Connected in a web of mutual interdependence

High oil prices, and record volatility in the price, creates serious challenges for the global economy, which is why the World Bank is trying to find new ways to manage the unpredictable cost of oil


A barrel of oil now costs twice what it did a year ago, and four times what it cost in 2002. Real prices are now higher than they were at their last peak – 1980 – and look like climbing further still. Plenty has been said about the global economic pain that trend is causing. But the price of oil is not just high, it is volatile, too, and that causes problems of its own.

“Volatility is worsening and the fluctuations are more pronounced than they were in the 1990s,” says Yan Wang, senior economist at the World Bank Institute. Wang says that unlike previous oil shocks, which were largely supply induced, recent price increases reflect growing energy demand in emerging markets, especially China and India. International capital flows seeking investment opportunities in the face of a declining dollar have also played an important role.    

Prices have gone up even though oil stocks around the world are not critically low.

Oil output by the Organisation of the Petroleum Exporting Countries (OPEC) has recently edged higher, and OPEC has “tremendous potential” to increase supply, says World Bank senior energy economist Shane Streifel.

Volatile prices make it harder for oil importers to budget for energy costs. Volatility also hurts economic growth, investment and trade, says the World Bank – several developing countries have lost ground in the fight against poverty as a result. The Philippines reckons 4 million people slid back into poverty in 2006 because of rising oil prices and a higher cost of living.

Oil exporters also face challenges managing revenues and planning development.

A booming oil sector and rising currency may mean other sectors in the economy fail to grow and develop. Volatile oil prices have put pressures on developing countries to look for ways to smooth out the bumps in the market.

The World Bank published a study in 2006 – “Coping with Higher Oil Prices” – that looked at the experience of 38 developing countries that tried various ways of managing volatility. Chile, Malaysia, Thailand, Indonesia and others used “price-smoothing,” in which a country sets a target oil price. The government subsidises oil if the international price goes above the target, and imposes taxes if it goes below.

But such a policy often ends up encouraging more fuel consumption and subsidising the rich. In Indonesia, the government reformed the fuel subsidies and compensated the poor by paying them conditional cash transfers.

Another technique identified in the report is hedging – using financial instruments such as futures and options and “collars” which could mitigate price risks at a cost. Countries can also build up oil security stocks that they can release to reduce the impact of a temporary shortage or a major price shock.

A longer term solution is switching to alternative fuels, including renewable or synthetic fuels, or reduce energy use through energy efficiency or by cutting the amount of energy used in production, which is becoming a priority. Energy switching is often from oil to much cheaper coal in developing countries in East Asia, worsening the environmental picture.

If the reasons for the changing supply and demand levels are well understood, the more interesting question is whether the forces shaping the demand and the supply curves will shift. World Bank managing director Graeme Wheeler addressed this point in a recent speech on oil price volatility. Some big variables are in play, he said.

On the demand side, the energy intensity of production in OECD economies has diminished markedly since the 1970s, argued Wheeler.

Greater efficiency and substitution into alternative energy sources will help to moderate oil demand, but Chinese demand for oil is currently increasing by 15 percent a year. The International Energy Agency (IEA) projects global energy demand to rise more than 50  percent between now and 2030 – with China and India accounting for almost half of this increase.

On the supply side, there’s limited excess capacity in oil producing countries and many potential new sources of supply carry considerable political risk, said Wheeler. “With the lack of net investment in oil refining capacity over the past two decades and the long gestation periods in installing new refining capacity, these supply constraints will be costly to rectify.” 

The IEA estimates that US$20 trillion needs to be invested in the energy sector over the next 25 years to secure sufficient supplies, he noted.

“There’s been considerable debate over the role that oil speculators and traders might have played in exacerbating volatility and inducing upward pressure on prices,” said Wheeler. “Some of this sentiment may date back to concern about the role that Enron’s energy traders played in manipulating the market for natural gas on the West Coast. My impression is that increased speculative activity in futures markets result from the high level of oil prices and uncertainty about forward prices, not the other way around.”

Whatever its sources, Wheeler said that high and volatile oil prices present challenges to governments in managing the terms of trade impact and its consequences for traditional macro-policy instruments, and regulatory and distribution policies. 

“Oil producers have often struggled with the effects of exchange rate appreciation on traditional export industries and the ensuing deterioration in governance – often characterised by growing corruption.  While GDP per capita in resource-rich countries increased by 50 percent in the four decades to 1998, per capita income growth for resource-poor countries was four times higher.”

