Oil Prices Shocks1[1]

OIL-ITS DEEP IMPACT

OIL SHOCKS Oil prices shocks have a stagflationary effect on the macroeconomy of an oil importing country: they slow down the rate of growth (and may even reduce the level of output – i.e. cause a recession) and they lead to an increase in the price level and potentially an increase in the inflation rate. An oil price hike acts like a tax on consumption and, for a net oil importer like the United States, the benefits of the tax go to major oil producers rather than the U.S. government. 1The size of the shock, both in terms of the percentage increase in oil prices and the real price.  - The shock’s persistence  - The dependency of the economy on oil and energy  - The policy response of monetary and fiscal authorities MOVEMENTS IN PRICES The price of oil has fluctuated widely over the past 50 years. Before 1973, prices were effectively dictated by a buyers’ cartel of major global oil companies (the so-called ‘Seven Sisters’). The first ‘oil shock’ occurred when members of the Organization of Petroleum Exporting Countries (OPEC), acting partly in response to the United States’ support for Israel in the 1973 Yom Kippur war, agreed to control oil supplies and raised prices fourfold. Oil prices stabilized in the late 1970s, before rising to a new peak with the outbreak of war between Iraq and Iran in 1981. The peak was short-lived and prices generally declined in real terms over the next twenty years, with the exception of a brief upturn associated with the 1991 Gulf War. By 1999, the oil price fell as low as $13/barrel, equivalent in real terms to the price prevailing before 1973. Prices began to recover in 2000, initially responding to cutbacks in OPEC output and then to strong global demand, particularly from the United States and China. The price of $60/barrel currently prevailing, and expected, on the basis of futures prices, to persist

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OIL-ITS DEEP IMPACT through 2006, is well above that observed for most of the period and comparable only to the short-lived peak of 1981. THE ECONOMIC IMPACT OF OIL SHOCKS, PAST AND PRESENT The oil shocks of 1973, 1981 and 1991 all coincided with recessions in the United States. In these circumstances, it is not surprising that the recent increase in the price of oil should raise concerns about the possibility of a new recession In reality, however, the significance of the relationship between oil prices and macroeconomic activity has been overstated.

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OIL-ITS DEEP IMPACT

HOW OIL SHOCK AFFFECTS MARKET THE FIVE SHOCKS 1973-75 OPEC SQUEEZES THE WEST “In the background was a long period of OPEC frustration that constant oil prices, against the backdrop of rising global inflation were resulting in steady decline in real oil revenues” The responsiveness of oil prices to macroeconomic shocks is clear in the case of the original 1973 oil shock. An inflationary upsurge was well under way by the time OPEC oil ministers met in October 1973. Wage and price controls had been imposed in the United States in 1971, but had broken down by early 1973—the oil shock merely administered the coup de grace, leading to the final abandonment of controls. Prices of all kinds of commodities were skyrocketing, and monetary policy was being tightened in response, making a decline into recession inevitable. Because of the cartelized nature of the oil market, oil prices responded with a lag, just as the world economy was beginning its downturn. FINANCIAL MARKET RESPONSE Bonds: The U.S. Treasury ten-year constant maturity bond posted a yield of 6.81 percent on October 18, 1973. the day before the oil embargo began. Initially the ten-year yield actually declined, reaching a low of 6.67 percent two months later. Over subsequent months, bond markets gradually sold off as the oil price hike began to be viewed as permanent, with serious inflationary consequences. But the bond market continued to trade in an orderly fashion. There were no sudden, sharp yield spikes. By March 18. 3

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OIL-ITS DEEP IMPACT 1974. when the oil embargo ended, ten-year Treasuries were up to a yield of just 7.24 percent. However, when prices continued upward even after the end of the embargo, bond yields resumed an upward path, topping 8 percent in the fall of 1974 and rising further to a peak of 8.5 percent a year later. All told, the t1rst oil shock produced a cumulative increase of almost 2 percentage points in long-term U.S. Treasury yields. Stock markets: The U.S. equity market, us measured by the S&P 5(K) index, was badly shaken by the events in the Middle Hast and the Arab oil embargo. From just before its imposition until oil prices began to stabilize in early 1975. Average stock prices nearly halved. The value of U.S. equities dropped by 50 percent or $600 billion, about 40 percent of GDP. By comparison, that plunge was only slightly less severe than the collapse of the high tech bubble of 2000-03. Currencies: The Japanese yen. Which had been allowed to appreciate against the U.S. dollar after the 1971 collapse of the Bretton Woods system, weakened significantly in the aftermath of the oil shock? The Japanese economy was viewed as more vulnerable to a contraction in oil supplies. The currency traded at about 265 to the dollar just before the oil embargo. It weakened to about 300 by the middle of 1974 and then fluctuated narrowly around that level until 1977. When the Carter Administration took office with a mandate to deal with the growing Japanese trade surplus. The German mark followed a similar pattern, but weakened less than the yen and turned up sooner. The deutschemark weakened from about 2.40 just before the embargo to above 2.80 by January 1974. But by the end of 1974 it was already stronger than before the oil shock and it continued to appreciate against the dollar subsequently.

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OIL-ITS DEEP IMPACT

1979-81: IRANIAN REVOLUTION AND IRAN-IRAQ WAR “Worldwide crude oil production was 10% in 1980 than in 1979” In 1981 recession was caused by the Volker credit squeeze, when interest rates were increased sharply, with the objective of ending an inflationary spiral of which rising oil prices were a symptom rather than a cause. FINANCIAL MARKET RESPONSE Bonds: The second oil shock had a fur more profoundly adverse impact on bond markets than the initial one, even though oil price advance was relatively smaller. Yields on tenyear U.S. Treasuries were already moving progressively by the time events began to unfold in Iran late in 1978. By December the yield had pierced the 9 percent level, over 1 percentage point higher than the year before. As oil prices started to escalate in subsequent months, yields traded in a narrow range without a clear upward trend until the second half of the year. The swirl of events over the closing months of the year—the takeover of power by Ayatollah Khomeini, the hostage crisis, and the quick imposition of a freeze on Iranian assets in the United States —led to sharp increases in bond yields. By January 1980, ten year Treasuries were quoted above 11 percent. Over the next several weeks, as the hostage crisis dragged on with no end in sight, market confidence weakened further. By late February, the yield climbed above 13.5 percent, then a record high. There were subsequent temporary rallies, but the bond market continued under pressure even after oil prices peaked. Stock markets: it is remarkable, looking back at that turbulent period, that the major stock market indexes in the United States were little affected by the events in the oil and bond markets. To be sure, there were abrupt movements on a few days, but over all the stock market reacted more calmly than the bond market, especially during 1980. The best explanation is that some industries were thought to benefit from higher energy prices. Investors moved money out of investments in sectors thought to be most negatively affected—recall that this was the time of the U.S. government bail-out of Chrysler, so everyone knew that the auto industry was a casualty. But they moved into energy-related stocks and other industries, with no permanent net erosion of equity values.

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OIL-ITS DEEP IMPACT Currencies: The Iranian revolution came just after the Carter Administration had put in place in November 1978 its elaborate program to defend the dollar. That included drawing on IMF credit lines as well as issuance of the so-called Carter bonds, in which the U.S. Treasury borrowed in currencies other than the dollar that worked for a while to restore some confidence, and the dollar briefly rallied across the board. Like after the first oil price shock, the yen continued to come under some pressure in the foreign exchange markets as oil prices climbed higher. But the experience of the deutschemark was different. By the end of 1979. As the U.S. rate of inflation began to ratchet higher. The deutschemark was again appreciating strongly. That trend should continue well into 1980. 1990-91 IRAQ INVADES KUWAIT AND FIRST GULF WAR “The impact of oil prices was negligible, not least because Saudi Arabia and other Arab nations were allied with U.S. forces and made efforts to counteract the price increase” FINANCIAL MARKET RESPONSES Bonds: The yield on ten year U.S. Treasuries was trading about 8 percent at the of the Iraqi invasion. In sharp contrast to the previous oil shocks, the rapid run-up in crude oil prices had only a minimal impact on the bond market in this episode. The yield peaked at just over 9 percent in September and soon fluctuated gradually lower, both during the preparations for Operation Desert Storm and after its successful implementation. Bond market participants were convinced at the time that the oil price spike would not be sustained, in large measure because of Saudi involvement in the war effort. They were right. Stock markets: In contrast to the bond market, stocks fell back noticeably between the Iraqi invasion and the end of 1990, but they quickly retraced the decline once it was clear that the operation would be successful. Currencies: The exchange market reaction was entirely different from the first two oil shocks. The deutschemark and the Japanese yen actually strengthened during the run-up in oil prices, and only settled back after hostilities ended and oil prices retreated.

