PROJECT REPORT ON CAUSES AND REPERCUSSIONS OF VOLATILITY IN PRICE OF CRUDE OIL

SUBMITTED BY, SAGAR KHANNA T.Y.B.M.S. SEMESTER V ACADEMIC YEAR 2011-2012

PROJECT GUIDE PROF. SUNITA PAWAR

SUBMITTED TO UNIVERSITY OF MUMBAI

S.I.E.S COLLEGE OF COMMERCE AND ECONOMICS, SION (EAST), MUMBAI-22

DECLARATION I, Sagar Khanna, a student of S.I.E.S College of commerce and economics, Sion (East) Mumbai-400022, studying in T.Y.B.M.S. hereby declare that I have completed a project on CAUSES OF VOLATILITY IN CRUDE PRICES AND ITS REPERCUSSIONS ON THE GLOBAL ECONOMY during the academic year 2011-2012. The information submitted is true and original to the best of my knowledge.

DATE: MUMBAI

SIGNATURE OF STUDENT PLACE:

Certificate I, Prof Sunita Pawar, hereby declare that Sagar Khanna of S.I.E.S College of commerce and economics, Sion (East) Mumbai-400022, studying in TY BMS has completed his project on CAUSES OF VOLATILITY IN CRUDE PRICES AND ITS REPERCUSSIONS ON THE GLOBAL ECONOMY during the academic year 2011-2012 the information submitted is true and original to the best of my knowledge.

Prof. Sunita Pawar (Project Guide)

Dr. Minu Thomas (Principal, S.I.E.S College of Commerce and Economics)

Acknowledgment

I have taken efforts in this project. However, it would not have been possible without the kind support and help of many individuals. I would like to extend my sincere thanks to all of them. I am highly indebted to Prof. Sunita Pawar for helping me select this topic and for her guidance and constant supervision. My sincere thanks to her for providing me with the necessary information regarding the project & also for her support in completing the project. I would like to express my gratitude towards my parents for their kind cooperation and encouragement which help me in completion of this project. I would like to express my special gratitude and thanks to members of the broking industry for giving me such attention and time and also for providing their valuable opinions and feedback. My thanks and appreciations also go to my colleagues in developing the project and people who have willingly helped me out with their abilities.

CONTENTS

1. 2. 2.a 2.b

EXECUTIVE SUMMARY.............................................................07 A BRIEF OVREVIEW A BRIEF INTRODUCTION..........................................................08 TYPES

2.b.i BRENT CRUDE..............................................................................10 2.b.ii OPEC REFERENCE BASKET.....................................................13 2.b.iii DUBAI CRUDE...............................................................................15 3. 3.a CAUSES HISTORICAL OVERVIEW OF CRUDE OIL PRICES.............16

3.a.i PRE EMBARGO PERIOD.............................................................20 3.a.ii ARAB OIL EMBARGO..................................................................22 3.a.iii CRUDE OIL PRODUCTION - IRAN AND IRAQ......................24 3.a.iv CRUDE OIL PRODUCTION - NON OPEC COUNTRIES......27 3.a.v OPEC PRICE CONTROL.............................................................28 3.a.vi OTHER GEO POLITICAL FACTORS......................................31 3.a.vii CONSUMPTION OF CRUDE OIL BY THE U.S. ....35 3.a.viiiOIL PRODUCTION - RUSSIA....................................................36 3.a.ix CRUDE OIL FUTURES TRADING AND SPECULATION...37 4. 5. 6. RELATIVE VOLATILITY COMPARISON...............................40 INVESTOR VIEWS ON REASONS FOR VOLATILITY..........42 REPERCUSSIONS

6.a IMPACT ON THE STOCK MARKET.............................................44

6.b IMPACT ON THE GLOBAL ECONOMY.................................................45 6.c IMPACT ON INDUSTRIAL COUNTRIES................................................51 6.d IMPACT ON DEVELOPING AND TRANSITION ECONOMIES.........57 6.e IMPACT ON OIL IMPORTING HIPC AND CIS COUNTRIES.............61 6.f IMPACT ON OPEC COUNTRIES...............................................................64 6.g.POLICY IMPLICATIONS...........................................................................71 6.h RESPONSES OF ADVANCED ECONOMIES TO PREVIOUS OIL PRICE HIKES..............................................................................................74 7. CONCLUSION.................................................................................................82 8. BIBLIOGRAPHY.............................................................................................83

EXECUTIVE SUMMARY

The purpose of this project is to better understand what actually happens when crude oil price moves in a particular way and what implications this movement has, the world has truly become a global village and it is not possible to live in isolation from the global economy and since this movement affects the global economy, it affects each and every one of us. This study is undertaken with a macro economic and global outlook, since oil being a material object, its price rise cannot have a universal affect on every person and economy, some people will be the worst affected while some may thrive due to it, hence to make it as objective as possible, a global outlook has been charted out. The reasons and implications are multiple but some are of more priority than other, hence the most significant reasons have been charted out, as it may be practically unrealistic to list all causes and effects. At the end of the study, there should be a clearer idea as to what happens and why it happens. The technical aspects, such as number of rigs, functioning and otherwise, have been skipped as they have to be understood in detail and an isolated study may not project such a clear picture than otherwise. This study provides an overview of the causes and effects.

A BRIEF INTRODUCTION

In recent times when one speaks of crude oil, it is often mistaken that crude oil prices all over the world are consistent with each other or are the same in all parts of the world. However there are certain classifications of crude oil based mainly on the places where they are rigged or the places where they originate from, these are further classified further into sub classifications on the basis of the sweetness of the oil or in other words its quality. The major classifications of crude oil are listed below-

Brent Crude OPEC Reference Basket Dubai Crude West Texas Intermediate

The inherent characteristics of these will be further discussed in order to get a better understanding of the crude oil prices or the variations in crude oil prices.

Note In the following explanations, the reason for putting in the trading related information along with the characteristics of the above types of crude oil is because in recent times it is often said that crude oil price volatility is also caused due to speculative reasons than due to tangible ones(demand and supply), in this case it is important to understand the functioning of the futures trading (through which most people buy crude oil futures, in a crude sense these resemble the shares of a company although with different reasons for existence and different rationales behind their trading).

GLOBAL PRODUCTION SCENARIO A Brief overview of the current scenario with regard to global crude oil production of various nations and various Unions and cartels. RANK 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 19 20 21 22 23 24 25 Arab League Russia Saudi Arabia United States Iran China Canada Mexico United Arab Emirates Brazil Kuwait Venezuela Iraq European Union Norway Nigeria Algeria Angola Libya Kazakhstan United Kingdom Qatar Indonesia Azerbaijan Colombia India Oman Country World Production(bbl/day) 87,500,000 24,171,503 10,540,000 8,800,000 7,800,000 4,172,000 3,991,000 3,289,000 3,001,000 2,798,000 2,572,000 2,494,000 2,472,000 2,399,000 2,365,000 2,350,000 2,211,000 2,125,000 1,948,000 1,790,000 1,540,000 1,502,000 1,213,000 1,023,000 1,011,000 903,000 878,700 816,000 Share of Date of World % Information 100% 29.71% 12.01% 11.59% 10.75% 4.95% 4.74% 3.90% 3.56% 3.32% 3.05% 2.96% 2.93% 2.85% 2.81% 2.79% 2.62% 2.52% 2.31% 2.12% 1.83% 1.78% 1.44% 1.21% 1.20% 0.97% 1.04% 0.95% 2011 2009 2011 2011 2011 2009 2009 2009 2009 2009 2009 2009 2009 2009 2009 2009 2009 2009 2009 2009 2009 2009 2009 2009 2009 2011 2009 2009

BRENT CRUDE

Brent Crude is the biggest of the many major classifications of crude oil consisting of Brent Crude, Brent Sweet Light Crude, Oseberg, Ekofisk, and Forties (BFOE). Brent Crude is sourced from the North Sea. The Brent Crude oil marker is also known as Brent Blend, London Brent and Brent petroleum. It is used to price two thirds of the world's internationally traded crude oil supplies.

The name "Brent" comes from the naming policy of Shell UK Exploration and Production, operating on behalf of ExxonMobil and Royal Dutch Shell, which originally named all of its fields after birds (in this case the Brent Goose). Petroleum production from Europe, Africa and the Middle East flowing West tends to be priced relative to this oil, i.e. it forms a benchmark.

Brent blend is a light crude oil, though not as light as WTI. It contains approximately 0.37% of sulphur, classifying it as sweet crude, yet again not as sweet as WTI. Brent is suitable for production of petrol and middle distillates. It is typically refined in Northwest Europe. Brent Crude has an API gravity[1] of around 38.06 and a specific gravity of around 0.835.

The symbol for Brent crude is LCO. It was originally traded on the open-outcry International Petroleum Exchange in London, but since 2005 has been traded on the electronic Intercontinental Exchange, known as ICE. One contract equals 1,000 barrels (159 m3). Contracts are quoted in U.S. dollars. Each tick lost or gained equals $10. Prior to September 2010, there existed a typical price difference per barrel of between +/3 USD/bbl compared to WTI and OPEC Basket, however since the autumn of 2010 there

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has been a significant divergence in price compared to WTI, reaching over $11 a barrel by the end of February 2011 (WTI: 104 USD/bbl, LCO: 116 USD/bbl). Many reasons have been given for this widening divergence ranging from a speculative change away from WTI trading (although not supported by trading volumes), Dollar currency movements, regional demand variations, and even politics. The depletion of the North Sea oil fields is one explanation for the divergence in forward prices. In February 2011 the divergence reached $16 during a supply glut, record stockpiles, at Cushing, Oklahoma and is currently above $23(last checked on 27th September 2011). Historically the different price spreads are based on physical variations in supply and demand (short term).

[[1] - The American Petroleum Institute gravity, or API gravity, is a measure of how heavy or light a petroleum liquid is compared to water. If its API gravity is greater than 10, it is lighter and floats on water; if less than 10, it is heavier and sinks] The chart below gives us a idea of the movement of Brent crude over the last 24 years and it can be seen that the movement in no way has been steady, especially in the last four to five years (Where the price had reached $147 and dipped below $30 (intraday movement) a fall of almost 80%). Such a pattern can also be seen in 1991 (due to the gulf war) but although of not the same magnitude.

