Oil prices & global economy

Ali AZZOUZ MSc Asset Management Petroleum Economics Engineer Algeria Email : ali_azzouz_iap@yahoo.fr

Title:

Has this recent high oil prices really affected the global economy?

Ali AZZOUZ

October 2006

1/17

Oil prices & global economy Content 1. Introduction………………………………………………………………............................……………....…… 2. Causes of recent high oil prices and its evolution since 1999……………...............………
3. Impact of high oil prices on the global economy……………………………………........................
3.1. Impact of last oil shocks on the global economy………………………........................……. 3.1.1 Impact of the 1973-1975 oil shock on the world economy………………................. 3.1.2 Impact of the 1979 oil shock on the world economy……………………….................. 3.1.3 Impact of the 1991 oil shock on the world economy……………………............................

3.2 The variables that can be affected from the increase in oil prices…...............……... 4. Analysing the changes in recent GDP “Gross Domestic Product” with recent oil prices………………...……..........................……………….............…......
4.1 Variation of GDP in some important countries and in the world………............................... 4.1.1 Recent Variation on USA real GDP “Gross Domestic Products”………........................ 4.1.2 Euro-zone Countries GDP and its variation…………………………...................……...... 4.1.3 Variation on China’s GDP………………………………………………….............................….... 4.1.4 Changes in Japan GDP……………………………………………………...............................…….. 4.1.5 Changes in World GDP……………………………………………….............................………...... 4.2 The Impact of recent rise in oil prices on GDP growth………...............………............……...

5. Analysing the recent Inflation “Consumer Price Index”……………..................…...…………..
5.1 Variation of Inflation in some important countries and in the world…...................... 5.1.1 Recent Variation on USA Inflation…………………………………………............................. 5.1.2 Euro-zone Countries Inflation and its variation……………………..................….…….. 4.1.3 Variation on China’s Inflation……………………………………………...........................…..... 5.1.4 Changes in Japan Inflation……………………………………………............................….…….... 5.2 Recent World Inflation and oil prices……………………………….......................………..….....

6. Analysing the changes in other macro-economic Variables with the recent oil prices…………………………………………………………………………..........................................….…...

6.1 Interest Rate………………………………………………………………...................................………….... 6.2 Trade Balance…………………………............................................................................
Conclusion…………………………………………………………………………….................................………….... References……………………………………………………………………………..................................…………....

Ali AZZOUZ

October 2006

2/17

Oil prices & global economy

1. Introduction:
The universe is made of cycles, all things are related to each other, and all things are going or seeking for equilibrium. Such are the oil prices; they are strongly related to many things. In a free market environment where the competition dominates, the oil prices change mainly with the change in supply and demand either a shift in supply or demand or an increase or decrease in one of them affect the oil prices. And the change in oil prices has an output to the global economy. Many theories studied the phenomena and agreed that when oil prices exceed a certain level will strongly affect the economy and the more sudden and the more rapid the prices increase the more significant their effect on the economy [1] [2]. In The recent years there have been an increase in oil prices and has reached more than $72 per barrel in 08/2006 [3], the question is: has this increase of oil prices reached the level to hurt the economy? In other words: has this recent high oil prices really affected the global economy?

To answer this question I will follow the following methodology: First I will briefly present the causes of recent increase in oil prices and the evolution of the oil prices since 1978. After that I will present the impact of high oil prices on the global economy by studying the past oil price shocks and their effects on the economy. The objective of this part is determining the macroeconomic variables that can be affected by the rise in oil prices. Finally I will take some macroeconomic variables and analyse their changes with the change in the recent oil prices.

