Question

After you have read the "Financial Times" article on pages 92 - 93 of our text book: Please answer and comment of the following Questions:

The fluctuations in oil prices in the times between 2008 and 2012 were caused by the global recession, the ending of many stimulus packages in industrialized countries, and a more regulated energy trading, which resulted in lowering demand for oil worldwide. Two Questions:

1. What was the consequence of this low demand?

2. What was the impact of the cheating in production quantities practiced by some  members of the "Organization of the Petroleum Exporting Countries" (OPEC), like Angola, Iran, Nigeria, and Venezuela?

Answer 1

ANSWER-

What was the consequence of this low demand?

ECONOMIC AND FINANCIAL CONSEQUENCES -

A. Key Channels
Oil prices impact growth and inflation through various channels: direct effects on prices and activity for
both importers and exporters; indirect effects via trade and other commodity markets; monetary and
fiscal policy responses; and investment uncertainty. Through these channels, oil prices can also have
immediate repercussions—even absent discretionary policy responses—on fiscal and external balances.   
The shift in real income from net oil-exporting economies, which tend to have higher average saving
rates, to net oil-importing countries, where the propensity to spend tends to be higher, should generally
result in stronger global demand over the medium term. However, the effects could vary significantly
across countries and over time: while some exporting economies may be forced by financial constraints
to adjust both government spending and imports abruptly in the short term, benefits for importing
countries could be diffuse and offset by higher precautionary savings if confidence in growth prospects
remains subdued. Second-round effects of low energy prices on other commodity markets could
generate additional terms of trade changes for a range of commodity exporters.
In oil-importing countries where declining oil prices may reduce medium-term inflation expectations
below target and reduce external financing pressures, central banks may respond with additional
monetary policy loosening, which, in turn, can support growth. In oil-exporting countries, however,
lower oil prices might trigger sharp currency adjustments, re-pricing of credit and sovereign risk, and
contractionary fiscal policy measures, unless buffers are available to protect expenditures from the
decline in tax revenues from the oil sector.   
Abrupt changes in oil prices, by increasing uncertainty, can also reduce investment and durable goods
consumption. To the extent that the return from an irreversible physical investment project depends on
the price of oil, increased uncertainty about the future price of oil could cause firms to delay investment
and reduce capital expenditures (Kilian 2014; Bernanke 1983; Pindyck 1991). Similarly, uncertainty
generated by sharp movements in oil prices can also hinder the consumption of durable goods (Kilian
2014). In addition, rising uncertainty of future oil price can also lead to more precautionary demand of
crude oil, with second-order impacts on activity (Anzuini, Patrizio, and Pisani 2014).
Falling oil prices also reduce overall energy costs as prices of competing energy products are forced
down and oil-fired electrical power becomes cheaper to produce (Figure 6). For energy-intensive
sectors, this should lead to higher profit markups and more supportive conditions for investment and
employment. In addition, since oil is feedstock for various sectors, including petrochemicals, paper, and
aluminum, the decline in prices directly impacts a wide range of processed or semi-processed inputs.
The transportation, petrochemicals, and agricultural sectors, and some manufacturing industries, are
thus usually major beneficiaries of lower oil prices as discussed later in this section. For consumers,
lower energy costs and declining inflation more generally, increase real disposable income and support
consumption.
The channels above operate with different strengths and lags depending on the source of the oil price
change, its direction, and the oil-intensity of countries.   
  
• Sources of price movements. Oil price movements driven by supply shocks in oil markets are
often associated with significant changes in global output and income shifts between oil-
exporters and importers. In contrast, changes in prices driven by demand shocks have tended to
lead to weaker effects (Cashin, Mohaddin, and Raissi 2014; Kilian 2009; Peersman and Van
Robays 2012).
• Asymmetric effects. Oil price declines generally appear to have smaller output effects on oil-
importing economies than oil price increases (Jimenez-Rodriguez and Sanchez 2005; Hoffman
2012). This asymmetry could be caused by uncertainty, frictions and varying monetary policy
responses to different types of movements in oil prices.
  