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OIL-ITS DEEP IMPACT 1996-99: DEMAND-INDUCED PRICE SURGE “Global demand began to swell as the high-tech bubble encouraged a big investment boom in North America and Europe and as the Asian economies began to recover.” In the wake of the Asian financial crisis and a pick-up of Iraqi oil sales under the United Nations oil for- food program, oil prices plummeted to $10 per barrel in late 1998. Then oil prices began to head sharply higher—but this time, unlike the three previous episodes. Without any geopolitical trigger. Rather, global demand began to swell as the high-tech bubble encouraged a big investment boom in North America and Europe and as the Asian Economies began to recover. OPEC was either unable or unwilling to match increased demand by raising output. By the middle of 2000. oil prices tripled. It represented an even sharper price advance than during the shock of the Iranian revolution. The eventual peaking in the oil price coincided with President Clinton's decision to sell crude oil from the Strategic Petroleum Reserve, although analysts disagree as to how important that action was in taming the market pressures. FINANCIAL MARKET RESPONSES Bonds: Yields on ten-year U.S. Treasuries moved up alongside the rise in oil prices. At the end of 1998. The yield was just above 4.5 percent. By Februarys 1999. it went above 5 percent. By June 1999 it exceeded 6 percent. Thereafter. It fluctuated narrowly just below that level by the time oil prices reached a peak. Naturally, rising oil prices were not the only factor influencing bond market participants. The furious increase in stock prices, especially for high tech companies, was generating huge reallocations of investment funds into stocks and out of bonds. Moreover, economic growth was accelerating. In the United States., the Federal Reserve, concerned about a buildup of inflationary pressures, as progressively tightening monetary policy. European monetary policies were also being tightened. So in a sense, it was a conventional late-cycle boom, with both oil prices and bond yields responding in a classic way. Stocks: Stock markets largely ignored the crude oil price advance of 1999-2000. The lure of rapidly escalating high tech stocks overshadowed it. Currencies: The deutschemark and Japanese yen reactions were entirely reversed from past experience. The yen strengthened sharply throughout the oil price advance, while the deutschemark tended to weaken.

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OIL-ITS DEEP IMPACT 2002-05: IRAQ II AND SURGING DIL DEMAND “The tripling of crude oil prices since 2002has had generally more muted and often paradoxical effects on the financial markets” FINANCIAL MARKET RESPONSES Bonds: Bond market participants have shown little of the concern, or sometimes fear, associated with oil price surges of similar magnitude in the previous thirty years. Accordingly, yields have exhibited little of the volatility, and none of the upward tendency, of the four previous episodes, hed Chairman Greenspan has remarked that the recent bond market behavior is not readily explainable—his word is "conundrum." Part of that conundrum has to do with the absence of heightened intiationary expectations, despite the upward pressure on energy costs, which have yet to feed through into prices generally. Stocks: While the stock market has rebounded from the depths of the tremendous sell-off of 2000-03, recently investors have expressed great uncertainty about future prospects for corporate earnings The higher energy costs bother them, even as bond investors are unimpressed Currencies: The dollar depreciated sharply from March 2002 until the end of 2004 but has rallied since. The latest oil price surge has been a factor in the Japanese yen market, but not in the market for euros. Other factors are weighing on the European common currency. Including political questions raised by defeat of the constitutional referendums in France and the Netherlands. A very similar analysis applies to the current period. Although the limits to supplies of oil imply that prices must increase in the medium term, the fivefold increase in prices from $13/barrel to $65/barrel over the past five years cannot be explained in this way. Rather the increase is the product of booming demand in the United States and China, which can in turn be attributed to the expansionary monetary policy adopted by the US Federal Reserve in response to the dotcom crash and recession of 2000 and 2001.

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OIL-ITS DEEP IMPACT

Black dots indicate oil shocks. The first two are the OPEC embargo (1974) and the Iranian Revolution (1980). The second set involve the future shocks which may occur in near future due to various reasons such as     

Low Supply More Demand Cartel by OPEC Oiloholics Political Reasons Depression of the Econnomy

How strong we really are? India and other South Asian countries are forecast to sustain a GDP growth of 6-6.3% in the next two years, though global economic growth could fall to 3.2%, according to the World Bank’s Gobal Economic Prospects report. India is expected to absorb future oil price shocks and would experience mixed effects of the fall of the dollar vis-à-vis other world currencies, Bank’s economic policy and development prospects group director Uri Dadush said while releasing the report. The report said the world economy accelerated sharply in 2004, expanding by an estimated 4%. Even stronger growth was experienced by a number of large developing countries — China (8.8%), Russia (8%) and India (6%). India is likely to get about $5

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OIL-ITS DEEP IMPACT billion in FDI this fiscal. India, which is benefiting from liberalization, robust growth in exports and higher foreign exchange reserves position, is managing the oil shocks well. Improvement in productivity and competitiveness of the manufacturing sector has also helped the country in absorbing oil price shocks. The government and the RBI took a series of fiscal and monetary measures to stem inflation. Dadush said the depreciation of dollar against rupee could have a mixed impact. It has the negative impact of damaging competitiveness of Indian companies and affecting forex reserves. It also has the positive impact of reducing India’s external debt burden and oil import bill. India and its South Asian neighbours are also expected to reduce poverty level by half in the next 10 years on the back of sustained high economic growth. The report said South Asia posted 7.5% growth in 2003 powered by a robust 8.2% growth in India during April-March 2003-04. India, which contributes 80% to South Asia’s output, is slated to grow 6-6.5% this fiscal. Considering India’s prospects, the Bank expects the region to log 6.3% growth in 2005 but is slated to come down marginally to 6% in 2006.1

Is India prepared for another shock? Experience shows that oil price shocks have had only a marginal impact on the Indian economy, especially in the long-term perspective. Any effect on major economic segments has often been more because of inflationary fears rather than economic weaknesses. India in 1990-91 took the initiative with some other countries to create an “oil pool account” so that it can help absorbing any future oil shock prices. Fortunately the development of derivative markets and products on oil and their use by market globally have also helped to bring discipline to the oil market and a reduction of pure dependence on OPEC or a select few nations.

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OIL-ITS DEEP IMPACT During the past three years, India did confront several oil price spurts, prompting policymakers to think of various alternatives, besides raising petrol and diesel prices. In JuneAugust 2000-01, international oil prices rose to $32 a barrel. The average price of imported crude during the whole year was $27 a barrel. In mid-2000, when the oil prices surged to $31-32 per barrel, the Petroleum Ministry hiked petro-product prices by over 20 per cent in September. This pushed up the monthly inflation to 8 per cent in the secondhalf of 2000-01 compared to 6 per cent in the first. But the following year, inflation rolled back to 3.7 per cent negating all fears of a prolonged period of high inflation. Thus, the impact on inflation was short-lived despite international oil prices rising 35 per cent, from $22 to $30 a barrel. The key to this riddle is the two advantages which insulate India from any long-term impact: Low dependence on the global economy and the structure of oil product consumption, which is very different from those in other South-East Asian countries. The oil consumption pattern and the abundance of non-oil energy resources have shielded the country from the effects of oil-price shocks. In India, the major energy source is coal — accounting for over 52 per cent of total commercial energy — followed by oil at 34 per cent. Such a situation is unique to India. The direct impact of oil is largely on the transport sector, which consumes over 42 per cent of the oil products. Nearly 84 per cent of the energy consumed by industry comes from coal. Similarly, in agriculture, the main energy source is power (about 90 per cent) or coal; oil accounts for a mere 10 per cent and is used mainly for operating agricultural pumps. Hence, contrary to general perception, the direct impact of oil price shocks on industry is not that grave. Also, any decline in exports would be more because of sluggishness in the US economy, which accounts for one-fifth of India's exports, than oil price hikes. Moreover, exports contribute only 12 per cent of GDP. Also, despite the Administrative Price Mechanism (APM) being done away with from April 1, 2002, the Petroleum Ministry continues to covertly exercise full power over petro-product pricing.