2. Causes of recent high oil prices and its evolution since 1999
Since 1999 oil prices started to increase to reach nearly $72 per barrel in 08/2006 [3] and many factors have put forward to explain these extreme movements in oil prices. Among these factors, the rising demand of oil (US and China demand), low stocks (oil companies are trying to became more efficient by operating with very low stocks), OPEC strategy (Managing its supply), action of speculation, violence in the Middle East, other political tension in non Middle East countries such as Nigeria and Venezuela and Insufficient US refining capacity (low US gasoline stocks) have helped in driving world crude oil price. [4]

Ali AZZOUZ

October 2006

3/17

Oil prices & global economy
Figure 1
80

Evolution Of Crude Oil Prices

70

60

50

40

30

20

10

0 1978 1997 1997 1997 1997 1998 1998 1998 1998 1999 1999 1999 1999 2000 2000 2000 2000 2001 2001 2001 2001 2002 2002 2002 2002 2003 2003 2003 2003 2004 2004 2004 2004 2004 2005 2005 2005 2005 2006 2006 2006

Source: Data extracted from EIA (Energy Information Administration) [3]

This graph shows the movement of oil prices since 1978 and the recent increase in oil prices has started from 1999 to go down in 2002 and started again to rise until 2006 to reach nearly $72 per barrel. We can see that from 2002 to 2006 the oil prices were more than doubled.

3. Impact of high oil prices on the global economy
Oil and gas are an important part of our everyday life, they heat and cool our homes and provide electricity. Many other products are made from oil and gas, including plastics, medications, clothing, cosmetics and many other items we may use daily. In addition to individual consumption of oil and gas, the industrial sector, transportation sector…etc which rely mainly on oil and gas.

3.1. Impact of last oil shocks on the global economy
The world economy has experienced many recessions accompanied with oil shocks, the 1973-1975 economic recession followed the oil embargo, 1980-1982 recession followed the second oil shock caused by the Iraq-Iran war and the Iranian revolution and the Gulf war which causes the rise in oil prices and another economic recession was occurred [1]

Ali AZZOUZ

October 2006

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Oil prices & global economy
3.1.1 Impact of the 1973-1975 oil shock on the world economy
The growth rate fell to 2.1% in 1974 and to 1.4% in 1975, The impact on worldwide trade also was tremendous: after a growth rate of 12% in 1973, growth was negative in the following two years -5.4% in 1974 and -7.3% in 1975, Another factor which has changed significantly was the flow of Foreign Direct Investment. While the annual Foreign Direct Investment Growth reached 40% in 1973, the rate fell by half in 1974, The oil shock of 1973-1975 had had a big effect on the US economy, however its GDP growth fell from more than 5.7% in 1973 to -0.5% and -0.19% in 1974 and 1975, Another factor which was significantly affected by this oil shock, is inflation, which was more than tripled from 1972 to 1974, from 3.3% to 11.1%, This changes also impacted upon the unemployment rate, which rose from 4.9% in 1973 to approximately 8.5% in 1975, NB: Data extracted from the reference [2]

3.1.2 Impact of the 1979 oil shock on the world economy
Worldwide economy growth slightly decreased from 4.7% in 1978 to 4% in 1979 to reach 0.8% in 1982, Greater fluctuation in the international trade, from 5.2% to -3.1% in 1982, US GDP growth fell by 0.23% in 1980 and unemployment in the US rose from 5.8% in 1979 to 7.6% in 1981 and 9.7% in 1982. Also US inflation rose from 7.6% in 1978 to 13.5% in 1980. NB: Data extracted from the reference [2]

3.1.3 Impact of the 1991 oil shock on the world economy
Worldwide GDP dropped from 2.5% to 0.8% in 1991, US GDP fell by 0.17% , the US unemployment rate rose from 5.6% in 1990 to 7.5% 1992, Foreign Direct Investment FDI was negative from 1990 to 1992 NB: Data extracted from the reference [2]

3.2 The variables that can be affected from the increase in oil prices
Global economy has experienced three oil shocks which were followed by economic recessions where many macroeconomic variables were affected. As oil is an important source of energy in nowadays world, the changes in its prices have an important role in the global economy. Ali AZZOUZ October 2006 5/17

Oil prices & global economy
If oil prices rise, individual and national expenses will rise which means oil prices are very important to the health of the global economy. Many experts analysed the impact of high oil prices on the global economy and they have found that many factors will change with the change in oil prices. High oil prices affect the global economy through a variety of channels; as summarised on the diagram bellow: [5] [6] [2] Shift in income from oil importing to exporting countries

