Oil Prices and the Global Economy:Is It Different This Time Around?
Kamiar Mohaddes (Cambridge, CAMA, and ERF) & HashemPesaran (USC Dornsife INET and Trinity College, Cambridge)
EPRG Energy & EnvironmentFebruary 7, 2017
MotivationI The recent plunge in oil prices has, however, brought into question thegenerally accepted view that lower oil prices are good for the US and theglobal economy.
I It has been argued that near-zero interest rates in most industrializedeconomies, and the fact that the US has started to export crude oil again,have altered the traditional channels through which the benefit of loweroil prices gets transmitted to the real economy (Obstfeld et al. 2016).
I Moreover, it has been suggested that the positive correlation between oilprices and equity markets in the past few years provides evidence of aslowdown in global economic activity, as a softening of global aggregatedemand has reduced firms’profits and demand for oil (Bernanke 2016).
I Therefore, it is argued that the decline in oil prices this time around is notgood news for the US economy, and by implication for the rest of theindustrialized global economy.
Motivation II
I But the net overall outcome for the global economy is far morecomplicated and depends on domestic political economy considerationsand the feedback effects of oil price changes on global energy demand,interest rates, financial markets and world trade.
I Given that there are many channels through which oil prices can affecteconomic activity (both real and financial) in the US and elsewhere, onecould for instance use the GVAR modelling approach to capture thecomplicated patterns of global economic interactions; taking into accountnot only the direct exposure of countries to the shocks but also theindirect effects through secondary or tertiary channels.
I The GVAR is a multi-country framework which links country-specificmodels in a coherent manner using time series and panel data techniquesand has been used in bank stress testing, the analysis of China’semergence on the rest of world economy, international transmission ofreal and financial shocks, and forecasting.
Overview of the Results
7/14/2016 Is cheap oil really good for the global economy? FT.com
http://www.ft.com/cms/s/0/c939c540490c11e68d6872e9211e86ab.html#axzz4EOPSWPq4 1/4
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July 14, 2016 10:22 am
Kamiar Mohaddes and M Hashem Pesaran
The old view is largely correct, say two experts
re low oil prices good for the world economy?
A decade ago that question would have been met with an unbridled “yes” from most investors, whowere used to seeing stock markets rise when energy prices fell, or struggle when oil got too hot.
But in recent years oil prices and equity markets have started to move in tandem, leading prominenteconomists, including former Federal Reserve chairman Ben Bernanke, to question this longheldview. Oil’s crash to below $30 a barrel in early 2016 triggered a stock market selloff as investorsworried it signalled a sharp slowdown in the world economy.
So did we economists have it wrong all along? Are higher oil prices actually better for global growthand investor returns? We were keen to find out.
Click here to try our new website — you can come back at any time
Is cheap oil really good for the global economy?
©Reuters
Recent Plunge in Oil Prices
I Oil markets have experienced frequent episodes of boom and bust, eversince oil was produced in large commercial quantities in Pennsylvaniaback in 1859.
I Real oil prices have fluctuated between highs of $145 to lows of $15 perbarrel over the period 1946M1 and 2016M6.
I The control of oil markets by the major international oil companies, theso called Seven Sisters, backed by the UK and US governments, meantlow and relatively steady oil prices until the late 1960s.
I However, a new era began with the foundation of OPEC in 1960, the1968 coup in Libya which led to new agreements initially with theindependent oil companies and then with the Seven Sisters across allmajor oil producers in the Middle East and elsewhere, not to mention thestart of a downward trend in US oil production in 1971.
Recent Plunge in Oil Prices II
Nominal and Real Oil Prices US Oil Production(2015 US dollars) (1000 barrels/day)
0
50
100
150
1946M1 1963M8 1981M3 1998M10 2016M5
Nominal Oil Prices Real Oil Prices
4000
6000
8000
10000
1946M1 1963M9 1981M5 1999M1 2016M6
Data sources: United States Energy Information Administration (EIA).
Recent Plunge in Oil Prices IIII As a result, oil markets entered a new phase as the Seven Sisters lostcontrol to markets and oil producers, oil prices quadrupled, ushering in anera of high oil price volatility and frequent periods of boom and bustoften triggered by military and political events.