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OIL-ITS DEEP IMPACT With the oil dependence of agriculture and industry, which account for over 55 per cent of GDP, being only 10-14 per cent, GDP growth is unlikely to be affected this year. In this respect, the World Bank's projection of only a marginal fall in GDP growth, from 5.4 per cent in 2002-03 to 5.3 per cent in 2003-04, seems convincing. Hence, even in the event of oil prices shooting up, the major sectors of the economy are unlikely to be affected. In India, oil price/supply volatility impacts inflation mainly through the transport sector. Stagnancy in the development of the Railways is to blame for this. Essentials as well as consumer durables are now largely transported by road and, so, whenever diesel and petrol prices are hiked, the prices of these goods also go up, affecting mainly the poor and the middle class. Moreover, the nexus between truck owners and traders often adds to the problem. As opposed to the situation during the 1991 Gulf War, the country now has a sizeable foreign exchange reserves and a current account surplus. The foreign exchange reserves can meet up to four years' oil import requirement compared to only five months' in 1991. As per estimates, the total import bill for oil and oil product is expected to rise 20 per cent this fiscal to touch $16,857 million against $14,048 million last year. As regards international oil pricing, analysts are not only apprehensive of the US' role but also skeptical of OPEC's dominance. They feel that, in the post-Saddam regime, the US will start pumping Iraqi oil, which has been under-utilized for a decade because of the UN embargo. Iraq's supplies can slacken the OPEC's grip on the supplies, and oil prices may crash. For India, the post-war period is more important. American occupancy may jeopardize India's oil investments in Iraq. Though India has two months' oil stock, efficient management of other energy sources, including oil, is essential. Creation of strategic oil reserves is warranted. This war would not be the end, but the beginning, of consolidation by oil-producing countries against the US. Even though the US may retain its power in West Asia, bickering will shackle the free flow of oil.

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OIL-ITS DEEP IMPACT

EMERGING CONCEPTS The Oil Gauge Model To assess the response of activity and inflation to higher oil prices, Oil gauge Model is used. This model examines the impact of oil prices on inflation by looking both at the long-run positive correlation between inflation and growth, as well as on the asymmetric impact of oil prices on activity. To estimate the effect of oil prices on activity, net oil price Increase is used. Specification, namely, one in which the oil shock is defined as the change in the real (inflation-adjusted) price of oil relative to the maximum price of the last four quarters. With the use of a VAR methodology, impulse response functions of real activity and inflation to a 10% increase in the price of oil is derived. Then the response is done according to country by country. Our Oil gauge Model finds that a 10% increase in the price of oil shaves G7 real GDP by 0.15% in the first year and 0.30% over two years. The response of inflation to an oil price increase of 10% is 0.26% in the first year and 0.45% over two years. These estimates suggest that the developed economies have become better cushioned against oil spikes. A subject we have discussed before.

The results are broadly in line with the well-established MULTIMOD model of the IMF, which has been used to gauge the impact of higher oil prices on the global economy. According to the Oil Gauge, there are significant differences across economies with the 13

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OIL-ITS DEEP IMPACT US and Italy apparently most affected on the growth side and Japan and the UK, the most affected on the inflation front. Applying these estimates to the 30% increase in the price of oil over the last 3 months, we find that this latest spike could shave as much as 45bp from G7 real GDP and boost headline inflation by 75bp.with a lower impact on core inflation. While those results certainly imply a meaningful potential impact, they are not enough to derail the global economy. Since oil prices spent some time at levels not far from the latest highs in October and November of last year, some of the impact may already have been absorbed. THE OILOHOLICS The two main engines for the world, the U.S. and China (also the two biggest consumer of oil), have both had their growth boosted by lax monetary condition in the past couple of years. Indeed high oil prices can partly be seen as consequence of low interest rates. The two most important prices in the world is the price of the money and the price of the oil, and they are linked. If the interest rates are abnormally low (in bonds yields as well as short term rates), then the global demand increases in response, oil prices should rise – especially if production capacity is tight, as it is today. Excessive growth in demand in America and China is, in effect, imposing a tax on others by pushing the world prices higher than they otherwise be Even more serious, with the little spare capacity in the oil industry, such rapid growth in consumption leaves the market vulnerable to any supply disruption, like those that initiated previous oil shocks. China has single handedly accounted for one-third of the growth in global oil demand since 2000. It’s easy to point out ginger at China's growing oil demand but America remains the biggest consumer, using one quarter of the world’s output of the black stuff. The best long term solution-for America as well as the world economy-would be higher petrol taxes in the United States. Alas there is a little prospect of that happening. America, unlike Europe, has fuel-economy regulations to petrol taxes. But even with those it has failed abysmally. These regulations have been so abused that the oil efficiency of its vehicles has fallen to a 20 year low. America and China in their different ways are drunk on oil consumption. The longer they put off taking the steps needed to curb their habit, the worse the headache will

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OIL-ITS DEEP IMPACT be, George Bush once learned a lesson about the alcohol. Its time for him to wean America off the oiloholism. IVANHOES PROJECTION According to Ivanhoe (a renowned Economist) the critical date is when global public demand will substantially exceed the available supply from the few Persian Gulf Moslem oil exporters. The permanent global oil shortage will begin when the world's oil demand exceeds global production--i.e., about 2010 if normal oil-fields decline occurs, if the world's key oil producer, Saudi Arabia, has serious political problems that curtail its exports. World oil production will thereafter continue to decline at a dwindling rate.

According to Ivanhoe the major discoveries of oil is nearly over and even in future if some discoveries happens it would be not as huge as earlier ones. So he says that the

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OIL-ITS DEEP IMPACT production would increase due to some technological advances but ultimately the supply would come down and there would be huge increase price of oil.

PAPER BARRELS "What About So Called 'Reserve Growth'"? In recent years, the USGS and other agencies have revised their estimates of oil reserves upwards. Peak Oil "deniers" often point to this revisions as proof that fears of a global oil shortage are unfounded. Unfortunately, these upwards revisions are best classified as "paper barrels", meaning they exist on paper only, not in the real world: recently as 1972, the USGS was releasing circulars that estimated US domestic oil production would not peak until well into the 21st century, and possibly not until the 22nd century. This was despite the fact US production had already peaked in 1970, just as Hubbert had predicted. Richard Heinberg reminds us, "in 1973, Congress demanded an investigation of the USGS for its failure to foresee the 1970 US oil production peak." This concept of paper barrel actually means that the oil is only present in the paper not physically. This makes the oil trading in the derivative market very volatile as sometime back it was mentioned that there is a lot of oil is still left, which in turn would give a positive indication to the investors who are going to trade futures in oil. The basic reason for the investor would be if there is lot of oil then price would come down which would bring down the cost of production for the manufacturing companies which would make greater profits.

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ROLE OF USA Following his four predecessors, President Bush has identified US dependence on imported oil as an urgent energy, economic, and national security concern. Imports now supply more than 50 percent of US oil consumption: by 2020 dependence on imports will reach 64 percent (US DOE, 2001). Another aspect of their US energy plan is to open areas that previously have been off limits. In theory, this could reverse the increase in the cost of production and the decline in the productivity of drilling. The most visible new frontier lies beneath the Arctic National Wildlife Refuge (ANWR). Here, the US Geological Survey estimates that about 7.8 billion barrels of oil are technically recoverable. Such a field would be the largest discovery in the US since 1968. The schedule of production from the ANWR will have relatively little effect on prices. The effects of the ANWR aside, the US policy is based on the assumption that it is better to develop domestic resources of oil and have the economic benefits accrue to U.S. firms rather than overseas producers. This argument ignores the economic opportunity costs associated with efforts to increase domestic production. Between 1973 and 1980, the total footage of wells drilled increased three fold. The surprise (disappointment) lies with the outcome of this investment. During this same period, U.S. production declined 7 percent and the oil and gas sector share of GDP declined below 2 percent. The gap is caused by geologic limits on the ability to increase domestic production, regardless of economic incentives to increase production. The US President George W Bush was raring to launch an attack on Iraq. Whether Iraq had weapons of mass destruction or not, it certainly had the world's second largest reserves of petroleum, after Saudi Arabia. The US, on the other hand, is the world's largest consumer and importer of oil. It was certain whatever else, the desire to control Iraq's oil lubricated the US war machinery. Oil companies from the other four permanent member countries in the UN Security Council (the UK, France, Russia and China) also 17

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OIL-ITS DEEP IMPACT had interests in Iraqi oil fields. The US oil tactics were clear. Countries that participate in the US effort against Hussein will get a fair share in the post-Hussein Iraqi oil party. "It was pretty straightforward. Several countries, including India, Italy, Vietnam and Algeria, already had Agreements with Iraq to extract oil. But these are in the cold bag due to the UN sanctions on Iraq. In a post-Hussein Iraq, these agreements are likely to be scrapped in favor of US companies. All this speculation has led to a rapid rise in oil prices -hovering close to US $30 to the barrel, US $5 of which is being labelled 'war premium'.

