Oil and economy measuring the relationship

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1 Mohd Afzanizam Abdul Rashid Chief Economist Oil and economy measuring the relationship 1.0 The current spectre of oil Crude oil prices have declined significantly in The common benchmark, West Texas Intermediate (WTI) and Brent, fell by 45.9% and 48.3% to close at USD53.27 and USD57.33 per barrel respectively at the end of last year. Currently, both benchmark is trading at USD46.07 and USD47.43 per barrel respectively, giving another 13.5% and 17.3% decline since the end of December The supply glut in the crude oil market has yet to dissipate and the decision by the Organisation of Petroleum Exporting Countries (OPEC) to maintain its production quota at 30 million barrels per day (mbpd) on November 27 is not helping to stabilise the market. In addition, there are also concerns on slowing economy particularly in China and Europe which gives us the impression that demand for oil is not forthcoming going forward. As a result, Malaysian economy is perceived to be vulnerable as most foreign economists have been very bearish on the evolving outlook in Some are saying the government may miss its fiscal deficits target, more pronounced slower growth in 2015 and risks of sovereign rating downgrade. In this piece, we would like to take stock on the overall impact of oil price to the economic growth using Panel Data Analysis. It covers 20 countries both oil-exporting and oilimporting countries with data series ranging between 1992 and The result shows that both countries have positive relationship with gyrations in oil prices. Undoubtedly, oil-exporting countries will be the worst hit, judging from the larger coefficient relative to oil-importing countries. However, Malaysia is in a better position to withstand the oil shocks, drawing comparisons with other oil-exporting countries. Chart 1: West Texas Intermediate (WTI) crude (USD per barrel) SD: USD SD: USD SD: USD100.3 Ave: USD SD: USD55.5-2SD: USD33.1-3SD: USD Jan-04 Jan-06 Jan-08 Jan-10 Jan-12 Jan-14 Source: Bloomberg For Internal Circulation Page 1

2 2.0 A sneak peak on the oil market demand and supply. Based on the latest Monthly Oil Market Report in December, non-opec oil supply is forecast to increase by 1.36 mbpd to mbpd in 2015, representing an increase of 0.12 mbpd over the previous report. Assuming that OPEC oil production at 30 mbpd, global oil supply could increase to 93.3 mbpd in This would lead into an excess of oil supply by 1.0 mbpd over demand this year (See Table 1). Strong oil supply was mostly coming from Americas, Former Soviet Union (FSU) and China with 3-year compounded annual growth rate (CAGR) standing at 5.3%, 0.5% and 0.8% respectively whilst that of OPEC oil supply growth was 0.4%. The supply and demand balance suggests that there is a glut in the oil market. Nonetheless, the demand profile showed that China has a significant share of around 12% of total global oil demand. We believe that China s authority has the policy flexibility to craft an effective stabilization policy with Reserve Requirement Ratio (RRR) currently standing at 20%. During the Global Financial Crisis (GFC) in 2008 and 2009, RRR was brought down to as low as 15.5%. As such, the central bank would be able to cut RRR by 450 basis points should be required to stimulate the economic activities. This should give us the comfort on demand prospect. Table 1: World oil demand and supply in million barrels per day (mbpd) e 2015f 3-yr CAGR Demand OECD % Americas % Europe % Asia Pacific % DCs % FSU % Other Europe % China % Total world demand % Supply OECD % Americas % Europe % Asia Pacific % DCs % FSU % Other Europe % China % Processing gains % Total non-opec supply % OPEC NGLs + non conventional oils % OPEC crude oil production * 30** 0.4% Total world supply % Supply less demand (0.50) 0.60 (0.10) (0.50) 1.00 Source: OPEC * as of 3Q2014 ** Current production quota For Internal Circulation Page 2

3 3.0 Measuring the relationship panel data analysis model. Using the panel data analysis, we will try to estimate such equation: (1) Where = Gross Domestic Product (GDP), the dependant variable = Oil prices (WTI) in natural log form = number of labour in natural log form = total investment as percentage of GDP in natural log form = Error term For labour, we will use the number of population as a proxy for the number of labour force since not all countries provides such statistics. All data series were sourced from International Monetary Fund (IMF) World Economic Outlook database. There will be 20 countries involved in this study and the lists are as follows: Oil exporting countries 1. Kingdom of Saudi Arabia 2. Russia 3. Kuwait 4. Nigeria 5. Qatar 6. UAE 7. Iran 8. Angola 9. Venezuela 10. Libya Oil importing countries 1. USA 2. China 3. Japan 4. India 5. South Korea 6. Germany 7. France 8. Singapore 9. Italy 10. Taiwan Source: US Energy Information Agency (EIA) We will run the regression for overall, oil-exporting and oil-importing countries separately. Our objective for the study is to establish the relationship between oil prices and GDP. The model essentially resembles production function of an economy which typically covers labour and capital. In this case, we will use oil as another factor in the conventional equation. For Internal Circulation Page 3

