S. dollar in 81 percent of the countries. Vulnerability increased in nearly 80 percent of the countries, with several countries registering an increase of more than 10 percentage points of GDP. Most of the worst hit countries were not oil producers and had high oil vulnerability in The 15 large economies with the highest per capita GDP in 1996 saw only moderate changes in vulnerability, an increase of up to 2 percentage points of GDP. All 14 countries that had the lowest per capita GDP in 1996 experienced higher vulnerability in 2006, in 2 of the countries by more than 10 percentage points of GDP. As concerns the contribution of oil consumption to vulnerability, changes in the proxy real exchange rate helped offset the effects of higher Extractive Industries for Development Series 1

12 oil prices in nearly 90 percent of the countries, with an offset of more than 40 percent in 43 countries. Declining oil intensity also helped offset the price effect in 71 percent of the countries. In 10 percent of the countries, however, increasing oil intensity equaled 25 percent or more of the price effect. For oil producers, everything else being equal, higher oil prices decrease vulnerability arising from production. About a third of oil-producing countries experienced declines in oil production during A comparison of 12 countries with large reductions in output showed that the combined impact of lower output and higher GDP offset the oil price increase, resulting in a net increase in vulnerability related to production in 3 countries. The net effect of consumption was to increase vulnerability in every country, and aggregate vulnerability (the sum of production and consumption effects) increased in 8 of these 12 oil-producing countries. Of the 84 countries that produced oil in both 1996 and 2006, changes in oil intensity increased vulnerability in 19 percent of the countries, but among the 63 countries that did not produce oil in either year, changes in oil intensity increased vulnerability in 41 percent. Oil production helped lower vulnerability in 72 countries. In only five countries did both production and consumption effects help to lower vulnerability. The study also examined changes in vulnerability by subdividing the period under review into two subperiods, and The oil price increase during the first subperiod was small, and correspondingly the change in vulnerability was also limited. The change in vulnerability was greater during the second subperiod, which saw a 2.5-fold price increase in nominal U.S. dollars. More countries experienced large increases and more countries also experienced large decreases in vulnerability during the second subperiod than during the first. In relation to consumption effects, deteriorating proxy real exchange rates worsened vulnerability in many of the countries during the first subperiod, but the exchange rate effect offset the price increase in nearly all countries during the second subperiod. The offsetting impact of changing oil intensity was smaller during the second subperiod because the price effect was generally much larger. In most of the countries, a decrease in oil intensity helped offset the price effect. This study s use of a refined Laspeyres index rather than a log mean Divisia index enables the incorporation of both production and consumption effects, thereby allowing the inclusion of countries that are not net oil importers. This paper highlights the role of changes in the oil share of energy and of energy intensity, both of which can be influenced by government policies, and also by oil production, which, even though it is largely a function of geology, can also be affected by a country s upstream fiscal, contractual, and regulatory frameworks. The technique employed provides a rapid assessment of where governments might focus their policies to reduce countries vulnerability to oil price shocks. 2 VULNERABILITY TO OIL PRICE INCREASES

13 INTRODUCTION As figure 1 shows, crude oil prices were relatively stable through the 1990s, but then embarked on a steady and substantial increase. By 2006, the price of a basket of marker crudes (Brent, West Texas Intermediate [WTI], and Dubai Fateh) was triple what it had been in 1990, and by the first half of 2008 was almost five times the 1990 price. Such large price changes for a commodity that is extensively consumed in its refined forms can have large effects on economies. The rising cost of oil consumption pushes other prices, and therefore inflation, upward, while reductions in demand as a result of higher oil prices can lead to reduced macroeconomic demand and unemployment (for examples of the calculation of the macroeconomic impacts of higher oil prices on developing countries see Malik 2008 for Pakistan and Essama-Nssah and others 2007 for South Africa). For oil producers, an offsetting factor derived from oil production reduces net imports. Figure 1 Average Annual Price of a Basket of Crude Oils, US$ per barrel Source: World Bank Development Economics Prospects Group. Note: The 2008 average price is for the first six months of the year. Extractive Industries for Development Series 3