The world learned about its dependence on oil in 1973.The cost of a barrel of crude oil rose from US $3 in 1972 to US $12 by 1974. This 'oil shock' forced the West to chalk out an aggressive plan to free itself of the clutches of OPEC. Take the example of the US, the world's largest consumer of energy and the biggest importer of oil. When the US began trying to diversify its oil sourcing and increase domestic production in 1973, it imported about 35 per cent of the petroleum it consumed.

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OIL-ITS DEEP IMPACT Today, it imports more than 50 per cent. As energy demand surged by 17 per cent during the 1990s, domestic oil production rose 2 per cent only. And oil accounts for 40 per cent of

the

total

energy

use

in

the

US

at

present.

The US doesn't see itself breaking free of dependence on oil imports anytime soon. In fact, some experts say that the percentage of US oil imports (as well as those of other oil importing countries) from the OPEC cartel, and specifically from the Persian Gulf, is only going to increase. 9/11 attack The terrorist attacks on the US on September 11, 2001, have revealed the cost the country has to pay for its oil dependence on the Gulf. Its oil ties with Saudi Arabia became a bit of an embarrassment when it was found that 15 of the 19 hijackers in the attacks were Saudi citizens. The US government's continued support for the autocratic Saudi family of Saudi Arabia causes considerable discomfiture to a country that plays the global cop and claims

to

defend

democracy

across

the

world.

Proposing the largest energy budget in US history, Spencer Abraham, US energy secretary, told a committee of the House of Representatives on March 6, 2002: " The budget request of $21.9 billion addresses the new security challenges we face as a nation after the events of September 11, as well as increased concern regarding our dependence on foreign oil, and the security of our critical energy infrastructure."

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World Recession and the Iraq War Dollar Hegemony & the Rise of the Euro Another source of huge funds were the continuous flow of petro-dollars into the US. After all, oil comprises 10% of world merchandise trade, and the billions of revenues generated each year by the Arab countries, flow back to the US in the form of dollar reserves of these countries. Moreover, neither Europe nor the Asian economies want to see the US economy collapse. •

First, they would not be able to liquidate their holdings in the US before that happened, and therefore would suffer huge losses.

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Secondly, the collapse of the US market for their goods would deal them a heavy blow.

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Thirdly, if the dollar lost value, American goods would become cheap in terms of other currencies, and displace European and Asian goods in their home markets.

So, unlike Iraq, the EU and Asia would want to proceed slowly, protecting the value of their investments as they withdrew them. So, with the capture of Iraq and its huge oil reserves, the US can prevent the catastrophic slide of countries shifting to the euro. With Iraqi oil within its control the US will dictate terms, not only to Saudi Arabia, but also to Iran, Russia, Venezuela, all of who were beginning to shift to the Euro. So, through this military action it can, not only safeguard its huge stocks of petro-dollars, it can also prevent the trade in oil shifting to the euro. So, the military action will give the US economy big gains and prevent (for the time) the collapse of the dollar vis-à-vis the euro. On the other hand this will be a severe hit to the euro, just as it was beginning to rise.

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Military Solution to an Economic Crisis After 9/11, the US used the event as a pretext to flex its military muscle throughout the world. By early 2002, the U.S. had sent troops into the Philippines, into Yemen, and Somalia. It had set up 13 new military bases in the oil-rich and gas-rich countries surrounding Afghanistan. And it had embarked on the biggest military build-up since the cold-war years of the Reagan administration. In March of 2002, the administration announced that it was prepared to use tactical nuclear weapons in first strikes. The aggression on Iraq amounts to an attack on all third world countries. It bombed the oil pipeline to Syria from Iraq. In end April a top US official warned Syria to mend its way or face "devastating attack". He demanded: Syria wind up its ‘terror offices’, stop support for Saddam, destroy all its chemical weapons (without providing any proof that they have them), stop support to the Hizbollah in Lebanon, release from prison all dissidents, and introduce democracy. Iran too has been threatened. Incidentally, both Syria and Iran have excellent relations with the EU and Russia. The writing on the wall is clear: Under the banner of the "war on terrorism," U.S. imperialism is utilizing its political, military, and economic strengths to restructure relations throughout world and to fortify its position as the hegemonic power over the world economy and the international system. ‘Shock and Awe’ do not frighten the People of the World The reports have been coming in of resistance in Iraq and will increase. Together with this, US threats to Syria, Iran and a lesser extent even Saudi Arabia is turning the entire Middle East into a boiling cauldron. But the US’s destabilisation plans extend well beyond the Middle East. These are all a part of the new grand strategy of the US imperialists to build its Empire and maintain the hegemony of the Dollar. This will result in great instability throughout the world, growing militarisation, fascism, and wars of aggression by the US directly or through their surrogates in other parts of the world. 21

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OIL-ITS DEEP IMPACT The ruthlessness and brutality of US’ ‘shock and awe’ campaign is to show to the world the futility of opposing US designs. It was planned to ‘shock and awe’ not only the Arabs, but also all dissidents throughout the world. A feeling of helplessness in the face of a mighty power may result in passivity amongst a section. Yet, on the other hand, the brutalities will give rise to enormous discontent and resentment. Besides, ‘shock and awe’ may frighten some only in the immediate sense. The recklessness will result in pockets of resistance growing in places least expected. To fight such a monster the people will soon realize that guerrilla forms of struggle, will be the only effective form to neutralize their mighty firepower. Today in Iraq, the US forces are panicky at even the smallest form of guerrilla action, or even open mass actions. The more they extend their Empire, the more they will get enmeshed in thousands of battles. These two factors combined will knock the teeth out of the US’s ‘shock and awe’ arrogance. No doubt the situation for a new revolutionary upsurge is turning more and more excellent. Amidst the impending great turmoil, and untold sufferings, sparks of a new light flash on the horizon. Let us all together, hand in hand, walk towards that new dawn. RAPID INCREASE IN OIL PRICES While crude oil prices have been rising since March this year, thus far the month of August has seen the most rapid increase, going up from $38 per barrel to around $48 by August 22. The most recent increases have been driven by a number of factors. The most important factor, of course, is the continued resistance of the Iraqi people to the US military occupation. In addition, the threats of terrorist attacks in the world’s largest oil producer, Saudi Arabia, are growing in recent months. The nervousness this has created in world markets has not been neutralised by OPEC’s promises of boosting production. 22

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At present, however, these factors, as well as other potential issues such as instability in Venezuela or strikes in Norway, or indeed any changes in any oil-producing country, can have substantial effects on prices at the margin and cause sudden price spikes. This is because world demand for oil rules very high at present. In consequence, current oil production is extremely close to current capacity, and there is little margin for major increases in supply in the near future.

THE ROLE OF THE USA Dependency on imported oil for the US is growing. Even before the 9/11 attack USA was trying to expand its Strategic Petroleum Reserve (SPR). This had a dual purpose: to maintain the domestic price of oil at a desired level by releasing petroleum from time to time to the domestic market and to maintain a massive reserve in case of any major political changes either in the Middle – East or in Venezuela. Increasing demand for crude oil in the international market is mainly due to the increasing demand of the USA to increase the stockpile in the SPR. There is another factor, which is equally important. Given the need for the US war efforts, its budget deficits are increasing. As a

result, the value of dollars in the

international market is falling, as it is becoming less and less attractive compared to euro. However, the international trade in crude petroleum is conducted only through dollars. If any oil producer will try to change the system by accepting euro, it cannot survive. Iraq was invaded, as Saddam Hussein had tried to change its foreign exchange reserve from dollars to euro and was ready to accept euro rather than dollars for its export of oil. OPEC (the Organisation of Petroleum Exporting Countries) was also considering the change from dollars to euro in early 2001. The US invasion of Iraq has stopped that effort. Given dollars is the only means of exchange in the international petroleum market, increased price of oil means more demands for dollars. That would automatically increase the value of dollars. Increased price of oil does not affect the US government, as it can

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OIL-ITS DEEP IMPACT print dollars at will and buy whatever it needs from other countries. There is no need for the US to earn foreign currencies in order to import, it can pay by its own currency i.e. dollars. If USA has balance of payments deficits, the IMF will not force it to devalue dollars. Instead, USA will ask other countries to buy US government bonds. Because of this unique position of dollars, by which USA can buy anything from other countries practically free of charge and force others to lend money to it. In this scenario, increased price of oil means increasing deposits in the US banks, increased sales of US government bonds, increased profits of the Western oil companies and as a result increased tax revenues of the US government. Thus, the war in Iraq can be financed by itself. How long this process will continue will depend on the willingness of the US allies in Europe and Japan to tolerate the increased price of oil, which hurts their economies as well. When the pressure from the allies would be strong, the price of crude oil will come down, as it is not a result of normal supply deficiency, but it is manufactured artificially to serve the imperial ambition of the US to dominate the world.