4 4.0 Panel data result For simplicity reasons, we will not discuss on the intricacy of panel data model such as fixed and random effects and Hausman test as this will require further explanation and more suitable for academic journal write-ups. From chart 1, we observed that the coefficients are generally positive number. This indicates that the relationship between oil prices and GDP are positively related. For example, every USD1 dollar increase in oil prices will result in 0.35 billion increase in GDP values for overall sample, 0.49 billion increase for oil-exporting countries and 0.19 billion increase in oil-importing countries ceteris parribus. And of course, the same is also true should oil price decline. The t-statistic values also suggest the relationship is significant at 5% level, which means that the relationship between these two variables can be accepted statistically speaking. Notice that the impact for oil-exporting countries is much more pronounced compared to the oil-importing countries. Such observation confirms the view that oil-exporting countries will stand to lose more during lower oil price environment. We also notice that investment does not play significant role in generating GDP growth for oilexporting countries (see Table 2). The t-statistic values indicate that it is not a statistically significant variable which is in stark contrast to oil-importing countries. Therefore, we can say that oil-exporting countries have been relying excessively on oil in order to build its economy. This is a worrying signal especially when oil prices are likely to remain low, at least in the near term. Chart 2: Coefficient for oil prices Source: Strategic Management, Bank Islam Table 2: Panel data regression result Source: Strategic Management, Bank Islam - Overall Oil exporting countries Oil importing countries Overall Oil-exporting Oil-importing countries countries Oil Coef Oil Coef Oil Coef t-stat t-stat t-stat 8.78 Labour Coef Labour Coef Labour Coef t-stat 7.82 t-stat 3.01 t-stat Investment Coef Investment Coef Investment Coef t-stat 1.85 t-stat 0.38 t-stat 3.81 Constant Coef Constant Coef Constant Coef. (3.2596) t-stat t-stat t-stat (3.46) For Internal Circulation Page 4

5 5.0 Conclusion The results were not surprising since oil-exporting countries are likely to be severely impacted by the low oil price environment. However, one needs to distinguish Malaysia with other oil exporting countries in several aspects. First, is the contribution of Oil & Gas to government s revenue. The IMF indicated that the contribution of Oil & Gas revenue to government revenue is around 22.5% of GDP for Middle Eastern countries. On the contrary, Oil & Gas accounted for 6.4% of GDP to government s coffers based on our estimates. Second, Oil & Gas exports comprise 63.6% of total export for Gulf Cooperation Council (GCC) countries whilst that of Malaysia is around 12.8% for the first eleven months of Given that, Malaysia is in a better position to withstand the effect of lower oil prices. We also believe that the OPEC member countries would eventually decide to reduce the production quota as the current oil prices are not healthy for their economy. This is based on the Fiscal Break Even Price (FBEP) for OPEC members. FBEP is a price at which the governments of oil-exporting countries balance their budget. According to IMF, the FBEP ranges from USD54 per barrel for Kuwait, USD106 for Saudi Arabia and USD184 for Libya. From our panel data estimates, it is clearly showed that oil exporting countries have been relying on Oil & Gas as their source of GDP growth. Should the current oil prices stay, GCC economies are likely to face challenging prospects with regards to their budgetary position. Already, fiscal deficits for Saudi Arabia will likely to widen to 5% of GDP in 2015 from -1.9% in the preceding year. For Internal Circulation Page 5

6 Produced and issued by BANK ISLAM MALAYSIA BERHAD (Bank Islam) for private circulation only or for distribution under circumstances permitted by applicable laws. All information, opinions and estimates contained herein have been compiled or arrived at based on sources and assumptions believed to be reliable and in good faith at the time of issue of this document. This document is for information purposes only and has no regard to the specific investment objectives, financial situation or particular needs of any specific recipient. No representation or warranty, expressed or implied is made as to its adequacy, accuracy, completeness or correctness. All opinions and the content of this document are subject to change without notice and may differ or be contrary to opinions expressed by other business areas or groups of Bank Islam as a result of using different assumptions and criteria. No part of this document may be used, reproduced, distributed or published in any form or for any purpose without Bank Islam s prior written permission For Internal Circulation Page 6