I 6 periods of sharp oil price declines (30% or more), in a relatively shortperiod of time (within 7 months), and with relatively large effects on theglobal economy can be identified between 1986-2014.
Recent Plunge in Oil Prices IV
Recent Plunge in Oil Prices V
I Therefore, while the fall in oil prices since June 2014 is large, it is by nomeans unprecedented.
I And there is an extensive literature on the economic consequences of oilshocks for the global economy in terms of their impacts on real outputand real equity prices, see for instance, Hamilton (2009), Kilian (2009),Cashin et al. (2014), Mohaddes and Pesaran (2016), and Mohaddes andRaissi (2015) among others.
I Overall the literature suggests that the initial impacts of oil price changesdiffer widely across different countries, with oil importers benefiting fromthe fall in oil prices (once demand conditions are controlled for) and oilexports losing from the price fall.
Recent Plunge in Oil Prices Vl
I It is worth noting that much of the literature on oil and themacroeconomy does not use a multi-country framework, and insteaduses a single-country VAR model, as representing the global economy.
I The majority of such studies in fact consider the effects of oil shocksexclusively on the United States, with the analysis being done mainly inisolation from the rest of the world. See, for instance, Kilian (2009).
I Unfortunately, these single-country models not only fail to take accountof economic interlinkages and spillovers that exist between differentregions, but more importantly their single-country framework does notallow them to consider heterogeneities across and within oil importersand exporters, which are arguably essential to analyzing the global oilmarket.
Analyzing the Oil Market Using a Multi-Country ModelI To analyze the international macroeconomic transmission of oil priceshocks, we make use of the global econometric model developed inMohaddes and Pesaran (2016).
I We model global oil markets separately, by specifying an oil priceequation which takes account of global demand conditions as well as oilsupply conditions across some of the major oil producing countries.
I We then integrate the oil market within a compact quarterly model of theglobal economy comprising 27 countries, with the euro area being treatedas a single economy, using a dynamic multi-country framework firstadvanced by Pesaran et al. (2004), known as the Global VAR.
I This approach allows for an analysis of the international macroeconomictransmission of the effects of country-specific shocks, taking into accountnot only the direct exposure of countries to the shocks but also theindirect effects through secondary and tertiary channels.
Analyzing the Oil Market Using a Multi-Country Model Il
I Firstly, the disaggregated nature of the GVAR-Oil model allows one to identifycountry-specific shocks and answer counterfactual questions regarding thepossible macroeconomic effects of oil supply disruptions in specific geographicalareas on the global economy.
I This is in contrast to most of the literature that focuses on theidentification of global supply shocks, rather than shocks to a specificcountry or region.
I Secondly, it allows one to deal with inherent heterogeneities that exist acrosscountries.
I For instance, in terms of oil reserves and production capacities.
I Thirdly, it allows one to take into account the economic interlinkages andspillovers that exist between different regions.
I Thereby enabling a study of the global economy in a coherent manner asopposed to undertaking country-by-country analysis.
Analyzing the Oil Market Using a Multi-Country Model IlI
Major Oil Producers Other Countries
Net Exporters Europe Asia Pacific Latin AmericaCanada Euro Area Australia ArgentinaIndonesia Austria India ChileIran Belgium Japan PeruMexico Finland KoreaNorway France MalaysiaSaudi Arabia Germany New Zealand Rest of the World
Italy Philippines South AfricaNet Importers Netherlands Singapore TurkeyBrazil Spain ThailandChina SwedenUnited Kingdom SwitzerlandUnited States
Analyzing the Oil Market Using a Multi-Country Model IV
GVAR
VARX (1)
VARX (2)
...VARX (26)
VARX (27)
1- GDP
2- Inflation
3- Interest rate
4- Bond yields
5- Equity prices
6- Exchange
rate
1- GDP*
2- Inflation*
3- Interest rate*
4- Bond yields*
5- Equity prices*
6- Exchange
rate* *
Trade Weights
Global
Oil Market
Impulse Response Analysis
Shocks
A dynamic oil price equation
I For the oil price equation we consider the ARDL specification
qotd = ad + εy ay (L)yt − εpo ap (L)p̃ot + εdt , (1)
where qotd is the logarithm of world demand for oil, yt is a measure ofworld real income (in logs), p̃ot is the logarithm of real oil prices, ad is afixed constant, ay (L) and ap (L) are polynomials in the lag operator, L,whose coeffi cients add up to unity, namely
ay (L) = ay0 + ay1L+ ay2L2 + ...
ap (L) = ap0 + ap1L+ ap2L2 + ...
with ay (1) = ap (1) = 1. Hence, εy > 0 is the long-run income elasticityof demand for oil and εpo > 0 is the long-run price elasticity of demandfor oil.