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OIL AND GDP Economists have always tried to find out relationship between oil price changes and the GDP growth. It has been calculated that oil price changes have very negligible effect on the GDP growth. It is said that 10% of oil price increase results in 0.5 – 1% loss in GDP growth. But in the last one-year the oil prices have raised almost 50% and it has significant effect on the GDP growth.

Granger Causality For many days economists have been trying to figure out whether oil prices have any effect on the GDP growth or not. A concept called Granger Causality is used to find out whether any correlation between oil prices and GDP growth exists or not. Here we first test the null hypothesis that the oil price variable under consideration is Granger caused by the GDP. The null hypothesis is generally rejected. Next we test for whether a given oil price variable Granger-causes the GDP, obtaining that oil price variables generally Granger-cause GDP at the 5% significance level. But it is seen that though the increase in oil prices leads to lesser GDP growth, decrease in oil prices do not influence the GDP significantly. Although there are certain instances in US and Euro areas where this hypothesis doesn’t follow, the GDP decline and break up of Former Soviet Union can be explained perfectly with the help of this hypothesis. The analysis shows that the fall in Soviet and former Soviet GDP in the 1980s and 1990s did not Granger cause the decline in oil production, but that a decline in oil production did Granger cause the fall in GDP. However, the coal to GDP relationship shows the opposite and the natural gas to GDP relationship shows no Granger causality at all. This puts into question the argument of normal inefficiency in Former Soviet Union and suggests that oil had something to do with the break-up.

Multi Hubbert Curve A Hubbert forecast of oil production shows that Soviet and former Soviet oil production is following a multi-cycle Hubbert trend and that the region’s oil production is forecast to

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OIL-ITS DEEP IMPACT peak in 2009. First cycle was from 19th century to 1996, with a 1987 peak. Discovery peaked in the 1960s. Privatization of Russian oil in 1996, better property rights and resumption of production at old fields fueled recent growth.

Rate of Production (millions of barrels per year)

Figure 2. Former Soviet Union Oil Production as Function of Cumulative Production--Forecast 6000

Actual Production

5000

95% Confidence Interval 2009

4000

1985

3000

2000

1996

1000

Forecast Peak in Production

0 0

50000

100000

150000

200000

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Cumulative Production (millions of barrels)

1.Oil Shocks and GDP Earlier oil prices shocks had negligible effect on the GDP. But it is gaining more and more importance. Today 40% of energy comes from oil and 90% of transport fuel is oil.

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OIL-ITS DEEP IMPACT If we observe the picture we can understand that there is declines of GDP after the oil price shocks in the 70’s and 80’s. This is a scenario, which is very similar to stagflation. This happened because those price shocks took place mainly because of reduced supply and not increase in demand. But this time around the scenario is bit different as prices are rising due to high demand. The price of oil reached a new all-time high (in nominal terms) in early-July, when the price of a barrel of crude oil rose to US$ 60 per barrel. So far, however, the high oil price has had negligible impact on demand, with the world economy growing by 4.1% last year – its fastest level since 1988. A number of explanations have been advanced as to why the world economy is much more resilient to higher oil prices than in the past. The main reason is the action taken by governments, especially in the developed world, to improve the energy efficiency of economies after the first oil price shocks of the 1970s. Thanks to measures such as fuel-efficiency standards, and also to the shift from manufacturing to services, the US economy now uses only half as much oil per unit of GDP than it did 30 years ago. Meanwhile, in value terms, oil’s share of OECD commodity imports has fallen from 13% in the late 1970s to 4% by the late 1990s. It is important to note that the price of oil is currently only at record levels in nominal terms and, in real terms, it is still much lower than the level during the last oil price shock in 1980, when a barrel of oil reached over US$ 80 per barrel in today’s prices. The fact that the current high oil price has yet to have an impact on economic growth is a surprise, since previous oil price shocks over the past 30 years have all caused, or at least contributed to, a recession in the US and the world economy. Oil price shocks would normally affect macroeconomic performance through a number of channels. First, higher oil prices transfer income from oil-importing countries, to oil exporting countries through a shift in the terms of trade. This results in a loss of real income for oil-importing countries. Second, higher oil prices reduce industry output through higher costs of production. Third, they directly increase inflation via higher

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OIL-ITS DEEP IMPACT prices of imported goods and petroleum products. If higher inflation leads to an upward spiral of wages, central banks may be forced to raise interest rates.

OIL SCENARIO TESTING The new concept to explain oil-GDP relationship is scenario testing. Scenario Using the global econometric model developed by Oxford Economic Forecasting, we simulate two scenarios. The first is of an increase in the price of crude oil to US$ 70 per barrel, reaching that level by the end of 2005, with the price of oil remaining at that level until the end of 2008. The second is of an increase in the price of crude oil to US$100 per barrel, with the price of oil reaching that level by the middle of 2006, and remaining at that level until the end of the forecast period. The first scenario is motivated by the fact that, at the time of writing, the price of crude oil had just reached US$ 60 per barrel, which suggests that a price of US$ 70 per barrel by the end of the year is not unrealistic. The second scenario, where the price of crude oil reaches US$100 per barrel by the middle of 2006, follows from a statement earlier in the year by investment bank Goldman Sachs that oil could reach US$100 per barrel in the next few years.

Assumptions We compare the two scenarios with a baseline model, which presupposes an average oil price of US$ 50 per barrel in 2005, US$ 44 per barrel in 2006, and US$ 35 per barrel in 2007. In both scenarios, we assume no specific policy response to the oil price shocks, in

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OIL-ITS DEEP IMPACT particular the possibility that national governments could introduce fuel price subsidies in an attempt to insulate consumers from the full impact of the higher oil price. Global Impact A permanent oil price shock would have a major impact on the world economy. According to our calculations, under the US$ 70 per barrel scenario, world GDP would be 0.6 percentage points lower by 2006, 1.9 percentage points lower by 2007, and 2.6 percentage points lower by 2008. The impact of the cost of oil reaching a US$ 100 per barrel would be even greater, with world GDP 0.8, 2.9 and 4.0 percentage points lower over the same period.

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THE UNSOLVED PUZZLE….. What exactly do oil exporting countries do with their export surplus? Exporters of oil are saving more of their recent windfall than in previous price booms. It's hard to spot where the money is going… The International Monetary Fund estimates that oil exporters' currentaccount surplus could reach $400 billion, more than four times as much as in 2002. In real terms, this is almost double their dollar surpluses in 1974 and 1980, after the twin oil-price shocks of the 1970s—when Russia's hardcurrency exports were tiny. The combined current-account surplus of China and other Asian emerging economies is put at only $188 billion this year. Whereas the IMF forecasts China's surplus to be about 6% of GDP this year, it predicts Saudi Arabia's—not much different in money terms, at just over $100 billion this year—to be a whopping 32%. On average, Middle East oil exporters are expected to have an average surplus of 25% of GDP. Russia might record 13% and Norway 18%. What will happen to all these petrodollars? In essence, they can be either spent or saved. Either way, a lot of the money can be recycled to oil-consuming economies and thus soften the impact on them of higher oil prices. If oil exporters spend their bonanza, they import more from other countries and thus help to maintain global demand. They are unlikely to spend the lot, however, because they tend to have higher saving rates than oil consumers: saving is around 40% of GDP in the United Arab Emirates (UAE) and Kuwait, for instance. A transfer of income from oil consumers to oil producers will therefore lead to a slowdown in global demand.

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OIL-ITS DEEP IMPACT If they save their windfall, but invest it in global capital markets, they can finance oil importers' bigger current-account deficits—in effect, lending the increase in fuel bills back to consumers. And by increasing the demand for foreign financial assets, they can boost asset prices and push down bond yields in oil-importing countries. This in turn can help to support economic activity in these economies. Experience shows that oil booms can be a blessing or a curse for producing economies, depending on how wisely the extra revenue is spent or saved. Too often, past windfalls have been celebrated with budgetary blow-outs, while the abundance of money has encouraged the postponement of economic reforms. This time, however, oil exporters seem to be spending less, instead running larger external surpluses, repaying debts and building up assets. In 1973-76, 60% of the increase in OPEC's export revenues was spent on imports of goods and services. In 1978-81, the proportion rose to 75%. But the IMF estimates that only 40% of the windfall in the three years to 2005 will have been spent. In Russia, the government has taken the sensible step of setting up an oil stabilization fund, which will be used to reduce its large foreign debt. That said, the country has been more eager than members of OPEC to spend its extra money. Around two-thirds of the increase in Russia's export revenues since 2002 has gone on imports. In most of the Middle East, governments are being more cautious than usual with their extra revenue because oil-exporting governments seem to have taken to heart the lessons of the 1970s and 1980s. First: don't assume that oil prices will stay high for ever: in real terms, OPEC's annual average oil revenue in 1981-2000 was only one-third of that in 1980. Second, don't waste your windfall. In previous booms, oil-producing countries gaily spent their petrodollars on lavish construction projects that required imported equipment and skilled foreign workers, but did little to create local jobs or to diversify economies. In its recently published Regional Economic Outlook for the Middle East and Central Asia, the IMF advises governments to give priority to spending that will have a more lasting impact on growth and living standards.

