INTERNATIONAL OIL PRICE UPDATE - OUT OF SESSION PAPER
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PACIFIC ISLANDS FORUM SECRETARIAT
FORUM ECONOMIC MINISTERS MEETING
Honiara, Solomon Islands
3-5 July 2006
OUT OF SESSION PAPER
INTERNATIONAL OIL PRICE UPDATE
The attached paper, compiled by the Forum Secretariat, highlights the international oil
price trends, outlines the reasons behind the recent step-up in oil prices and provides an
assessment of the possible macroeconomic implications for FICs and discusses some
policy options to cushion its impact. For information.PACIFIC ISLANDS FORUM SECRETARIAT
FORUM ECONOMIC MINISTERS MEETING
Honiara, Solomon Islands
3-5 July 2006
INTERNATIONAL OIL PRICE UPDATE
Purpose
This paper highlights the international oil price trends, outlines the reasons behind the
recent step-up in oil prices, provides an assessment of the possible macroeconomic
implications for FICs, and discusses some policy options to cushion its impact.
Background
2. International oil prices have increased rapidly in recent months. These significant
price movements are comparable to the four oil price ‘shocks’ in the last 35 years. The first
such shock to occur in 1973 was triggered by the Organisation of Petroleum Exporting
Countries (OPEC) production constraints, followed by the second episode in 1979 as a result
of the Iranian revolution and further reduction in OPEC production. The third was a brief
spike in oil prices during the 1990 Gulf war. The fourth was brought on by the Asian
financial crisis in 1997, which reduced oil demand and caused prices to slump.
3. The post-1990 crude oil price averaged around US$23 per barrel. However, oil prices
reached a historical high of $52 per barrel in October 2004, and in 2005 prices averaged close
to US$60. Annex 1 illustrates the recent oil prices trends. In April 2006, the crude oil prices
reached an unprecedented US$75 per barrel.
4. Oil prices are now at the highest level on record in nominal terms. However, in real
(US dollar) terms oil prices are well below the high levels observed following the second oil
shock of 1979. For example, the peak of almost US$40 per barrel seen in late 1979 is
equivalent to a level of nearly US$100 in today’s dollars.1 Nevertheless, oil prices in real
terms are around similar levels reached following the first oil shock in late 1973 and the price
spike at the time of the Gulf War in 1990.
5. The rapidly rising crude oil prices are a cause for concern. The International Energy
Agency (IEA), in collaboration with the International Monetary Fund (IMF), has estimated
that a US$10 per barrel increase in oil prices reduces global GDP by around 0.5 per cent in
the following year, and boosts consumer prices by a slightly larger amount.2 However, an
1
Bloomberg
2
‘Analysis of the impact of high oil prices on the global economy’, International Energy Agency, May 2004.
2important caveat regarding these results is that the analysis does not really distinguish
between supply and demand shocks. Nonetheless, results are useful for distinguishing that
impact differs between countries depending on the oil intensity of consumption and the degree
to which the country is a net importer of oil. For instance, the negative GDP impact is 0.3
percent for the United States; for Japan it is 0.4 percent; for Euro zone it is 0.5 percent; and
for Asia 0.8 percent. In this context, the correlation of oil shock periods and a subsequent
pullback in global industrial production is expected.
6. Oil price futures for end-December 2006 are predicted to be above US$60 per barrel.3
This is also supported by the recent4 signal from the President of OPEC that the oil cartel’s
policy stance will be guided by a new price band between the high US$50s and the low
US$60s range a barrel. This is extremely high when compared with OPEC’s last official
price band which was set between US$22 and US$28 a barrel. This band was ignored as oil
prices climbed over the last two years and the band was subsequently scrapped in early 2005.
7. This has consequences for FICs, not only because export markets are affected, but also
because the domestic economy is directly affected. However, it is important to emphasise
that while recessions have been linked to increased oil prices, not all increases in oil prices
have led to recessions, e.g. the 2003 oil spike due to Iraq invasion.
Issues
Reasons for the protracted oil price increase
8. Demand for oil has increased strongly in recent years in line with rising global
economic activity. Much of the increase in demand has come from China and other
expanding economies in Asia. The Chinese economy itself has accounted for close to one-
third of the increase in global demand in the past two years. Further economic expansion in
Asia will place ongoing pressure on oil demand, with per capita oil consumption likely to rise
significantly from current relatively low levels as incomes rise.
9. Although global supply capacity has also expanded in recent years, this has not
occurred at the same rate as global demand. Historically, OPEC has had significant excess
capacity and has adjusted its supply to reduce swings in market prices. However, OPEC now
accounts for less than 40 per cent of global supply, and that it is currently producing very
close to its capacity.5
10. Markets have focused on a number of threats to short-term oil supply including the
limited production in post-war Iraq largely due to the dilapidated condition of its
infrastructure, and the ongoing political instability in the Middle East and in other oil
producing countries.