• Advanced and developing economies. Since energy and food represent a larger share of
consumption baskets in developing countries (and production in developing countries tends to
be more energy-intensive), developing countries may end up benefiting more than in advanced
countries from a decline in oil prices. Inflation expectations in developing economies could also
be more responsive to changes in fuel prices. This is reflected in stronger effects of commodity
price shocks on inflation in developing countries than in advanced economies (Gelos and
Ustyugova 2012).   

B. Global Activity
The literature summarized in Annex 1 offers a range of estimates of the impact of a sustained, supply-
driven oil price decline (although all estimated are for oil price hikes). They suggest that a 45 percent oil
price decline (as expected, on an annual average basis, between 2014 and 2015) would be associated
with an increase in world GDP of about 0.7-0.8 percent in the medium-term (World Bank 2013; IMF
2014a; OECD 2014). This is broadly in line with simulations using a large-scale macroeconomic model,
and assuming that three-fifths of the about 50 percent oil price drop in the second half of 2014 was
caused by expanding supply, which should raise global activity up to 0.7 percent in 2015 (Arezki and
Blanchard 2014).   
The expected positive impact of an oil price decline on the global economy reflects the benefits from
lower oil prices for some of its largest economies, although there is a substantial uncertainty around
existing estimates.   
  
• In the United States, standard model simulations point to a net positive effect from declining oil
prices, that could be further reinforced in an environment of improving labor markets and rising
consumer confidence. Empirical estimates suggest that a supply-driven, sustained 45 percent
drop in oil prices could lift U.S. real GDP by more than 1¼ percent over one or two years (Annex
1). However, these are likely to be upper bounds of the impact of the most recent oil price drop
since they do not reflect the by now substantial share of energy production in the U.S.
economy.7 By 2013, energy production represented around 3 percent of U.S. GDP and 1.7 of
U.S. employment, and capital expenditure in oil- and gas-producing structures amounted to
around 20 percent of private non-residential investment. The energy sector also had a
disproportionately large footprint in capital markets, accounting for more than 7 percent of
stock market capitalization, 10 percent of investment grade credit and 16 percent of
outstanding high-yield bonds (Deutsche Bank 2014). The more low oil prices discourage U.S. oil
production, the less their likely beneficial growth impact on the U.S. economy.
• The European Union should be a net beneficiary from low oil prices, as imports of crude oil from
non-EU countries represent almost 3 percent of nominal GDP (in 2013, when oil prices averaged
$109/bbl). Historical estimates suggest that a 45 percent drop in oil prices could lift Euro Area
GDP by more than 1 percent (Carabenciov et al. 2008; European Commission 2012; ECB 2010;
Peersman and van Robays 2009; Alvarez and others 2011). However, the impact of the recent oil
price decline on GDP is likely to be smaller because of deflation concerns that currently weigh
on investment decisions (European Commission 2015). Should a prolonged period of negative
inflation set in—perhaps triggered by the oil price decline against the backdrop of a fragile
recovery—rising real interest rates could reduce the expansionary impact of the oil price
decline.
• In 2013, Japan imported oil and LNG amounting to about 4½ percent of its GDP, with contracts
indexed to oil prices. Real income gains from low oil prices could therefore be significant, even
though the effects will be observed only gradually as utility companies’ contracts adjust slowly.
Declining oil and LNG prices will particularly benefit energy companies, which have been unable
to fully pass on to consumers rising costs of energy imports following the closure of nuclear
reactors in the Fukushima accident. Hence, corporate profits and eventually investment should
be positively affected (Bank of Japan 2015). While lingering deflationary pressures continue to
affect households’ propensity to consume and corporates’ willingness to invest, aggressive
stimulus measures by the Bank of Japan and fiscal relief for households should ensure that low
oil prices lift domestic demand and lead to significant gains for the Japanese economy.   
• In China, the impact of lower oil prices on growth is expected to boost activity modestly by 0.1-
0.2 percent (World Bank 2015a) because oil accounts for only 18 percent of energy
consumption, whereas 68 percent is accounted for by coal (Figure 8). The sectors most
dependent on oil consumption—half of which is satisfied by domestic production—are
transportation, petrochemicals, and agriculture. Since regulated fuel costs are adjusted with
global prices (albeit with a lag), CPI inflation could fall over several quarters. The overall effect
would be small, however, given that the weight of energy and transportation in the
consumption basket is less than one-fifth. The fiscal impact is also expected to be limited since
fuel subsidies are only 0.1 percent of GDP (IEA, 2013). Despite significant domestic oil
production and the heavy use of coal, China remains the second-largest oil importer. Therefore,
the 45 percent annual average decline in oil prices in 2015 is expected to widen the current
account surplus by some 0.5-0.9 percentage point of GDP (World Bank, 2015a).
• Similarly, in Brazil, India, South Africa and Turkey, the fall in oil prices will help lower inflation
and reduce current account deficits—sources of vulnerability for several of these countries. The
precise impact will depend on the oil-intensity of consumption and production, the extent to
which global price declines are transmitted into local ones, the flexibility of local economies to
respond to falling oil prices, and the policy response.   