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[The prices are inflation adjusted so that it gives a better idea of the price range]

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OPEC REFERENCE BASKET

OPEC or the Organization of Petroleum Exporting Countries is an intergovernmental organization of twelve developing countries made up of Algeria, Angola, Ecuador, Iran, Iraq, Kuwait, Libya, Nigeria, Qatar, Saudi Arabia, the United Arab Emirates, and Venezuela. It represents the largest oil cartel in the world. The OPEC Reference Basket (ORB), also referred to as the OPEC Basket is a weighted average of prices for petroleum blends produced by OPEC countries. It is used as an important benchmark for crude oil prices. On June 15, 2005 the OPEC basket was changed to reflect the characteristics of the oil produced by OPEC members. The Reference Basket currently consists of a weighted average of the following blends of oil: Saharan Blend (from Algeria) Minas (from Indonesia) Iran Heavy (from Islamic Republic of Iran) Basra Light (from Iraq) Kuwait Export (from Kuwait) Es Sider (from Libya) Bonny Light (from Nigeria) Qatar Marine (from Qatar) Arab Light (from Saudi Arabia) Murban (from UAE)

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BCF 17 (from Venezuela)

Prior to June 15, 2005, the OPEC Basket consisted of the following: Arab Light (from Saudi Arabia) Bonny Light (from Nigeria) Fateh (from Dubai) Isthmus (from Mexico, a non-OPEC country) Minas (from Indonesia) Saharan Blend (from Algeria) Tia Juana Light (from Venezuela)

OPEC attempts to keep the price of the Opec Basket between upper and lower limits, by increasing and decreasing production. This makes the measure important for market analysts. The OPEC Basket, including a mix of light and heavy crudes, is heavier than both Brent crude oil, and West Texas Intermediate crude oil.

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DUBAI CRUDE

Dubai Crude is a light sour crude oil extracted from Dubai. Dubai Crude is used as a price benchmark or oil marker because it is one of only a few Persian Gulf crude oils available immediately. Dubai Crude is generally used for pricing Persian Gulf crude oil exports to Asia. The Dubai benchmark is also known as Fateh is used in the United Arab Emirates.

Forward trade of Dubai Crude is limited to one or two months. Dubai Crude is a light oil. It has a gravity of 31 API (specific gravity of 0.871) and a sulfur content of 2%/weight

As it is used for pricing persian Gulf crude oil exports to Asia, it is gaining more importance as the two biggest emerging markets of the world, i.e. India and China are present there and are fast becoming big consumers of oil, this makes it more significant.

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HISTORICAL OVERVIEW OF CRUDE OIL PRICES

In order to better understand the current movements of crude oil prices, it is necessary to take into account the movement in the past and this history will encompass its movement during times of crisis, prosperity, war or any other abnormal circumstance.

Since the historical analysis will include all the causes of price fluctuations, viz Geo Political Reasons Supply Factors Demand/Consumption factors Speculation

There will not be a separate analysis of the individual factors as there will be a lot of overlapping of data and will prove to be of not much use. The analysis will encompass all causes.

US has been the biggest consumer of crude oil prices, hence there has been a corresponding change in the level of prices in correlation to the consumption of crude oil prices in the US. It is necessary to analyze the history of crude oil prices in order to gain insight into their movement, although one cannot say that the movement has been steady and stable to say the least, an analysis gives us an idea of what causes oil prices to move drastically, and to what extent it influences the prices, the complexity and multiplicity of the factors which affect the movements makes it a little difficult to pinpoint the extent to which something influences oil prices or not, mainly because some events may overlap and make it difficult to bifurcate how much significance a factor ought to get, as most of these events have been more or less psychological and intangible rather than tangible. The following chart depicts the crude oil price movement over the last 65 years (annual price movements). An analysis of this chart can to a certain extent bring some lucidity into what are the major classifications of elements which have the most effect, and also the extent to which they have an impact, in the graph, major hikes or dips have been accompanied by the major event due to which the prices have moved sharply

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From the above graph it can be seen that to a certain extent prices tend to have a pattern of some sort, certain events have a relatively similar bearing on the prices.

In contrast to prices of other major commodities like gold and silver, price of oil has been relatively volatile and we can see that some patterns also emerge when it comes to oil, wherein in gold and silver, prices have more or less, steadily grown with a few exceptions. Although, this phenomena of price pattern repetition is not peculiar to oil, this can be witnessed in speculative commodities such as equities, which is in a way strange as oil in its essence is not a speculative instrument like a stock which is essentially a piece of paper entitling one to ownership of an intangible entity. Oil has specific material use, which means that the main or rather the only factors to determine its price should be demand and supply. This leads us to believe that although demand and supply constitute a part of the factors, they are not the only ones or rather they are not the only significant ones. Going back to the above chart, two especially wild price movements have beenDuring the periods of 1973-1987 where the price has moved from around $17 to $72 an increase of more than 300% mainly caused due to Iran-Iraq war and the Iranian revolution, clearly showcasing the effect of the mid eastern uncertainty on the price, also the price drop after the peak shows us that the price was highly inflated due to psychological factors rather than any real tangible factors, the price fell back to the level of $20 signifying a magnificent drop of around 70%. It obviously cannot be a matter of mismatched demand or supply as it is not practically possible for the dynamics of demand and supply to change so adversely unless there is an event of such a magnitude that it totally disrupts the normal demand supply components. And, during the period of 2008-2011 or from 2008 till date (although prices have been hovering in the $90 range(price last checked on 10th November 2011- $97) with a range of $5-$10 above and below this level) (Taking into consideration NYMEX Crude).This was mainly believed to be due to the negative emotions which were evoked after 9/11, these negative emotions involved a paradox of a kind, that is - souring of relations of the worlds largest consumer of oil and the middle eastern countries, the worlds largest producer cartel. Another facet during the oil price rally and fall in the 2008 period was due to speculation, or in other words, the act of buying and selling oil in the open market with an aim to manipulate its price and to gain profits out of it and not for any genuine demand for it.

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The facet of speculation, i.e. the structure, mechanisms, and other details will be covered later on. The above graph was analyzed as it was more relevant (due to changes in market dynamics and world environment) than the entire price history of oil, however the prices of oil over the last century should also be focused on to be thorough. The above analysis was an overview of historical prices of oil, the more specific details

will now be taken into account, not just the prices but also the oil production levels of various major oil producing countries to better grasp the supply situation and then put it against the backdrop of oil price movement.

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PRE-EMBARGO PERIOD This period was significant as it witnessed the formation of OPEC, in the present scenario probably the one entity which has a tremendous impact on the prices of oil. From 1948 through the end of the 1960s, crude oil prices ranged between $2.50 and $3.00. The price oil rose from $2.50 in 1948 to about $3.00 in 1957. When viewed in 2011 dollars, a different story emerges with crude oil prices fluctuating between $17 and $19 during most of the period. The apparent 20% price increase in nominal prices just kept up with inflation. From 1958 to 1970, prices were stable near $3.00 per barrel, but in real terms the price of crude oil declined from $19 to $14 per barrel. Not only was price of crude lower when adjusted for inflation, but in 1971 and 1972 the international producer suffered the additional effect of a weaker US dollar. OPEC was established in 1960 with five founding members: Iran, Iraq, Kuwait, Saudi Arabia and Venezuela. Two of the representatives at the initial meetings previously studied the Texas Railroad Commission's method of controlling price through limitations on production. By the end of 1971, six other nations had joined the group: Qatar, Indonesia, Libya, United Arab Emirates, Algeria and Nigeria. From the foundation of the Organization of Petroleum Exporting Countries through 1972, member countries experienced steady decline in the purchasing power of a barrel of oil. Throughout the post war period exporting countries found increased demand for their crude oil but a 30% decline in the purchasing power of a barrel of oil. In March 1971, the balance of power shifted. That month the Texas Railroad Commission set proration at 100 percent for the first time. This meant that Texas producers were no longer limited in the volume of oil that they could produce from their wells. More important, it meant that the power to control crude oil prices shifted from the United States (Texas, Oklahoma and Louisiana) to OPEC. By 1971, there was no spare production capacity in the U.S. and therefore no tool to put an upper limit on prices. A little more than two years later, OPEC through the unintended consequence of war obtained a glimpse of its power to influence prices. It took over a decade from its formation for OPEC to realize the extent of its ability to influence the world market.

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YOM KIPPUR WAR ARAB OIL EMBARGO

In 1972, the price of crude oil was below $3.50 per barrel. The Yom Kippur War started with an attack on Israel by Syria and Egypt on October 5, 1973. The United States and many countries in the western world showed support for Israel. In reaction to the support of Israel, several Arab exporting nations joined by Iran imposed an embargo on the countries supporting Israel. While these nations curtailed production by five million barrels per day, other countries were able to increase production by a million barrels. The net loss of four million barrels per day extended through March of 1974. It represented 7 percent of the free world production. By the end of 1974, the nominal price of oil had quadrupled to more than $12.00. Any doubt that the ability to influence and in some cases control crude oil prices had passed from the United States to OPEC was removed as a consequence of the Oil Embargo. The extreme sensitivity of prices to supply shortages became all too apparent when prices increased 400 percent or increased fivefold in six short months. From 1974 to 1978, the world crude oil price was relatively flat ranging from $12.52 per barrel to $14.57 per barrel. When adjusted for inflation world oil prices were in a period of moderate decline. During that period OPEC capacity and production was relatively flat near 30 million barrels per day. In contrast, non-OPEC production increased from 25 million barrels per day to 31 million barrels per day. OPEC and Non-OPEC countrys production are shown below.

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It can be seen below that the production of oil fell during the Arab oil embargo, although a more significant fall took place because of crisis in Iran and Iraq, which also shows the significance of these 2 countries with regard to oil prices.

During the past decade, production seems to have stabilized at around three to four crore barrels a day.

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CRUDE OIL PRODUCTION- IRAQ AND IRAN In 1979 and 1980, events in Iran and Iraq led to another round of crude oil price increases. The Iranian revolution resulted in the loss of 2.0-2.5 million barrels per day of oil production between November 1978 and June 1979. At one point production almost halted. The Iranian revolution was the proximate cause of the highest price in post-WWII history. However, revolution's impact on prices would have been limited and of relatively short duration had it not been for subsequent events. In fact, shortly after the revolution, Iranian production was up to four million barrels per day. In September 1980, Iran already weakened by the revolution and was invaded by Iraq. By November, the combined production of both countries was only a million barrels per day. It was down by 6.5 million barrels per day from a year before. As a consequence, worldwide crude oil production was 10 percent lower than in 1979. The loss of production from the combined effects of the Iranian revolution and the IraqIran War caused crude oil prices to more than double. The nominal price went from $14 in 1978 to $35 per barrel in 1981. This can be seen as one of the events where more than psychological factors, the actual decrease in the supply of oil led to the rapid increase in prices.

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The sharp dip during the year 79-80 indicates the period of strife, more than an 85% fall in production, while during the other periods production was more or less stable although not at the optimal level which Iran had achieved in the 70s.

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The production pattern of Iraq is more unstable than that of Iran, there can be seen 3 major drops in production, while Iran had just suffered a single setback with regard to its production. The first dip as discussed above is due to the Iran-Iraq crisis, The second dip during 1991 was mainly during the gulf war under the leadership of Saddam Hussein and The third dip during 2003 signifies the US invasion against Iraq for their war against terrorism while many people speculated this being the front and the actual reason being the crude oil present in Iraq.

