Selim Elekdag

Although oil prices are below their peaks of August 2006, they remain higher than they were in the recent past, heightening concerns that oil price variability will continue to pose significant risks for the global economy. In combination with the current widely held belief that oil markets will continue to be tight, the threat of shocks that could trigger further oil price variability has brought about a resurgence of interest in oil market issues, their implications for member countries, and appropriate policy responses. This article briefly surveys recent IMF research on oil market developments and issues.

Over the past few years, extensive research has been conducted at the IMF on oil market developments and issues. Many of these studies have become Executive Board papers and documents for internal circulation. Although numerous working papers have complemented these documents, they focus mostly on particular countries. This article surveys IMF studies that examine a wide range of questions or investigate core issues regarding the oil market that are relevant for a broad range of members.

One of the most prominent features of the oil market is that both supply and demand are highly inelastic in the short run, with the result that even small shocks can trigger large price fluctuations. On the supply side, Sommer (2005) starts off by presenting some basic stylized facts and then moves on to assess the longer-term oil market prospects. After highlighting that spare capacity is near historically low levels, he concludes that there are significant risks that the oil market will continue to be tight. In particular, Kochhar, Ouliaris, and Samiei (2005) focus on structural impediments that hinder investment in the oil sector, and a recent study by Mercer-Blackman (2006) finds evidence that real investment by international and national oil companies remains below the levels of the early 1990s—a key explanation of the current low production capacity levels.

Approaching longer-term oil market prospects from the demand side, Dargay, Gately, and Sommer (2007) investigate the relationship between vehicle ownership and income growth. Although interesting in their own right, this study’s findings also suggest that vehicle ownership will increase rapidly in developing and emerging market countries, with China stealing the limelight with a projected twentyfold increase by 2030. This breakneck expansion of vehicle ownership implies rapid growth in oil demand.

But can we attribute all of the recent oil price volatility to fundamentals? Antoshin and Samiei (2006) pose an interesting question by asking if speculation has contributed to the recent rise in oil prices. They do not find compelling evidence that speculative activity has affected short- and long-run price fluctuations but argue instead that speculative positions seem to follow oil price movements.

With the tightness in the oil market expected to continue well into the future, the natural question to ask is to what extent higher oil prices affect the global economy. In an attempt to answer this question, both theoretical and empirical strategies have been employed, and these are reviewed in turn.

On the theoretical front, the IMF has benefited from its macroeconomic models. Using the IMF’s first-generation model, MULTIMOD, Hunt, Isard, and Laxton (2002) quantify the impact of higher oil prices on industrial countries. Furthermore, they consider alternative scenarios to investigate the role of monetary policy and the structure of the labor market. Hunt (2006) extends the IMF’s latest model, the Global Economy Model (GEM), to include an oil sector, which he uses to investigate the role of oil shocks in the U.S. stagflation of the 1970s. Bebee and Hunt (2007) use the same model to examine the macroeconomic impact of the rise in energy prices since the end of 2003 in the euro area, the United Kingdom, and the United States.

Most recently, Elekdag and others (2007) have further extended GEM to a multicountry setting with a well articulated energy sector. In turn, Elekdag and Laxton (2007) used this latest version of GEM to analyze the causes and consequences of oil price fluctuations with the intention of trying to distinguish the role of supply and demand factors. One of their findings is that a supply-induced 100 percent increase in oil prices generates a decline in world GDP by 1.4 percent below the baseline and a rise in global inflation of about 1.5 percentage points. They also consider the global macroeconomic impacts of higher gasoline taxes.

Although the modeling approach offers a distinct structural perspective, most of the studies focusing on oil market issues have been empirically oriented. The recent run-up in oil price fluctuations has raised many issues, including its implications for global imbalances and the role of petrodollar recycling and its impact on world interest rates.

The first issue is addressed by Rebucci and Spatafora (2006), who examine the implications of the rise in oil prices for global imbalances. They argue that some of these imbalances have been exacerbated by higher energy prices. Because oil exporters only gradually increase their spending of oil revenues—a view supported by Berkmen and Samiei (2006)—global imbalances are likely to remain at elevated levels for longer than would otherwise have been the case.

In a related paper, Kilian, Rebucci, and Spatafora (2007) study the impact of oil shocks on countries’ external balances. One of their main results is that the effect of oil shocks on the current account depends critically on the response of the non-oil trade balance. Furthermore, the effect systematically differs between the United States and other importing countries. Similarly, Samiei (2007) finds that U.S. dependence on oil comes largely from gasoline consumption, which, as a share of GDP, is about five times that in other large industrial countries, owing primarily to lower prices and lower fuel-efficiency standards.

Kodres and Warnock (2006) ask how the recycling of oil export revenues affects global financial markets. The hypothesis is that because higher oil prices increase world net savings, and saved petrodollars are used to purchase securities, this triggers lower interest rates. Their study is not able to detect such a significant channel among other competing influences on U.S. yields, however, potentially because of data limitations.

This brings us to the research intended to guide countries in formulating the appropriate policy responses to developments in the oil market. Many notable studies have been released that cover issues including the pricing of petroleum products, taxation, revenue management, coping with dwindling oil reserves, investment in the oil sector, oil funds, transparency initiatives, implications for real exchange rates (Dutch disease effects), and impacts on external balances.

One of the most comprehensive studies of these core issues was compiled by Davis, Ossowski, and Fedelino (2003), whose book focuses on developing and implementing appropriate fiscal policy frameworks for oil-producing countries. Similarly, Husain and Davoodi (2005) argue that Middle Eastern and Central Asian countries that have benefited from higher oil revenues should use them to foster employment opportunities and to further promote the development of the private non-oil sector. Interestingly, Cheng, Mercer-Blackman, and Samiei (2007) find that oil exporting governments rely on traditional methods rather than on financial hedging to manage volatile oil revenues.

In the context of low-income countries, Katz and others (2004) try to answer the question of how to improve petroleum revenue management in sub-Saharan Africa. They emphasize that initiatives to increase transparency promote more effective oil revenue management, which is needed to lift the oil curse for these countries. More recently, Dudine and others (2006) consider the impact of the 2003–05 oil price shock on low-income countries with a focus on potential balance of payments needs.

This brings us to an issue critically relevant for the IMF: external financing considerations, including the use of Fund resources. A comprehensive paper, IMF, Policy Development and Review Department (2005), provides an overview of some of the key policy issues already discussed, along with a detailed review of financing issues that may be triggered by higher oil prices. In this context, Elekdag (2006) finds that oil price fluctuations are a robust global factor that significantly affects the likelihood that countries may seek recourse to Fund resources, even after controlling for other global factors and country-specific variables.