The Impact of Oil Price Increase on the Global Economy

Hyun Joon Chang

Korea Energy Economics Institute

  1. Introduction

The global economy experienced two oil shocks during the last three decades. The first occurred in 1973 following the Arab-Israeli War. It contributed to causing the first significant oil price increase by OPEC. In October 1973, Arab members of OPEC declared an embargo on exports. As a result, crude oil prices increased from an average of $4.15 per barrel in 1973 to $9.07 in 1974. The second took place in 1979. In the late 1970s, political unrest in the Mid-East created conditions for the dramatic oil price increases of 1979-1981. The government under the Shah of Iran, supported by the U.S., was the center of turmoil. When anti-west Islamic fundamentalists gained control of the country during the Iranian Revolution, Iranian oil production declined dramatically, leading to huge price increases. Crude oil prices increased from $12.46 per barrel in 1978 to $35.24 in 1981.

In an economic sense, an oil shock is defined as an increase of oil price large enough to cause a recession or a significant decline in global economic activity. The 1973 and 1979 episodes both qualify as oil crises by the definition. In 1974, GDP growth rate in OECD was 0.3 percent, -2.2 percent in US, -3.3 percent in Japan, and –0.5 percent in UK. In 1980, growth in OECD was 1.0 percent, -0.8 percent in US, 5.4% in Japan, and –3.0 percent in UK. Especially, the 1979 oil price increase put the industrial economies into a recession, this time the worst recession since the Great Depression. Inflation skyrocketed. For instance, U.S. inflation peaked at 13.5 percent in 1980, averaging 10.3 percent in the 1979-82 period.

Since March 1999, the global economy has experienced another sharp increases in oil price. In early 1999, most petroleum analysts viewed oil prices as artificially low, and the resulting low prices cut revenues to oil exporting countries. To address this situation, OPEC met in March 1999 and agreed to cut production, with goal of increasing crude prices to around or just above $20 per barrel. Although compliance to previous OPEC agreements had been difficult to maintain, adherence to this agreement has generally been good. Crude oil prices rose immediately, to $15 in April and to above $21 per barrel by September 1999. OPEC met again in September 1999 and agreed to maintain the production cuts through March 2000. The production cuts combined with persistent world economic growth pushed crude oil prices up, to above $24 in December 1999. In early January 2000, Saudi Arabia indicated OPEC’s resolve to stick to the production cuts through March, in spite of declining world crude oil and product inventories. Prices continued up, hitting $30 per barrel in January and February 2000. While lasting high crude oil prices lead to agreement to production increase in OPEC, oil prices was not going to fall because of declines of product inventories. With fluctuations, $30 per barrel had been maintained until US government decision to release 30 million barrels of SPR in September 2000. Crude oil prices hit above $35 per barrel (WTI $36.92 September 20, 2000) in September 2000, compared to $10 per barrel in February 1999. It was obviously most significant oil price increase after Iraqi invasion to Kuwait in 1990.

It has been argued that the recent oil price increases may be another oil crisis. Some assert that the recent oil price increase in third oil shock, while others affirm that it is totally different from the previous oil shocks. Even though there is little consensus on the oil crisis issue, it is evident that the recent oil price increases have affected differently between developing and developed countries. Many international organizations warned that high oil prices would hit developing countries. IMF, in September 2000, noted that poor countries, particularly dependent on non-oil commodity exports, have been hardest hit by the rise in world oil costs. The United Nations said rising oil prices took a heavy toll on cash-strapped developing countries in December 2000. On the other hand, we can little find that advanced or developed countries have severely been hit by rising oil prices, even though their domestic oil product prices have been skyrocketed.

In this paper, we assess the impact of oil price increase on the global economy, especially between developing and developed countries. First, we explain impact of oil price increases on the economy. Second, we investigate whether the impact is different between developed and developing countries. And in the next, we attempt to explain why the impact is different across developing and developed countries.

  1. Impact of oil price increases

Oil price changes affect economic activities such as growth, inflation, trade balance, and so on. It is generally agreed that oil price increases lead to sluggish economic growth. Many studies have supported this theoretically and empirically since the first oil shock in the 1970s. Actually, the oil shocks in the 1970s had significantly negative impact on the growth. Table 1 shows growth rates of the four countries around the oil shock periods of the 1970s.