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CRUDE OIL PRODUCTION NON OPEC COUNTRIES

The oil production in Non-OPEC countries is seen to be a sharp contrast to their middle eastern counterparts, with production remaining normal and having a steady growth with a mild reduction during 1991-93 again which may be due to the gulf war (due to the involvement of the United States) The major Non-OPEC Countries consist of o Russia o The United States o China o Canada and o Brazil

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OPEC PRICE CONTROL

OPEC has seldom been effective at controlling prices. Often described as a cartel, OPEC does not fully satisfy the definition. One of the primary requirements of a cartel is a mechanism to enforce member quotas. An elderly Texas oil man posed a rhetorical question: What is the difference between OPEC and the Texas Railroad Commission? His answer: OPEC doesn't have any Texas Rangers! The Texas Railroad Commission could control prices because the state could enforce cutbacks on producers. The only enforcement mechanism that ever existed in OPEC is Saudi spare capacity and that power resides with a single member not the organization as a whole. With enough spare capacity to be able to increase production sufficiently to offset the impact of lower prices on its own revenue; Saudi Arabia could enforce discipline by threatening to increase production enough to crash prices. In reality even this was not an OPEC enforcement mechanism unless OPEC's goals coincided with those of Saudi Arabia. During the 1979-1980 period of rapidly increasing prices, Saudi Arabia's oil minister Ahmed Yamani repeatedly warned other members of OPEC that high prices would lead to a reduction in demand. His warnings fell on deaf ears. Surging prices caused several reactions among consumers: better insulation in new homes, increased insulation in many older homes, more energy efficiency in industrial processes, and automobiles with higher efficiency. These factors along with a global recession caused a reduction in demand which led to lower crude prices. Unfortunately for OPEC only the global recession was temporary. Nobody rushed to remove insulation from their homes or to replace energy efficient equipment and factories -- much of the reaction to the oil price increase of the end of the decade was permanent and would never respond to lower prices with increased consumption of oil. Higher prices in the late 1970s also resulted in increased exploration and production outside of OPEC. From 1980 to 1986 non-OPEC production increased 6 million barrels per day. Despite lower oil prices during that period new discoveries made in the 1970s continued to come online. OPEC was faced with lower demand and higher supply from outside the organization. From 1982 to 1985, OPEC attempted to set production quotas low enough to stabilize prices. These attempts resulted in repeated failure, as various members of OPEC produced beyond their quotas. During most of this period Saudi Arabia acted as the swing producer cutting its production in an attempt to stem the free fall in prices. In August 1985, the Saudis tired of this role. They

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linked their oil price to the spot market for crude and by early 1986 increased production from two million barrels per day to five million. Crude oil prices plummeted falling below $10 per barrel by mid-1986. Despite the fall in prices Saudi revenue remained about the same with higher volumes compensating for lower prices. A December 1986 OPEC price accord set to target $18 per barrel, but it was already breaking down by January of 1987 and prices remained weak. The price of crude oil spiked in 1990 with the lower production, uncertainty associated with the Iraqi invasion of Kuwait and the ensuing Gulf War. The world and particularly the Middle East had a much harsher view of Saddam Hussein invading Arab Kuwait than they did Persian Iran. The proximity to the world's largest oil producer helped to shape the reaction. Following what became known as the Gulf War to liberate Kuwait, crude oil prices entered a period of steady decline. In 1994, the inflation adjusted oil price reached the lowest level since 1973. The price cycle then turned up. The United States economy was strong and the Asian Pacific region was booming. From 1990 to 1997, world oil consumption increased 6.2 million barrels per day. Asian consumption accounted for all but 300,000 barrels per day of that gain and contributed to a price recovery that extended into 1997. Declining Russian production contributed to the price recovery. Between 1990 and 1996 Russian production declined more than five million barrels per day. OPEC continued to have mixed success in controlling prices. There were mistakes in timing of quota changes as well as the usual problems in maintaining production discipline among member countries. The price increases came to a rapid end in 1997 and 1998 when the impact of the economic crisis in Asia was either ignored or underestimated by OPEC. In December 1997, OPEC increased its quota by 2.5 million barrels per day (10 percent) to 27.5 million barrels per day effective January 1, 1998. The rapid growth in Asian economies came to a halt. In 1998, Asian Pacific oil consumption declined for the first time since 1982. The combination of lower consumption and higher OPEC production sent prices into a downward spiral. In response, OPEC cut quotas by 1.25 million barrels per day in April and another 1.335 million in July. The price continued down through December 1998. Prices began to recover in early 1999. In April, OPEC reduced production by another 1.719 million barrels. As usual not all of the quotas were observed, but between early 1998 and the middle of 1999 OPEC production dropped by about three million barrels per day. The cuts were sufficient to move prices above $25 per barrel.

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With minimal Y2K problems and growing U.S. and world economies, the price continued to rise throughout 2000 to a post 1981 high. In 2000 between April and October, three successive OPEC quota increases totaling 3.2 million barrels per day were not able to stem the price increase. Prices finally started down following another quota increase of 500,000 effective November 1, 2000.

World Events and Crude Oil Prices 1997-2003

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OTHER GEO POLITICAL CAUSES Russian production increases dominated non-OPEC production growth from 2000 to 2007 and was responsible for most of the non-OPEC increase since the turn of the century. Once again it appeared that OPEC overshot the mark. In 2001, a weakened US economy and increases in non-OPEC production put downward pressure on prices. In response OPEC once again entered into a series of reductions in member quotas cutting 3.5 million barrels by September 1, 2001. In the absence of the September 11, 2001 terrorist attacks, this would have been sufficient to moderate or even reverse the downward trend. In the wake of the attack, crude oil prices plummeted. Spot prices for the U.S. benchmark West Texas Intermediate were down 35 percent by the middle of November. Under normal circumstances a drop in price of this magnitude would have resulted in another round of quota reductions. Given the political climate OPEC delayed additional cuts until January 2002. It then reduced its quota by 1.5 million barrels per day and was joined by several non-OPEC producers including Russia which promised combined production cuts of an additional 462,500 barrels. This had the desired effect with oil prices moving into the $25 range by March 2002. By midyear the non-OPEC members were restoring their production cuts but prices continued to rise as U.S. inventories reached a 20-year low later in the year. By year end oversupply was not a problem. Problems in Venezuela led to a strike at PDVSA causing Venezuelan production to plummet. In the wake of the strike Venezuela was never able to restore capacity to its previous level and is still about 900,000 barrels per day below its peak capacity of 3.5 million barrels per day. OPEC increased quotas by 2.8 million barrels per day in January and February 2003. On March 19, 2003, just as some Venezuelan production was beginning to return, military action commenced in Iraq. Meanwhile, inventories remained low in the U.S. and other OECD countries. With an improving economy U.S. demand was increasing and Asian demand for crude oil was growing at a rapid pace. The loss of production capacity in Iraq and Venezuela combined with increased OPEC production to meet growing international demand led to the erosion of excess oil production capacity. In mid 2002, there were more than six million barrels per day of excess production capacity and by mid-2003 the excess was below two million. During much of 2004 and 2005 the spare capacity to produce oil was less than a million barrels per day. A million barrels per day is not enough spare capacity to cover an interruption of supply from most OPEC producers.

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In a world that consumes more than 80 million barrels per day of petroleum products that added a significant risk premium to crude oil price and was largely responsible for prices in excess of $40-$50 per barrel. Other major factors contributing to higher prices included a weak dollar and the rapid growth in Asian economies and their petroleum consumption. The 2005 hurricanes and U.S. refinery problems associated with the conversion from MTBE to ethanol as a gasoline additive also contributed to higher prices.

World Events and Crude Oil Prices 2001-2005

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CRUDE OIL PRODUCTION - VENEZUELA

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The above graph shows the dip or rather the complete elimination of the production in Venezuela, although this was temporary, it had repercussions.

One of the most important factors determining price is the level of petroleum inventories in the U.S. and other consuming countries. Until spare capacity became an issue inventory levels provided an excellent tool for short-term price forecasts. Although not well publicized OPEC has for several years depended on a policy that amounts to world inventory management. Its primary reason for cutting back on production in November 2006 and again in February 2007 was concern about growing OECD inventories. Their focus is on total petroleum inventories including crude oil and petroleum products, which is a better indicator of prices that oil inventories alone. In 2008, after the beginning of the longest U.S. recession since the Great Depression the oil price continued to soar. Spare capacity dipped below a million barrels per day and speculation in the crude oil futures market was exceptionally strong. Trading on NYMEX closed at a record $145.29 on July 3, 2008.

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CONSUMPTION OF CRUDE OIL BY THE UNITED STATES Earlier US consumption was pointed out as a major factor when it came to influencing prices along with OPEC decisions and situations of the Middle Eastern countries, it is then imperative to analyze or mull upon the US consumption of oil. It is represented in the graph below-

The price rise in late 70s and early 80s resulted in a severe cutback when it came to the consumption of oil. Although the consumption increased after this, the net increase was marginal.

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OIL PRODUCTION - RUSSIA Russia is the second largest producer of oil and the largest non-OPEC producer country, it can be seen below that production was its lowest after the segmentation of USSR, however it can be noted that it did not have any adverse effect on the price of crude oil, thus marking it out as an significant mover of price, irrespective of it being such a large producer.

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Crude Oil Futures Trading Basics Crude Oil futures are standardized, exchange-traded contracts in which the contract buyer agrees to take delivery, from the seller, a specific quantity of crude oil (eg. 1000 barrels) at a predetermined price on a future delivery date. Crude Oil Futures Exchanges Crude Oil futures can be traded at New York Mercantile Exchange (NYMEX) and Tokyo Commodity Exchange (TOCOM). NYMEX Light Sweet Crude Oil futures prices are quoted in dollars and cents per barrel and are traded in lot sizes of 1000 barrels (42000 gallons). NYMEX Brent Crude Oil futures are traded in units of 1000 barrels (42000 gallons) and contract prices are quoted in dollars and cents per barrel. TOCOM Crude Oil futures prices are quoted in yen per kiloliter and are traded in lot sizes of 50 kiloliters (13210 gallons).Crude Oil Futures Trading Consumers and producers of crude oil can manage crude oil price risk by purchasing and selling crude oil futures. Crude Oil producers can employ a short hedge to lock in a selling price for the crude oil they produce while businesses that require crude oil can utilize a long hedge to secure a purchase price for the commodity they need. Crude Oil futures are also traded by speculators who assume the price risk that hedgers try to avoid in return for a chance to profit from favorable crude oil price movement. Speculators buy crude oil futures when they believe that crude oil prices will go up. Conversely, they will sell crude oil futures when they think that crude oil prices will fall.