The reduced form dynamic oil price equation
I We solve for p̃ot to obtain
p̃ot =
(1
1+ λεpo ap0
)ap +
(1− λεpo ap11+ λεpo ap0
)p̃ot−1 −
(λεpo
1+ λεpo ap0
)∞
∑`=2
ap` p̃ot−`
+
(λεy
1+ λεpo ap0
)ay (L)yt −
(λ
1+ λεpo ap0
)qot +
(1
1+ λεpo ap0
)εpt , (2)
which is a standard ARDL model in p̃ot , yt , and qot .
I To analyze the international macroeconomic transmission of oil priceshocks, we now need to integrate the above oil price equation within acompact quarterly model of the global economy.
I To this end we utilize the Global VAR (GVAR) framework, which is adynamic multi-country framework able to account not only for directexposures of countries to oil shocks but also indirect effects through thirdmarkets, originally proposed by Pesaran et al. (2004, JBES) and furtherdeveloped by Dees et al (2007, JAE).
The GVAR-Oil Model II We set all lag orders to unity and consider the simple dynamic oil priceequation
p̃ot = cp + φ1 p̃ot−1 + α1yt−1 + β1q
ot−1 + u
ot , (3)
p̃ot =N
∑i=1
ωi p̃oit , (4)
p̃oit = ln (Pot Eit/Pit ) = p
ot + (eit − pit ) , (5)
Pot is the nominal price of oil in US dollar, Eit is country ith exchange
rate measured by the units of country i th currency in one US dollar, andPit is the general level of prices in country i .
I The above decomposition of country-specific real oil prices into the USdollar price component and the "real" exchange rate component (heredefined by epit = eit − pit ) is important, since only the US dollar oil pricecomponent, pot , can be regarded as weakly exogenous.
I The real exchange rate component, epit , is determined endogenously withthe other variables in the country-specific models, such as real outputs.
The GVAR-Oil Model II
I Also to integrate the oil price equation within a multi-country set-up weneed to write the oil price equation in terms of pot .
I Note that p̃ot = pot + ept , where ept = ∑Ni=1 ωi epit .
I Using this result the oil price equation can be written as
pot + ept = cp + φ1 (pot−1 + ept−1) + α1yt−1 + β1q
ot−1 + u
ot . (6)
where as before we also have yt = ∑Ni=1 ωi yit and qot = ∑Ni=1 ωoi qoit .
The GVAR-Oil Model III
I In our multi-country set-up, the country-specific variables, epit , yit andqoit , are determined jointly with other macro variables.
I We consider the following country-specific models (for i = 1, 2, ...,N)
xit = ai0 + ai1t +Φixi ,t−1 +Λi0x∗it +Λi1x∗i ,t−1 + Υi0pot + Υi1pot−1 + uit ,(7)
xit is ki × 1 vector of country-specific endogenous variables that includeepit , yit , and qoit (as applicable), and x
∗it is k
∗i × 1 vector of
country-specific weakly exogenous (or ‘star’variables).
I The ‘star’variables, x∗it , are constructed using country-specific tradeshares, and defined by
x∗it =N
∑j=1
wijxjt , (8)
where wij , i , j = 1, 2, ...N , are bilateral trade weights, with wii = 0, and
∑Nj=1 wij = 1.
The GVAR-Oil Model IV
I The country-specific VARX* models are combined with the oil priceequation and solved for all the endogenous variables collected in thevector, zt = (pot , x′1t , x
′2t , ..., x
′Nt )′ = (pot , x′t )′,
I The combined model is referred to as the GVAR-Oil model, which allowsfor a two-way linkage between the global economy and oil prices.
I Changes in the global economic conditions and oil supplies affect oilprices with a lag, with oil prices potentially influencing all country-specificvariables. Similarly, changes in oil supplies, determined in country modelsfor the major oil producers, are affected by oil prices and in turn affect oilprices with a lag.