Decrease in GDP and Increase in Inflation

Lower investment (decrease in Foreign Direct Investment)

Deterioration in Trade Balance Rise in Oil Prices

Decrease in Business and consumer confidence

Rise in the cost of production of goods and services

Direct and indirect impact on financial markets

Increase in unemployment

Figure 2: The variables that change with the rise in oil prices, [5] [6] [2]

4. Analysing the changes in recent GDP “Gross Domestic Product” with recent oil prices:
GDP: is the total value of goods and services produced by a nation which is the sum of all the value added by all activities which produces goods and services. [7] [8] All changes in consumption, investment, government spending, imports and exports of a nation can affect the GDP growth, which is generally defined as the sum of all these factors as represented on the following formula: GDP = Consumption + investment + Government spending + (Exports – Imports) [9] Ali AZZOUZ October 2006 6/17

Oil prices & global economy 4.1 Variation of GDP in some important countries and the world
4.1.1 Recent Variation on USA real GDP “Gross Domestic Products”
From the statistics provided by IMF (International Monitory Funds) in World Economic Outlook 2006 the US real GDP has changed over time as shown on the following table: The US annual percent change in the real GDP [10]
1998 4.2 1999 4.4 2000 3.7 2001 0.8 2002 1.6 2003 2.7 2004 4.2 2005 3.5 2006 3.4

We can summarise from this table that the changes in GDP started from 1999 with 4.4% to reach 0.8% in 2002. The US economy has slowed down that time, a decrease of more than 3% in its GDP growth. This decrease in GDP coincided with the rise in oil prices as shown on Figure 1. From 2002 until 2004 there was a recovery in US economy, its real GDP growth has increased from 1.6% in 2002 to reach 4.2% in 2004. As oil prices raised from 2004 to 2006 the US real GDP went down from 4.2% in 2004 to 3.4% in 2006. This recent rise in oil prices has affected partly the US Real GDP in a way that the decrease in US real GDP coincided with the rise in oil prices. This in tow periods, the first period was from 1999 to 2001 and the second period was from 2005 to 2006.

4.1.2 Euro-zone Countries GDP and its variation
Euro Area annual percent change in real GDP [10]
1998 2.8 1999 2.9 2000 3.8 2001 1.9 2002 0.9 2003 0.7 2004 2.1 2005 1.3 2006 2.0

The Euro-zone countries real GDP growth started to went down from 3.8% in 2000 to reach 0.7% in 2004 and went up to 2.1% in 2004 than down to 1.3% in 2005. As we can see the variation in GDP in the Euro-zone countries is much more important than that of USA in this period of time. We can also see from this table and figure 1 that almost all these fluctuations on GDP coincided with the changes in oil prices.

4.1.3 Variation on China’s GDP
China’s annual percent change in real GDP [10]
1998 7.8 1999 7.1 2000 8.4 2001 8.3 2002 9.1 2003 10.0 2004 10.1 2005 9.9 2006 9.5

Ali AZZOUZ

October 2006

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Oil prices & global economy
China’s GDP did not come down until 2004, this slight drop of GDP, 10.1% in 2004, 9.9% in 2005 to 9.5% in 2006 may has a relation with the oil prices as they have risen from 2004 to 2006 (see figure:1). And as some experts suggest that the oil prices do not have a big impact on Chinese economy because its level of dependence on international oil is 20%, which is still lower [11].

4.1.4 Changes Japan GDP
Japan Annual percent change in real GDP [10]
1998 -1.8 1999 -0.2 2000 2.9 2001 0.4 2002 0.1 2003 1.8 2004 2.3 2005 2.7 2006 2.8

From this data it can be seen that the Japanese economy was not much influenced by the recent rise in oil prices. A little drop in its GDP was seen in 2001 and 2002.

4.1.5 Changes in World GDP
World annual percent change in real GDP [10]
1998 2.8 1999 3.7 2000 4.8 2001 2.6 2002 3.1 2003 4.1 2004 5.3 2005 4.8 2006 4.9

From this table we can see the overall GDP which is the world growth in recent years which came down in 2001 and 2005. The recent two rises in oil prices (Figure 1) are followed by a slight drop in world growth.