Wheeler pointed to governance arrangements based on frameworks similar to those adopted by Norway and the State of Alaska that are beginning to emerge in several developing countries. 

The goal is to convert non-renewable resource endowments into permanent sources of investment income using diversified asset strategies and strict budgetary or stabilisation rules.

Sovereign wealth funds are relevant here. These funds currently manage assets of around US$2.5 trillion and some projections suggest that this could reach US$12 trillion by 2015.  The IMF, World Bank, and OECD are developing a code of conduct for these funds, including provisions on institutional structure, risk management, transparency, and accountability. That follows concerns that such funds will use their wealth to achieve political rather than investment goals.

“Some of the political rhetoric has become highly inflammatory, [but] there are some important issues here,” said Wheeler. “Given that these are state-owned investment vehicles, would it be appropriate for them to take an aggressive speculative position like George Soros’ hedge fund did in shorting sterling in 1992?”

Soros’ investment behaviour is widely credited with forcing the UK to leave the European Union’s Exchange Rate Mechanism.

“If used responsibly, commodity hedges and other risk management building blocks can help enormously in managing balance sheet risk.  Hence, it’s pleasing to see that financial market instruments and strategies are being examined,” said Wheeler. “Governments are keen to manage their balance sheet risks.  They do so through a range of mechanisms by, for example, being conscious of the currency exposure of their assets and liabilities, by building up foreign exchange reserves, privatising assets, and adopting sound principles of fiscal management – including managing contingent liabilities.”

In 2000, the World Bank introduced several hedging products to help developing countries manage their balance sheet risks.  With these products, countries have the opportunity to manage exchange rate, interest rate, and commodity price risk in the portfolio of loans that they receive from the International Bank for Reconstruction and Development (IBRD), part of the World Bank. “We can also use these instruments to transform their non-IBRD portfolios,” said Wheeler. However, he waned that governments using derivatives have to understand their pricing characteristics.  “We have recently seen how competitive pressures drove investors to take on greater risks in their search for high yield,” he said. “We saw dominant institutional investors investing in complex structured products with risk and return characteristic that they did not fully understand – even more so when market liquidity began to dry up with corresponding uncertainty on how to value underlying cash flows.”

Even with efficient financial markets, there remains a critical challenge for many developing countries.

“One of the cruel ironies today is the connection between rising energy and food prices,” said Wheeler. “This coupling can have devastating implications for global poverty and food security.  Higher energy prices have increased fertiliser and transport costs and stimulated bio-fuel production.”

In the US, for example, a quarter of the maize crop – representing over ten percent of global output – went into bio-fuel production last year.  Higher energy prices, drought, and rising demand have led to a 75 percent increase in the price of staples since 2005 – prices are at a 20-year high.

“Just as the poorest on this planet are the most exposed to the effects of climate change, they are also highly vulnerable to the effects of rising fuel and food prices,” said Wheeler. “Food and energy prices usually represent over 70 percent of the consumption basket of the poor. The long-term consequences are considerable.  Poor households will cut back on food consumption and education – and girls will invariably be the first withdrawn from schooling.  Reliance on traditional fuels will increase with obvious environmental consequences.”

“This leads to an important point.  The catalyst of globalisation will only be sustainable if it can create opportunities and benefits for all. Today, given  the recent revisions to purchasing power parities, well in excess of over a billion people live on less than $1 a day.”

That means “the benefits of globalisation are by-passing many of the poorest,” says Wheeler: they are in danger of becoming politically and socially disenfranchised and disconnected from global society.

“We have seen how their exposure to higher food prices recently led to riots in West Africa and South Asia. A world where a large proportion of the population remains trapped in extreme poverty and unable to share the benefits and opportunities of globalisation, carries unacceptable costs in terms of human suffering, economic losses and political tensions, and has important potential implications for security within countries and across borders.”

Wheeler said that concerns about the slowdown in industrial economies, should not cloud the benefits of globalisation and the ways in which trade had boosted investment, spread technology, and enabled labor mobility – all of which “are boosting productivity growth and delivering millions of people from poverty.”

That’s why the price of oil – and the ability to manage volatility in the price – is so important. Wheeler pointed to the “drami” or “the endless knot” – one of the eight lucky signs of Buddhist philosophy – as an illustration of the challenges of globalisation.  “It symbolises how citizens of the world – across countries and over time – are connected in a web of mutual interdependence,” he said.