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So far most of the extra money is being saved, not spent, so where is it going? In the 1970s and early 1980s surplus petrodollars were largely deposited in banks in America or Europe. These banks then lent too many of them to oil-importing developing countries, sowing the seeds of Latin America's debt crisis. This time it is proving much harder to track the money, but much more seems to be going into foreign shares and bonds rather than into western banks. This may reflect a greater reluctance to hold deposits in foreign banks, because of the increase in official scrutiny after the terrorist attacks of September 11th 2001. the bulk of OPEC's surplus revenues has so far gone into dollar-denominated assets, those assets are increasingly held outside the United States. A big chunk is also going into hedge funds and offshore financial institutions, which are unregulated and so impossible to track. It is certainly true that Europe's exports to oil producers have risen faster than America's in recent years. Europe's share of OPEC's imports has climbed to 32%, compared with 32

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OIL-ITS DEEP IMPACT America's 8%. A recent report by ABN Amrofinds that while America's trade deficit with OPEC has grown markedly since 1999, the European Union's balance has barely changed.

On the other hand, around two-thirds of petrodollars are thought to have gone into dollar assets, pushing down American bond yields. In addition, America's economy is more sensitive to interest rates than that of the euro zone. suggests that America may have gained more from lower interest rates than the euro area has from higher exports, especially because OPEC still buys less than 5% of the currency zone's exports. Although higher oil prices have increased America's current-account deficit, Mr Jen reckons that it probably runs a balance-of-payments surplus in oil, with capital inflows from exporting countries exceeding its net oil import bill. How might the flow of oil money affect the dollar? Because oil is traded in dollars, rising prices initially increase the demand for greenbacks. But what happens next depends on whether oil producers buy dollar assets or swap their dollars for euros. Saudi Arabia, Kuwait, the UAE and most other Gulf states peg their currencies to the dollar, which might suggest that, like Asian central banks, they will continue to favour dollars. But unlike China's export surpluses, petrodollars are mostly not managed within official reserves, but by oil stabilisation funds and so forth. These are not subject to the same

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OIL-ITS DEEP IMPACT constraints as central banks to hold liquid assets and their aim is to maximise returns. This means, says Mr Jen, that oil exporters' assets are more footloose than those of Asian central banks. So far, the bulk of petrodollars may have gone into relatively liquid dollar assets, helping to support the greenback this year. But this money could flit if the dollar starts to slide again. And there is lots of it: for example, the Abu Dhabi Investment Authority, with assets of maybe $250 billion, is one of the wealthiest players in global financial markets. Russia's central bank has reduced the share of dollars in its foreign reserves over the past couple of years, but it is still around 65%. The central bank has said that leaves the dollar dangerously vulnerable. But what about the exchange-rate policies of the oil exporters themselves? Most oil exporters peg their currencies to the dollar or resist appreciation through heavy intervention, in much the same way as China and other Asian countries have done. So should America and others demand that oil exporters revalue their currencies, as they have called on the Asians to do? By pegging their currencies to the dollar, these economies have in effect had to adopt America's monetary policy. With interest rates too low, excess domestic liquidity has stoked inflation and asset prices. The broad money supply of the Middle East oil exporters has grown by almost 24% in each of the past two years and the average inflation rate has risen to almost 9% this year. To curb inflation, Gulf economies need more flexible exchange rates and monetary policies. If oil prices remain high, so will oil exporters' surpluses. The IMF forecasts an average annual current-account surplus of $470 billion over the next five years (assuming an average oil price of $59 a barrel). The oil exporters will have to play a role in helping to reduce global imbalances. Importing more and letting their currencies rise, as well as increasing government spending and liberalizing their economies, would be steps in the right direction.

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A Special report on two of the most important oil exporting countries… SAUDI ARABIA Saudi Arabia has run a trade surplus since it started to publish official statistics in 1967. Its main export commodities are obviously petroleum and petroleum products, which comprise more than 90 percent of total exports. Given its import requirements and oil export capacity, trade surpluses are virtually assured well into the future. But we still think that it is important to consider these points about the countries surplus.  Saudi Arabia runs deficits in international service transactions, which have averaged US$12 to US$20 billion in recent years. Saudis typically spend abroad a lot of money each year.  The country does receive more income from its investments abroad than it pays out to foreigners on their investments within Saudi Arabia. That is not surprising given the meager opportunity that has been available for foreign investment in the country, and it's likely to change if and when Saudi Arabia succeeds in attracting and closing deals with foreign investors in Saudi assets that have up until now been off limits to foreigners. And, net transfers out of Saudi Arabia are among the largest in the world—some US$15 billion per year or about nine percent of GDP —reflecting the repatriation of earnings of the country's huge expatriate workforce.  Saudi Arabia's current account swings from deficit to surplus based on the level of its merchandise trade surplus. In 1998, the current account was in deficit by US$13 billion, but the huge increase in the trade surplus that accompanied the upswing in oil prices between 1998 and 2000 brought the current account into a surplus of more than US$14 billion in 2000. Falling oil prices in 2001 brought the current account surplus down to less than US$6 billion and, if current oil output and price levels persist throughout 2002, the Saudi current account will be back in deficit in 2002.

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OIL-ITS DEEP IMPACT  Since the nationalization of the oil industry in the 1970s, there has been little opportunity for direct investment. Similarly, portfolio investment inflows have been tiny, and for the same reason. Financing of past current account deficits has been accomplished through bond issues and bank lending and in recent times of large current account surpluses, repayment of debt has been the priority.

VENEZUELA Venezuela's balance of payments have typically shown current account surpluses driven by merchandise trade surpluses based on the country's substantial exports of oil. Deficits in both services and international income accounts have also been the norm, but these have usually been smaller than the trade surplus so that the current account has been in surplus.  The year 1998, with its very low levels of international oil prices, was an exception to this normal pattern—lower oil prices reduced oil export revenues by more than US$6 billion from their 1997 level and, given normal growth in imports, the trade balance shrank to less than US$3 billion from more than US$10 billion in 1997. Venezuela had a current account deficit in 1998 as a result.  The year 1998, with its very low levels of international oil prices, was an exception to this normal pattern—lower oil prices reduced oil export revenues by more than US$6 billion from their 1997 level and, given normal growth in imports, the trade balance shrank to less than US$3 billion from more than US$10 billion in 1997. Venezuela had a current account deficit in 1998 as a result.  Oil exports fell due both to falling export volumes (as Venezuela met its OPEC production quota limitations) and falling prices, and the current account balance fell to US$5 billion in 2001. At the same time, the government budget balance was deteriorating as oil revenues fell. Confidence in the Chavez administration weakened.  During 2001, foreign direct investment in Venezuela declined to about US$3 billion compared to US$3.3 billion in the recession year of 1999 and US$4.5 to 5.5 billion during recent non-recession years. There is evidence of growing capital

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OIL-ITS DEEP IMPACT flight from Venezuela beginning in 1999; the financial accounts "other assets, liabilities" and "errors and omissions" accounts show large deficits indicating private businesses and individuals acquiring assets outside of Venezuela.  Given the shrinking current account surplus, lower inflows of foreign direct investment and rising capital flight, Venezuela's overall balance of payments turned negative during 2001 and its international reserve levels began to decline rapidly from a peak of US$13.6 billion during 2000 to less than US$9.5 billion by year-end 2001.  Faced with a continuation of this trend in early 2002, the government elected to stop defending the US$ peg and let the bolivar float.