I Estimation is carried out on a country-by-country basis, and the GVARmodel is solved for all variables simultaneously.
I To solve for the endogenous variables, zt , we first note that x∗it =Wixt ,where Wi is a k∗i × (k + 1), matrix of fixed constants (which are either 0or 1 or some pre-specified weights, wij ), k = ∑Ni=1 ki , k
∗i = dim(x
∗it ).
Solving the GVAR-Oil Model I
I Stacking the country-specific models we now have
xt = ϕt +Φxt−1 +H0xt +H1xt−1 + Υ0pot + Υ1pot−1 + ut ,
where
Φ=
Φ1 0 · · · 00 Φ2 · · · 0...
.
.
.. . .
.
.
.0 0 · · · ΦN
, H0 =
Λ10W1Λ20W2
.
.
.ΛN0WN
, H1 =
Λ11W1Λ21W2
.
.
.ΛN1WN
,
ϕt =
a10 + a11 ta20 + a21 t
.
.
.aN0 + aN1 t
, Υ0 =
Υ10Υ20...
ΥN0
, Υ1 =
Υ11Υ21...
ΥN1
, ut =
u1tu2t...uNt
,
I We also note that the oil price equation can be written as
pot +w′epxt = cp + φ1
(pot−1 +w
′epxt−1
)+(α1w′y + β1w
′q)xt−1 + uot ,
where wep , wy and wq are k × 1 vectors whose elements are either zeroor is set equal to the weights wi or w oi , assigned to epit , yit or q
oit .
Solving the GVAR-Oil Model II
I Combining the above oil price equation with the country specific modelswe obtain(
1 w′ep−Υ0 Ik −H0
)(potxt
)=
(cpϕt
)+
(φ1 φ1w
′ep+α1w′y + β1w
′q
Υ1 Φ+H1
)(pot−1xt−1
)+
(uotut
),
(9)
which can be written more compactly as
G0zt = bt +G1zt−1 + vt .
I Under the assumption that Ik −H0 is invertible the GVAR-Oil model hasthe following reduced form solution:
zt = at + Fzt−1 + ξt , (10)
whereat = G−10 bt , F = G−10 G1, ξt = G
−10 vt .
Effects of Lower Oil Prices on the Global Economy
Global Real Equity Prices Global Long-Term Interest Rates
Global Real GDP Oil Prices
Notes: Figures show median impulse responses to a one-standard-deviation decrease inoil prices, with 95 percent bootstrapped confidence bounds. The horizon is quarterly.
Effects of Lower Oil Prices on Long-Term Interest Rates
United States Euro Area
United Kingdom Japan
Notes: Figures show median impulse responses to a one-standard-deviation decrease inoil prices, with 95 percent bootstrapped confidence bounds. The horizon is quarterly.
Effects of Lower Oil Prices on Inflation
United States Euro Area China
United Kingdom Japan
Notes: Figures show median impulse responses to a one-standard-deviation decrease inoil prices, with 95 percent bootstrapped confidence bounds. The horizon is quarterly.
Effects of Lower Oil Prices on Real GDP
United States Euro Area China
United Kingdom Japan
Notes: Figures show median impulse responses to a one-standard-deviation decrease inoil prices, with 95 percent bootstrapped confidence bounds. The horizon is quarterly.
Analyzing the Oil Market Using a Multi-Country Model V
I We find that the fall in oil prices tends to lower interest rates andinflation in most countries, and increase global real equity prices, withthese effects showing up relatively quickly, typically within two quarters.
I However, the positive real output effects, both at the global level and atthe country levels, take longer to materialize following an oil price fall,with the positive median impulse responses generally manifestingthemselves in the medium-term, around four quarters after a negative oilprice shock.
I Thus the empirical evidence based on the GVAR-Oil model supports theview that an oil price fall is good news for the US, the other majoreconomies, as well as for the global economy.
Analyzing Oil Price Changes Using Monthly Data
I To evaluate the effects of recent falls in oil prices, we need to investigatethe output-oil price relationship over a number of sub-periods, includingthe episode of oil boom and bust since 2008.
I Unfortunately, however, quarterly macro series that exist are notsuffi ciently long for a reliable analysis of output-oil price relationship overdifferent sub-periods, particularly the post-2008 crisis period.