Table 1. GDP Growth rates

1972-74 / 1978-80
1972 / 1973 / 1974 / 1978 / 1979 / 1980
US / 6.1 / 5.9 / -2.2 / 4.8 / 3.2 / -0.8
Japan / 9.4 / 10.2 / -3.3 / 6.0 / 5.9 / 5.4
UK / 3.5 / 5.3 / -0.5 / 3.6 / 1.5 / -3.0
West Germany / 3.0 / 5.3 / 0.4 / 3.3 / 4.5 / 1.8
OECD total / 5.7 / 6.3 / 0.3 / 3.9 / 3.3 / 1.0

Source: OECD

As seen in Table 1, GDP growth rates just after an oil price shock sharply fall down. In 1974, OECD GDP growth is 0.3 percent, compared to 6.3 percent in 1973. Also, In 1980, GDP growth rate of OECD is 1.0 percent, compared to 3.3 percent in 1979. This fact lets us know the impact was significant. Some economists assert that the oil crisis caused a decline in GDP of 4.7 percent in the US, 2.5 percent in Europe, and 7.0 percent in Japan[1]. And, according to the US government, the 1979 increase in oil prices caused world GDP to drop by 3 percent from the trend[2].

Oil price increases lead to high costs of production, raising a sharp inflation. In 1974, inflation skyrocketed, peaking at 12.4 percent in OECD. In 1980, inflation in OECD reached to 12.9 percent. Table 2 shows inflation rates in OECD countries over the oil price hike periods.

Table 2. Inflation in OECD countries over the oil price hikes

1972-74 / 1978-80
1972 / 1973 / 1974 / 1978 / 1979 / 1980
US / 3.2 / 5.6 / 10.2 / 7.5 / 11.3 / 13.5
Japan / 4.7 / 12.0 / 26.0 / 3.8 / 3.6 / 8.0
UK / 7.7 / 7.3 / 11.0 / 8.2 / 13.4 / 18.0
W. Germany / 5.9 / 5.8 / 6.5 / 2.7 / 4.1 / 5.5
OECD / 5.0 / 7.5 / 12.3 / 7.9 / 9.9 / 12.9

Source: OECD.

Then we can ask whether all the oil price increases affect economic activities seriously. We know all the oil price increases do not cause economic turmoil. Some conditions for oil price hikes are needed to cause economic recessions. The 1973 and 1979 crises shared three key characteristics. First, the disruption in oil supplies occurred at a time when the world economy was expanding at a rapid rate. The rapid economic growth stimulated greater use of petroleum. Second, both disruptions occurred when the world’s crude oil capacity was being stretched to the limit. Third, each crisis took place at a time when investment in oil and gas exploration had tapered off, making it impossible to achieve a speedy increase in non-OPEC output[3].

We can ask to ourselves if the recent oil price hikes may satisfy the above three conditions. First, the recent oil price hikes took place at a time when the global economy was expanding rapidly. We know that developed countries like US experienced booms and developing countries such as Korea, Malaysia, Indonesia, Taiwan, and Thailand rapidly overcame economic turmoil due to the financial crisis of 1997. This economic expansion started to increase petroleum use.

Table 3. GDP and oil consumption growth rates

1997 / 1998 / 1999 / 2000
GDP growth / 4.1 / 2.5 / 3.3 / 4.7
Oil consumption growth
World
OECD
Non-OECD / 2.4
1.0
4.3 / 0.7
1.2
0.0 / 1.6
1.2
1.9 / 1.3
0.0
3.4

Source: World Economic Outlook, IMF. Short-Term Energy Outlook, EIA.

Second, in Table 4, we can see OPEC’s production and capacity use. In capacity use, OPEC is expected to use around 90 percent of their capacity for production. The capacity use will be very high relative to previous capacity. The high capacity use might be caused by lack of new investment in production capacity of OPEC in a last decade.

Table 4. Estimates of OPEC productive capacity and capacity use

Capacity(1000bd) / Output(1q 2001) / Capacity use(%)
Algeria
Indonesia
Iran
Kuwait
Libya
Nigeria
Qatar
Saudi Arabia
UAE
Venezuela
OPEC 10
Iraq
Total / 900
1,350
3,800
2,200
1,450
2,300
750
10,500
2,500
3,050
28,900
3,100
32,000 / 827
1260
3744
2151
1430
2124
710
8498
2271
2954
25,970
2,221
28,191 / 91.9
93.3
98.5
97.8
98.6
92.3
94.7
80.9
90.8
96.9
89.9
71.6
88.1

Source: EIA

  1. Different Impact between Developed and Developing Countries?

It is generally agreed that the recent oil price increases affect the global economy severely. Here, we present IMF’s study[4] on the impact of oil price increases on global economy. Particularly, we assess the differential impacts across developing and developed countries.