14 Net oil importers (considering both crude oil and oil products) experience an adverse shock when oil prices rise and thereby increase import bills, while net exporters experience a favorable shock. The magnitudes of these shocks vary widely, and there has been interest in quantifying the impact of oil price changes on different economies. Economists have measured economies vulnerability to oil shocks in a number of ways. This study uses a simple measure that has the advantage of allowing changes in vulnerability over time to be broken down into different components. This permits us to highlight the major factors determining levels of and changes in vulnerability. At the same time, this breakdown of vulnerability into its constituent components allows us to examine an individual country s performance to examine whether it is out of line with that of other similar countries and, if so, what aspects of its oil use might be subject to policy interventions that could reduce its vulnerability. The decomposition analysis used here is an extension of methods widely used to analyze greenhouse gas emissions. It has the novel and essential feature of separating the effects of oil price changes on the value of oil production and the costs of oil consumption. 4 VULNERABILITY TO OIL PRICE INCREASES

15 METHODOLOGY Various approaches to measuring vulnerability and decomposing it into contributing terms have been proposed and examined. VULNERABILITY AND WHY IT MATTERS Several recent studies have examined energy security for a number of countries. Energy security is usually broadly defined, encompassing not only the impact of higher prices of oil and other fuels, but also supply diversification between fuels and between countries supplying the same fuels. Such studies have been carried out by the Asia Pacific Energy Research Centre (2007) and the United Nations Development Programme (2007) for countries in the Asia and Pacific region, by the Energy Sector Management Assistance Program (ESMAP) for low income countries (ESMAP 2005a) and for Sub-Saharan African countries (ESMAP 2005b), by Forfás (2006) for Ireland, by Gupta (2008) for a group consisting mainly of industrial countries, by the World Bank (2005) for Ukraine, and by the World Energy Council (2008) for European countries. All these studies have in common the idea that high import dependence on oil increases an economy s vulnerability to oil price shocks. They differ in how to measure this and in whether a measure of oil import dependence should be combined with other indexes to generate a multidimensional index of energy security. The indexes that are combined with the value of oil imports, which indicates the extent to which a price change will provide a shock to the economy, are primarily of two types. The first group includes indexes that help explain the size of the import bill, such as the difference in levels of domestic oil production and consumption or the extent of energy use in the economy. The second group includes indexes that relate to the economy s ability to absorb a shock, such as the amount of foreign exchange reserves or the size of the budget surplus. The schemes used to combine these indexes are not usually based on any formal criteria for determining their relative weightings, and indeed, may involve some double counting, for example, the degree of energy intensity is a determinant of the oil import bill for a given country. The most commonly used measure of the vulnerability of an economy to changes in the international price of oil is the ratio of the value of net imports of crude oil and oil products to the value of gross domestic product Extractive Industries for Development Series 5

16 (GDP). Both can be measured in U.S. dollars (the currency in which crude oil prices are quoted) or in local currency. The African Development Bank Group (2006), the International Energy Agency (2004), and the World Bank (2005) provide rationales for the use of this measure. When global oil prices change, economies may be affected by means of three separate routes. The first route is direct effects on the terms of trade. The change in the terms of trade occurs as a result of the increase in the price of imports relative to the price of exports. In the simplest case, the economy of an oil-importing country that does not have excess foreign reserves and cannot access additional external financing will have to deflate and GDP will fall. The magnitude of the fall is moderated by the price elasticity of demand for oil. As consumers substitute away from oil, the volume of imports is reduced, thereby offsetting some of the adverse effects of the increased prices. In this case the change in GDP is given by the following formula: %ΔGDP = %ΔP (1 E) (NI/GDP), (1) where %ΔGDP = percentage change in GDP, %ΔP = percentage change in the price of oil imports, E = price elasticity of demand for oil, NI/GDP = value of net imports of oil as a share of GDP. Thus the magnitude of the impact of a given percentage change in the price of oil on the economy is proportional to the share of the value of net oil imports in GDP and is negatively related to the price elasticity of demand for oil. Where the short-run price elasticity of demand is low, as appears to be the case from the limited evidence available, the impact is close to the measure of vulnerability used in this study. The long-run price elasticity of demand is greater than the short-run price elasticity, thus if the price remains at the new higher level over a period of a few years, demand is reduced further relative to where it would have been in the absence of the price increase. Where countries have access to additional financing through their exchange reserves or through borrowing, the initial impact on GDP through deflation will be lower. However, a country will be unable to finance a persistent price change indefinitely unless it runs a persistent surplus on its balance of payments. In practice, the impact of an oil price rise on GDP may be partly or totally offset by a simultaneous increase in the price of export commodities, for example, minerals, or may be reinforced by an increase in the prices of other imported commodities, for instance, foodstuffs. The measure given by equation (1) is the change in GDP relative to what would have happened in the absence of the oil price rise. 6 VULNERABILITY TO OIL PRICE INCREASES