I We cannot therefore make use of the GVAR-Oil model, but instead weconsider bivariate relationships between oil prices, equity prices anddividends (as a proxy for real economic activity).
Analyzing Oil Price Changes Using Monthly Data II
I In what follows we shall mainly focus on the effects of lower oil prices onthe US economy for three reasons:
I Firstly, the US economy has not been dependent on oil imports as muchas other industrialized economies, with oil production having first peakedin 1971 (before the shale oil revolution).
I The US started to export crude oil in January 2016 after a 40-year ban.
I Secondly, the US oil and gas sector attracted significant investment overthe past decade, including small firms issuing large amounts of debt(estimated over $350 billion just between 2010 and 2014).
I As a result, the losses for US investors in equity and bond markets havebeen substantial following the recent fall in oil prices, with valuations ofUS energy companies falling dramatically and the number of gas and oilcompanies in the US filing for bankruptcy soaring, which could haveindirect effects on the US economy through secondary or tertiary channels.
Analyzing Oil Price Changes Using Monthly Data III
I Thirdly, thanks to advances in hydraulic fracturing and directional drilling,oil production has significantly expanded in the US over the past 10 years.
I US oil production has risen from 5 million barrels per day (b/d) inJanuary 2008 to 9.2 million b/d in January 2016, around 84% increase.
4000
6000
8000
10000
1946M1 1963M9 1981M5 1999M1 2016M6
Data sources: United States Energy Information Administration (EIA).
Real Oil Prices and Real US Equity Prices (S&P 500),1946M1-2016M3
0
50
100
150
1946M1 1963M8 1981M3 1998M10 2016M30
1000
2000
3000
Real Oil Prices ($/b)Real Equity Prices (right scale)
Data sources: Robert Shiller’s online database, Federal Reserve Economic Data(FRED), and United States Energy Information Administration (EIA)
Correlations between Changes in Real Oil Prices, EquityPrices and Dividends
Period Real Oil and Real Oil PricesEquity Prices and Dividends
Full Period1946M2—2016M3 0.008 (0.035) -0.105 (0.034)
Sub-Periods1960M1—1980M12 0.018 (0.063) -0.071 (0.063)1981M1—2000M12 -0.139 (0.064) -0.163 (0.064)2001M1—2016M3 0.199 (0.073) -0.252 (0.072)
Sub-Sub-Periods2001M1—2007M12 -0.144 (0.109) -0.088 (0.110)2008M1—2016M3 0.404 (0.093) -0.329 (0.096)
Data sources: Robert Shiller’s online database, Federal Reserve Economic Data(FRED), and United States Energy Information Administration (EIA).
Has the Relationship Between Real Oil and Equity Pricesbeen Stable Over Time?
I To conduct a more robust statistical analysis we use rolling regressions ofthe rate of change of real equity prices on the rate of change of real oilprices, estimated with 10-year windows.
I The coeffi cients were not statistically different from zero before 1990,became negative in 1991 and initially falling (being statistically significantfrom 1991 to 2001), and then eventually rising and becoming positivesince the 2008 financial crisis (being statistically significant from 2012).
I It is then perhaps not surprising that there is no consensus in theliterature on the relationship between oil and equity prices (Jones andKaul 1996 and Wei 2003).
I Overall, the empirical evidence suggests that the relationship between realoil and stock prices is not stable over time. As such, the recent perverserelationship between equity returns and oil price changes should not betaken as evidence that lower oil prices are bad for the real economy.
Rolling Estimates of the Effects of Changes in Oil Priceson Equity Prices
0.4
0.2
0.0
0.2
0.4
1980M1 1989M2 1998M3 2007M4 2016M3
Notes: Rolling estimates of the coeffi cient of the rate of change of real oil prices andits two standard error bands. Dependant variable is the rate of change of real USequity prices (S&P 500). The window size is 120 months.Data sources: Robert Shiller’s online database, Federal Reserve Economic Data(FRED), and United States Energy Information Administration (EIA).
Has the Relationship Between Real Oil and Equity Pricesbeen Stable Over Time? II
I A significantly positive relationship between oil and equity prices hasemerged since the global financial crisis in 2008, which has been discussedextensively by the media as well as by prominent economists over the lastfew months.
I See Bernanke’s blog at Brookings on February 2016 and Obstfeld et al.’sIMF blog on March 2016.
