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Opportunities and challenges of fluctuating oil prices for economic development in the context of

the small oil dependent T&T economy

Roger Hosein

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Rationale

Policy makers in developing economies are typically very concerned about the price of oil as wide fluctuations tend to provide a variety of economic challenges. For example, volatility in the price of crude oil can expose an economy to a greater degree of risk in turn affecting the investment decisions made by economic agents.

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Introduction

This paper explores the various opportunities and challenges that arise from fluctuating oil prices for the Trinidad and Tobago economy. The discussion is cast within the framework of the historical experience of the T&T economy for the time period, 1966- to May 2009.

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Statistical Properties of Oil Price DataFor the time period January 2nd 1990

to May 12th 2009, the nominal daily price of crude oil averaged US$34.25 with a standard deviation of US$23.76.

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For this same time period the kurtosis value for the oil price return series of 23.5 demonstrates that the data is characterized by a fat tail. The Jarque Bera test confirms that the returns series is non-normally distributed. When a data series has a thick tail it can be modeled using a conditional normal distribution which implies that although on any one day the data may be normally distributed the parameters of normality change from day to day. The existence of a small negative skewness statistic suggest the existence of a left tail.

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Fig 1: Trends in daily oil price returns and the daily price of oil, January 2nd 1990 to May 12th 2009

0

20

40

60

80

100

120

140

160

oil returns

oil price

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When this type of volatility clustering exists it infers that the variances are autocorrelated so that shocks in one time period do not die out quickly but takes time to dissipate.

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Econometric model

An EGARCH (1,1) model is preferred to an ARCH/GARCH specification to capture because:

 1) The model does not impose any restrictions on the 2) In contrast to the ARCH/GARCH model, the EGARCH model

allows the coefficient to either have a positive or a negative value. For | | < 1, the EGARCH (1,1) model is both stationary and ergodic.

3) The parameter in the EGARCH model can be used to judge the impact of shocks. For >0 a positive shock gives rise to more volatility than a negative shock. The opposite is also true.

4) The parameter provides an indication of the influence of the conditional shock on the conditional variance. 

and,

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w LgLikihood

Table 1: Estimates of ARCH, GARCH and EGARCH models

ARCH (1,1) Normal

0.00046(0.000)

0.2889(0.000)

11217.58

GARCH (1,1) Normal

0.0000(0.000)

0.0817(0.000)

0.9132(0.000)

GARCH (1,1) Generalised error distribution

0.0000(0.000)

0.06319(0.000)

0.9268(0.000)

11352.8

GARCH (1,1)t-distribution

0.0000(0.000)

0.0555(0.0000)

0.9327(0.0000)

11388.1

EGARCH (1, 1)

-0.2216(0.000)

0.1808(0.000)

0.9906(0.000)

-0.0110(0.0144)

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The coefficient of is negative and statistically significant and this infers that for daily oil price returns data for the time period January 2nd 1990 to May12th 2009 as a whole, shocks tended to have asymmetric effects on oil price returns volatility. Because the sign is negative, negative shocks reduce volatility more than positive shocks.

Notice that the estimated value of beta is close to unity and is significant. This infers that when there is a shock to crude oil volatility, it takes time to die out, i.e. there is some element of volatility persistence. The failure of shocks to die out provides a variety of challenges and opportunities for fiscal policy. The rest of this presentation discusses some of the various opportunities and challenges that occur with fluctuations in commodity prices for oil exporting economies.

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Challenges During oil price Upswings

0T0NT

Wages

Fig 2: The Impact of the Dutch Disease on Employment and Prices

L0NT

L0TL0NBT

W0

L0 L0’

L1T

W1

L1’L1

L1NT

W2

L2 L2’

S Effect

Rm Effect

Indirect Deindustrialization

Labor

a) Dutch Disease

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b) Rent seeking and producer unfriendly institutions

RentsProfits

0 0 rent seekers

P1

P2

B2

B1

B3

R2 R1

productive entrepreneurs

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c) Vertical and Horizontal Equity Impact of GATE

Gate is horizontally efficient but vertically inefficient (evidence of resource curse behavior).

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The values in the Table 2 above show a strong degree of correlation between government expenditure and oil prices in the time interval 1966-2008 and for the sub time period 1990 – 2008. This is reflective of a procyclical stance.

Table 2: Correlation between government expenditure (US$mn) and oil prices, for the

listed time periods.

1966-2008 0.93

1990-2008 0.97

4. Procyclical behavior

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This procyclical behavioral pattern was compounded by a type of irrational behaviour on the government behalf which saw an unfounded increase in the pace at which the speed of adjustment parameter from an adaptive expectations perspective.

5. Chasing the goose that lays the golden egg.

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Specifically for the last 3 years the calculated values of the smoothing parameter () are listed in the Table 3 below:

Table 3: Changes in the adaptive expectations adjustment parameter, 2006, 2007, 2008.

2006-2007 0.25

2007-2008 0.52

2008-2009 0.90

Source: own computations.