THE BLACK GOLD Olivier Blanchard provides a typical introduction: “In the 1970s, the price of oil increased dramatically. This large increase was the result of the formation of the Organization of Petroleum Exporting Countries (OPEC), a cartel of oil producers. Behaving as a monopolist, OPEC' reduced the supply of oil and in doing so, increased its price. . . . The relative price of petroleum, which had remained roughly constant throughout the 1960s, almost tripled between 1970 and 1982. There were two particularly sharp increases in the price, the first in 1973-1975 and the second in 1979-1981, (2003, 152) “ The analysis usually concludes that these oil-price shocks resulted in "a combination of a recession and large increases in the price level". Usually left out of the analysis is any discussion of why the OPEC cartel, originally formed in1960, suddenly and dramatically increased prices. If authors do consider this matter, they usually blame the price rise, at least in late 1973, on the October War of that year, when the Arab members of OPEC cut production and embargoed oil shipments to the Netherlands and the United States in

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OIL-ITS DEEP IMPACT retaliation for those countries' support of Israel. This action, as the story continues, led to negative supply shocks, inflation and rising unemployment in oil buying countries. But one realizes on a careful analysis that this theory neglects the simple facts that, first, the Bretton Woods system ended in late 1971, resulting in foreign-exchange markets that were suddenly much less stable than they had been over the previous three decades; and that, second, as a result, in order to maintain purchasing power, the OPEC countries were raising the prices of crude oil prior to the political events that culminated in October 1973. Simply stated, the cartel model of monopoly rent seeking is incomplete given the changing institutional environment in which OPEC countries found themselves after August 1971. Viewed from the oil producers' viewpoint, the breakdown of Bretton Wcxjds severed the tight link from U.S. dollars to other currencies or quantities of commodities. Rather than raising the relative price of oil, OPHC countries were only "staying even" by dramatically raising the dollar price of oil.

The Oil Price of Gold When the price of oil is analyzed in terms of gold, instead of in terms of U.S, dollars, the 1970s look quite different. The U.S. dollar price of oil hardly changed from the end of World War II to the late 1960s from 1947 to 1967, it rose by less than 2 percent annually on average (from $2,07 to $3.07 per barrel), not even keeping up with U.S. price inflation. Thus, given the Bretton Woods system, the oil/gold price was also nearly fixed. Throughout this entire period, through to the end of Bretton Woods in late 1971, 10-15 barrels of oil would buy an ounce of gold. As figure 1 indicates, the situation changed dramatically in the early 1970s. In 1970, slightly more than 10 barrels of oil would purchase an ounce of gold. By the next year, when the Bretton Woods agreement ended, with gold priced at $42 and oil fixed in terms of U.S. dollars at S3.56, oil sellers needed nearly 12 barrels of oil to buy an ounce of gold. This "real" oil price decline and general worldwide Inflation did not go unnoticed in the oil-producing countries.

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In response to the more rapid than expected fall in the value of the dollar after August 15, 1971, the Teheran Agreement of 1971 was amended in January 1972. The new agreement called for an 8.49 percent increase in the posted price of oil, "which corresponded to the rise [of 8.57 percent] in the price of gold vis-a-vis the US dollar". At that same meeting, it was decided that "in future, postings were to be adjusted upwards or downwards on a quarterly basis in line with an index based on the movement of the currencies of nine major industrialized countries (Britain, France, West Germany, Italy, Japan, Belgium, Holland, Sweden and Switzerland) vis-à-vis the US dollar. After two years of the floating dollar, OPEC was acutely aware of the diminishing value of oil in terms of gold. In the words of the Kuwaiti oil minister in 1973, "What is the point of producing more oil and selling it for an unwarranted paper currency?” Now let’s have a look at the figure given below….

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In the given figure, the ratio of two axis values is fixed at ten to one, which means that any time the two data lines cross, 10 barrels of oil exchange for one ounce of gold. As the figure indicates, oil prices continually played "catch up" with gold prices throughout the decade of the 1970s. We focus on gold not as an argument that OPEC simply followed the price of gold to set its price or that political explanations are unimportant, but to make the point that the arbitrary choice of the unit of account can change the results o the analysis dramatically. Our argument is simply that any analysis of OPEC behavior must include the changing international institutions and cannot focus solely on the situation as seen from the U.S. buyer’s perspective.

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IS LM ANALYSIS INCORPORATED IN OIL PRICE IMPACTS In this section of the report, we would try to incorporate the increase in oil prices and the resultant effects on inflation in the subsequent adjustments in the IS LM curves. Then we would try and analyze whether the theory holds good under practical conditions also. First of all, we would try to establish what ideally should happen with an increase in the oil prices and then we would compare with what is actually happening. IS curve describes all the points that are in equilibrium in the goods market i.e. the combinations of output and interest rate at which output produced is equal to the output demanded. A shift in IS curve takes place when there is a change in autonomous factors i.e. independent of aggregate output, that is unrelated to the interest rates. A change in interest rate that affects equilibrium output causes only movement along the IS curve. Examples of such autonomous factors can be: 1) Change in autonomous consumer expenditure. Lets say, in an economy if suddenly there is a discovery of a huge oil field which perhaps contains more oil than Saudi Arabia. The future outlook of such an economy would be very positive and consumers become more optimistic, so the autonomous consumption expenditure would rise. This in turn, would force the aggregate demand curve up at the same interest level, thus shifting the IS curve rightward. 2) Change in the autonomous investment expenditure. Now, after such a discovery the firms become more confident of profitability. So at same level of interest the planed investment expenditure goes up, thus pushing the aggregate demand curve up. And this in turn shifts the IS curve to the right. 3) Change in government spending. Since the government spending is not related to interest rate, it is also an autonomous factor. With an increase in government spending the aggregate demand goes up and the IS curve shifts rightward.

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OIL-ITS DEEP IMPACT 4) Change in taxes. If there is a decline in taxes then the consumers will be left with more disposable income so at any given interest rate the aggregate demand will be higher and thus the IS curve would shift to its right. 5) Change in net exports unrelated to interest rates. Any change in net exports related to interest rates would merely cause a movement along the IS curve. But any change unrelated to interest rates would cause a shift in IS curve. For e.g. if the Indian jeans suddenly become the “in thing” in US then net exports would rise. This would lead to a higher aggregate demand curve and consequently there would be a rightward shift in the IS curve. LM curve describes equilibrium in the money market. The combinations of output and interest rate at which demand for money and the supply of money is equal. There can be two factors which can cause a shift in the LM curve: 1) Autonomous change in money demand. Money demanded here means demand for holding money rather than investing in any interest bearing securities. This demand can change autonomously i.e. not caused by price level, aggregate output, or interest level. For e.g. there occurs a major financial crisis in a country. Many firms go bankrupt. So, now the bonds will become more risky than holding money. This will cause an increase in the demand for money at all levels of interest rates and aggregate output which will in turn shift the LM curve to its left.

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OIL-ITS DEEP IMPACT The effect on interest rates of a change in demand for money: money supply kept at fixed level by the authorities

Rate of interest

MS

r1

r

L' L O Money

2) Change in money supply. Any increase in money supply would shift the LM curve to its left. An increase in money supply can be achieved by the government by making open market purchase of government bonds or by lowering the CRR ( Cash Reserve Ratio).

Rate of interest

The demand for and supply of money M S' MS

r2

r1

L O

Q2

Q1 Money

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OIL-ITS DEEP IMPACT Now, if we analyze the effect of increase in oil prices, we can straight away observe that our net exports would come down because the oil has become dearer and as such the import bill gets inflated. This will bring down the net exports. So, now we have one autonomous factor which should cause a shift in IS curve. Since the net exports have come down this will pull the aggregate demand downwards and as a result the IS curve will shift to its left.

Rate of interest

LM

r1 r2

IS1 IS2 O

Y2

Y1

National income

As we can observe from the graph, with a leftward shift in the IS curve the national income would come down as well as interest rate would come down. Of course, the assumption here is that the LM curve does not shift. Now, if we try and find out whether practically this has happened or not. We get the figures of interest rate i.e. bank rate prevailing in the Indian economy, according to which during last four years the bank rate has been revised downwards two times from 6.50% till October 2002 to 6.25% till Aprill 2003 and then again to 6.00% till December 2005. But, as we can observe that the national income or the aggregate demand has not fallen but increased. This indicates that there is something that has happened in the money market. 44

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OIL-ITS DEEP IMPACT So now we have a scenario in which the interest rates are falling but the national income is increasing. This can only happen when the LM curve shifts rightwards. This means that there has been a steady decline in the money supply over the years. HUBBERT’S PEAK THEORY The law of conservation of energy states that energy can not be created, only converted. Despite the apparent abundance of oil it follows this law of nature. Geophysicist M. King Hubbert created a mathematical model of petroleum extraction which predicted that the total amount of oil extracted over time would follow a logistic curve. This in turn implies that the predicted rate of oil extraction at any given time would then be given by the rate of change of the logistic curve, which follows a bellshaped curve now known as the Hubbert curve.