4.2 The Impact of recent rise in oil prices on GDP growth:
As summarised above the changes in GDP were small compared with past economic recession at a moment of oil price shocks where big drops on GDP growth occurred. The countries that have been hurt most by the increase in oil prices are OECD countries and other Oil-Importing countries [5]. The worldwide GDP fell from 4.8% in 2000 to 2.6% in 2001 which is a little big drop compared with that of 2004-2005, from 5.3% to 4.8%. In the first drop of world GDP growth the oil prices reached more than $30 per barrel (oil prices rose by $10 per barrel in one year 2000-2001). In the second rose which was in 2002-2005 the GDP dropped from 5.3% to 4.8% and the oil prices were more than doubled in a period of more than 3 years, which means that the impact is not very important (there was not a sudden increase in oil prices).

Ali AZZOUZ

October 2006

8/17

Oil prices & global economy

Figure 3 :
70 60

Oil Prices and World GDP Growth

50

40

30

20

10

0 1998 1999 2000 2001 2002 2003 2004 2005 2006

Oil Prices $ per barrel

Worldwide GDP %

Source: Data extracted from EIA (oil prices) and IMF (GDP) [3] [4]

The graph shows the variation in recent oil prices with the Worldwide GDP, a big increase of oil prices faced by small fluctuations on GDP, which means this recent changes in oil prices did not really influenced the Worldwide GDP Growth.

5. Analysing the recent Inflation “Consumer Price Index”
The inflation is an important indicators for the macroeconomic of a country, is defined as the rise in the prices of good and services [12] or the rise in price level [13]. Among the measures of inflation we find The Consumer Price Index, Producer Price Index, Wholesale Price Indexes and Commodity Price Index [13]. In this case I used the Consumer Price Index to see the variations of Inflation. The Consumer Price Index is a number used to measure change. To determine the Consumer Price index, an arbitrary date should be set and a number should be attributed to this date, than determine the change in prices by referring to the number which is the set as a base [14]. The chart bellow shows the movement in World Oil Prices and Inflation, it shows the strong relation between oil prices and inflation, when oil prices rise, inflation also rise and when oil prices drop down, inflation also decreases. This relation demonstrates that oil has a relation with many other goods and services as discussed already.

Ali AZZOUZ

October 2006

9/17

Oil prices & global economy

Figure : 4

Source : Energy Information Administration (EIA) [15]

5.1 Variation of Inflation in some important countries and in the world:
5.1.1 Recent Variations in USA Inflation (Consumer Price)
USA annual percent change in Inflation [10]
1998 1.5 1999 2.2 2000 3.4 2001 2.8 2002 1.6 2003 2.3 2004 2.7 2005 3.4 2006 3.2

The recent increases of oil prices have small impact on the US inflation, as shown on the table above the consumer price increased from 1.5% in 1998 to 2.2% in 1999 than 3.4% in 2000. Another increase was from 1.6% in 2002 to 3.4% in 2005.

Ali AZZOUZ

October 2006

10/17

Oil prices & global economy
Figure : 5
4

US Consumer Price

3,5

3

2,5

2

1,5

1

0,5

0 1998 1999 2000 2001 2002 2003 2004 2005 2006

Source: Data extracted from the World Economic Outlook April 2006 IMF [10]

This chart shows clearly how US inflation changed with the change in oil prices (see figure: 1 for oil prices). One increase in oil prices was in 1999 and the other from 2003, as figure 5 shows, the inflation increased in 1999 and from 2003 to 2005.

5.1.2 Euro-zone Countries Inflation and its variation
Euro-zone countries annual percent change in Inflation [10]
1998 1.1 1999 1.1 2000 2.1 2001 2.3 2002 2.2 2003 2.1 2004 2.1 2005 2.2 2006 2.1

The recent increases of oil prices have not influenced the Euro-zone countries Inflation at all. As shown on this table, only the rise in oil prices of 1999 which affected a little the inflation, an increase from 1.1% to 2.1% in 2000 than remained nearly constant.