I The question is why is this the case?
I Firstly, while markets are generally effi cient and therefore equity pricesreflect the fundamentals, there are also episodes when real equity pricesdo not reflect the state of the economy.
I In such periods any evidence of a perverse relationship between realequity and oil prices could be due to the disconnect between equitymarkets and economic fundamentals and not necessarily any breaks inthe relationship between oil prices and the real economy.
Has the Relationship Between Real Oil and Equity Pricesbeen Stable Over Time? III
I Secondly, Sovereign Wealth Funds (SWFs) accumulated large assetsduring the most recent oil boom (2002-2008) and they have come to playa major role in reserve management of oil revenues.
I The prominent examples are:
I Norway’s Government Pension Fund ($830),I Abu Dhabi Investment Authority ($773),I Saudi Arabia’s Fund (SAMA) ($685),I Kuwait Investment Authority ($592),I Qatar Investment Authority ($256).
With the exception of Norway all figures refer to June 2015.
SWF Portfolio Allocation
On average 65% of SWF assets are held in public and private equities (61%Norway; 72% SAMA; 65% Kuwait; 68% Qatar; 62% Abu Dhabi—figures basedon 2014).
Has the Relationship Between Real Oil and Equity Pricesbeen Stable Over Time? IV
I During periods of rising oil prices, these funds are topped up with equitypurchases.
I However, when oil prices are falling most major oil exporters withdrawmoney from the funds in order to maintain, for instance, their welfareexpenditure.
I The equity transactions of SWFs in turn induce an unintended positivecorrelation between oil and equity prices.
I Whilst it is true that such effects might not be that large, they couldtrigger larger effects due to known market over-reactions. See alsoBlanchard (2016).
Are Lower Oil Prices Beneficial for the US and the WorldEconomy?
I Ideally we need to consider how oil prices and real activity are related (asopposed to equity markets).
I However, quarterly GDP series that exist are not suffi ciently long for areliable analysis of output-oil price relationship over different sub-periods,particularly the post-2008 crisis period.
I While a number of investigators have used monthly measures of USmanufacturing output, this is not suffi ciently representative of aneconomy such as that of the US.
I Instead we use real dividends on S&P 500 as a proxy for economic activity.
I In the long run there has to be a relationship between real dividendsand the economic climate.
Real Oil Prices and Real Dividends (S&P 500),1946M1-2016M3
0
50
100
150
1946M1 1963M8 1981M3 1998M10 2016M30
10
20
30
40
50
Real Oil Prices ($/b)Real Dividends (right scale)
Data sources: Robert Shiller’s online database, Federal Reserve Economic Data(FRED), and United States Energy Information Administration (EIA).
Correlations between Changes in Real Oil Prices, EquityPrices and Dividends
Period Real Oil and Real Oil PricesEquity Prices and Dividends
Full Period1946M2—2016M3 0.008 (0.035) -0.105 (0.034)
Sub-Periods1960M1—1980M12 0.018 (0.063) -0.071 (0.063)1981M1—2000M12 -0.139 (0.064) -0.163 (0.064)2001M1—2016M3 0.199 (0.073) -0.252 (0.072)
Sub-Sub-Periods2001M1—2007M12 -0.144 (0.109) -0.088 (0.110)2008M1—2016M3 0.404 (0.093) -0.329 (0.096)
Data sources: Robert Shiller’s online database, Federal Reserve Economic Data(FRED), and United States Energy Information Administration (EIA).
Rolling Estimates of the Effects of Changes in Oil Priceson Real Dividends
0.08
0.06
0.04
0.02
0.00
1980M1 1989M2 1998M3 2007M4 2016M3
Notes: Rolling estimates of the coeffi cient of the rate of change of real oil prices andits two standard error bands based. Dependant variable is the rate of change of realdividends (S&P 500). The window size is 120 months.Data sources: Robert Shiller’s online database, Federal Reserve Economic Data(FRED), and United States Energy Information Administration (EIA).
Are Lower Oil Prices Beneficial for the US and the WorldEconomy? II
I The coeffi cient of real oil price changes on dividends have been negativeover the whole sample period, and statistically significantly negative formost of the period.
I The beneficial effects of lower oil prices on dividends have become evenmuch stronger over the more recent episodes, with the rolling estimatesbecoming particularly large and statistically significant post 2009.