Notwithstanding these estimated benefits, past episodes of oil price declines have been associated with
a wide divergence of growth paths (Box 3). In particular, in several instances, oil price declines were
associated with or followed by periods of financial stress in large advanced or emerging economies and
growth failed to pick up strongly.   
With a confluence of cyclical and structural forces at work in the global economy, the expected gains for
growth from the drop in oil prices could be lower than suggested by the standard model simulations.
Indeed, these forces help explain why global growth forecasts (World Bank 2015a; IMF 2015a) continued
to be downgraded since mid-2014, despite the decline in oil prices and signs of a strengthening U.S.
recovery. Conversely, the possibility remains that these headwinds prove weaker than expected and
global growth surprises on the upside.

• Weak global demand. Disappointing global growth prospects and weak oil demand are likely to be
responsible in some part for the price drop as documented above. Demand-driven changes in oil
prices tend to have a smaller impact on growth, as these are outcomes rather than sources of
economic fluctuations (Kilian 2009).
• Crisis legacies. Uncertainties associated with financial vulnerabilities, rapid household debt growth,
elevated unemployment, and slowing long-term growth potential may encourage households and
corporations to save real income gains from falling oil prices, rather than to invest or consume.
• Limited monetary policy room. The monetary policy loosening typically associated with demand-
driven declines in oil prices in the past is unlikely to materialize and the accompanying decline in
inflation may prove a mixed blessing. Specifically, with policy interest rates of major central banks
already at or near the zero lower bound, the room for additional monetary policy easing is limited
should declining oil prices lead to a persistent undershooting of inflation expectations.

• Reduced investment in the energy sector. A sharp decline in oil prices is associated with rising
uncertainty, potentially causing investments in new oil exploration and development to adjust
abruptly. Leveraged and higher production cost investments in shale oil (United States), tar sands
(Canada), deep sea oil fields (Brazil, Mexico), and oil in the Arctic zone could be particularly sensitive
to abrupt changes in prices. Planned new oil exploration and development, especially in East and
Southern Africa (e.g., in Kenya, Uganda, Zambia), are also likely to be affected.   
• Sharp adjustments for exporters. The sudden decline in oil prices is straining both private and public
sector balance sheets among major oil exporters, causing in some cases sharp slowdowns with
significant cross-border spillovers.   
• Changing relationship between oil and activity. Evidence suggests that the impact of oil prices on
activity has significantly declined since the mid-1980s as a result of the falling oil-intensity of GDP,
increasing labor market flexibility, and better-anchored inflation expectations. The weaker
relationship also points to a smaller response of activity to price changes at present.

2 ANSWER

The property-rights interpretation of the transformation of the world oil market is consistent with the observation that the world price during the 1970s did not appear to be threatened by cheating – such as the granting of secret price concessions by some members of OPEC in order to capture market shares from the others. Furthermore, there is evidence that the companies considered the expropriation risk in the 1960s to be real. In fact, significant episodes took place in Algeria, Iraq, Egypt, Iran, Libya, and Peru. These episodes illustrated the latent power of governments over the companies and the reality of the political risks inherent in the industry. The nationalization of foreign oil companies was an appealing way for governments to develop government-owned enterprises and to win popular support. Implicit threats of expropriation stood behind many less extreme forms of regulation.