4.1.3 Variation on China’s Inflation
China annual percent change in inflation [10]
1998 -0.8 1999 -1.4 2000 0.4 2001 0.7 2002 -0.8 2003 1.2 2004 3.9 2005 1.8 2006 2.0

Ali AZZOUZ

October 2006

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Oil prices & global economy
The impact of the rise of oil prices on inflation is clear in China’s case, the inflation increased from -1.4% in 1999 to 0.4% in 2000 and from – 0.8% in 2002 to 3.9% in 2004. Thus the China’s inflation has changed a lot since the oil prices start to rise in 1999.

5.1.4 Changes in Japan Inflation
Japanese annual percent change in inflation [10]
1998 0.6 1999 -0.3 2000 -0.9 2001 -0.7 2002 -0.9 2003 -0.3 2004 -2005 -0.3 2006 0.3

The main change in Japanese inflation is from 2005 to 2006 as shown on the table.

5.2 Recent World Inflation and oil prices
Figure 6 :
12,00

World Inflation (Consumer Price CP)

10,00

8,00

6,00

4,00

2,00

0,00 1998 1999 2000 2001 2002 2003 2004 2005 2006

Advanced Economies CP

Emerging Markets and Developing countries CP

Source: Data extracted from the World Economic Outlook April 2006 IMF [10]

Figure: 6 summarise the changes in Consumer Prices in both blocs in the world, the Advanced Economies such as USA, Japan, Euro Area,… etc and the Emerging Markets and developing countries such as Middle east, Central and eastern Europe, developing Asia, Africa,…etc

Ali AZZOUZ

October 2006

12/17

Oil prices & global economy

Figure : 7
70

Oil Prices and World GDP Growth

60

50

40

30

20

10

0 1998 1999 2000 2001 2002 2003 2004 2005 2006

Oil Prices $ per barrel

Source: Data extracted from EIA [3]

If we compare the evolution of inflation since 1998 (figure: 6) and the evolution of oil prices (figure: 7), we will see clearly the impact of oil prices on the inflation. Oil prices rose from nearly $25 per barrel in 2002 to reach more than $70 per barrel in 2006, and if we look to the changes occurred on inflation, we will see that the Advanced Economies Inflation rose slightly from 2002 to 2006 and that of Emerging Markets and developing countries was still going down but the rate of the decrease was very small compared with the years before. If we compare this recent variation in inflation with that in periods of oil shocks discussed already, we can conclude that the changes occurred in inflation in recent years are not so important, because when oil shocks happened the inflation doubled even tripled in some cases.

Ali AZZOUZ

October 2006

13/17

Oil prices & global economy

6. Analysing the changes in other macro-economic Variables with the recent oil prices
6.1 Interest rate
The interest rate is the cost of borrowing money or the rent paid to borrow money, which is expressed as a percentage usually over a period of one year [16] [17]. Interest rate has an important role in the macro-economy of a state, if interest rate increases, the investment decreases which causes a fall in national income [16]. The following graph shows the changes occurred on Interest rate in the Advanced Economies (USA, Euro-Zone, Japan…) since 1998.

Figure : 8
5,00 4,50 4,00 3,50 3,00 2,50 2,00 1,50 1,00 0,50 0,00 1998 1999

advanced economies interest rate

2000

2001

2002

2003

2004

2005

2006

advanced economies interest rate

Source: Data extracted from the World Economic Outlook April 2006 IMF [10]

If we compare this figure with the figure: 7 of oil prices, we will see that when oil prices rose in 1999-2000 the interest rate also rose, and the same thing happened from 2003 to 2006. The impact is small but we can not ignore it, because a small change in the interest rate hurt the rate of investment therefore the employment.

Ali AZZOUZ

October 2006

14/17

Oil prices & global economy 6.2 Trade Balance:
The Trade balance is the difference between the financial value of exports and imports over a certain period of time [18]. The trade balance presents the exports and imports of a country; it shows their difference and the position of country, if it is a net importer or a net exporter.