I The rolling estimates give a clear indication of the changing nature ofthe relationships between oil prices, equity prices, and dividends, but donot allow for changing dynamics between these variables.
I Therefore, to check the robustness of the results to the dynamics ofadjustments between oil price changes and the economy, we alsoestimated ARDL models, one with the rate of change of real equity and oilprices and another with the rate of change of real dividends and oil prices.
Estimates of the Long-run Coeffi cients of Real Oil Pricesbased on Various ARDL Regressions and Sub-samples
1970M1 1970M1 1990M1 2008M12016M4 1989M12 2007M12 2016M4
(a) ARDL Model with Real Equity Prices
Oil Price Coeffi cient −0.159∗∗ −0.176∗ −0.185∗∗∗ 0.202∗
(0.073) (0.100) (0.039) (0.118)
ARDL Order (6, 12) (2, 12) (1, 1) (4, 4)
(b) ARDL Model with Real Dividends
Oil Price Coeffi cient −0.016 −0.046∗∗∗ −0.092∗∗ −0.111∗∗(0.017) (0.014) (0.043) (0.048)
ARDL Order (1, 3) (2, 1) (5, 0) (1, 0)
Notes: Symbols ***, **, and * denote significance at 1%, 5%, and 10% levels,respectively.Data sources: Robert Shiller’s online database, Federal Reserve Economic Data(FRED), and United States Energy Information Administration (EIA).
Estimates of the Long-run Coeffi cients of Real Oil Pricesbased on Various ARDL Regressions and Sub-samples II
1970M1 1970M1 1990M1 2008M12016M4 1989M12 2007M12 2016M4
(c) ARDL Model with Industrial Production
Oil Price Coeffi cient −0.053∗∗ −0.084∗∗∗ −0.019 −0.098(0.025) (0.029) (0.014) (0.075)
ARDL Order (12, 11) (2, 11) (3, 3) (12, 10)
(d) ARDL Model with Manufacturing Production
Oil Price Coeffi cient −0.075∗∗∗ −0.116∗∗∗ −0.022 −0.067(0.027) (0.036) (0.017) (0.063)
ARDL Order (3,11) (2, 11) (3,3) (12,8)
Notes: Symbols ***, **, and * denote significance at 1%, 5%, and 10% levels,respectively.Data sources: Robert Shiller’s online database, Federal Reserve Economic Data(FRED), and United States Energy Information Administration (EIA).
Are Lower Oil Prices Beneficial for the US and the WorldEconomy? III
To summarize:
I There is no stable relationship between real oil prices and equity returnsover the last 71 years
I The perverse response of equity markets to oil price changes shouldnot be taken as evidence that lower oil prices are no longerbeneficial for the US and the world economy.
I In fact, using relatively long time series on dividends and oil prices weshow that, as in previous episodes of falling oil prices, lower oil pricesimprove profit opportunities and dividends in the oil importing economieswhich is overall good for the world economy.
I This supports the findings from the GVAR-Oil model.
I However, due to uncertainties over the US elections, the surge in financialmarket volatility etc., it is likely that there will be a delay in thematerialization of any economic benefits of lower oil prices.
Are Lower Oil Prices Beneficial for the US and the WorldEconomy? IV
I Nevertheless, the fall in oil prices has hit the major oil exporters thehardest.
I It is not surprising therefore that the fall in oil prices has forced oilexporters to cut back on their welfare programs, withdraw fromtheir oil funds, and attempt to diversify their economies.
I At the world level, however, we would expect the increase in spending byoil importers to exceed the decline in expenditure by oil exporters (giventheir different marginal propensities to consume/invest), and soeventually lower oil prices should also be beneficial for the world economy.
I This was also clearly illustrated within the GVAR-Oil framework
I This in turn implies that demand for energy is going to start to rise,which will put upward pressure on oil prices in the medium term, and theequilibrating process starts to take place.
Do Global Oil Supplies Respond to Lower Oil Prices?I Non-OPEC oil exporters, particularly US oil producers, tend to respondreasonably quickly and positively (negatively) to oil price rises (falls).
I As noted earlier, US production had been rising since 2008, but peaked aroundApril 2015 (at 9.45 million b/d) and since then, with continued low oil prices,has fallen to 8.46 million b/d in the first week of September 2016.