The impact of an oil price increase of $5 per barrel on the global economy (IMF)

-Higher oil prices affect the global economy through a variety of channels

In the case of oil price increases, there will be a transfer of income from oil consumers to oil producers. On an international level, the transfer is from oil importing countries to oil exporters, and oil exporters tend to expand demand only gradually. It will affect income redistribution of the global economy.

Also, when oil prices increase and energy input prices rise, there will be a rise in the production costs in the economy, depending on degree of competition of the markets. As the oil intensity of production in developed countries has fallen over the past three decades, the cost side impact of increases in oil prices can be expected to be less than in past oil price increases. 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 a demand side impact of oil price increases. When oil prices rise, consumers are likely to delay or postpone their purchasing durables such as automobiles. This demand side impact leads to relative increase in inventories to sales and then decline industrial production.

Finally, depending on expected duration of price increases, the change in relative prices creates incentives for suppliers of energy to increase production and investment, and for oil consumers to economize.

-The impact on Industrial Countries

For the developed industrial countries, real GDP falls 0.3 percentage points below the baseline in 2001 and 2002. Headline CPI inflation rises in all countries in the short run, with particularly large impact in the US and euro area. The financial impact of the increase in oil prices is smoothed out. Exchange rates relatively stable. Lower expected future profits result in a fall of 1-2 percent in equity prices in the developed countries.

Interestingly, the cost-side impact is large in the US, as it has a higher energy intensity of production than other developed countries. The higher the fuel tax wedge, the smaller the proportional impact on retail prices of a given rise in oil prices. The US has the smallest wedge and hence the biggest impact. The inflationary consequences and monetary policy response are most significant in the US and euro area, reflecting a combination of relatively high energy consumption, inertia in the inflation process, and differences in resistance to real income losses.

-The impact on developing and transition Economies

The impact on developing countries seems to be at least as large as for many of the industrial countries. Oil exporting countries suffered seriously from the oil price decline in 1997-98 are expected to benefit substantially with recent oil price increases. On the other hand, there is a negative impact on oil importing countries, especially as dependency on oil has not fallen to the same extents as in industrial countries. Oil price increases affect developing countries very differently. Oil exporting countries such as UAE have a large current account surplus while many oil importing countries are expected to be adversely affected. The oil price increase would add to its current account deficit by 1.25 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.

In major emerging market economies, the results vary widely by region, depending 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. Among the oil importing countries, the largest impact on GDP growth and the balance of payments is expected to be in India, Korea, Pakistan, Philippines, Thailand, and Turkey. The oil price increases will affect China’s economic recovery, yet the direct impact of oil price hikes on China’s economy should be much less than that on most Asia-Pacific countries as the ratio of net oil imports to domestic oil consumption is much lower than the Asian average. The ratio for China is 22 percent, but 100.2 percent for Japan and 61.4 percent for the rest of Asia Pacific. Also, oil occupies only 26.6 percent in China’s primary energy consumption, much lower than other Asian countries, which are heavily dependent on oil.

While the Heavily Indebted Poor Countries (HIPC countries) and transition economies account for 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.

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 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 5. Permanent $5 per barrel increase in the price of oil

2000 / 2001 / 2002 / 2003 / 2004
World GDP
Industrial Countries
Real GDP
Real Domestic Demand
Trade balance ($ billion)
US
Real GDP
Real Domestic Demand
CPI Inflation
Trade Balance ($ billion)
Euro Area
Real GDP
Real Domestic Demand
CPI Inflation
Trade Balance ($ billion)
Japan
Real GDP
Real Domestic Demand
CPI Inflation
Trade Balance ($ billion)
Developing Countries
Real GDP
Domestic Demand
Trade Balance ($ billion) / -0.2
-0.2
-0.2
-26.7
-0.3
-0.3
0.8
-12.2
-0.2
-0.3
0.7
-10.8
-0.1
-0.2
0.3
-10.5
-0.1
26.1 / -0.3
-0.3
-0.4
-20.3
-0.4
-0.5
0.5
-9.1
-0.4
-0.5
0.5
-7.8
-0.2
-0.3
0.2
-8.5
-0.2
20.3 / -0.3
-0.3
-0.4
-22.4
-0.4
-0.4
0.3
-10.5
-0.4
-0.6
0.4
-6.2
-0.3
-0.4
0.1
-6.5
-0.2
-0.1
22.4 / -0.2
-0.2
-0.2
-24.6
-0.2
-0.3
0.2
-12.5
-0.2
-0.5
0.3
-5.2
-0.2
-0.3
0.1
-5.3
-0.2
-0.1
24.6 / -0.1
-0.1
-0.1
-24.7
-0.1
-0.2
0.1
-7.3
-0.1
-0.3
0.1
-4.7
-0.1
-0.2
-4.4
-0.2
-0.1
24.7

Source: IMF.