Billion $
100,00

Figure : 9

Advanced Economies Trade Balance

0,00 1998 -100,00 1999 2000 2001 2002 2003 2004 2005 2006

-200,00

-300,00

-400,00

-500,00

-600,00

-700,00

Advanced Economies Trade Balance

Source: Data extracted from the World Economic Outlook April 2006 IMF [10]

If we compare this figure which is the evolution of Advanced Economies Trade Balance with the oil prices (figure 7) we will see that the oil prices have a very big impact on the trade Balance. Some advanced Economies were net exporter until 1999 while the oil prices rose and the majority of Advanced Economy countries shifted from the net exporter to the net importer. And the financial value of the imports continues to increase as oil prices increase.

Ali AZZOUZ

October 2006

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Oil prices & global economy

Conclusion:
In the analysis we have analysed the movement of the main macroeconomic variables in the recent years while oil prices have increased, and we have seen that almost all the variables in all over the world have changed and have affected by the recent oil prices, but not a level to drive the global economy into a recession. The last oil price shocks have driven the economy into recessions, nearly the same scenario was happened in the recent years, the price of oil was more than doubled, from $30 a barrel to more than $70 a barrel but the economy did not go into recession, what is the exception this time? I believe that the reason was the period of time in which the oil prices reach the high level and their speed of increase. In the past recessions the oil prices took a few months to double but in the recent years the movement of oil prices was more gradual which was extended over several years (from 2002 to 2006).

Ali AZZOUZ

October 2006

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Oil prices & global economy

References:
[1] The Effects of Oil Shocks on the Economy: A Review of the Empirical Evidence, Marc Labonte,
June 2004: http://www.taxpayer.net/energy/pdf/CRS_ReportOil_Shocks_Jun04.pdf#search=%22CRS%20Report%20for%20Congress%20oil%20shocks%22 [2] Past oil prices shocks: Political background and economic impact, evidence from three cases by Pascal Ditté and Dr Peter Roell: http://www.isn.ch/pubs/ph/details.cfm?lng=en&id=20499 [3] EIA: http://tonto.eia.doe.gov/dnav/pet/pet_pri_wco_k_w.htm [4] Html Document: http://news.bbc.co.uk/2/hi/business/3708951.stm [5] Analysis of the Impact of High Oil Prices on the Global Economy (International Energy Agency) May 2004: http://www.iea.org/textbase/papers/2004/high_oil_prices.pdf#search=%22the%20economic%20 effects%20of%20high%20oil%20prices%22 [6] The impact of Higher Oil Prices on the Global economy (International Monitory funds) Prepared by the research department and approved by Michael Mussa, December 8, 2000: http://www.imf.org/external/pubs/ft/oil/2000/oilrep.PDF#search=%22impact%20of%20oil%20pri ces%20on%20the%20global%20economy%22 [7] Glossary: www.tepper.cmu.edu/afs/andrew/gsia/investclub/Glossary.htm [8] National Statistic Glossary: http://www.statistics.gov.uk/about/glossary/economic_terms.asp [9] Encyclopedia Wikipedia: http://en.wikipedia.org/wiki/GDP [10] World Economic Outlook April 2006, IMF, International Monitory Funds: http://www.imf.org/external/pubs/ft/weo/2006/01/pdf/weo0406.pdf [11] HTML Document: Rising Oil Prices Effect on china’s Economy: http://english.peopledaily.com.cn/english/200009/15/eng20000915_50569.html [12] Trader Glossary: http://www.trader-soft.com/option-trading/option-glossary/i.html [13] Encyclopedia Wikipedia: http://en.wikipedia.org/wiki/Inflation [14] HTML Document: http://inflationdata.com/inflation/Articles/Difference.asp [15] Energy Information Administration (EIA) : http://www.eia.doe.gov/emeu/security/sld002.htm [16] Encyclopedia Wikipedia: http://en.wikipedia.org/wiki/Interest_rate [17] Glossary: http://www.fhb.com/loans-mort-glossary.htm [18] Encyclopedia Wikipedia: http://en.wikipedia.org/wiki/Trade_balance

Ali AZZOUZ

October 2006

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