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Peak Oil Mega-trend Firstly, Peak Oil does not mean that the world is running out of oil any time soon, peak oil means that the world is about to pass the point of maximum rate of production after which production is expected to decline as it becomes ever more costly to find and extract new oil fields thus resulting in diminishing supply. The theory of Peak Oil is based on the principle originally developed by M King Hubbard in the 1950's, who observed the rate of production and depletion of oil output from the United States oil fields over time which culminated in a bell shaped curve. M King Hubbard went on to use his findings to accurate predict that U.S. oil production would peak by 1970 and decline rapidly. The below updated graph illustrates the most recent forecast projection for global Peak Oil which implies that the supply output peak is imminent, where the test will come when supply fails to respond to rising demand as the worlds economies return to trend growth.

Whilst the developed world continues to stabilize and in some cases cut back on total oil consumption due to improvements in technology and switch to renewable's and alternatives such as natural gas. However much of the reduced western oil demand (ignoring the recession) for oil consumption can be attributed to the exporting of industrial production abroad to China and India, which remain several decades away from reaching the level of West in terms of stabilization of consumption as the collective total of 2.5 billion people of both countries consume on a per capita basis less than 10% of that of the average western person.

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Peak Oil is a reality, the major cheap oil fields across the big producing nations have already passed their peak outputs and are declining fast in output and where discoveries of new economically recoverable reserves are not keeping pace with. We got a taste of the consequences of peak oil during 2008 when Crude oil soared to $147, where a small shift in the supply demand balance can cause extreme shifts in price as MARKET SENTIMENT (speculators) drives prices into ever increasingly volatile price trends. Therefore, oil and energy commodities despite continuing to exhibit high price volatility over the next 10 years, will still result in an rising trend curve as the oil price escalator repeatedly moves to ever higher trading ranges, therefore I expect we will continue to see extremely high price volatility in the region of 50% as speculative funds continue to dominate short-term trends in the highly liquid crude oil markets, which the long-term inflationary mega-trend (as a consequence of emerging markets growth, population growth and fiat money printing) continues to force oil prices ever higher.

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RELATIVE VOLATILITY COMPARISON

In order to further emphasize on the peculiarity of the price movement of oil, the price movement charts of gold and silver will be shown, this will show the relative price instability of oil It can be seen that the price of gold has been comparatively one sided with regard to its movement, that is a steady growth in its price, after 2003 and before this a period of price stagnation can be seen, this being not too harmful or rather not harmful at all is not something to be analyzed. The recent upswing in its prices has also been due to increase in demand as a relatively stable instrument.

40

Similarly in silver prices, except for a couple of blips (literally two in number), the prices have been more or less stable, however since the recent unstability in silver prices is still fresh in our minds, people may count silver too as a commodity with unstable and volatile prices but however history proves otherwise.

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INVESTOR VIEWS ON REASONS FOR VOLATILITY

A better idea of the reason can be found out by consulting people who have experience in speculative products, as futures trading in oil in India is relatively minimal and in its nascent stage, there are not many people who trade or deal exclusively in crude oil, however a survey of these experts would help in bringing about transparency in what drives prices. The following pie diagram shows the opinions of a few investors on question What according to you is the main reason for the extreme volatility in prices we encountered? This was asked only keeping into perspective the recent volatility and does not depict the historical picture.

Reasons for Volatility

Speculation Demand Upsurge Supply Concerns Geo Political Factors

It can be seen that most were of the opinion that Geo political factors were the reasons for the volatility, while the factor of speculation may have fuelled this and may have amplified it, but the primary cause still remains the various geo political factors, In the present day, the oil price surge can be attributed to have taken seed at 9/11 and then have gained momentum after the Iraq invasion by the United states of America.

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REPERCUSSIONS Crude oil being a fuel is a major factor when it comes to industrial development and as well as the over all functioning of the economy, At the same time it cannot be said that the crude oil does not affect the common man (although in terms of industrial growth it does, but that is an indirect effect, a more direct effect is being taken into consideration), this can be backed up by the recent rise in petrol prices, (around 73 rupees in Mumbai, 45 rupees per liter was a very recent situation which spiraled out of control), One may further argue that the poor man who does not own a vehicle will not be much affected by this, however there have also been rises in the prices of diesel although not as substantial as that of petrol, there have been rises nonetheless, this rise in diesel prices affects the transportation business which in turn affects the poor who are directly or indirectly linked to agricultural activities, a higher transportation cost means a lower margin of earning for the farmer or producer, this also leads to inflation. Hence from above we can see that in the most direct sense, crude price rise affects the industries and at the same time has a significant impact on the common man. The repercussions will be discussed in detail, including affect on macroeconomic factors like GDP, and also micro economic factors like demand for commodities.

Crude oil is both a major driver and beneficiary of the inflation mega-trend because during times of high inflation or expectations of future high inflation the highly liquid crude oil market is utilized to both hedge against and speculate in favor of future inflation, thus one could say illustrates the self full-filling prophesy at work as witnessed during 2008 that saw inflation hedging result in a surge in the crude oil price to $148, which had the effect of dragging inflation higher, only to crash as a consequence of the financial crisis which continued into the deflation of late 2008 and early 2009. In addition to its inflationary impact, crude oil is also subject to Peak Oil, which the next section touches upon.

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Oil Price Impact on the Stock Market The consensus view as iterated on a near daily basis in the mainstream press and on the internet is that rising oil prices are generally bearish for the stock market, and falling oil prices are generally bullish. However, the Dow and Crude Oil price illustrates that most of the time the oil price and the stock market (Dow Jones index) can be expected to trend in the same direction. This clearly implies that most of the time a rising oil price is associated with economic growth and thus rising future prospects for corporate earnings are discounted by rising stock prices. Whereas a falling oil price is associated with weaker future economic activity and thus implies lower future corporate earnings which is again discounted in the present. As mentioned earlier, rising oil prices are part of an inflationary mega-trend, which means that as higher oil prices trend higher, the associated costs can be expected to be passed into consumers in an orderly manner, thus the peak oil mega-trend is bullish for nominal stock prices. The only fly in the ointment is that as illustrated by the oil price trend during the first half of 2008, when there was a serious divergence between the stock market and the oil price as mania gripped the market that sent inflation soaring, and thus as the oil price soared the stock market entered into a severe bear market. However this divergence did not persist as oil price bubble burst sending the oil price literally crashing lower, playing catch up to the stocks bear market into the March 2009 low. A rising trend for oil prices is bullish for the stock market as long as it does not involve a parabolic mania driven spike that is likely to kill future economic demand and is thus discounted in the present by the stock market trending lower, with the oil prices soon catching up to the stock price decline as occurred during the second half of 2008. The current situation with oil prices hovering just above $100, is not bearish for the stock market as long as the oil price does nothing more than just trend higher rather than enter into a mania driven spike for instance to say $150 by mid summer, therefore a gradual uptrend is unlikely to impact negatively on the stock market. Inversely a weak oil price is likely to be bearish for the stock market. However the current outlook is at worst suggestive of oil prices consolidating before trending higher and therefore continue to support a bullish outlook for stock prices.

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Impact on the Global Economy The latest World Economic Outlook projections were based on an assumed path of oil prices that is about $5/barrel lower in 2001 and 2002 than suggested by futures markets during October and November 2000. Higher oil prices affect the global economy through a variety of channels:

There will be a transfer of income from oil consumers to oil producers. As the propensity to spend of those who lose income (energy consumers) is generally larger than the propensity to spend of those who gain income (energy producers), there will be some fall in demand. On an international level, the transfer is from oil importing countries to oil exporters (Table 1), and oil exporters tend to expand demand only gradually (in the past, they have spent about 1/3 of their additional revenues after one year, rising to 75 percent after 3 years). In addition, a reduction in demand can also occur within producing countries that allow higher oil prices to feed through to consumers, as energy producers tend to have a lower propensity to consume than energy consumers.

45

46

47

There will be a rise in the cost of production of goods and services in the economy, given the increase in the relative price of energy inputs, putting pressure on profit margins. As the oil intensity of production in advanced countries has fallen over the past three decades, the supply side impact for a given increase in oil prices can be expected to be less than in past episodes. In developing countries, however, where the oil intensity of production has declined less, the impact may be closer to that in the earlier period. There will be an impact on the price level and on inflation. Its magnitude will depend on the degree of monetary tightening and the extent to which consumers seek to offset the decline in their real incomes through higher wage increases, and producers seek to restore profit margins. These responses can create a wage/price spiral, as was the case, for example, during the oil shocks in the 1970s. There will be both direct and indirect impact on financial markets. Actual as well as anticipated changes in economic activity, corporate earnings, inflation, and monetary policy following the oil price increases will affect equity and bond valuations, and currency exchange rates. Finally, depending on expected duration of price increases, the change in relative prices creates incentives for suppliers of energy to increase production (to the extent that there is scope for doing so) and investment, and for oil consumers to economize. To undertake an analysis of these five channels, several simulations of a sustained $5 per barrel (20 percent) increase in the price of oil were run using MULTIMOD, focusing on the implications for real GDP, inflation, and monetary policy. In these simulations, it is assumed that the monetary authorities in advanced countries target expected core inflation, while fiscal policy is passive, allowing automatic stabilizers to operate. The results, reported in Table 2, indicate that a $5 per barrel increase in the price of oil would reduce the level of global output by around percentage point over the first 4 years, after which the output losses slowly fade away. The impact is somewhat larger for industrial countries than for developing countries as a group, particularly as regards domestic demand, largely due to terms-of-trade effects (as many developing countries are net oil exporters). However, as discussed below, the significant diversity across developing countries, in particular the mixture of oil exporters and importers, means that the impact on individual developing countries is often large.

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Table 1. Impact of an Oil Price Increase of - $5 per barrel on Oil Exporting and Oil Importing Countries Petroleum $5 per barrel increase Oil Exporters Dependent 1/ Diversified Oil Importers Total

(in billions of U.S. dollars) World of which: Advanced of which: USA Japan Euro-11 Developing of which Western Hemisphere Middle East and Europe Asia Africa OPEC Transition of which Russia 59 5 0 0 0 48 8 32 0 8 40 6 5 6 3 0 0 0 3 2 0 1 0 0 0 0 -65 -52 -17 -10 -17 -10 -3 -1 -4 -2 0 -3 0 0 -44 -17 -10 -17 41 7 31 -3 6 40 3 5

(in percent of GDP) World of which: Advanced of which: USA 3.3 3.0 0.0 -0.2 -0.1 0.0 -0.2 -0.2 -0.2 0.0 -0.2 -0.2

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Japan Euro-11 Developing of which Western Hemisphere Middle East and Europe Asia Africa OPEC Transition of which Russia Source: WEO and staff calculations.