17 For net oil exporters, an oil price rise is equivalent to an increase in GDP, as the increase in the value of production is greater than the increase in the cost of consuming oil. Absent changes in levels of production and consumption, a price increase will reduce vulnerability. Again, the greater the price elasticity of demand, the smaller the increase in consumption with rising GDP assuming that price increases are passed through to consumers and the greater the overall benefit from the oil price increase. A rising oil price may also encourage an increase in oil production, leading to an improvement in the net import position. Except in those few countries with significant spare capacity, short-run elasticities of supply are likely to be low. The second route is indirect effects from real wage, price, and structural rigidities within the economy. Higher oil prices drive up input costs, reduce non-oil demand, and lower investment. For net oil importers, tax revenues can fall and budget deficits can increase. To control inflationary pressures, governments might restrict the money supply, thereby driving up interest rates. The pressure of price increases can lead to wage increases, and these in turn can lead to unemployment. The magnitude and timing of such effects depends on the structure of the economy and the nature of the government s policy response. The third route is a global effect through the impact on world output. The rise in oil prices has tended to reduce global demand from oil-importing countries by more than it has increased demand from exporting countries, leading to a general reduction in world GDP below where it would have been in the absence of the price shock. This is felt as a reduction in the demand for exports by all countries, whether oil importing or exporting. The total effect of a sustained change in the oil price level on an economy is therefore manifested through a number of different channels and changes over time as economies adjust to their new situation. The index of vulnerability used in this study provides a simple way to calculate the maximum direct effect of an oil price increase on the terms of trade. By comparing the level of vulnerability of different economies at a point in time, those that are particularly vulnerable to oil price increases can be highlighted. One can then consider the factors that help determine the magnitude of vulnerability. Economies change over time in ways that may make them more vulnerable to oil price increases or less so, and the change in vulnerability will be related to changes in these underlying variables. The decomposition analysis introduced in this paper is a starting point for linking these factors together. Extractive Industries for Development Series 7

18 COMPONENTS OF VULNERABILITY TO OIL PRICES The level of vulnerability can be linked to a number of relevant components by a Kaya (1990) type of identity. ESMAP (2005a) proposed the following identity: net oil imports/gdp (net oil imports/total oil use) (total oil use/ total energy use) (total energy use/gdp). (2) This identity, in which net oil imports are measured in volume terms and GDP is measured in current U.S. dollars, highlights the three major factors that directly contribute to the magnitude of oil imports. When a country must import all the oil it uses, its vulnerability will be higher. Similarly, provided that net oil imports are positive, if oil is the major source of commercial energy in an economy, then this also tends to increase its vulnerability. 1 Finally, when the ratio of energy used to the level of GDP is high, again vulnerability will tend to be high. This study, and another ESMAP (2005b) study that used the value of net oil imports, describe the distribution of the three factors across countries. The latter study also computed vulnerability and the levels of the three factors in 1990 and 2003, but did not link changes in vulnerability to changes in the three factors in any accounting sense, and thus did not calculate their relative importance in explaining changes in vulnerability. For countries that were net oil importers throughout the period of analysis, Bacon and Kojima (2008) use an extension of the approach described to highlight some additional factors that affect the vulnerability indicator. As equation (3) shows, they measured vulnerability (V) by the ratio of the value of net oil imports to the level of GDP, both in current US dollars: 2 V = (NIV$/GDPC$) (P$) (NI/OC) (OC/EC) (EC/GDPRL) (GDPRL/GDPCL) (a) (b) (c) (d) (e) (GDPCL/GDPC$), (f) (3) where NIV$ = net import value in dollars, that is, volume of net imports of oil and oil products per year in barrels times annual crude price in current U.S. dollars, GDPC$ = value of GDP in current U.S. dollars, 1 In this study, energy refers to commercially traded energy and does not include freely collected or homegrown biomass such as firewood, dung, and agricultural residues. 2 For consistency with previous studies of vulnerability, this study treats net oil imports as positive and net oil exports as negative. 8 VULNERABILITY TO OIL PRICE INCREASES