Hubbert, in 1956, predicted oil production in the continental United States would peak in the early 1970s. U.S. oil production did indeed peak in 1970, and has been decreasing since then. According to Hubbert's model, U.S. oil reserves will be exhausted before the end of the 21st century. Given past oil production data and barring extraneous factors such as lack of demand, the model predicts the date of maximum oil production output for an oilfield, multiple oil fields, or an entire region. This maximum output point is referred to as the peak. The period after the peak is referred to as depletion. The graph of the rate of oil production for

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OIL-ITS DEEP IMPACT an individual oil field over time follows a bell-shaped curve: first, a slow steady increase of production; then, a sharp increase; then, a plateau (the "peak"); then, a slow decline; and, finally, a steep decline. The curve might shift a little rightward if there is a major disruption in supply or if there is somewhere a substantial discovery of an oil field. But sooner than later we are going to reach the peak. Most of the economists now accept the relevance of the theory. And they agree that the peak of oil is indeed very near. Though the range of their prediction varies in terms of the exact time when this peak would occur. But they accept the inevitability of the concept. The ride down the Hubbert’s peak is steep and if the whole world doesn’t recognize and acknowledge the fact as soon as possible the ride down the curve can be catastrophic for the human civilization. The issue is not one of "running out" so much as it is not having enough to keep our economy running. In this regard, the ramifications of Peak Oil for our civilization are similar to the ramifications of dehydration for the human body. The human body is 70 percent water. The body of a 200 pound man thus holds 140 pounds of water. Because water is so crucial to everything the human body does, the man doesn't need to lose all 140 pounds of water weight before collapsing due to dehydration. A loss of as little as 10-15 pounds of water may be enough to kill him. In a similar sense, an oil-based economy such as ours doesn't need to deplete its entire reserve of oil before it begins to collapse. A shortfall between demand and supply as little as 10-15 percent is enough to wholly shatter an oil-dependent economy and reduce its citizenry to poverty. The question now is that can we make our ride down the curve a little smoother instead of going crashing down. Can we make the curve a little flater? We can probably manage that by making small changes in our consumption pattern and slowly shifting to other sources of energy. Here we can take small and painless steps at the individual level. Some of interesting and simple steps that one can take can be:

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OIL-ITS DEEP IMPACT 1) Buy organic. Most commercial fertilizers are made of oil. But there is another alternative to it, using organic fertilizers. Thankfully in India we still have farmers in many parts of the country using organic fertilizers. 2) Be vegetarian. According to a research in US, one kg of beef requires 15 times the energy than eating canned corn. And also, any amount of grain can feed 5 times the number people as if it were to be used for feeding livestock and then consumed by people as meat. 3) Drive the speed limit and inflate tires properly. The fuel efficiency of a vehicle is directly related to road load of the vehicle. The important point is that as one increases the speed of the vehicle, the power required to keep the car running increases exponentially. Also, an under-inflated tire requires more energy to roll. For e.g. if the tire is under-inflated by as little as 2 psi, it will cause a 1% increase in fuel consumption.

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CASPIAN SEA Introduction Since the breakup of the Soviet Union, much of the world's interests, nevertheless the United States’, has shifted to the huge oil and gas reserves on and off shore of the Caspian Sea region. Contracts worth billions of dollars had since been signed, with the newly independent countries, and many joint ventures had been formed, to develop the region’s oil and gas fields. Yet, there is still not one reliable export route to transport those products to the open water, and thus to the world markets. Proposed pipelines for the Caspian Sea oil and gas had been hindered by the political instability of the region. From Nagorno-Karabakh, the ethnically steaming enclave between Azerbaijan and Armenia, to Mazar Al-Shareef, the capital of the Taliban’s rivals in northern Afghanistan, and through the war-ravaged Chechen capital Grozny, conflicts and wars have chattered the hope of every dreaming entrepreneur to find the best, fastest, and safest route on the pipelines checkerboard. In addition to the warring conflicts, the region is surrounded with other timing bombs: the Arab-Israeli no-war no-peace status, the Russo-Turkish eternal feud, and the Indo-Pakistani on/off border clashes and military buildup. Add to this regional explosive formula the U.S. - Iranian enmity, the separatists Abkhaz in Georgia, the Russian internal instability, and the region seems, undoubtedly, the most dangerous and geopolitically complicated area in the world. Economic Analysis Total oil reserves of the Caspian Sea region, estimated at above 200 billion barrels, exceeds that of Western Europe and/or the United States (110 BBL) and puts it in second place after the Middle East (700 BBL). Total production, currently at 1 million b/d, could reach 3.4 million b/d by the year 2010, assuming that hydrocarbons can be transported to world markets.

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OIL-ITS DEEP IMPACT The bulk of this production potential will come from Azerbaijan and Kazakhstan, the two countries with more than 80% of the expected oil reserves and where 85% of the foreign investments in the region are concentrating. The expected increase in demand for oil is inducing the rush toward the Caspian region. Experts estimate world demand for crude oil could rise 30% by year 2010. And the world's largest customer, the United States, may be importing 70% of its oil by 2010, compared to 50% today. Furthermore, Asian demand for oil is forecasted to almost double, from 18.1 million b/d to 31.7 million b/d, between 1995 and 2010 .This latter increase, could be very beneficial for the Caspian oil and gas supplies. Pipe Line Route Analysis The United States wants to see as many different pipeline routes as possible to prevent any one country from developing a stranglehold over the flow of oil from the region. Russia, however, wants to ensure that most of the Caspian oil would go via its territories. To ease doubts about the safety of the Baku-Novorossiysk pipeline in volatile Chechnya, Russia is considering a bypass around the secessionist region. However, the psychological damage, along with the United States insisting on multiple routes, proved more influential. Oil companies as well as the financial institutions that had rushed early to the region, had already prepared the alternative routes for pipelines and had negotiated the construction of these pipelines with the region's governments. Some of the proposed pipelines are still debatable on the basis of their economical feasibility, such as the 2,000 miles long pipeline from Kazakhstan to China, at a $9 billion cost. Others, such as the Turkmenistan-Iran-Turkey pipeline, which was initially seen as an impossible choice, due to the U.S. objection for the project. The pipeline runs 900 miles into the Iranian territory before connecting to the Turkish pipeline, which is already under construction. Last December, the first part of the pipeline which connects Turkmenistan to Iran, a 125 mile line at $195 million, was opened. It seems that the pipeline diplomacy has began to produce some fruitful results, at least on the U.S.-Iranian front.

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OIL-ITS DEEP IMPACT The Existing Oil Exporting Routes in The Caspian Region: •

Kazakhstan - Russia Pipeline which extends from Atrau to Samara (200,000 b/d). From Samara oil will be shipped via the Russian pipelines system.

•

The Russian pipeline system which, though underutilized, do not have the capacity to transport the vast amount of oil and gas the Caspian region is expected to produce. This system extends from Samara to:

•

o

- Latvia and Lithuania(Baltic Sea)

o

- Ukraine, Poland

o

- Bulgaria, Slovenia, and Greece

o

- Novorossiysk (Black Sea)

Kazakhstan-Iran oil swaps: Kazakhstan currently ships 30,000-40,000 b/d of crude oil from Aktau, its Caspian port, to the Iranian port of Neka, on the Caspian Sea, using coastal barges and small tankers. While Iran uses the Kazak oil, after blending it to produce a comparable Iranian crude feedstock, in its Tehran and Tabriz refineries, in the north, Kazakhstan would have the option of lifting either Iranian Light or Iranian Heavy blend crude at Kharg Island in the Persian Gulf. The volume of this swap deal will peak at 120,000 b/d in mid 1998.

•

Baku-Novorossiysk Pipeline: It is also called The North-South Route. This is the oldest exporting pipeline from the region and it is still the only pipeline that Azerbaijan uses to export its oil to the Black Sea. The capacity of the pipeline is very limited, thus a new 42 inch pipeline is under construction that will run along the old one with a planned Chechnya bypass.

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BIBLIOGRAPHY 1. www.oilcrisis.co 2. www.econmist.com 3. www.search.epnet.com 4. www.economictimes.com 5. Business world magazine 6. Business line 7. www.iea.com 8. www.rbi.org.in 9. world economic outlook 10. www.bloomberg.com 11. www.hubbertspeak.com 12. www.lifeafteroilcrash.com 13. www.bized.ac.uk 14. www.imf.org 15. www.feer.com 16. ICFAI journals

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