0.0 0.0 3.5 1.1 6.4 4.8 5.3 6.1 2.1 2.2

0.0 0.0 -0.4 -0.4 0.0 -0.4 0.0 -0.3 -0.1 0.0

-0.2 -0.3 -0.3 -0.3 -0.4 -0.2 -0.6 0.0 -0.6 0.0

-0.2 -0.3 0.6 0.2 3.6 -0.2 1.4 4.9 0.5 2.2

An oil-dependent exporter is defined as a country for which at least 10% of export earning are derived from the (net) exports of oil. Some of the limitations of this exercise should be recognized. First, these results underestimate the global impact in that they do not incorporate the impact of higher prices of other energy products, such as gas, which is a particularly important source of energy in the transition countries. Second, the impact of the rise in oil prices may be amplified if they exacerbate existing macroeconomic imbalances or lead to inappropriate policy responses, particularly in oil importing countries. Third, the simulations take little account of relative demand effects within countries.

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The Impact on Industrial Countries For the industrial countries as a group, real GDP falls 0.3 percentage points below the baseline in 2001 and 2002 before recovering subsequently, while real domestic demand follows a similar profile but with a somewhat greater short-term loss of 0.4 percentage points because of negative terms-of-trade effects. The impact on activity and demand in the United States and euro area are somewhat larger than the industrial country average, while the impact on the group "other industrial countries" is smaller than the average because the largest two members of this group-the United Kingdom and Canada-are net oil exporters. Headline CPI inflation rises in all countries in the short run, with particularly large impact in the United States and euro area, resulting in an increase in real and nominal short-term interest rates as monetary policy responds to counter second round wage and price increases (as noted earlier, the monetary authorities are assumed to target core inflation). The financial impact of the increase in oil prices is quite muted. Exchange rates remain relatively stable, with the dollar appreciating slightly relative to the yen and euro because the United States faces a smaller terms-of-trade shock. Lower expected future profits result in a fall of 1-2 percent in equity prices in the advanced economies. If adverse confidence effects were to magnify these effects, the corresponding effect on the real economy would also be larger. Financial market considerations are discussed in more detail below. These differences in response reflect the net effect of the differing importance of the four most important channels through which the oil price hike is transmitted to activity in the short-term-a temporary impact on supply potential proportional to the energy intensity of production (as the change in relative prices of intermediate goods temporarily disrupts existing production arrangements), the fuel tax wedge, the increase in expected core inflation, and the terms-of-trade impact on real incomes. The supply-side impact is largest in the United States, as it has a higher energy intensity of production than most other industrial countries. The higher the fuel tax wedge, the smaller the proportional impact on retail prices of a given rise in oil prices. The United States has the smallest wedge and hence the biggest impact. The inflationary consequences and monetary policy response are most significant in the United States and euro area, reflecting a combination of relatively high energy consumption (which increases the inflationary impact in the United States), inertia in the inflation process (which is particularly important in the euro area, with its labor market rigidities), and differences in resistance to real income losses (which is low in Japan). The negative terms-of-trade impact, on the other hand, is smaller in the United States than the euro area and Japan, as the United States has significant domestic oil production, and is positive for the other industrial countries as a group.

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Table 2. Permanent $5 per Barrel Increase in the Price of Oil: Baseline Scenario (Percent deviation from baseline unless otherwise specified) 2000 World GDP -0.2 2001 -0.3 2002 -0.3 2003 -0.2 2004 -0.1

Industrial Countries Real GDP Real Domestic Demand Trade Balance ($ billion) -0.2 -0.2 -26.7 -0.3 -0.4 -20.3 -0.3 -0.4 -22.4 -0.2 -0.2 -24.6 -0.1 -0.1 -24.7

United States Real GDP Real Domestic Demand Core Inflation CPI Inflation Short-Term Interest Rate Real Effective Exchange Rate Trade Balance ($ billion)

-0.3 -0.3 0.3 0.8 0.6 0.3 -12.2

-0.4 -0.5 0.3 0.5 0.8 0.5 -9.1

-0.4 -0.4 0.2 0.3 0.5 0.4 -10.5

-0.2 -0.3 0.1 0.2 0.2 0.3 -12.5

-0.1 -0.2 0.1 0.1 0.1 0.3 -73.0

Euro Area Real GDP Real Domestic Demand Core Inflation CPI Inflation Short-Term Interest Rate

-0.2 -0.3 0.1 0.7 0.5

-0.4 -0.5 0.3 0.5 0.7

-0.4 -0.6 0.3 0.4 0.5

-0.2 -0.5 0.2 0.3 0.2

-0.1 -0.3 0.1 0.1 ---

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Real Effective Exchange Rate Trade Balance ($ billion)

-0.5 -10.8

-0.8 -7.8

-1.0 -6.2

-1.1 -5.2

-1.1 -4.7

Japan Real GDP Real Domestic Demand Core Inflation CPI Inflation Short-Term Interest Rate Real Effective Exchange Rate Trade Balance ($ billion)

-0.1 -0.2 --0.3 0.2 -0.7 -10.5

-0.2 -0.3 0.1 0.2 0.2 -1.0 -8.5

-0.3 -0.4 0.1 0.1 0.2 -0.9 -6.5

-0.2 -0.3 0.1 0.1 ---0.7 -5.3

-0.1 -0.2 -----0.1 -0.5 -4.4

Other Industrial Countries Real GDP Real Domestic Demand Current Account ($ billion) -0.1 --7.4 -0.2 --6.4 -0.2 0.2 3.2 -0.2 0.3 1.0 -0.1 0.4 -0.7

Developing Countries Real GDP Domestic Demand Trade Balance ($ billion)

1

-0.1 --26.1

-0.2 --20.3

-0.2 -0.1 22.4

-0.2 -0.1 24.6

-0.2 -0.1 24.7

Includes countries not in other groups.

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Table 3 provides summary comparisons of this simulation result with estimated impact on industrial economies from two other global macroeconomic models: the OECD's INTERLINK and McKibbin-Sachs Global 2 (MSG2). The results show some interesting differences which highlight the uncertainties surrounding the estimated impact of an oil price increase.

The inflationary impact of the oil price shock, and the associated monetary response, are smaller in the other models. These estimated effects may be too small, as the baseline MULTIMOD results appear consistent with the weight of oil prices in CPIs. Despite a more limited monetary tightening, the real GDP effects using MSG2 are similar to those in the baseline scenario. The smaller impact reported by the OECD probably largely reflects both the more muted monetary policy response and the temporary nature of the assumed oil price shock. Table 3. Comparison of the Baseline Scenario with Outside Simulations Effects on Real GDP (in percent) First year Second year Third year Effects on CPI Inflation (in percentage points) First year Second year Third year

All Industrial Countries1 MULTIMOD2 OECD3 MSG2 United States MULTIMOD2 OECD3 MSG2 Euro Area MULTIMOD2 -0.2 -0.4 -0.4 0.7 0.5 0.4 -0.3 -0.1 -0.2 -0.4 -0.1 -0.3 -0.4 ---0.3 0.8 0.1 0.3 0.5 0.1 0.2 0.3 --0.1 -0.2 -0.1 -0.2 -0.3 -0.1 -0.3 -0.3 -0.3 0.6 0.2 0.2 0.4 0.2 0.1 0.3 --0.1

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OECD3 MSG2 Japan MULTIMOD2 OECD3 MSG2

-0.2 -0.0

-0.1 -0.2

---0.2

0.2 0.3

0.2 0.2

0.1

-0.1 -0.2 -0.1

-0.2 -0.1 -0.1

-0.3 ---0.1

0.3 0.2 0.3

0.2 0.1 0.0

0.1 --0.1

Source: The OECD simulations are reported in ECSS(2000)5, "Oil: Impact and Policy Implications of the Current Situation," October 24, 2000. The MSG2 simulations were generated by Warrick McKibbon of the Brookings Institution at the staff's request. 1 Corresponds to OECD countries in the OECD and MSG2 simulations. 2 Baseline scenario. 3 The OECD simulations consider a shock in which the oil price averages about 13 percent above baseline in the first year (2000), is 22.5 percent above baseline throughout the second year, and declines to 10 percent above baseline by the end of the third year. The results described above are based on price equations which incorporate historical estimates of the degree of resistance to declines in real income in advanced economies. It is possible, however, that the extent of inflation pass through from terms-of-trade disturbances has declined in recent years as labor markets and profit margins have become more flexible. In the current episode, the pass through from the oil price hike into core inflation in advanced economies appears to have been relatively limited, implying that the second round inflationary effects might be smaller than assumed above. It is also possible that the wage response is being delayed as relatively few labor contracts have come up for renegotiation, as the most recent hike in oil prices occurred since midAugust. Nevertheless, to explore the effects of limited second round effects further, Table 4 reports a second MULTIMOD simulation which assumes that there is no pass through of the impact effects of higher oil prices into core inflation. As core inflation remains unchanged, the assumed monetary policy rule calls for essentially no change in shortterm interest rates. As a result, the fall in real GDP and real domestic demand is only around one half of the impact reported in the baseline. Other MULTIMOD results indicate that delaying the monetary response can significantly increase the loss in output if it erodes confidence in the central bank's commitment to control inflation, reinforcing one of the lessons from past oil shocks that the monetary response should be prompt. Finally, some additional simulation results also suggest that monetary policy errors can significantly increase the loss in output if they erode

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confidence in the central bank's commitment or ability to control inflation. The conclusion one can draw from these results is that monetary authorities need to make a broad based assessment and make use of a wide range of analytic tools in estimating the extent to which the oil price increase is likely to pass through into core inflation and have an impact on potential output in the short run.