19 P$ = price of oil in current U.S. dollars, NI = volume of net oil and oil products imports in barrels per year, OC = volume of consumption of oil products in barrels per year, EC = total primary energy consumption in quadrillion British thermal units per year, GDPRL = value of GDP in constant local currency, GDPCL = value of GDP in current local currency. The various terms in parentheses correspond to (a) the price of oil, (b) the share of imported oil in total oil consumption, (c) the share of oil in total energy, (d) the energy intensity relative to real GDP, (e) the inverse of the GDP price deflator, and (f) the exchange rate. The energy intensity term is measured relative to GDP in real terms so that, when the values at two different points in time are compared, this ratio is not affected by movements in domestic prices, but only by changes in real output, which could be expected to be linked to the use of energy. This step necessitates the introduction of two more terms to balance the identity, one linking GDP in real local currency to GDP in current local currency and the second converting this to U.S. dollars. The product of the last two terms, (e) (f), is proportional to the real exchange rate. This study generalizes equation (3) in two ways. First, to be able to compare the various components of vulnerability across countries, energy intensity cannot be measured in real local currency, but has to be measured in real U.S. dollars so that all values are in equivalent units. Because energy intensity is important for understanding differences between countries, the study measures this term by the ratio of energy consumed to real GDP in dollars converted at purchasing power parity (PPP) rather than at market exchange rates, using recently released valuations based on 2005 data. The value at PPP better reflects the general level of economic development, and hence is more relevant in a ratio pertaining to the total use of energy in an economy. 3 The use of GDP data expressed in constant U.S. dollars also necessitates introducing an additional term: the ratio of GDP in real U.S. dollars to GDP in real local currency (the real GDP converter). This ratio is constant over time, but allows equation (3) to retain the last two terms, which play an important role in explaining changes in vulnerability. The second generalization is designed to accommodate those countries that are net importers throughout the period, those that are net exporters throughout the period, and those that switch from one state to the other during the period. Increases in oil prices have two effects on an economy: a favorable 3 Valuing GDP in dollars at market exchange rates does not necessarily reflect the relative purchasing powers of two economies, because exchange rates are determined only by the export and import of traded goods and ignore the production of nontraded goods. In addition, capital asset transactions and interest rate policies, neither of which reflects the real production of the economy, can also affect exchange rates. Extractive Industries for Development Series 9

20 effect related to the extent that a country produces oil and an adverse effect related to the extent that it consumes oil. Where relative changes in levels of production and consumption result in a switch from a country being a net exporter to a net importer, being able to separate the two effects is useful. To this end, the identity is written as shown in equation (4) as the sum of two terms that separate the production and consumption of oil and oil products: V = (NIV$/GDPC$) [P$ (OC/EC) (EC/GDPR$) (GDPR$/GDPRL) (GDPRL/GDPCL) (GDPCL/GDPC$)] [(P$) (OP) / (GDPC$)], (4) where OP = volume of domestic production of crude oil per year, GDPR$ = GDP measured in U.S. dollars at 2005 PPP values. The identity is based on estimating the cost of imports (or the value of exports) from data on physical production and consumption. Relating vulnerability to each term, the impact of variations in any one term while all others are held constant can be identified. For example, if the share of oil in energy increases while overall energy intensity remains constant, vulnerability will worsen. DECOMPOSITION OF CHANGES IN VULNERABILITY The level of vulnerability and the magnitude of the important components of vulnerability can indicate how countries might reduce their vulnerability to oil price shocks. In addition, changes in vulnerability over time can provide insights into the evolution of vulnerability and reveal whether countries are following development paths that are amplifying the impact of oil price shocks. To relate changes in vulnerability to changes in the different components of the equation (4), some form of index number technique must be used. Investigators have used different indexes for similar purposes (see Ang 2004 for a review of these indexes). The logarithmic mean Divisia index has been widely used for studies decomposing changes in carbon emissions into various components, but this method presents difficulties when the sign of the variable to be explained changes, as can be the case for vulnerability when a country shifts from being a net exporter to a net importer. In this case, Chung and Rhee (2001) propose the use of a mean rate of change index instead, while Ang and Liu (2007) use an extension of the logarithmic mean Divisia index approach. Neither of these methods is suitable for decomposing the sum (or difference) of two terms, each of which is the product of several factors, as in this study. 10 VULNERABILITY TO OIL PRICE INCREASES

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