ENERGY AND SUSTAINABLE DEVELOPMENT Impact of the Oil Shocks: Transmission Channels and Models for Impact Evaluation Cristina Mocci Italian Ministry of Economy and Finance Rome, th December Cover

Cristina Mocci – Impact of the Oil Shocks Impact of Oil Shocks Outline 1.Oil shock’s scenarios 2.Transmission channels and impact on the economic system 3.Models for impact evaluation 4.An example: the Oxford Energy Model (OXEMOD)

Cristina Mocci – Impact of the Oil Shocks  Oil shock’s scenarios Impact of the Oil Shocks (1) – Oil shock’s scenarios Impact of the Oil Shocks (1)

Cristina Mocci – Impact of the Oil Shocks The sources of oil shocks Demand driven shocks D emand grows in markets with a limited oil spare production, transport and refining capacities. As consequence, demand/supply disequilibrium and price pressure Supply driven shocks Real or potential production losses due to natural disasters, geo-political instability or pressure policies on prices adopted by producers

Cristina Mocci – Impact of the Oil Shocks Determinants of oil scocks Accelerating Global Demand Low Non-OPEC Supply Growth History of Low Investment OPEC Spare Capacity Reduced Bottlenecks in Downstream Impact of shocks magnified in absence of spare capacity - Geopolitical - Production losses - Speculators Global oil system’s ability to respond to shocks weakened Accelerated rise in oil prices Volatility in oil prices Occasional spikes in oil prices Determinants of oil shocks

Cristina Mocci – Impact of the Oil Shocks Impact of the Oil Shocks (2)  Transmission channels in the economic system Impact of the Oil Shocks (2) – Transmission channels in the economic system

Cristina Mocci – Impact of the Oil Shocks Main Direct Effects Impact on consumer prices, output and government balance (real balance) Terms-of-trade deterioration among importing and exporting countries

Cristina Mocci – Impact of the Oil Shocks Terms of Trade Losses

Cristina Mocci – Impact of the Oil Shocks Second-round effects More costly to reallocate capital or labor between sectors differently affected by oil shocks; aggregate employment and output declining in the short run (allocative effects) Higher inflation expectations Investment postponement Extensive recycling and respending of extra revenues in producer countries

Cristina Mocci – Impact of the Oil Shocks Robustness of Economic Systems Limiting the inflationary effects of oil price increase avoiding second-round effects and positive expectations on future inflation through credible monetary institutions and suitable policy interventions Development of lower oil intensive productions Development, adoption and diffusion of oil efficient technologies Balance negative effects of oil shocks on terms- of-trade Robustness of Economic Systems

Cristina Mocci – Impact of the Oil Shocks Impact of the Oil Shocks (3)  Models for impact evaluation Impact of the Oil Shocks (3) – Models for Impact Evaluation

Cristina Mocci – Impact of the Oil Shocks International Forecasting Models Spreadsheet model of global oil demand and supply and INTERLINK Model (OECD) MULTIMOD, GVAR and GEM (IMF) Oxford World Macroeconomic Model (OEF) National models

Cristina Mocci – Impact of the Oil Shocks Models’ Features Treatment of a large number of macroeconomic variables and historical data Utilization of the main achievement of economical theory Treatment of global economy Development of flexible interface and reporting tool

Cristina Mocci – Impact of the Oil Shocks Models’ Drawbacks Models ignore the impact on capital asset (stock obsolescence) Models fail to account for the possible impact on consumer and business confidence Risks of wider difficulties in oil-importing market economies having weak financial situations often under-evaluated Deterministic nature of models does not allow treatment of uncertainties

Cristina Mocci – Impact of the Oil Shocks Impact of the Oil Shocks (4) – The Oxford Energy Model (OXEMOD)  The Oxford Energy Model (OXEMOD) Impact of the Oil Shocks (4)

Cristina Mocci – Impact of the Oil Shocks OXEMOD-1 OXEMOD permits global economy simulation through different country model structures interacting each other It combines general equilibrium with dynamic autoregressive models to better fit historical data during transition It contains an Energy Model

Cristina Mocci – Impact of the Oil Shocks OXEMOD-2 Interactions among the macroeconomic system and energy demand, supply and prices are modeled Likely monetary policy reaction to shocks are included The most important sources of energy products are endogenous and there are equations which express energy supply produced by OPEC, Eastern Europe, Latin America and the USA These key variables are linked to oil world demand, prices and investment both in the short – long run

Cristina Mocci – Impact of the Oil Shocks How OXEMOD runs? 1.Fuel’s demand is estimated for each country as function of economic activity and energy prices, so to obtain an initial value for the global demand 2.Unbalances of single fuel demands with respect to global production are estimated taking into account stocks and capacity utilization rate of extraction plants 3.World fuel prices are changed up. Supply/demand balance is achieved through second-round effects on the economic system

Cristina Mocci – Impact of the Oil Shocks OXEMOD Simulations Three kinds of oil shock’s simulations 1.supply driven 2.demand driven 3.price change

Cristina Mocci – Impact of the Oil Shocks Supply Driven Shocks A production loss is applied A larger output from producer countries can compensate the production cut in the limit of available spare capacity Stocks limit the impact in the short term Prices rise and push demand down to balance production cut

Cristina Mocci – Impact of the Oil Shocks Demand Driven Shocks Market demand increases due to economic growth Spare capacity is used to expand supply New investments are assumed to favour production rise in the medium term Prices are adjusted according to production constrains

Cristina Mocci – Impact of the Oil Shocks Price Change Price variations are exogeneously applied In the short run stocks increase to compensate demand fall OPEC reduces production while non- OPEC producers increase lightly oil supply to balance the market

Cristina Mocci – Impact of the Oil Shocks A Simulation Result Source: Oxford Economic Forecasting, 2005

Cristina Mocci – Impact of the Oil Shocks Some interesting points What is the problem ? Lack of refining, transport infrastructures and production capacity or demand surges of new economies or sudden supply perturbations ? What is oil reserve data reliability ? Are we in the “peak” or in a temporary trouble ? Is the uncertainty of unforeseenable catastrofic events counterbalanced by the lower weight of oil in the global economy ? Are evaluation models in the context ? Are oil forecasts more reliable than the haruspex’s prophecies ?