I This large fall in oil production is mainly due to the fact that unconventional oil(which now forms around half of US oil output) tends to respond to oil pricechanges very much like any other manufacturing process.
I Since mid-2014 the number of US oil and gas companies that have filed forbankruptcy has now reached 59, and is expected to rise further, soon overtakingthe 68 bankruptcies that were filed at the peak of the dot-com bust in 2002-03.
I Moreover, the ECB recently estimated that energy related investments in theUnited States have fallen by 65% cumulatively since mid-2014, with the energysector contribution to GDP growth in the US being overall negative.
Do Global Oil Supplies Respond to Lower Oil Prices? II
I In contrast to the US, oil production from OPEC is likely to be lessresponsive to price changes, with political factors playing a significant rolein the process.
I It has long been argued, dating back to the first oil crisis of 1973/74, thatmajor oil exporters that heavily depend on oil revenues, set their oilproduction to achieve a given level of oil revenues (the so-called targetrevenue model, see Bénard (1980), Crémer and Salehi-Isfahani (1980),and Teece (1982)), and as a result respond perversely to price changes.
I The result is a backward-bending supply curve where a sustained fall inoil prices can lead to increased oil production from some OPEC membercountries who own large reserves of low cost oil, a demanding welfareprogram, and a fragile political system.
Monthly Oil Production for Iran, Iraq, Russia, SaudiArabia, and the US (1000 barrels/day)
0
5000
10000
1985M1 1992M11 2000M9 2008M7 2016M5
US RussiaSaudi Arabia IraqIran
Data sources: United States Energy Information Administration (EIA).
Do Global Oil Supplies Respond to Lower Oil Prices? III
I Amongst the non-OPEC producers, Russia has continued to increaseproduction — behaving very much as predicted by the target revenuemodel.
I Canada’s production has become more volatile but continues to show arising trend.
I Oil production in Norway and Mexico has stabilized following a downwardtrend since early 2000.
Strong Oil Demand and Supply Growth in 2015
I Overall, despite falling oil prices, oil production has continued to riseworld-wide, with OPEC and non-OPEC contributing to the rise, almostequally in 2015.
Investment in Oil and GasI For now, only US production from unconventional oil has been decliningunder pressure from lower oil prices.
I However, according to the International Energy Association (IEA) globalupstream oil and gas investment has been falling by around 23% and 19%in 2014 and 2015 respectively, and BP reported recently that oil and gasinvestments fell by $160 billion in 2015 and is expected to fall by another$50 billion in 2016; this in turn will have implications for future supply.
Production costs (p/b) by type and regions
Production costs for US and Canada
Do Global Oil Supplies Respond to Lower Oil Prices? IVI There is an important analogy between the Ricardian theory of rent onagricultural land and modelling of oil prices.
I Ricardo (1817) observed that rent rises as land of lower quality arebrought under cultivation in conditions of rising demand for agriculturalproducts. In the same way, profit from productive oil fields rise as costlierfields are brought into production.
I With significant heterogeneity of breakeven production costs across fieldsin different parts of the world, as well as across different types of oil fieldswithin a given region, it is not surprising that it is the production of thehigh cost unconventional oil that is first to be negatively affected by loweroil prices.
I If over the next year or so current low oil prices prevail, further productioncut backs from such fields are to be expected, in particular for the US oilproduction which is expected to gradually adjust downward.
Concluding RemarksI As with all markets, lower oil prices will eventually lead to higher demand andlower supplies.
I The beneficial income effects of lower oil prices will show up in higher oil demandby oil importers including the US, while the loss of revenues by oil exporters willact in the opposite direction, but the net effect is likely to be positive.
I On the supply side, the effects of lower prices are mixed with the US productionfalling and OPEC production rising (mainly from Saudi Arabia and Iraq).
I The rise in OPEC production initially appears to be counterintuitive, but reflectsthe fact that some of the major oil producers try to compensate their loss ofrevenues by raising production.
I This means that oil markets equilibrate, but very slowly.
I Oil prices are likely to fluctuate within a wide range, the ceiling being themarginal cost for US shale oil producers (around $60 per barrel).
I This episodic process gets further accentuated by new reserve discoveries,technological advances in oil production and alternative energy sources.
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