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Impact on Developing and Transition Economies The impact on individual developing countries would likely be at least as large as for many of the industrial countries. On the one hand, oil exporting countrieswhich suffered seriously from the decline in oil prices in 1997-98benefit substantially (this includes a number of countries that have recently experienced financial crises, such as Ecuador, Indonesia, Russia, and Venezuela). On the other hand, there is a significant adverse impact on oil importing countries, especially as dependency on oil has not fallen to the same extent as in industrial countries. Figure 6 illustrates how the impact of a $5 per barrel oil price hike will affect developing countries differently. For example, in the top right quadrant the square marked United Arab Emirates shows that country has a large current account surplus and that the oil price increase is expected to further increase that surplus by more than 5 percent of GDP. By contrast, many of the oil-importing HIPC and transition economies are expected to be adversely affected. For example, Belarus was expected to be running a current account deficit of over 7 percent of GDP. The oil price hike would add to the current account deficit by about 1.6 percent of GDP. Mali, shown in the lower left quadrant, is an example of a HIPC country that is running a current account deficit of almost 15 percent of GDP. The oil price increase would add to its current account deficit by 1 percent. A number of countries also face additional pressures from weak non-oil commodity prices, and have limited access to capital markets, which will further increase the adverse impact on domestic absorption. Table 4. Permanent $5 per Barrel Increase in the Price of Oil: Alternative Scenario (Percent deviation from baseline unless otherwise specified) 2000 World GDP -0.1 2001 -0.1 2002 -0.1 2003 -0.1 2004 -0.1

Other Industrial Countries Real GDP Real Domestic Demand Current Account ($ billion) -0.1 -0.1 -31.4 -0.2 -0.2 -22.1 -0.1 -0.2 -16.2 -0.1 -0.1 -13.7 ---0.1 -11.8

Developing Countries Real GDP -0.1 -0.1 -0.2 -0.2 -0.1

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Domestic Demand Trade Balance ($ billion)

--31.4

--22.1

--16.2

0.1 13.7

0.1 11.8

Major Emerging Market Economies Table 5 summarizes the impact of a $5/barrel increase in the price of oil, estimated by IMF country desks for 16 major emerging market countries, separating out the direct effect of higher oil prices, and the second round effects stemming from the decline in global growth and higher interest rates in advanced economies. The results vary widely by region, depending in large part on the relative size of oil importing to exporting countries. Asia experiences the largest negative impact on growth. Latin America, emerging Europe and Africa are less adversely affected by the oil shock owing the larger influence of net oil exporters in aggregate activity. There is an even wider variation within and across regions as to the impact of the oil price rise on inflation, depending on the pass through to domestic prices and whether countries allow the oil price increase to feed through into administered energy prices. Asia is expected to experience the largest increases in inflation, owing in part to the rapid pass through of oil price increases to domestic prices. Figure 6. Impact of a $5 per Barrel Oil Price Increase on Current Account Blances

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Table 5. Emerging Markets-Estimated Effects After 1 Year of a $5 Oil Price Hike Real GDP First Round External Total Effect (percent)1 Inflation Current Account First Round External Effect (percent of GDP)1 -0.1 -0.1 -0.1 -0.3 -0.1 -0.2 -0.1 -0.1 -0.4 -0.2 -0.5 -0.3 -0.5 Total

Latin America Argentina Brazil Chile Mexico Asia China India Indonesia Korea Malaysia Philippines Thailand Emerging Europe and Africa Pakistan Poland Russia

-0.0 -0.1 -0.1 -0.1 0.1 -0.2 -0.2 -0.4 0.5 -0.4 0.2 -0.5 -0.4

-0.1 -0.1 -0.1 -0.2 -0.1 -0.2 -0.2 -0.1 -0.4 -0.5 -0.4 -0.3 -0.5

-0.1 -0.2 -0.2 -0.2 0.0 -0.4 -0.4 -0.5 0.1 -0.9 -0.2 -0.8 -0.9

0.6 0.1 1.0 1.0 0.1 0.7 0.4 1.3 1.0 0.8 1.0 0.8 0.4

0.1 0.2 -0.1 -0.4 0.3 -0.3 -0.2 -0.5 1.0 -0.8 0.5 -0.7 -1.0

0.0 0.1 -0.2 -0.7 0.2 -0.5 -0.3 -0.6 0.6 -1.0 0.0 -1.0 -1.5

0.4 -0.4 -0.2 1.0

-0.2 -0.1 -0.1 -0.3

0.1 -0.5 -0.3 0.7

0.3 0.4 0.0 0.0

0.6 -0.8 -0.2 2.1

-0.3 -0.2 -0.2 -0.3

0.2 -1.0 -0.4 1.8

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South Africa Turkey

-0.2 ---

-0.2 -0.2

-0.4 -0.2

1.2 ---

-0.6 ---

-0.3 -0.3

-0.9 -0.3

Source: Staff estimates. 1 The external shock is calculated by the Research Department and is the sum of two second round effects on the current account: a decline in exports due to a fall in global demand of 0.3 percent (assuming an export elasticity of two), and an increase in shortterm debt payments, owing to the increase of world interest rates of 80 basis points, except for Asia where it is a scaled version of a similar exercise computed by APD. The first round effects on the current account are, on the whole, similar to those for growth. For all countries the external effects of the reduction in export demand and an increase in interest rates leads to a deterioration in the external accounts, although these effects tend to be much smaller than the first round effects, particularly for oil importers. Among the oil importing countries, the largest impact on GDP growth and the balance of payments is expected to be felt in India, Korea, Pakistan, Philippines, Thailand, and Turkey. Both Pakistan and Turkey were already expected to run sizable current account deficits, and given the oil price increase their current account deficits are expected to worsen by a further percent of GDP. The oil price hike generally benefits the six oil exporters in the sample, and the external current account position universally improves substantially. The impact on activity, however, is more ambiguous. Domestic demand and output can fall even in oil exporting countries, as the propensity to consume of oil producers within each economy is lower than the propensity to consume of oil consumers, and second round effects due to lower demand for exports and higher U.S. interest rates also slow activity. Overall, growth is projected to rise in Russia and Indonesia but to fall in Argentina, China, Mexico, and Malaysia. How do the above results compare with estimates by other analysts? Most of the work that has been published by other analysts has focused on measuring the direct effect of the oil price hike, and are generally consistent with. There are relatively few estimates of the impact on growth and inflation in developing economies. Recent work on the impact of the oil price rise in Asia by Deutsche Bank and Merrill Lynch, like the staff estimates, suggest relatively moderate effects.

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Oil Importing HIPC and CIS Countries While the Heavily Indebted Poor Countries (HIPC countries) and transition economies account for only a small share of global GDP, many of them are among the most seriously affected by higher oil prices. Indeed, 30 of the 40 HIPC countries, and a majority of the Commonwealth of Independent States (CIS) countries, are net oil importers. Most of these countries have very low per capita incomes, high level of oil imports relative to GDP, large current account deficits, high external debt, and very limited access to global capital markets. Many HIPC countries, and to a lesser extent the transition countries, are clustered in the lower quadrant, indicating these countries are already running large current account deficits and will encounter a significant deterioration in that balance. In the absence of international assistance, the lack of access to private capital markets will likely make the impact of higher oil prices on output relatively large, as it will have to be met primarily through a reduction in domestic demand. The direct impact of higher oil prices on the HIPC and transition countries are set out in . To put the impact of the oil shock in perspective, note that the largest negative first round impact on the current account for the emerging market economies was 0.5 percent (the Philippines), while the average impact for the oil-importing HIPC and CIS economies is expected to be 0.8 percent and 1.7 percent, respectively. All of the CIS and several HIPC countries will be seriously affected, with trade balance deteriorating by more than 1 percent of GDP. With essentially no access to international capital markets, this could well lead to a sharp contraction in domestic demand. The first round impact on the current accounts of the HIPC and transition economies is about $0.7 billion for both groups. In terms of quotas, this is around one eighth of quota for the average oilimporting HIPC and one quarter of quota for an average oil-importing CIS country.

Table 6. Selected HIPC and CIS Countries-Preliminary Estimates of First Round Effects of an Oil Price Increase and IMF Quotas First Round Effect1 (percent of GDP)2 Millions of US $3 (percent of IMF Quota)4 HIPC Countries5 Lao People's Dem.Rep Sao Tome & Principe Guyana -0.8 -2.2 -2.1 -2.0 -653.3 -36.4 -1.0 -18.5 -13.4 -71.8 -10.3 -15.7

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Burundi Mauritania Mali Ghana Nicaragua Sierra Leone Senegal Kenya Ethiopia Honduras Madagascar Guinea-Bissau Benin Togo Rwanda Uganda Guinea Malawi Zambia Niger Central African Rep. Chad

-1.8 -1.8 -1.3 -1.1 -1.0 -0.9 -0.9 -0.9 -0.9 -0.8 -0.8 -0.8 -0.6 -0.6 -0.5 -0.4 -0.4 -0.4 -0.4 -0.4 -0.3 -0.3

-13.6 -18.0 -32.9 -66.7 -23.2 -5.7 -40.5 -92.2 -53.8 -49.5 -31.6 -1.9 -15.4 -8.1 -10.5 -26.2 -13.1 -8.8 -13.7 -7.4 -3.4 -4.3

-13.6 -21.4 -27.2 -13.9 -13.8 -4.2 -19.3 -26.2 -31.0 -29.4 -19.9 -10.5 -19.1 -8.6 -10.1 -11.2 -9.4 -9.8 -2.2 -8.7 -4.8 -5.9

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Mozambique Tanzania Cote D Ivoire Burkina Faso

-0.3 -0.3 -0.2 -0.1

-11.6 -23.0 -19.5 -2.6

-7.8 -8.9 -4.6 -3.4

CIS Countries Moldova Mongolia Kyrgyz Republic Belarus Ukraine Tajikistan Armenia

-1.7 -3.6 -1.9 -1.7 -1.6 -1.4 -1.4 -1.3

-692.1 -48.9 -19.9 -22.3 -170.0 -390.0 -15.8 -25.1

-24.2 -30.6 -30.0 -19.4 -33.9 -21.9 -14.0 -21.0

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OPEC Countries A $5 per barrel oil price hike is expected to raise the net trade balance of the OPEC countries by approximately $64 billion (7 percent of GDP); after allowing for the impact of lower global growth, the net trade balance would improve by 6.5 percent of GDP. All of these countries are expected to experience improvement of their current account balances of between 4 and 9 percent of GDP, with Iraq as the largest beneficiary. Amongst the other countries, Venezuela stands to gain the least and Nigeria the most, reflecting the relative importance of oil in the economy. 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. In many oil exporting countries, a significant proportion of higher oil revenues will accrue to the government . The reaction of the government, in turn, is likely to depend on the underlying financial situation of the country. Saudi Arabia, which has traditionally been a net creditor, may choose to replenish reserves. The authorities may also decide to use some of the additional revenue to ease spending restraints adopted as oil prices declined. For other oil exporters that have in the past been net debtors, such as Mexico and Venezuela, a rise in oil prices would not only increase export earnings but could also lower external borrowing costs, assuming the higher oil prices would reduce the risk premia charged these countries as their future export earnings rose. Table 7. OPEC - Preliminary Estimates of First Round Effects of an Oil Price Increase and Global Slowdown Effect (current account as a percent of GDP) First Round1 Venezuela U.A.E. Libya Kuwait Algeria Saudi Arabia Qatar Nigeria 4.0 5.6 5.8 6.0 6.6 6.7 6.8 8.7 Global Slowdown2 -0.2 -0.3 -0.2 -0.3 -0.2 -0.2 -0.3 -0.3