3
Bloomberg
4
Statement dated 14 March 2006
5
International Energy Agency
311. Overall, the recent increase in oil prices appears to reflect a combination of demand
and supply factors. Although some of these may be transitory and scope exists for some
degree of substitution to other energy sources, the long-run growth in demand and relatively
modest production capacity increases suggest that a good part of the increase in prices could
persist. Hence, even if the prevailing short-term supply uncertainties were to dissipate, it
seems unlikely that the per-barrel oil price will return to OPEC’s earlier US$22–US$28 target
band in the foreseeable future. This is the contemporary consensus prediction by market
analysts and it appears to be consistent with recent developments in oil futures prices, which
have also risen in line with the spot price.
Macroeconomic implications
12. The sharp increases in oil prices in the 1970s had significant adverse effects on the
world economy, putting upward pressure on inflation rates and lowering economic growth.6
These price increases were ‘supply shocks’, where the effects on activity arise because higher
oil prices increase the costs of production across the economy, representing a reduction in the
aggregate supply of goods and services that can be sustained at any given price level. In
addition, the rise in oil prices represents a loss of real income to oil consumers, which implies
that aggregate demand in net oil-consuming countries will be weaker than otherwise. This
income is transferred to oil producers and if there is no equivalent boost to aggregate demand
in those countries, there will be a net negative effect on world economic growth.
13. Oil price shocks have an almost immediate impact on the economy as it increases
production input costs and final consumer prices of retail fuel, amongst other consumables.
These increases have the potential to temporarily increase the headline inflation rate and if
they become ingrained in price and wage setting behaviour then it could translate to
continuing inflation. Oil price shocks are also usually associated with a slowing domestic
economy, household consumption and private investment in particular, and rising
unemployment rates.
14. The key channel of transmission through to domestic economic activity is from lower
consumer and investment spending. Increases in retail petrol prices act as a ‘tax’ on
household income reducing discretionary income and the volume of household consumption
expenditure. Businesses experience rising input costs, but since consumer prices are sticky,
full cost increases cannot be passed onto final prices. Businesses must rationalise spending in
order to maximise profitability and the sacrifice in such instances is usually investment
spending, although this usually happens with a lag. There will be further negative impacts on
economic growth through reduced exports to the extent growth in major trading partners is
reduced.
6
Oil Price Strike Back, in Business Review Federal Reserve Bank of Philadelphia (22/3/2002) makes reference
to the seminal work by James Hamilton (1983), on the relationships between output and oil-price increases –
demonstrated through the finding that five of the six recessions in the United States between 1947 and 1975 were
preceded by a significant increase in the price of oil.
415. Through the channels discussed earlier, protracted oil prices will be a drag on
aggregate outputs in FICs given the significant dependence on oil imports required to support
economic activity.
16. High oil prices will likely affect the poor and disadvantaged groups through higher
prices for kerosene for cooking and lighting, and higher transportation costs. Further, prices
of basis necessities that are imported would also increase as a result of higher transportation
costs.
Macroeconomic Implications of Oil Price Shock – Australian Economy
The likely negative macroeconomic implications of the recent oil price shock to the Australian
economy include:
1. A transitionary increase in headline inflation. The Reserve Bank of Australia estimates show a
US$10/barrel increase in oil prices at A$/US$ exchange rate of around 0.70 results in adding about 9
cents/litre to retail petrol prices and about ½ pc point to headline inflation.
2. A decline in household consumption expenditure as fuel consumption is inelastic in the short term,
meaning higher fuels prices effectively increase ‘taxes’ paid by consumers. Given that household
savings ratio is already negative, reducing savings is not a feasible option, rather reduced consumption
of other goods and services.
3. Increased uncertainty for businesses; higher oil prices and current uncertainty regarding future
direction of oil prices (as reflected by futures contracts) could see some businesses delay investment
decisions.
Source: ANZ Investment Bank, Oil prices and the Australian economy, Weekly Market and Strategy Update, No. 41/ 2004 –
www.anz.com.
17. Protracted rise in oil prices add directly to headline inflation although the effect drops
out of the annual rate calculation after a year (i.e. does not cause a permanent upward shock to
prices in the first instance). Policy makers tend to focus on core inflation excluding the
impact of petrol and volatile items. This is not impacted in the first instance by higher oil
prices, but can be influenced by second round effects where higher oil feeds into production
costs and wage demands, and ultimately higher prices to consumers.
18. A cursory examination of inflation rates in FICs over the last year suggests moderate
pass through effect of higher oil prices, at least at the aggregate level. However, low data
integrity due to dated CPI baskets and often poor survey coverage, including the fact that
transmission of higher prices may be lagged, can be plausible explanations. The adoption of
prudent macroeconomic policies has also contributed to the moderate inflation levels in some
FICs. More so, further examination of other macroeconomic variables, such as the variability
of Real Effective Exchange rates, current account and balance of payment positions, real
sector outputs, and balances in the financial account, will help reconcile the macroeconomic
effects of higher oil prices in FICs.
