Monday, May 28, 2012

High Oil Prices: More Bad Than Good

High Oil Prices: More Bad Than Good
High oil prices are not good for everyone. While oil producers and probably some investors would benefit from high oil prices, the world in general would not.

We know that prices of seemingly unrelated commodities are highly correlated.[1]  So expensive food prices are most likely correlated with high oil prices.  And with the current global economic slowdown more people will be hurt.

Lucas Chancel and Thomas Spencer (May, 2012) report that high oil price appears to have played a role in the global financial crisis and the US subprime crisis. It worsened the balance-of-payment leading up to the financial crisis, and reduced aggregate demand via decreasing consumption.[2]  Oil exporting countries have been fueling the global liquidity glut.

Bernanke (June, 2011) said that the depreciation of the US dollar can explain a small part of the rise of oil prices, and the direction of causality runs from commodity prices to the US dollar.  Also see Plantier (2012) on the causes of commodity price hikes. There is no dispute on this matter since we know that the terms of trade shocks and commodity prices explain large parts of the currency.[3][4] 

High oil prices are not good for growth.  Oil is considered a curse for developing countries.  It has a negative impact on economic growth because it alters the incentives and increases rent.  It reduces hours worked and productivity.[5]  And for developed countries it increases the cost of production of goods and services. The sum of all the Arab countries nominal GDP in US dollars in 2012 is 86 percent of Franc's GDP and 16 percent of the US GDP.

But there is another bad wrinkle to high oil prices, the US government believes that high oil prices fuel terrorism.  The Institute for the Analysis of Global Security posted an article (not dated) explaining this causality.[6]  They essentially imply that high oil prices mean high revenues in the oil-producing rentier states and booming economic conditions.  The article adds that "ordinary Muslims contribute to charities in good faith believing their money goes toward good causes while others know full well the terrorist purposes for which their money will be used.  The money is funneled via the hawala system, which is the unofficial method used in many developing countries for transferring money, and "one of the key elements in the financing of global terrorism."  Foreign Policy In Focus published an article on this issue by Nafeez Mosaddeq Ahmed, December 15, 2010, where he cites Wikileaks documents revealing the US state of mind on this issue.[7]

Is the association of oil prices and terrorism born by the data?

Lets look at the available data.  I examine the West Texas price of oil published on the website of the Federal Reserve Bank of St Louis.  The price of oil is too high relative to its average.  For example, the average real price over the period from 1947 to 2011 is 14 USD a barrel.  West Texas sells for more than 100 USD a barrel today (British Petroleum publishes a real oil price series based on a number of prices from 1861 to 2010. The average is 29.44 USD).  Figure 1 demonstrates.

Figure 1

I also examine the Polity IV data set, which reports casualties by terrorism globally.  The data measure the number of non-combatant civilian and political targets who died by bomb attacks by non-state actors.  I sum the casualties across countries and places for each year.  For example, if there are casualties in two places A and B in a particular year I simply add casualties in A to those in B.  I then plotted the oil prices and casualties in a scattered plot in figure 2.

Figure 2

The correlation coefficient over that sample is nearly 0.80, which is really high. And, although the casualties data cover the whole world, high oil prices and casualties jumped after the invasion of Iraq in 2003.  I also found that past observations of oil prices explain terrorism while observations of casualties from terrorism do not explain oil price with the p values of the F statistic 0.09 and 0.41, respectively.[8]  However, this relationship needs more scrutiny because the cross sectional - time series raw data include terrorism casualties which are not related to oil, for example, the Oklahoma bombing and the recent terrorism act in Norway. And it is unclear whether certain oil producing countries do in fact cause terrorism casualties around the world.  Financing terrorism activities could be also be related to some institutional factors such as the type of political system, government, economic institutions, geopolitical factors, etc, non of which is clear from figure 2. 

The world would be less violent, grow faster, and general prices would be much more stable if the price of oil is lower than it is now.  But it is difficult to see how would that happen with China and India, for example, expecting to demand more oil, the US military continuing to be spread around oilfields, Iran continuing its standoff against the West, trouble continuing in Nigeria, and uncertainty and tensions are running high in places like Libya, Iraq and the Gulf. These factors can put an upward pressure on oil prices given limited production and reserves. 

For oil prices to fall the world oil supply has to increase substantially. It is possible if, first, Iraq’s aim to increase production to 12 million barrels a day comes true, but this will take a long time.  Second, the US (the largest consumer of oil by far) becomes energy self-sufficient again via improved technology that would increase production of gas and oil from proven reserves, which were inaccessible in the past.  There are some credible media reports that this will be the case. And, finally, Saudi Arabia follows through with its claims and invests in solar energy.[9]

One risk that will arise from lower oil prices would be more consumption of oil, and that would have adverse environmental effects. While technological progress would help reduce the demand for oil relative to alternative renewable energy, reasonable and well-designed taxes on oil consumption along with policies to induce tighter consumption efficiency, could also moderate the adverse environmental effects. 

It is highly probable that global terrorism and violence would diminish significantly, global growth picks up, and inflation falls if the price of oil falls to its historical average, somewhere around 30 US dollars.

[1] See Pindyck and Rotemberg, 1991, “The Excess Co-Movement of Commodity Prices,” Economic Journal  1991, Vol. 10, No. 403, 1173-1189.
[5] Laabsa and Razzak, 2010, Taxes, Natural Resource Endowment and the Supply of Labor,
[8] I used four lags.