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Iraq
1 2

13.0

-0.4

Computation is based on an increase of oil prices of $5 per barrel. Computation is based on a decline in exports due to a fall in global demand of 0.3 percent (from Multimod) assuming an export elasticity of 2. Both the baseline simulation reported above and the OECD simulations assume that oilexporters would spend around 75 percent of their additional export revenues on imports after three years, in line with historical averages. However, this estimate could be on the high side and hence the increase in imports by major oil exporters could be underestimated. In the GCC countries, the completion of major infrastructure projects, greater government expenditure controls, and rising privatization receipts may well reduce the short run propensity to spend the additional revenues. More generally, the oil price rise is viewed by many as temporary, which may increase the desire to save the proceeds. Finally, countries that run down reserves in response to the oil price falls in 1997 and 1998 may use current revenue to rebuild external reserves and strengthen their fiscal positions, and there appears to be a determined effort by most oil exporters to avoid the boom-bust cycle of the past. C. Financial Markets An increase in the oil price, by affecting economic activity, corporate earnings, inflation and monetary policy has implications for asset prices and financial markets. Table 8. Selected Oil-Exporting Developing and Transition Countries: First-Year Impact of a 20 Percent Increase in Oil Prices on Public Sector Revenues1 1998-99 Averages Fiscal Position Oil revenue as a Estimated impact on percent of total public Overall balance government revenue sector revenue (percent of GDP) (percent of GDP) Africa Algeria2 Angola Cameroon Congo, Rep. of 58.4 78.8 23.3 64.2 -2.2 -14.1 -1.2 -12.9 4.6 8.5 0.6 3.2

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Gabon Nigeria

49.9 75.7

-12.8 -7.5

2.8 8.2

Asia Brunei Darussalam 77.3 -26.8 4.4

Middle East and Europe Bahrain Egypt Iran Kuwait Oman Qatar Saudi Arabia Syrian Arab Rep. 51.5 7.1 41.0 58.5 69.6 69.8 63.9 43.4 -4.8 -3.3 -2.8 7.0 -2.1 -2.8 -8.4 -0.5 1.7 0.2 4.8 3.2 2.6 2.4 2.7 1.4

Western Hemisphere Mexico Trinidad and Tobago Venezuela Countries in Transition Azerbaijan Kazakhstan 10.3 2.4 -4.3 -6.5 0.4 2.4 34.4 11.2 69.9 -1.1 -0.6 -2.5 0.4 0.4 1.8

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Russia

7.4

-5.7

0.6

Source: IMF staff estimates. 1 Countries classified as fuel exporters in the World Economic Outlook. 2 Hydrocarbon (incl. gas). The impact on financial markets in turn provides additional channels through which the oil price increase would affect economic variables. However, given cyclical developments in the world economy, it is unclear to what extent the recent increase in the oil price has been directly responsible for the recent turbulence in advanced country financial markets and movements in currency markets. In the case of oil importing emerging markets, however, there have been noticeable adverse effects across a range of financial and currency markets, which appear directly linked to oil market developments, while risk premia on external debt of most oil exporters have declined significantly. In equity markets, an increase in oil prices would be expected to lead initially to a weakening in the earnings of firms producing energy intensive output and in their market valuations. This would occur both through higher production costs, which would be particularly severe in the traditional manufacturing and transportation companies, as well as through the slowdown in demand. Subsequently, if the oil price rise were deemed to be permanent, there would be adjustment costs entailed in changing the input mix, with substitution away from oil. There is evidence that in both industrial and emerging countries there have been adverse effects of higher energy prices on production costs and corporate earnings. Until the beginning of this year, however, these effects were masked by cyclical upturns, increasing business and investor confidence, rising profit margins, and in the case of the Asian countries, sharp recoveries from the downturns in the preceding years. Thus in the first year or so following the rebound in oil prices (mainly in 1999) global equity markets appeared to be rising almost in tandem with the rise in oil prices.Since then, there has been a sharp sell-off in global equity markets, particularly in the technology sectors, and a significant increase in volatility in these markets. There are clear indications that the increase in oil prices has had an adverse effect on equity markets by affecting the pace of activity and corporate earnings, as well as confidence. Nevertheless, it is important to note that the sell-off in equity markets reflects a number of other developments. The most important of these is a sharp scaling back of earnings expectations and a more realistic assessment of growth prospects of companies, particularly in the technology sector, which is largely independent of developments in oil prices. More narrowly, there have been concerns about the operations of companies in the telecom sector, which appear to have overextended themselves, leading to spill-over effects in the rest of the technology sector. Another important and related factor has been the tightening in monetary policy in the United States and also in Europe, with spill-overs effects globally. Although some of the tightening has been clearly in response to concerns

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about rising inflation and inflationary expectations due to the increase in oil prices, in the United States at least it also reflects growth above potential and tight labor markets. The effect of the oil price rise in the fixed income markets has been relatively limited, and in some cases has been offset by other developments. This reflects, in particular, the evidence that the effect of the oil price hike on inflation has been relatively muted. An assessment of inflation indexed bonds in the major countries suggests that expectations of inflation, after increasing markedly last year, have stabilized or even eased .Government bond yields, after rising last year by about 75 to 100 basis points, have fallen back this year, partly reflecting the government debt buybacks mainly in the United States. It is also possible that the surpluses by oil exporters have been invested in the government bond markets, leading to the downward pressures on yields At the shorter end of the yield curves, there has been an increase, reflecting both the tightening monetary stance as well as the increase in inflation.

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In the case of oil importing emerging markets, yields on local currency denominated debt have increased somewhat more than the increase in yields in industrial countries. This reflects in part the larger impact on inflation, given the greater energy intensity in emerging markets, but may also reflect uncertainties about the monetary response. Spreads on hard currency debt have also increased somewhat over the past year, and reflect some waning in external investor confidence in the prospects of these economies which may be related in part to higher oil prices. In the case of major oil exporting emerging markets, particularly Russia, there has been a significant decline in spreads reflecting improving external and fiscal balances. Finally, in currency markets it has been suggested that the desire to invest the proceeds of oil exporters in U.S. dollar denominated assets, and increased transactions demand for dollars in which oil is priced, have meant that higher oil prices are associated with a stronger value of the U.S. dollar. A recent study suggests that higher oil prices are positive for the U.S. dollar exchange rate and have exacerbated the downward pressures on the euro. While there are a variety of other factors underlying the configuration of the G3 currency rates, it is possible that in the recent period higher oil prices have had some effect on the G3 currencies. It should be noted, however, that the value of the Japanese yen has continued to be high against the euro, even though Japan's dependence on oil is similar to that of the euro area. The currencies of several emerging markets have recently come under pressure as oil import bills have increased, and there has been some slackening in the flow of portfolio capital and direct investment. However, the pressure on currencies has been exacerbated by a variety of economic and political factors unrelated to developments in the oil market.

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Policy Implications For much of the period since the October 2000 World Economic Outlook was completed, oil prices have averaged $5 per barrel higher than assumed in that exercise. A sustained oil price increase of that size would imply a permanent transfer of about percent of GDP from global oil importers to oil exporters, relative to the WEO baseline, with additional transfers of income from oil consumers to oil producers within countries. Such a terms of trade shock would affect the global economy through supply and demand effects as well as via second-round effects on inflation, for example, through higher wage claims. This in turn would affect the extent to which central banks raise interest rates to offset inflationary pressures, and therefore the impact of the oil price increase on real activity. The impact on asset prices and financial markets would provide additional channels. As simulations in Section 2 indicate, the size of the impact on demand and activity depends critically on these factors. While it is still too early to make a final judgment, the latest data suggest that the impact on core inflation in advanced countries has been relatively modest to date and there is little sign of feed through into wage claims. Although there has been a decline in consumer and business confidence, they so far remain relatively strong and although stock prices have fallen, the decline appears to be much more due to non-oil related factors. On the other hand, however, there are signs that expenditure by oil producing countries may be lower than the staff's model suggests, which would tend to increase the adverse effects on global growth, and the impact of higher prices of other fuels-notably gas- also needs to be taken into account. Overall, were oil prices in 2001 to be $5/barrel higher than anticipated in the WEO baseline, the overall impact on global growth would likely be of the order of percent in terms of yearly average growth, with the effects concentrated in 2001. If oil prices were to fall back-as the most recent futures market data suggest-the $5/barrel shock would be temporary rather than permanent in nature, and the impact on activity therefore reduced.

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In developing countries, the impact of a sustained $5/barrel oil price increase would vary widely across countries. It would be the largest in Asia, where there are relatively few oil producers. Given current account surpluses or small deficits in many of these countries, balance of payments are not in most cases a concern, but there would be an unwelcome brake on activity in present circumstances. The impact would generally be smaller in the Latin American countries, while many of the HIPC and several CIS economies would be quite seriously affected. With regard to policy implications, as experience in previous oil shocks shows, monetary policy in advanced countries will need to prevent second round price effects. This will help ensure that there is only a price level effect, but not a continuing impact on the rate of inflation. This is likely to be helped at the current juncture by generally greater flexibility of labor markets in most advanced countries. The underlying fiscal stance should in general remain broadly unchanged, although automatic stabilizers can play a role in supporting activity. On the microeconomic side, any adjustment of taxes on gasoline and other petroleum products would need to be considered in terms of what is appropriate from the overall fiscal and macroeconomic situation. If the oil price increase appears to be temporary, there would appear to be little merit in adjusting taxes. However, if prices remain, or are expected to remain, at a higher level and ad valorem taxes generate revenue increases greater than required for fiscal policy considerations, there is bound to be some rethinking of the best use of the revenue windfall. The appropriate strategy will depend upon the tax structure of the country concerned.

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The macroeconomic policy implications for oil importing developing countries are similar to those for advanced economies in terms of monetary policy and the fiscal response, with the appropriate macroeconomic response also depending upon the cyclical situation, existing policy stance, and exchange rate regime. Countries with fixed exchange rates will, of course, be unable to ease the impact on activity through a currency depreciation. Finally, it is particularly important that oil importing countries minimize budgetary costs by passing through the hike in oil prices onto administered energy prices, especially if there is a reduction in access to international capital markets, constraining the ability to use foreign borrowing to finance the deterioration in the external accounts. The major policy issue for oil-importing HIPC and CIS countries is their inability to cushion the impact of the terms-of-trade shock. This implies that, in the absence of additional concessional official finance, the adjustment to the oil price hike would need to come from a reduction in domestic demand relative to output. Such an adjustment would most probably require a combination of fiscal tightening and a depreciation in the real exchange rate. As long as an adequate policy response is implemented, there would be a strong case for additional international assistance to help cushion the short-term disruptions caused by an oil price hike that appear likely to be temporary. Unlike in oil-importing countries, the main policy issue in the major oil-exporters is ensuring that the fiscal and terms-of-trade benefits of higher oil prices do not lead to an excessively procyclical policy stance. Given the high volatility of oil prices, it is particularly important to ensure that government spending is not increased rapidly to levels which may become unsustainable if oil prices fall in the future.