5Policy options
19. The broad areas through which public policy interventions can be made include:
economy-wide subsidy, sector-specific subsidy, monetary policy, effective use of pricing
mechanisms and oil substitution. It must be noted that the discussions in the section below
does not suggest a bias towards any one form of intervention, nor does it cover the costs and
benefits of each option in any detail. The discussions provide a general overview of some
policy responses to help cushion the impact of higher oil prices.
Economy-wide subsidy
20. A reduction of fiscal duty on petroleum products can be considered if the price
exceeds a trigger threshold level, set by authorities. This will provide relief to all the sectors
of the economy. For example, Fiji could reduce fiscal duty rates which are currently
chargeable at 18 cents per litre on diesel and 44 cents per litre on motor spirit. In addition, the
rate of Value Added Tax on all petroleum products (where applicable) could be reviewed,
although this should be weighed up against the possible distortions introduced to the taxation
system.
Sector-specific subsidy
21. Sector-specific intervention can also be considered by governments to provide relief
from the oil price increases to targeted disadvantaged groups and the essential sectors. Policy
intervention through the provision of direct subsidies and tax rebates to sectors affected
significantly by increases in fuel prices could be seen as an extension of government’s social
obligations. Evidence in economic literature indicates that subsidising kerosene is one of the
most direct instruments a government could use to cushion the poor from the effects of oil
price rise, although there is little evidence in favour of general petroleum subsidies. These
fiscal policy interventions need to be considered on a case by case basis.
22. In addition to subsidies or tax rebates, other forms of fiscal assistance can also be
considered based on individual country preferences and administrative feasibility. These have
in the past included waiver of export taxes, and direct price support though with mixed
results. Therefore, it is essential that guidelines for FIC government intervention needs to be
formulated to improve the levels of transparency in the criteria for granting subsidies.
Monetary policy
23. Central banks (where applicable) may be tempted to gradually tighten monetary policy
in response to higher inflation rates caused by increasing oil prices. This may be necessary
over the short term to maintain macroeconomic and price stability, including the need to
protect foreign exchange reserves. The costs and benefits of the monetary policy decision
needs to be considered in the context of short to medium term national policy objectives. As
widely recognised, price stability should remain the underlying target of monetary policy.
24. Oil price increases result in higher foreign currency denominated energy bills and, if
all other factors remain constant, this worsens the balance of payments constraints. An option
would be to consider external borrowing and/or balance of payments support from donor
resources. Nonetheless, external borrowing must be consistent with individual FICs medium-
term external debt management strategy. Members may wish to note that the IMF has
6recently launched the Exogenous Shocks Facility (ESF) which provides policy support and
financial assistance to low-income countries facing exogenous shocks, including oil price
hikes.7
Using pricing mechanisms
25. Petroleum products are under price control in some FICs. This allows for a periodic
review of petroleum prices through a template developed for this purpose in consultation with
stakeholders. However, in light of the continued developments in the sector, there is room for
review of the various components contained in the template based on possible changes to
business operations/cost structure. A review of pricing template may be of some assistance in
re-aligning landed costs of petroleum products.
Oil substitution
26. The current high oil prices can be viewed as a signal to reduce the heavy reliance on
oil. To this end, a number of technologies could be considered including blending petroleum
with ethanol as being done in Brazil, use of Jatropha oil as a substitute to kerosene, bio-fuel
alternatives, and resorting to large scale renewable energy sources. However, it is unlikely
that these solutions can be implemented in the short run, although it is encouraging to note
that some FICs have already commenced work to tap alternative sources of fuel.
Regional solutions
27. Tapping on the opportunities provided by regionalism, such as bulk procurement of
petroleum products at the regional or sub regional levels are currently being explored, as
mandated under the Pacific Plan, and these, if implemented, could provide some assistance to
FICs over the medium to long term.
Conclusion
28. The implications of the oil price escalation will differ from one FIC to another. On the
whole, FICs are faced with the serious challenge of dealing with the effects of the protracted
higher oil prices, and bridging the financing gap both in terms of the fiscal balances and the
balance of payments.
Pacific Islands Forum Secretariat, Suva
14 June 2006
7
.Details of the key features of the ESF facility and the conditionalities involved are available on
http://www.imf.org/external/np/exr/facts/esf.htm. Low-income countries, as per the IMF definition, are eligible
to apply.
7ANNEX 1
Tapis Crude Oil Price (2001-2006)
80.00
70.00
60.00
U S $ p er b arrel
50.00
40.00
30.00
20.00
10.00
0.00
Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1 Q2 Q3 Q4 Q1
2001 2002 2003 2004 2005 2006
Source: Platts Oilgram Price Reports
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