This is a rapid increase in the value of , and has no real foundation. (Note, the government amidst increased public pressures later modified the budgeted oil price to US$45).

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Opportunities during commodity price upswings

During a commodity price upswing an economy can develop a tremendous amount of resources with which to help change its economic development prospect. The T&T economy has benefited significantly from the boost in prices of its comparative advantage products. In particular, the T&T government was blessed with an economic windfall between 1999 and 2007 of US$2,805.6m, with the economic rent for the period 1999 – 2007 tallying to US$6,955.2m.

a) Build up of economic resources

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Resources obtained from the windfall in economic activity could be used to help enhance the amount of capital investment made by the government and this in turn can help to expand both the infrastructural capital base and also help to diversify the economic base. By 1988 the government of T&T had established four ammonia plants; it had majority ownership in two of these and complete ownership in another. It had also established a steel plant, a granular urea plant and a methanol plant.

b) Diversification Strategy

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Significantly the government of T&T spent heavily during the first oil boom years on building up its human and infrastructural capital. For example, expenditure on education (an important factor in creating human capital) increased considerably from US$27.4m to US$55.7m between 1976 and 1983, an increase of 103%, with health expenditures (an important factor in maintaining human capital) increasing from US$0.5m to US$24.4m between 1977 and 1983.

Concerning infrastructural capital, expenditure on electricity increased from US$7.8m in 1976 to US$17.3m in 1980 with housing expenditure increasing substantially from US$7.8m to US$191.8m during the interval of time 1976-82. Other important infrastructural capital areas such as roads, national transportation, water and telecommunications also benefited substantially, as indicated in Table 4.

C) Social Capital and infrastructural capital

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Table 4: Funds Allocated to Long-term development projects in T&T, ($USm), 1976 – 1983.

Education Health Electricity Housing Roads National Transport Water Telecommunications

1976 27.39 7.80 0.47 6.11 9.11 7.24 1.93

1977 19.62 0.50 9.11 6.67 19.36 9.28 26.46 13.70

1978 22.20 1.22 8.07 37.09 22.88 13.74 64.58 18.66

1979 27.58 6.82 9.27 49.45 55.85 9.12 78.19 25.76

1980 17.23 4.89 15.92 86.05 98.91 22.23 44.76 29.17

1981 27.37 10.07 17.34 111.18 16.09 13.22 45.24 29.57

1982 47.39 13.13 3.61 195.10 189.48 8.64 34.98 41.81

1983 55.70 24.35 191.80 87.67

Source: Accounting for the Petrodollar (1983).

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Apart from these direct long-term development investment outlays listed above, a plethora of subsidies were granted. For example, between 1973 and 1983, the basic food subsidy increased from US$1.6m to US$92.5m with subsidies to the utilities increasing by 3,351.1% during the same interval of time from US$10.7m to US$369.3m. No doubt, these trends in government expenditure and government subsidies helped to alter the factor endowment bundle of the T&T economy.

d) Other interventions

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The type of foreign investment a small open developing economy like T&T attracts is cost based. During a commodity price upswing the profitability of crude oil production expands and if the increase in the price level is expected to span the medium run in length then this can enhance capital formation in the energy sector. During the period 1995 to 2008 the correlation between FDI inflows and the amount of meters drilled for crude oil was 68%. FDI inflows provides opportunities along the lines proposed by Sir Arthur Lewis for the benefiting host economy.

e) FDI

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Table 5: Trends in some aspects of the Factor Endowment Portfolio of T&T, 1966 - 2007.

   Human capital

Physical labour Infrastructural Capital Land Resources EntrepreneursYear Physical capital

 

US$ Gross Capital

Formation (m)

US$ FDI m

Primary school

graduates

Labour force (000)

Telephone lines in

service 000 connections

Water: annual production in

millions of gallons

Electricity mn

kilowatts hours

crude oil production (m barrels)

marine production 000 barrels

Natural gas production (m of cubic

metres)

Graduates with first degrees from

the U.W.I. St Augustine Campus

1966 166.9 24.85 216063 351   19385.8 701 55603   3367.6 100

1970 212.5 83.20 227254 364 35.1 21422.3 907.3 51048 25692 3428 133

1975 594.6 180.56 204004 391 23331.1 1124.2 78621 63525 3580.2 288

1980 1908.5 143.42 166763 431   32269.1 1892.9 77618 60510 5601 388

1985 1384 49.67 168790 474 1181.1 50795.5 2903.1 64259 49823 7550 433

1990 699.9 109.40 189752 467.6 164.9 56166.4 3466.1 55039 41672 6645.5 547

1995 847.1 295.7 191641 521 205.4 55051.1 4228.6 47576 36746 7757.4 839

2000 1657..3 679.5 168734 564 290.6 65759 6307.7 43680.5 34710 15473.6 1661

2001 1838.9 834.9 163206 576.5 306.9 64044 5688.2 41521.3 32151 16485.8 1633

2002 2001.8 790.7 147328 586.2 318.2 73288 6036.1 47706.6 38792 18861.6 1708

2003 2987.7 583.1 141401 596.6 319.8 72591 6423.9 48981.1 39992 26794 1817

2004 2317.7 972.7 136,327 613.5 321.2 76135 6709.6 44984.7 35898 30255 1952

2005 2458.0 598.7 134298 623.7 327.6 77562 6803.2 52739.6 43879 33250

2006 2592.5 512.2 133562 625.2 331.2 79231.1 7102.4 52104.8 40057.8

2007 2944.3 830 622.4 43807 41906.78

2008

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Opportunities during a downswing in commodity prices