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Responses of Advanced Economies to Previous Oil Price Hikes The rapid increase in oil prices over the past eighteen months is the fourth such episode in the past three decades. At the end of 1973, the first "oil price shock" triggered by production constraints agreed by OPEC brought a lengthy period of stable prices and market conditions to an abrupt end. Prices subsequently remained high in real terms, and the further reduction of OPEC production at the end of 1979 (in part because of the Iranian revolution) precipitated the second oil price shock. Although real oil prices fell somewhat through the early 1980s, these two shocks resulted in a fifteen-year period of historically high oil prices which ended at the beginning of 1986 when OPEC, or more specifically Saudi Arabia, abandoned production constraints. The third, and very temporary, spike in prices occurred in the second half of 1990 on fears of major supply disruption as a result of the Persian Gulf crisis. When these fears were not realized, prices soon fell back to their pre-crisis level. Looking at the economic conditions and policy responses surrounding earlier oil price shocks, the 1973/74 price rise came at a time of strong growth in the global economy which led to rising inflationary pressures. Real GDP in the G7 countries increased by 8 percent (annualized) in the first half of 1973, with inflation in this period rising to 7 percent compared with 4 percent in 1972. Monetary and fiscal policies were already being tightened in response to these pressures: short-term nominal interest rates increased from 4 percent on average in the G7 in 1972 to nearly 8 percent in 1973 (although the increase was much smaller in real terms), and there was also some improvement in general government structural balances. As a result, economic activity was probably already slowing-albeit from a very strong level-when the oil shock occurred. The direct terms of trade loss resulting from the 1973/74 oil price increase was equivalent to around 2 percent of GDP in the OECD area and, combined with the earlier tightening of macroeconomic policies, led to an accelerating contraction in output throughout 1974 and the first half of 1975. Current account imbalances in the OECD area also became unevenly distributed among countries as a result of different rates of growth, inflation, and supply-side adjustment. To counter the contraction, fiscal policies were substantially eased-mainly in 1975 among the main industrialized countries (an exception was Germany, which eased in 1974). The monetary policy response was more varied across countries, however, and this was directly reflected in subsequent inflation experiences. Faced with the combination of falling output and rising inflation in 1974-1975, the United States, France, Italy, the United Kingdom, and Canada chose to reverse the earlier tightening of the monetary stance and to pursue generally accommodative policies. In the United States, for example, the Federal Funds rate, which had increased to around 12 percent in mid-1974, declined rapidly to under 6 percent in the first half of 1975, with real interest rates remaining close to zero for the rest of the 1970s. The expansionary policy stance in these countries may have contributed to the strong rebound of activity that began in the second half of 1975 and continued thereafter. Considering the usual policy lags, however, these policy measures may have added an excessive procyclical impulse, contributing to the

74

inflation difficulties that followed and adding to the eventual costs of disinflation. For these countries, the main policy message from the first oil shock is that macroeconomic stimulus is not a viable substitute for real adjustment.

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Table A1. Impact of Nominal Oil Price Hikes (U.S.$, unless otherwise stated) Direct Impact on Net Trade Balance of Advanced Countries (U.S.$ Billions) -88 -232 -38 -96 (% of GDP) -2.6 -3.7 -0.2 -0.4

Oil Prices Episode 1973 to 1974 1978 to 1980 1989 to 1990 1999 to 2001 Pre-hike1 Post-hike2 Change 3.2 13.3 17.9 17.9 11.6 36.6 28.3 29.0 8.4 23.3 10.4 11.1

Source: IMF staff estimates. 1 The average oil price in the first year of each episode. 2 The average oil price in the last year of each episode, except for 1990 and 2001. For 1990, it is the average price for the second half of the year. For 2001, the price is projected using futures markets data. In contrast, Germany and Switzerland maintained the restrictive monetary policies that had been put in place before the oil shock hit. The inflation impact of the oil price rise was largely limited to the first round effect, and consumer price inflation returned to low single-digit levels in the second half of the 1970s. In Japan, easy monetary conditions in the early 1970s contributed to a surge in output and inflation in 1973. In mid-1973, however, the Bank of Japan tightened monetary policy and maintained a firm antiinflationary stance in response to the oil shock. Inflation rose to nearly 25 percent following the oil price rise, driven by the momentum that had already built up in the economy, combined with Japan's high dependence on imported oil, but then declined rapidly to around 4 percent by 1978. A further notable point regarding the first oil shock was the substantial rise in the labor share of national income in all G7 countries apart from the United States. Reflecting in part the widespread use of indexation mechanisms, wages reacted strongly to the oil price rise, while firms were unwilling or unable to pass along higher wages and non-wage labor costs into output prices. Profitability fell and financial difficulties in the corporate sector increased, leading to sharp declines in investment and stockbuilding that were major contributors to the fall in GDP in 1975. The 1979/80 oil price hike, which had a terms-of-trade impact on advanced countries around one percentage point of GDP larger than the first shock, occurred at a time when the advanced economies were growing at a more moderate pace compared with the leadup to the previous shock. This was accompanied by higher unemployment and lower capacity utilization. Inflation, while still high in many countries, was generally declining

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rather than increasing as in 1973-with the notable exception of the United States where inflation pressures had been building even before the second oil shock hit. Compared with the first oil price shock, the policy response reflected macroeconomic concerns which focused more squarely on containing the inflation impact-including preventing a wage-price spiral and ensuring real wage adjustment. In the main industrial countries, short-term interest rates, which had already been rising prior to the oil price hike, were increased further in 1980 and 1981, with a cumulative average increase from 1979 to 1981 of 3 percentage points. This monetary policy tightening restored positive real interest rates, which averaged around 2 percent in the G7 in the early 1980s. Fiscal policy was also tightened, with structural deficits in most of the advanced economies declining from 1979 to 1982. While actual budget deficits in the G7 increased by 2 percentage points of GDP over this period, the cumulative discretionary tightening was around 1 percentage points of GDP after taking into account the effect of automatic stabilizers and higher interest rates. Wage growth did not pick up as it did in the first crisis and, reflecting this, the share of labor costs in G7 national income was broadly stable in the early 1980s. The policy response to the increase in oil prices in the second half of 1990 followed the pattern of the 1979/80 period. The very short-lived nature of this increase, coupled with the declining role of oil in overall economic activity, also limited the impact on inflation. In particular, the industrial countries maintained non-accommodative monetary policies in order to curtail the inflation impact of the oil price rise. In the United States, for example, the Federal Funds rate increased immediately after the sharp oil price rise in August, before declining subsequently as the economy slowed. In Europe, the oil shock came on top of fiscal stimulus arising from the reunification of Germany. To stem the inflation risks arising from this combination of pressures, short-term interest rates in Germany, France, Italy, and the smaller euro area economies increased substantially between 1990 and 1991, rising further in 1992. While the general government structural balance deteriorated sharply in Germany between 1990 and 1991, structural deficits declined in all the other major industrial countries over this period (apart from Japan, which maintained an unchanged surplus). These policy responses contributed to a rapid decline in inflation in the G7 countriesconsumer price inflation fell from 5 percent in 1990 to just over 4 percent in 1991 and 3 percent in 1992. In Japan and, to a lesser extent, the United Kingdom, the monetary tightening following the oil shock represented a delayed response to the asset price buildup of the late-1980s. The unwinding of these asset price pressures exacerbated the subsequent slowdown in these economies.

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Overall Policy Lessons 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. These short-term effects die away, in part because the response of oil production and consumption to price changes rises significantly over time. However, there can also be more long-lived negative effects on activity associated with the losses in capital due to large changes in relative prices of inputs, as well as the impact of lagged increases in the prices of oil substitutes. The disruption caused by an oil price hike also depends on the state of the business cycle, the response of macroeconomic policies, and the flexibility of the underlying economies. Key lessons from the past are:

Monetary policy should not accommodate second-round impacts of oil price shocks. Indeed, it is important to take action to pre-empt the second-round effects of the consequent inflationary pressures. If the monetary authorities accommodate an oil price shock, the resulting increase in inflation tends to get incorporated into inflationary expectations, which become persistent and significantly raise the costs of the subsequent disinflation. The underlying fiscal stance should remain broadly unchanged. Accommodating an oil price increase through expansion of the structural fiscal deficit has similar negative consequences as monetary accommodation, although automatic stabilizers can play a role in supporting activity. In particular, it is advisable for countries that administer domestic fuel prices to let oil price hikes feed through into domestic prices, rather than allow an increase in the underlying fiscal deficit. Greater flexibility of markets-in particular labor markets-can reduce the costs of an oil price hike on activity. In 1979, the high degree of real wage flexibility in Japan contributed to the relative stability of employment and output in response to an oil price shock. Non-market solutions, such as quantitative restrictions, should be avoided. Exceptionally low oil prices may also produce undesirable results. A period of very low prices may lead to reduced investment in such areas as oil exploration, refining capacity, and distribution systems, as well as energy-saving technologypotentially increasing subsequent price volatility and uncertainty if supplies of oil and refined products do not keep pace with rising demand.

Many of these lessons have already been reflected in the functioning of the global economy. In particular, monetary authorities have become more independent and have been given clear mandates to maintain price stability, while continuing structural policy initiatives have made economies more flexible. In addition, the oil intensity of production-particularly in the advanced economies-is lower than in the past, partly due to

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the impact of previous oil price hikes on technology, and several advanced countries are now significant oil exporters. Consequently, the oil price increase required to provide a terms-of-trade impact on advanced countries of the size seen in 1973/74 or 1979 would be very large-a price rise of over $50 per barrel. As far as taxes on petroleum products are concerned, such taxes are an important source of revenue in most advanced countries, but vary widely across countries and over time. The oil price hikes of the 1970s led to falls in effective tax rates as specific excise taxes on petroleum products were not altered. Since the mid-1980s, however, taxes have tended to increase. Any adjustment of taxes on gasoline and other petroleum products would need to be considered in terms of what is appropriate from the overall fiscal and macroeconomic situation. If the oil price increase appears to be of short duration, there would appear to be little merit in adjusting taxes. However, if prices remain, or are expected to remain, at a higher level and ad valorem taxes generate revenue increases greater than required for fiscal policy considerations, there is bound to be some rethinking of the best use of the revenue windfall. The appropriate strategy will depend upon the tax structure of the country concerned. Particularly for countries that have regulated prices, a full pass through of the oil price increase would generally be appropriate, if consistent with the overall macroeconomic and fiscal situation of the country.

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CONCLUSION

Hence in conclusion, we can say that the causes of crude oil price fluctuations are many, however they are mainly geo political, this is due to the great significance of crude oil in all countries and the power it gives the countries which produce crude oil over those who are heavily dependent on it. In recent times, it can be said that coupled with these geo political causes, a factor of speculation has been added, which has further amplified the situation of extreme volatility. On the topic of the repercussions, it can be said that too much movement in the prices can prove detrimental to the global outlook as a whole with perhaps the notable exceptions of oil exporting countries, who may gain. The various policies mentioned can be undertaken to minimize price rises, however it cannot totally negate the impact.

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BIBLIOGRAPHY Websites: www.imf.org www.oil-price.net www.en.wikipedia.com www.wrtg.com www.dubaimerc.com www.investopedia.com www.futurescrude.com www.oecd.org

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