Table 6. Emerging Markets: Estimated Effects after 1 year of a $5 Oil Price Hike

Real GDP / Inflation / Current Account
(percent of GDP)
Latin America
Argentina
Brazil
Chile
Mexico
Asia
China
India
Indonesia
Korea
Malaysia
Philippines
Thailand
Emerging Europe and
Africa
Pakistan
Poland
Russia
South Africa
Turkey / -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
0.1
-0.5
-0.3
0.7
-0.4
-0.2 / 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
0.3
0.4
0.0
0.0
1.2
- / 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
0.2
-1.0
-0.4
1.8
-0.9
-0.3

Source: IMF (2000)

Table 7. Current Account Effects for a Sample of Developing Countries from $10 Increase in Oil Prices (as percent GDP)

Oil Importers / Oil Exporters / All Developing
East Asia and Pacific
South Asia
Latin America
Sub-Saharan Africa
Europe and Central Asia
Middle East and North Africa
Total Developing Countries
HIPC / -1.0
-0.9
-0.7
-0.7
-1.7
-1.1
-1.1
-1.4 / 2.0
0.0
2.0
19.5
10.3
11.4
5.7
19.0 / -0.7
-0.9
0.8
3.2
1.5
8.6
1.5
1.7

Source: World Bank (2000)

The impact of the recent oil price increase on developed countries has been less than the impact of price rises during the oil price shocks of 1973-74 and 1979-80, because output is much less dependent on oil than before. Nevertheless, the oil price rise has increased inflationary pressures and trade deficits in some of the industrial countries, as well as exacerbating tensions over the level of gasoline taxes. Oil-importing developing countries have been more severely affected than industrial countries, because they consume more energy for a given output and have less access to the external financing required to meet expenditure levels.

The United Nations said rising oil prices took a heavy toll on cash-strapped developing countries. The total bill for oil imports by the world’s 133 developing countries excluding China rose from 100 billion dollars in 1999 to about 160 billion dollars in 2000. The hefty 60-billion dollar increase was the equivalent of about 1.3 percent of GDP of the world’s poorer nations.

The oil-importing emerging market economies should be able to smooth the impact of the shock with private finance, through some with already large current deficits will have to proceed with caution. Oil-importing developing countries without access to private capital markets will face an additional official financing need of about $18 billion. Since countries will be undertaking some degree of adjustment, and the need for official aid flows to oil exporters may be much less for a time, the net additional call on international donors does not appear insurmountable.

Table 8. Growth of World GDP, 1998-2002

1998 / 1999 / 2000 / 2001 / 2002
World total
High-income countries
OECD
US
Japan
Euro Area
Non-OECD countries
Developing countries
East Asia and Pacific
Europe and Central Asia (ECA)
Latin America and the Caribbean
Middle East and North Africa
Sub-Saharan Africa
East Asia-5 countries*
Transition countries of ECA
Developing countries
Excluding the transition countries
Excluding China and India / 1.9
2.1
2.1
4.4
-2.5
2.7
0.7
1.0
-1.4
0.0
2.0
3.3
5.6
2.0
-8.2
-0.7
1.2
-0.6 / 2.8
2.7
2.7
4.2
0.3
2.4
4.2
3.2
6.9
1.0
0.1
2.2
5.7
2.1
6.7
2.5
3.3
2.2 / 4.1
3.8
3.7
5.1
2.0
3.4
6.3
5.3
7.2
5.2
4.0
3.1
6.0
2.7
6.9
5.0
5.3
4.7 / 3.4
3.0
2.9
3.2
2.1
3.2
5.1
5.0
6.4
4.3
4.1
3.8
5.5
3.4
5.5
4.2
5.1
4.4 / 3.2
2.8
2.7
2.9
2.2
2.8
5.1
4.8
6.0
3.9
4.3
3.6
5.5
3.7
5.1
3.7
5.0
4.5

* Indonesia, the Republic of Korea, Malaysia, the Philippines, and Thailand.