During an upswing there is an element of crowding out of the amount of non oil revenues collected as a proportion of total government revenues. Although ideally the government should have made these changes during a commodity upswing, during a commodity downswing they are forced to set an appropriate target for the non oil fiscal account balance.

a) Improvement in fiscal accounting process

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During a boom, worker ethic and wages may have become unrealistic. A good example here is the Community and Environmental Protection and Enhancement Program (CEPEP) which was introduced by the T&T government in 2002. Basically the program provides employment for unskilled and semi-skilled persons. The challenge with CEPEP, however, is that it needs to do more to equip workers with a greater stock of skills to enhance their long run employment prospects. As it stands the work is light and productivity is very low. During a downswing in commodity prices, there is the opportunity to target the restoration of worker ethic and any misalignment between worker productivity and wages may be corrected. The economy may also have realized a greater dependence on government handouts and transfers and subsidies and this may now be corrected. A decline in commodity prices gives government an adequate block of reasons to reduce its hand out mentality, and to promote a better work ethic amongst its population.

b) Worker Ethic

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Challenges during a commodity price downswing

Meeting public expectations in terms of social handouts and cutting public expenditures in line with expected revenues is one of the main challenges that a commodity exporting economy may face in periods of declining commodity prices. This type of action may sprout social tensions. For the T&T economy, transfers and subsidies as a percentage of total GDP had a 88% degree of comovement with the trend in oil prices. Specifically whilst in 1994, transfers and subsidies as a percentage of GDP was 7.4%, this increased to 12.4% by 2008.

a) Public Perception

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b) Inflation

One would expect that during a recession the rate of inflation would decrease as the level of aggregate demand moves into deficit. However, during the first recession that engulfed the T&T economy in the time period 1983-1993, the average rate of inflation was 10%.

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c) Economic Growth

Economic growth can potentially be compromised. This was the case during the 1980s.

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For the T&T economy, there is an inverse relationship between the current account balance and the unemployment rate.

d) Unemployment

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e) CAB and M/L Condition

One major challenge in oil abundant economies is there may arise the need to devalue the currency and this is sometimes done without a proper understanding of the Marshall - Lerner condition and whether that condition holds. Thus the T&T economy, in the midst of declining current and fiscal account deficits during the 1980s engaged a 33% devaluation of the T&T dollar in December 1985 and a further 15% devaluation in August 1988. In 1993 the T&T government floated its dollar and associated with this float was a 25% depreciation of the T&T dollar. Between 1985 and 1993 the T&T dollar therefore lost 54% of its value to the US$ and the current account balance moved from US$-105.3 to US$-107.8m.

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Minimizing oil price volatility effects on the macroeconomy

When oil revenues are siphoned off into a SF this limits the extent of the volatility that is transmitted. Whilst a stabilization fund does exist in T&T it holds a mere US$3bn. Clearly then a critical policy adjustment is that the SF has to be complemented by a long run price of crude oil. Windfall prices should be defined as prices above this long term level, and relevant surpluses should be creamed off to a stabilization fund. To calculate a long term price of crude oil, one could possibly use a Hodrick Prescott filter and extract the long term trend component from the real oil price series and then smoothen it using some technique.

a) SF and the Long term oil Price

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Table 6: Estimated windfall per barrel of crude oil using a long term price of US$35

  Actual Price of oil

AP-Budgeted Price

AP-Long term price

2004 41.5 16.5 6.5

2005 56.5 31.5 21.5

2006 66 33.2 31

2007 72.3 22.3 37.3

2008 100 30 65

Source: computed

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b) Non Oil Balance

Another policy requirement for the T&T economy to consider is to enhance the resilience of its economy to oil price shocks. This model requires a strengthening of the economic base away from a narrow dependence on hydrocarbon based resources. This strategy can involve a clear non oil revenue based policy stance. The diversification of the asset base of the economy would require prudent management as the BT sector expands over time. In this regard the government planned industrial investments are welcome but these has to be founded on comparative advantage theory. The government has to be wary that its attempts at picking winners does not simply result in rent seeking and inefficiency.

c) Governance Process

There is a need to strengthen the general governance process. The extent of corruption in the T&T economy has started to become too entrenched and there is need for a greater degree of public accountability. Recent empirical literature such as Collier (2007) have demonstrated that countries with strong institutions tend to be less affected by the resource curse than others. In 2001 T&T’s corruption perception index was 5.3, but by 2007 this had declined to 3.4, indicating a greater degree of corruption. A strong thrust must be made to review this situation.

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Thank you